Mause and Groeteke (2012) argue that when a subnational government operates under a debt brake, it may not have sufficient taxation/expenditure autonomy. Historically, U.S. state and local jurisdictions operated within a strong federalist system, with clear autonomy from the federal government. Over the past half century, however, that fiscal autonomy has eroded significantly. This is reflected in the increased share of state and local expenditures funded from federal government transfers. More importantly, the loss of autonomy is reflected in the increased regulation and control of state and local expenditures by the federal government. This is most evident in the loss of state control over Medicaid. Many state governments accepted the Obama administration policy to expand enrollment in Medicaid, with the provision that the federal government would finance most of the increased cost. In effect, these states lost control over one of the major components of state budgets.
The ‘silent bailout’ of the states by the Obama administration during the Great Recession, created even greater dependence on the federal government. Without that federal bailout, many states would not have been able to meet their financial obligations. They are now more dependent on federal government transfers than before the financial crisis (Congressional Budget Office, 2012),.
Much of the fiscal stimulus during the Obama Administration was used to subsidize state and local governments (Congressional Budget Office 2009). This funding enabled state and local government to address fiscal stress during the Great Recession, and in some cases to avoid bankruptcy. But the bailout of state and local governments had disincentive effects, similar to that accompanying bailouts in the financial industry. Anticipating bailouts, municipal governments have less incentive to impose fiscal rules, and to pursue prudent fiscal policies. When municipalities receive bailouts, credit rating agencies lump them together, rather than assessing the riskiness of each jurisdiction in issuing debt. The inefficiency and misallocation of lending to municipal governments weakens the public finances of all jurisdictions participating in the bailout, including state and federal governments as well.
The Great Recession revealed the wide disparities between jurisdictions pursuing prudent and profligate fiscal policies. Illinois, for example, has accumulated hundreds of billions in debt and unfunded liabilities in public sector pension and health care plans. The state has also assumed liabilities incurred in Chicago and other highly indebted local jurisdictions. The subsidies received by the state and local governments in Illinois from the fiscal stimulus most likely enabled them to pay bills and avoid bankruptcy. But the negative side of these government bailouts are the disincentive effects.
A credibility problem has emerged due to this bailout of local jurisdiction by the state governments. The accumulation of debt and unfunded liabilities in pension and health plans in the City of Chicago and in school districts around the state has exposed them to the risk of default and bankruptcy. The state of Illinois has responded with large bailouts, which in turn further weakens finances of the state government. Illinois now has one of the lowest credit ratings in the country, and pays a relatively high risk premium on its debt. Even more ominous, is legislation in California that would shift the liabilities of local governments and school districts to the state government. As these bailouts off state and local governments become more ubiquitous, it will be more difficult to enact effective fiscal rules (Wall Street Journal 2017e).
Linked to the issue of ‘bailout rules’ are the legal rules relating to insolvency and bankruptcy. Rules for insolvency and bankruptcy exist at the local level in the U.S. These laws provide for an orderly settlement of debts when a jurisdiction fails to meet the obligations. Insolvency rules provide for a renegotiation of debt without the government having to enter bankruptcy proceedings. When insolvency rules and bankruptcy rules are in place they provide credibility to fiscal rules to constrain debt. Neither the borrower, nor the credit markets can count on bailouts which undermine fiscal discipline. However, rules for insolvency and bankruptcy do not exist at the state and national level in the U.S. There is no supranational central bank, nor government comparable to the European Union. This means that the credibility of fiscal rules depends upon the commitment of state and national officials to enforce the fiscal rules. The track record of some state governments, and our national government in enforcing the fiscal rules now in place over the past half century has not been good.
State and local governments in the U.S. are more sensitive to the constraints imposed by credit markets compared to the federal government. Credit ratings on debt issued by state and local governments vary considerable; and the interest rates charged for debt issued by state and local governments varies considerably as well.