In a Bad State: Responding to State and Local Budget Crises, by David Schleicher (Oxford University Press, 248 pp., $29.95)

Imagine, sometime in the next decade, that the governor of Illinois and the mayor of Chicago hold a joint press conference to declare that the state and city can’t pay their bills. Schools close, crime spikes, garbage goes uncollected, and public employees protest proposed job and pension cuts. It’s a mess. What, if anything, should the federal government do?

Yale law professor David Schleicher opens his new book with this scenario and question. In a review of past federal responses to state and local fiscal distress, he finds that the national government has answered with policies ranging from austerity to defaults to bailouts.

In the complex and infrequent event that American states or cities find themselves on the fiscal precipice, federal policymakers want to achieve three things: prevent major macroeconomic contraction, preserve the bond market so that states and cities can continue to borrow and build infrastructure, and discourage states and cities from making irresponsible future budget decisions. The hitch, Schleicher observes, is that the national government can achieve only two of the three goals. Solving a fiscal crisis is like remodeling your home: you want it to be fast, cheap, and good—but if it’s fast and cheap, it won’t be good; if it’s good and fast, it won’t be cheap; and so on. This is Schleicher’s “trilemma” of fiscal troubles in our federal system.

Consider three likely reactions to the hypothetical insolvency of Illinois and Chicago. Some federal officials will argue that austerity is not the answer. Laying off hundreds of public employees and slashing services will tank the state’s economy. Human suffering will result as crime increases; student-teacher ratios in classrooms will spike; homelessness will rise as health care becomes scarcer. Raising taxes in such an environment will encourage individuals and businesses to flee the state. In short: austerity is too economically painful.

Other federal officials, primarily those elected from other states, will argue that the taxpayers they represent should not have to bail out the profligacy of others. If the federal government bails out Illinois and Chicago, then surely other state and local governments will spend irresponsibly, expecting a federal rescue if things go awry. The federal government shouldn’t encourage moral hazard.

Still other federal officials will say that default cannot be the answer because state and local governments build and maintain much of the nation’s infrastructure—roads, sewers, trains, buses, and more. To do this, they need to borrow money by issuing bonds. Default would not just cut off Illinois and Chicago from the bond market; it would also increase the borrowing costs of other states and cities around the country. Slowing down state and local government infrastructure spending will reduce national economic growth.

This example shows that powerful arguments exist against austerity (cutting services and raising taxes to balance the books and make payments jeopardizes citizens’ well-being); against bailouts (asking others to pay for irresponsible budgeting encourages future recklessness); and against default (cutting the state or local government off from debt markets increases borrowing costs in other jurisdictions). In short, state and local fiscal crises create situations in which all options are bad.

How have federal policymakers weighed these options? Schleicher examines the limited number of cases. When Alexander Hamilton planned for the national government to assume the states’ Revolutionary War debts, he was, in effect, crafting a federal bailout of some fiscally distressed state governments. But when local governments faced debt crises induced by the issuance of bonds to build railroads in the late nineteenth century, the federal government chose austerity.

Turning to more recent examples, Schleicher analyzes the creation of Chapter 9 municipal bankruptcy law during the Great Depression and the responses short of bankruptcy to the fiscal crises of New York City in the 1970s and Washington, D.C., in the 1990s. The twenty-first century saw major municipal bankruptcies in California cities and Detroit, along with the unique case of Puerto Rico. Here, the federal government responded in different ways, often deploying a combination of strategies from the austerity, default, and bailout playbooks. Finally, the federal response to the Covid-19 pandemic represented a massive bailout to all states and cities, regardless of their fiscal position. It should be noted, however, that while the CARES Act prohibited states from using the money to pay down debt or plug budget holes, and the Federal Reserve’s Municipal Liquidity Facility was similarly stringent, the American Rescue Plan was more of a traditional bailout.

Schleicher offers a thoughtful set of policy recommendations. Congress should include rules in Chapter 9 municipal bankruptcy law that treat the sort of “tax-stripping” bonds issued by New York City and Puerto Rico as “voidable transactions,” he argues. Puerto Rico used these bonds simply to forestall insolvency for a number of years, while New York City used them to provide liquidity in order to enact various reforms. The second approach is far preferable.

In fact, Congress and the courts should reform Chapter 9 to “allow and encourage states to put multiple and overlapping governments in a single case,” he writes. Courts could then consider a plan of adjustment’s effect on citizens served by overlapping governments and spread the pain among them. This would resemble Congress’s approach to Puerto Rico’s debt crisis: it assigned one judge to handle all insolvency cases arising from local governments, public authorities, and the commonwealth government. Such a reform would prevent a Detroit-style scenario—in which police and fire services were cut, as they are part of the city government, while school services remained untouched, as they were governed by a separate school district, though all services went to the same citizens.

Schleicher also proposes that states “reform their constitutional debt limitations to include pension underfunding” and “repeal the most aggressive constitutional protections for pensions.” Such changes would make it clear that underfunded pensions are a form of debt that create an unavoidable future obligation on the part of the government employer. They would also help clarify, in the event of a bankruptcy, who stands where in the line to get paid. (Do general-obligation bondholders outrank pensioners? Courts in Detroit and Central Falls, Rhode Island, came to opposing conclusions.) Getting rid of excessive protections, such as the “California Rule” that forbids the reduction of pension benefits the minute a new employee is hired, would clear the way for states to make sensible changes. But public-employee unions would fight such proposals with ferocity.

Still, Schleicher’s book is full of good sense and insights that will prove useful to experts and policymakers. He takes complex crises involving budgetary, accounting, and legal terms of art and renders them vivid and graspable. In recent decades, experts haven’t done a great job explaining the stakes when state and local governments go broke. Schleicher’s book changes that. Providing conceptual tools to help policymakers understand their options and specialists communicate the relevant and inevitable tradeoffs, his book is a big step forward.

Photo by Justin Sullivan/Getty Images


City Journal is a publication of the Manhattan Institute for Policy Research (MI), a leading free-market think tank. Are you interested in supporting the magazine? As a 501(c)(3) nonprofit, donations in support of MI and City Journal are fully tax-deductible as provided by law (EIN #13-2912529).

Further Reading

Up Next