Planet Money
8:59 am
Tue July 17, 2012

Why South Dakota Won't Bail Out Maine

Originally published on Fri August 24, 2012 11:00 am

Last week, on a trip to New York City from Washington, D.C., I found myself talking about economics with a British intern sitting next to me. He asked a disarmingly simple question: Could the U.S. ever find one state asking others to bail it out, similar to the way Greece or other countries are seeking aid from other nations in the European Union?

My instinct was no — but I had to think about why. As it turns out, two economists in D.C. have written a concise history that helps explain the answer.

The economists are C. Randall Henning, an American University professor of international economic relations, and Martin Kessler, a research analyst at the Peterson Institute for International Economics. Their paper, Fiscal Federalism: U.S. History for Architects of Europe's Fiscal Union, walks readers through the interplay between state and federal finance from Alexander Hamilton to the insolvency of Jefferson County, Ala., last fall. It was put out by Bruegel, an economic think-tank in Brussels, earlier this year.

Although they didn't set out to answer the British intern's question explicitly, Henning and Kessler's paper more or less does.

The gist: The federal government long ago made clear that it wouldn't bail the states out; the states have similarly declined to bail out local governments; states almost universally balance their budgets; and — perhaps most importantly — the federal government has sweeping fiscal powers, and knows how to use them.

The longer answer, the economists write, starts with Alexander Hamilton's famous vision for a financial system, which he began pushing soon after the U.S. Constitution was adopted. In addition to establishing a Bank of the United States, he wanted the federal government to take over the accumulated debt of the U.S. states — some $25 million of it, largely built up to fund the Revolutionary War. That amounted to maybe 13% of the country's economic activity at the time.

The U.S. assumed state debt on one other occasion, after the War of 1812. But then it quickly established a "no bail-out" precedent. After a financial panic in 1837, Washington refused to step in when several states defaulted on their own debt — despite pressure for a bailout from foreign creditors like Britain and the Netherlands.

The eight states that defaulted (along with the then-territory of Florida) ultimately repaid their debts after several years. Most subsequently adopted the forerunners of today's balanced-budget provisions. Now, every state but Vermont holds itself to a balanced budget, using various mechanisms, and with varying degrees of strictness. (States do let themselves borrow for capital projects like roads, but commit specific revenues to supporting the debt, from future fuel taxes, for example.)

Strikingly, Henning and Kessler write, the federal government has never bailed out a state since, and only once has a municipality been bailed out by a state. This despite 170 jurisdictions declaring bankruptcy in the two decades leading up to 2009. (Camden, N.J., is the lone exception, though Washington, D.C., was also bailed out by the federal government in the 1990s, under a constitutional clause putting the federal district under congressional authority.)

But the most crucial distinction between Europe and the U.S. may also be its most obvious, the authors say: The U.S. has a central government with broad regulatory, taxing and spending authority, and it has the will to use all three. Much of the U.S. banking system, they note, is already centrally regulated — something Europe is only now attempting.

On the taxation and spending front, meantime, the federal government serves to spread out the cost of helping states when they need it. The stimulus bill passed in 2009, for example, sent $170 billion from Washington over two years to help plug holes in their budgets.

That kind of thing, of course, accomplishes much the same results as having healthy states bail out weaker ones, even if South Dakota — which ended its fiscal year in the black — never has to cut a check directly to Maine (where one projection puts year's budget shortfall at 15% of its budget).

This emergency funding mechanism helps make up for the fact that balancing state budgets often means cutting spending in bad times, just when many economists argue government should maintain or increase spending.

Still, Henning and Kessler warn that these lessons don't necessarily provide Europe with an easy-to-follow blueprint. Much of the success of the U.S. model is probably a function of how the various elements came together over time, they say.

States adopted balanced-budget amendments independently, for example, without outside coercion. That suggests that states my avoid saddling themselves with debt for more fundamental reasons, and the balanced-budget requirements are simple evidence of that fiscal conservatism. By contrast, the euro zone is talking about a complex combination of rewards and punishments imposed on each country by the group as a whole.

"The euro area will not want to replicate US institutions," Henning and Kessler write, "but will want to bear in mind the lessons from US successes and mistakes when redesigning its own institutions."

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