A WA L L S T R E E T J O U R N A L O P - E D

A Blue-State Bailout in Disguise wall street journalopinion

by Paul E. Peterson

September 15, 2011 Last Thursday, the president urged Congress to pony up roughly $200 billion in taxpayer money to provide more jobs for teachers [and] more jobs for construction workers and more money to carry out other state and local activities. He urges Congress to spend this money even after handing out hundreds of billions of dollars for similar purposes as part of the 2009 stimulus package, as well as a score and more billion dollars again in 2010. These vast contributions to the coffers of state and local governments, though pitched as a jobs bill, are in reality the latest in a series of bailouts for debt-ridden state and local governments. They are of special benefit to states in the blue regions of the country where the presidents most fervent supporters reside. In many blue states, legislators have copied the politicians in Washington by running up state debts to extraordinary levels. Nationwide, state debt is running around $3 trillion. If unfunded pension liabilities are factored in, estimated liabilities leap forward by another $1 trillion to $3 trillion, depending on the optimism of the assumptions made. The bond market has taken notice. Before the 2008 financial crisis, state sovereign debt was just about the safest place to invest. Because investors did not pay taxes on the interest, states were able to borrow money at rates below those paid for federal securities. With the onset of the financial crisis, not only did borrowing costs rise across the board, but differences in interest rates among states widened dramatically. Bond holders concluded that some states, like Greece, had been extraordinarily profligate and, even worse, lacked the will to rein in their expenditures. In a new study at Harvards Program on Education Policy and Governance, we discovered why the Obama administration is so interested in helping out the states. States with a bluish huethat is, states with legislatures that are heavily Democratic and have a highly unionized public-sector work forcemust pay interest rates that are often an extra half a percentage point higher than states with a reddish coloring. Specifically, a 20 percentage-point increment in either the Democratic share of the state legislature or a comparable increase in the share of the public work force that is unionized drives up interest rates by nearly a half a percentage point on a five-year security note. That amount is nontrivial. In Obamas home state of Illinois, it is costing governments over $700 million annually.

Paul E. Peterson

A Blue-State Bailout in Disguise

The impact of these political factors on interest rates is in addition to the impact of standard economic factors, such as a states unemployment rate, its gross domestic product growth, and its debt-to-GDP ratio, all of which are themselves shaped in part by the states political climate. In short, the bond market has concluded that the more unionized the state and the bluer its political coloring, the riskier it is to hold bonds marketed by that state. States will face even higher interest rates if the presidents proposed limit on the deductibility of state and municipal bond interest income (to help pay for the jobs plan) is enacted. If the interest is no longer deductible, investors will demand a higher rate of return for buying bonds, and state calls for more federal aid will intensify. Federal rescue of states is a dramatic departure from past practice. State bankruptcies date back to the 1840s when, amid a financial crisis, Pennsylvania, Michigan, Illinois and five other states discovered they had invested too heavily in infrastructure. The last state bankruptcy was in Arkansas during the 1930s. But overall the instances were few; in each case the federal government refused to come up with a fix. Bankrupt states paid the price, but for the country as a whole, a system of fiscally sovereign states has proven incredibly beneficial to the nations economic well-being. Every state is responsible for its own police, fire, schools, transport and much more, and most of the time they do reasonably well. If they manage their affairs so as to attract business, commerce and talented workers, states prosper. If states make a mess of things, citizens and businesses vote with their feet, marching off to a part of the country that works better. It is this exceptional federalist system that helped drive the rapid growth of the American economy throughout the first two centuries of the countrys history. Because state and local governments competed with one another for venture capital, entrepreneurial talent and skilled workers, governments generally had to be attentive to the needs of both citizens and commerce. When it comes to fiscal sovereignty, U.S. federalism is exceptional. Hardly any other country in the world has anything like it. Only Switzerland and Canadatwo nations that arent doing that badly these dayscome close. But federal fiscal bailouts put our federal system at risk. In essence, the national government is acting as if states are too big to fail. In the next financial crisis, the federal government may decide that states need to be treated like General Motors or,

Paul E. Peterson

A Blue-State Bailout in Disguise

Hoover Institution

Stanford University

at least, be given ever bigger handouts of the kind the Obama administration seems committed to making. But if the federal government is going to tacitly assume responsibility for state debts, then those $3 trillion in sovereign state debt must be added to the $14 trillion national debt that has already caused grave concern, pushing the current U.S. debt into the danger zone. Even if pension liabilities are ignored, the combined federalstate-local debt runs in excess of 120% of GDP. The costs go beyond dollars and cents. The more often the federal government bails out the states, the more Washington bureaucrats will insist on regulating state and local affairs. At some point the United States will see the end of state fiscal sovereignty and the demise our federal system of government. About the Author

Paul E. Peterson is a senior fellow at the Hoover Institution and a member of the Koret Task Force on K12 Education, and editor in chief of Education Next: A Journal of Opinion and Research. He is also the Henry Lee Shattuck Professor of Government and director of the Program on Education Policy and Governance at Harvard University. His research interests include educational policy, federalism, and urban policy. Some of his current research efforts include evaluating the effectiveness of school reform plans around the country. Peterson is a member of the American Academy of Arts and Sciences and has won numerous awards, including the Woodrow Wilson Foundation Award and the Thomas B. Fordham Foundation Prize.

Reprinted by permission of the Wall Street Journal. 2011 Dow Jones & Co. All Rights Reserved.

Paul E. Peterson

A Blue-State Bailout in Disguise

Hoover Institution

Stanford University