Yale Law School professor David Schleicher joins Allison Schrager to discuss the fiscal situation of American states and localities. His new book, In a Bad State, is out now.

Audio Transcript

Allison Schrager: Welcome to Risk Talking, a podcast about economics. I'm your host, Allison Schrager, and today I'm so excited to be joined by David Schleicher. David is a professor of law at Yale Law School and an expert in federalism, state and local government, urban environment, and several other disciplines. His work has been published in academic and popular outlets, including the Yale Law Journal, the University of Chicago Law Review, the Atlantic, and Slate. He hosts Digging a Hole: The Legal Theory podcast. Today we'll discuss his new book In a Bad State: Responding to State and Local Budget Crises, which draws on economics, history, law, and political science to chart a course on how federal officials can best address the state and municipal financial shortfalls, which is a big problem that we've been expecting to come. I think this book is very well-timed, and I'm delighted we're going to talk about it. Thank you so much for joining me.

David Schleicher: Thank you so much for having me. I'm really looking forward to it.

Allison Schrager: Me, too. I love that you started your book talking about how influential the wonderful Dick Ravitch has been to you, because he actually introduced us.

David Schleicher: He did. You came to our class among other things, you get Dick and I to teach a class on the law on state and local budgets, and we were doing a class on pensions and we thought, "Who better?" Getting people excited about pension accounting is not easy, but you did an amazing job of it, and so we're forever grateful.

Allison Schrager: Thank you. I was overwhelmed with how smart your students were. I know Yale Law has that reputation, but if you consume Twitter, you're like, you question that, and then you're like, "Wow, these students are the smartest group of people this age I've ever seen assembled."

David Schleicher: Yeah. I think that we can be confident that no one is their best self on Twitter.

Allison Schrager: Yeah, that's true. Or is represented fairly.

David Schleicher: There you go. Absolutely.

Allison Schrager: All right, so we're going to get to the meat, because I'm actually very excited about this book because this is, I think a question that anyone who's paying attention to state and municipal finances, which we all should, because they said with an earlier guest actually what is happening in Washington with the debt ceiling or the Inflation Reduction Act. We talk about it a lot, it gets a lot of attention. But in terms of our actual lives, I think what happens on the state municipal level actually matters a lot more to us and has a much bigger impact on our quality of life and honestly, the taxes we're going to pay. I think this is such an important issue that we really don't give enough attention because it's not as big of headlines as federal policy.

David Schleicher: Yeah, absolutely. There's an old joke that says, "The federal government is an insurance company with an army." But anything you actually touch, can physically touch, any infrastructure of any sort, or services you consume and need to care about in one way or another are almost all directly provided by the state and local governments. They're often funded sometimes with money from the federal government, but they are directly private and partially funded by state and local governments. The fiscal health of state and local governments is extremely important to, say, the question of state capacity in America.

Allison Schrager: It seems like we don't talk about it until you're Illinois or if you're a municipality, Detroit, but it seems like we've been talking about this big shoe to drop on state municipal bankruptcies for a while and it doesn't come, but that doesn't mean we should be complacent.

David Schleicher: Yeah, absolutely. Two things. One is that it definitely would've come in the last couple of years had the federal government not dropped a ton of money on state and local governments. The pandemic created huge fiscal problems for a number of jurisdictions. The federal government responded by providing a huge amount of aid. The effect of that is that has had benefits and costs, which I'm sure we'll talk about, but you can't just look through the defaults or absence of defaults, to ask the question of "Are states and cities in fiscal trouble?" State and fiscal budgets are very procyclical. We end up cutting really important things during recessions and spending too much during non-recessions. Then we have the question of federal bailouts.

Allison Schrager: Yeah, it's a very complicated issue, so what to do about this. But you have a very sort of organized, clean way to think about it. You describe it as this trilemma.

David Schleicher: Yeah. When a state or city faces a fiscal problem, fiscal crisis, take New York City in the 1970s or Detroit, or Puerto Rico or whatever it is. We've had, over the course of American history from Hamilton's assumption of state debts, we've had a series of state and local fiscal crises. We have a lot of governments and some of them are going to have crises. The question is, what should the federal government do? Well, the federal government has three things it would like to achieve, which are, it doesn't want to have too severe cuts during recessions, because that creates even bigger recessions. It doesn't want to encourage state and local governments to think that the federal government will always stand behind them, a problem we call moral hazard. It wants federal state and local governments to be able to continue to borrow because state and local governments need to borrow to build infrastructure.

The federal government needs state and local governments to build infrastructure. The problem is that in a crisis, the federal government has to choose a policy outcome that can achieve no more than two of those three outcomes. If it provides bailouts, it avoids cuts, it allows for continued borrowing, but it creates moral hazard. If it kind of helps override sovereign immunity and makes creditors pay, well, that will avoid some cuts today and will not create moral hazard, but it will harm the bond market going forward. If it forces austerity one way or another, it will create a bigger recession today, even though it'll avoid moral hazard and cuts and harms the debt markets. The effect is that the federal government has to choose one of three bad options.

Allison Schrager: We'll get later to your solution for this. But as they say, like many things you can't have your cake and eat it, too. I guess that’s certainly a problem with government spending that I think with the federal government we seem to have forgotten, but state and local tend not to have the same luxury.

David Schleicher: Well, one of the things is that the state and local governments face much harder budget limits than did the federal government, absent the federal government giving them money, because the federal government can print its own money. It borrows in dollars and prints dollars. It can't have a fiscal crisis in the same way that states do. States are much more like Greece, in which the currency is printed by someone else, some entity outside of themselves, and therefore their budget constraints are real and defaults are not merely their own choice and not the way that it is for the federal government.

Allison Schrager: Your book is really, I think, a useful way to think about federalism in America, but do you think it would also have some lessons for Europe?

David Schleicher: Oh, I'll tell you a story which is,  my wife was—brilliant woman—was an official for many years of the IMF, so I've spent a lot of time thinking about sovereign debt. The initial file name for this paper was the “DMF” or “Domestic Monetary Fund,” as a source of ideas about how to think about this problem. The problems are similar. They're obviously very large differences, the biggest one being the existence of a superior sovereign. But the structural problems of states and the structural problems of countries in the Eurozone are not entirely different.

Allison Schrager: Yeah, especially now, but my favorite part about this book is the history, just because I love economic history and reading through it, it's not just our evolution of how to think about state and local finances, but really I think it's a snapshot into how our country has been evolving in thinking about federalism and in terms of dealing with any sort of economic pain.

David Schleicher: Yeah, absolutely. One of the things when people talk about federalism, they very frequently think about it in terms of the federal government telling states and cities not to do something. That is a face of federalism, if you will. But very often we make federal policy intended to encourage the ability of states and cities to do stuff. That is to say federalism is a policy choice and not merely a kind of received constitutional wisdom or a restriction put on by the federal government. We can choose to have more or less decentralization. Over time we have, and it has had benefits and costs.

Allison Schrager: Let's just go through the history a little bit, just because it's so interesting. I guess this all started with someone who's now become a bit of a celebrity again, Alexander Hamilton. What was his vision for this sort of tension between what the federal government should be doing and what the states are responsible for doing?

David Schleicher: He was a very avid centralizer, and so when states and local governments—this is the fight discussed in “Cabinet Battle #1.” A bunch of states had a lot of Revolutionary War debt, and the question was what to do about it? Because they lacked a lot of capacity to raise the money to deal with it, then were going to have a lot of problems. Hamilton's solution was to nationalize a lot of this and to assume state debts. This had the effect of providing some economic stimulus. The debt actually played a currency role, which was quite interesting, and had the effect of meaning that states didn't need to raise taxes too much. It had effect of strengthening the union. That was very much his intention. It also had another side effect, which is less discussed in your AP history classes, which is that it made British and Dutch investors think that the federal government would stand behind states forever.

In the period that followed, in the 1820s and 1830s, state and local governments built a lot of infrastructure, the most famous of this is the Erie Canal. It was a great project. But investors were willing to invest huge amounts of money, mostly British and Dutch investors, but also some rich Americans, in American infrastructure projects. State banks that turned out not to work. State and local governments being able to borrow this money at cheap rates effectively started cutting their taxes like crazy and imagining that these projects would be self-financing. The result was in the late 1830s and 1840s, eight states in a territory were forced to default because you can't borrow and not have revenue forever. When this happened, European state, European investors came to the federal government and were like, "Well, of course you're going to stand behind this. You stood behind it before," and Congress considered offering another bailout, but it chose to go in a different direction in the 1840s.

Allison Schrager: What was that?

David Schleicher: It let the states default, and eight states defaulted. There's actually kind of an interesting denouement to this story, which is this default in the 1840s, and then a follow-on default in the post-Reconstruction era left a lot of British investors high and dry. After World War I, when the U.S. sought to enforce loans it made to Britain, Britain said, "Well, we'll pay you back, but reduced by the amount that U.S. states have defaulted on British investors," they wanted an offset for that money. The U.S. said, "No, we're not states." It didn't work out that way, but it highlighted how big a deal. The initial default in 1840s was a really big deal. John Quincy Adams thought that this was going to cause a war between Britain and the United States. It didn't, but it was like a sorts of extreme tension between the countries.

The U.S. decided not to do a bailout in the 1840s. The one story is like a bailout will lead to moral hazard. In the 1840s, they say, "Well, defaults are where we're going to go." This had the effect of drying up funds for borrowing. From the 1840s really to the 1910s, state governments are largely out of investing infrastructure. Infrastructure becomes something that local governments do and state governments are mostly out of, in part because the states can't borrow, especially the states that defaulted. In part because states in response to their default passed pretty severe debt limits, limits on their own ability to borrow, legal limits on borrowing, that kept them out of this, that they then decided not to apply to the local governments.

Allison Schrager: Do you think less infrastructure was built as a result? Do you think that slowed economic growth?

David Schleicher: Not in that period, because local governments kind of stepped into the fore. States realizing they'd done this, state courts made these legally questionable decisions that these things, these debt restrictions that they had passed didn't apply to local governments. Local governments then began investing. The railroad boom of the 1860s through the 1890s was largely funded. Well, not the transcontinentals, the transcontinentals were largely funded by the federal government, but all of the rest of the railroads were funded, largely funded by state and local governments. One thing to note is that the default of the 1870s, which state defaults of the 1870s and 1880s in the southern states, really did have a pretty big effect on growth and infrastructure in southern states. Southern states were, after 1880, barred from international and national bond markets for many, many years and as a result, weren't able to invest in the infrastructure of the type we saw of a boom in the north of things like the Brooklyn Bridge, and Central Park, and kind of other famous forms of infrastructure.

Allison Schrager: Then what changed? Did people just sort of forgive state governments anyway? They knew there was a specter of default hanging over just because memories are short in bond markets?

David Schleicher: There was an effect, but it was not permanent. There's a big debate in sovereign debt markets about how long is the effect of default. You can think of this as the Argentina question, how is it that Argentina has defaulted—I don't know—a dozen times. That's an exaggeration, but it's defaulted a number of times. The question is, "Well, why would anyone ever lend money to Argentina ever again?" The answer the literature gives is that their defaulting on debt has an effect on your ability to borrow. It is not permanent. Investors will either forget or they'll chase yield in the future. Arkansas, which in the book I jokingly call, "The American Argentina," defaults three times, once in the 1840s, once in the 1880s and then once in the 1930s. Each time it is limited from borrowing to invest in infrastructure. It eventually gets back into the market later. But it really has an effect. I'll note, I can't prove this causally, but Arkansas is one of the poorest states in the union.

Allison Schrager: Still, do you think that is hanging over them still today?

David Schleicher: No, it doesn't affect their debt ability to borrow today. But it had an effect at a time when there were real benefits from investing infrastructure and then getting the developments that would ensue from that. People moving to a place creates reinforcing agglomeration effects.

Allison Schrager: So, moving on, it seems we set the system up in the 18th century of maybe as well, we were a new country, so being fairly forgiving. Then in the 19th century we just went the other way and really drew this hard line. But then we get to the 20th century, and it seems that things started to blur a bit. There were two major financial crises in New York City and Washington, D.C., and they did ultimately get some assistance, but with substantial strings attached.

David Schleicher: In the period before the second half of the 20th century, and after Hamilton, the federal government doesn't offer bailouts. There's one large reason for it, that it couldn't. It just didn't have the revenue that state local governments are just much bigger than the federal government. They theoretically could have offered bailouts, but it was not likely, state and local government were just much, much bigger than the federal government. By the time you get to New York or Washington, D.C. the federal government is becoming the very large fiscal entity is today. The federal government is faced with real choices about bailouts, and New York is a famous example. The story everyone knows about the New York fiscal crisis, even if you're not into the weeds on these things, is the daily news headline "Ford to City: Drop Dead," which was President Ford's taking the position that a bailout would not be offered.

This shows up in the popular media. There's a whole discussion about this in Annie Hall, the Woody Allen movie. But it turns out that in fact, the federal government did offer aid to New York through the Seasonal Financing Act that provided emergency loans to New York City. In the case of Washington, D.C., the federal government just offered a bailout. Washington, D.C. is just, that's as pure bailout as you'll find. The federal government suddenly gets this other option in its holster and it has to decide whether to use it.

In New York, it waits until New York State has imposed pretty substantial conditions on New York City and they've engaged in some pretty substantial fiscal reforms. In Washington, D.C., the aid is attached to conditions itself, because the federal government can't order a city to standard things the way that it can order the state can, cities or creations of state law. But Washington, D.C. is obviously differently situated from a city inside a state. It's not inside a state. The federal government does a bailout of Washington, D.C. but also creates, as New York State did for New York City, a control board that controls its budget and removes from electoral politics a lot of its fiscal powers until the situation is righted. It provides a bailout with conditions.

Allison Schrager: It seems that as the country got richer in general, we became more able to bail everyone out, even individuals. Because we also had a big creation of the welfare state for both individuals and for state municipalities. But you still have this moral hazard problem, not so much for individuals, but more for states and cities. These conditions were, as I said, fairly onerous. Do you think this got around the trilemma or does it still exist?

David Schleicher: I think it was the way to mitigate the problems of offering bailout. In New York, both the conditions imposed by the state and then the fact that the terms of the federal aid were pretty—they were there, but they were still quite stingy. They were like loans at a quite high interest rate, designed to mitigate the moral hazard cost of offering aid. When we get to the policy solution, I think this is a pretty attractive solution. It's what we do in some ways in the international sphere, that aid comes attached to conditions. One other thing about the New York example that I quite like, and I think it's a model for other places, is not using aid to avoid a reckoning, but using aid to help respond to reckoning after it's happened. You see in a bunch of instances that sometimes if you provide aid to avoid default or avoid a series of very severe cuts, you're kind of kicking the can.

Whereas in New York, the crisis happened and big reforms were enacted, and then the federal aid came in to provide a kind of backstop to those reforms. That mitigates the moral hazard because the other downsides are felt also. Jurisdictions don't want to go through the kind of thing that New York went through, but allows for a mitigation of the other types of harms. If you think about the aid offered to Detroit by the state and by private foundations, they came after the bankruptcy filing. We can talk about Detroit if you want to, and this is a kind of model for if the federal government is going to provide federal government or a state government is going to provide aid when it might provide aid and on what terms it might.

Allison Schrager: Yeah, let's talk about municipal bankruptcy because that also was established during the Great Depression. But as you point out, and it wasn't really put to the test or applied until Detroit.

David Schleicher: Yeah, no, municipal bankruptcy gets passed in the 1930s, but it's mostly just a kind of way to do workouts. That is, say there's, the court has very little authority and it's used by almost no one. Then in the 1970s while the court, while Congress is considering what to do about New York City, one of the options that New York City considers is municipal bankruptcy. Everyone realizes that the law is pretty insufficient. While they're deciding what to do, it takes too long. New York City doesn't end up filing and there's some other reasons why it doesn't, but the Congress reforms mutual bankruptcy to take basically its modern form, but even after that there aren't a lot of uses of it. One of the things to make mutual bankruptcy constitutional even, it requires states to directly authorize the use of bankruptcy.

States frequently don't want to do this for one municipality because they think it's going to harm the ability of other jurisdictions in the same state to bar out. The municipal bankruptcy isn't a big deal in terms of practice. There are a few examples here and there, but isn't a big deal in practice until the early 2000s, when you start seeing a bunch of jurisdictions in California, in Rhode Island, and then the big one in Detroit, then kind of follow on in Puerto Rico, which is not a formal municipal bankruptcy, but it's basically the same thing.

Allison Schrager: Bankruptcy does seem like a viable option. Do you think it should be extended to the states?

David Schleicher: Absolutely, I do. David Skeel, a professor at Pennsylvania and on the Puerto Rico oversight board, has proposed extending municipal bankruptcy to the states. One of the things that's ironic about municipal bankruptcy is that there's this huge debate in the sovereign debt world about whether we should have a bankruptcy law for countries. We have informal mechanisms for working out debts like the Paris and London clubs, but no judicialized process. But in America we have this judicialized process that applies only to cities. States can default if they want to. They're protected by sovereign immunity, but they don't have a judicial mechanism for if they default ensuring that creditors are treated fairly, for assessing whether the state is in a truly perilous fiscal condition, the way that we do for municipalities.

I think municipal bankruptcy is quite a good system. It has a couple of elements that I really like. One is that it is a mechanism for balancing the trilemma. The trilemma is three harms, but you don't have to choose one or all of the other. One way to think about what municipal bankruptcy does is it puts an official in assessing the fairness of the balance the jurisdiction is drawing between austerity and default. I think that's pretty attractive. It also serves an important kind of political role, which is that it allows us to see the differences between jurisdictions that are actually too far gone and need to default from jurisdictions that are just strategically playing with their creditors. Because it goes in front of a court, there's an entity, a trusted entity, hopefully, to kind of assess the solvency of the jurisdiction. I'm a big fan of municipal bankruptcy, and I do think it should be extended to state governments.

Allison Schrager: Why isn't it?

David Schleicher: There are some theoretical constitutional questions. Municipal bankruptcy has a kind of very interesting constitutional history, which is when the law was first passed, the Supreme Court found it unconstitutional, and then Congress passed basically identical law right after, and then as part of the broad switch in time that saved nine. After Franklin Roosevelt's court-packing scheme, the Supreme Court finds that the law is constitutional, but written into it are certain protections for state and local for functionality. But there's some people who think that applied to states and not to municipalities would be unconstitutional. I don't think they're right. But there are people who think so. But when this was broached during the pandemic era, it got a lot of pushback, and it got a lot of pushback from a variety of people who had a couple of takes on it. One of them is that states aren't in that bad fiscal position, they don't need bankruptcy. That's, I don't know, fine as far as I'm concerned, if they don't need it, then they won't use it. Nothing wrong with that, with authorizing it.

Allison Schrager: Well, also, they don't need it now.

David Schleicher: Exactly, right. The second story was that it would create terror in the markets if even the option was available. In the debt market, this doesn't do very much for me either. First off, it exists for municipalities and municipalities are able to borrow. How different is it, really? Those were the two arguments against it, but I don't think they're particularly availing, they're particularly good. I'm a big fan.

Allison Schrager: Well, again, one of the things I really loved about this, especially the history, was is you see how the federal government approaches these problems, you also see the evolution in how our country, one, thinks about state's rights and also in responsibilities and also just our tolerance of doling out economic pain or realizing downside risk. I think you see in the 20th centuries, it's sort of a new evolution, one, as you said, of after the financial crisis, but really with the pandemic and the CARES Act, which was quite generous to states. Do you think that that created more moral hazard?

David Schleicher: Yes. I do, I think more of the American Rescue Plan, but to go back to the first part of your question, I think this is absolutely right. Probably the biggest period of defaults in American history involved local governments that were funding railroads, and we had a huge number of defaults. This was a really big national political issue. Again, most people aren't focused on the economic issues of state and local governments in the 1870s and 1880s. But it was a really big issue that in fact, when a bunch of Iowa cities didn't want to pay their creditors and the Supreme Court made them, they resisted so much that President Ulysses Grant had to threaten to send federal troops to Iowa to enforce municipal bond contracts. It's like a crazy story. Iowa is this staunch Union state, and Grant is sitting there threatening to send the Union Army to enforce municipal bond contracts involving railroads. It seems wild.

But the effect of this was to really create the modern municipal bond market, which we were willing to bear the downside of making recessions worse at the time in order to gain the upside of state and local governments being able to borrow. As a result, we see this extraordinary boom in infrastructure development in the late part of the 19th and early part of the 20th century that resulted in almost all of the infrastructure we know and love today, still, more than a hundred years later. When we look ahead more than a hundred years to the pandemic era, the jurisdictions faced a lot of crisis during the pandemic era. Not only was it an ordinary recession, but there was also the particular costs of the public health emergency.

The federal government offered a lot of aid. First in the CARES Act and then in a whole bunch of other bills, but then really dramatically in the post-election ARP. This had some pretty big effects. The result of it was that states were in a better fiscal position than they were pre-recession, right? The amount of aid far exceeded any fiscal losses that we saw. This had a couple of effects. One is that it spurred inflation. I think that that seems pretty clear. But the second is that it created some confidence in jurisdictions that the federal government would stand behind them. This is a pretty real effect. Seeing moral hazard in the short run is quite hard to see because it's a prediction of how people behave in the future.

Some states have been quite responsible with their budgets during the pandemic era. You look at a place like Connecticut, which coming into the pandemic was one of our poster children for fiscal mismanagement. They've been remarkably careful during the pandemic era, but a number of other jurisdictions, we're both New Yorkers, let's just say, not been as careful with the one-time type of federal aid and maybe setting themselves up for fiscal crises in the future. My joke about this is that I sometimes say that some jurisdictions feel like they're playing Brewster's Millions with the money. You get to keep a bunch of money if you spend it immediately, the challenge facing Brewster in the movie. Sometimes it feels like these jurisdictions are doing that, the money comes in and they feel like they absolutely have to spend it right away to create kind of long-term liabilities and what's going to happen in the next period when things go badly is something I guess we'll have to see.

Allison Schrager: Well, it's not like that. I have mixed feelings about the federal government bailing out states and municipalities, but at least when it happens, you can feel like, "Well, Congress people will be accountable and this is the will of the voters, whatever." But I think as you point out, and I wonder, do you think this could also create a lot of moral hazard that the Federal Reserve now has a facility for municipal bonds, and they bought quite a few. Not only that, in the years leading up to it, there were a few politicians who said, "If the Fed is bailing out banks, they should also bail out states and municipalities." Now, we're talking about bailouts without even Congress getting involved. Do you think that could also cause more?

David Schleicher: The Federal Reserve actually took, I think, a pretty limited intervention into the municipal bond market. They did so after Congress asked them to basically, so as part of the CARES Act, Congress gave money to the Federal Reserve to set up a whole bunch of facilities to intervene in a whole variety of markets. But one of them was the municipal bond market, what the Federal Reserve did, and Federal Reserve kind of saw the point you were making and said, "Oh my goodness, if we get too involved in buying municipal bonds, we're going to end up deeply enmeshed in politics and we can't be that way. That's not a viable place for a central bank to be." When they created the municipal liquidity facility, they made the terms of it very, very strict. The rates were high, and that limited the willingness and jurisdiction.

Basically, Illinois and the MTA in New York were the only jurisdictions that directly accessed the municipal liquidity facility for the very reason you suggest, which is that if the federal government starts loaning money through an unaccountable entity to state and local governments, when the money comes due, they're going to face a lot of pressure to roll the loans over or face a lot of political blow back. The people running the program for the Federal Reserve, I'm sure, were deeply cognizant of this problem, which is you just can't have a bunch of faceless bankers telling the state, "You've got to cut your homelessness money." That's not a viable situation. While a number of politicians argued that the Federal Reserve should get more involved in financing state and local debt, the Federal Reserve itself, I think, very wisely declined this option.

Then as part of a bill that was passed at the close end of the Trump administration, the Treasury took its money back from the Federal Reserve for running this program. The Federal Reserve could theoretically create it again under certain circumstances, maybe, I don't know. But the Federal Reserve hasn't shown a ton of indication that it wants to do so, because the one they're extremely cognizant of is that they don't want to have any responsibility for how well the subways in New York are run. The very worry that you suggested, and that people like Senator Liz Warren were pushing this type of thing, were exactly the kind of thing they were resisting, and I think they did so admirably.

Allison Schrager: Yeah, well, like I said, let's hope it stays that way. It's interesting seeing how this evolves with our institutions and our outlook toward economic pain and autonomy.

David Schleicher: Yeah, absolutely. One of the things that's so interesting about studying the kind of debt crises is that they're crises. Sometimes people will say, "You should never let a good crisis go to waste." But I think that a lot of times crises reveal a great deal about what it is we're willing to deal with, the types of harms we're willing to deal with, how we feel about risk. The trade-offs there are really, really severe. It is a window into changing American attitudes towards risk and growth through looking at how we address state and local fiscal crises.

Allison Schrager: Which is why I said I think this book really comes out at a good time, because we don't want to come up with solutions on the fly. Now, as I said, the reaction that we shouldn't have state bankruptcies because they don't need it—now is the time to set up the rules around this, when they don't need it.

David Schleicher: Absolutely. One thing to note is, so because of the federal aid state and local governments are in pretty good shape right now, which is exactly when we should be planning for what's going to go wrong. We saw this relatively recently, which is that we had a state and local fiscal crisis. If you followed the debate that we had during this period, it was in Maine. I talked to a variety of politicians, and thinkers, and writers in this area at the time because they call you on the phone and say "Hey, something about this." You had to teach them basic facts about state fiscal affairs, and about there's bankruptcy and everything else because they'd never thought about it before. I hope the book is well-timed. The publisher and I have a joke, which is that it's, like well, we're not rooting for jurisdictions to have crises, but we're not, not rooting for them either. Book sales are important, too.

Allison Schrager: Well, you never know. Maybe they'll wait for a crisis, although honestly I don't see, I could look at Illinois in Chicago and think "Everything's fine," but it could be one of those books where someone finds it and maybe it's a couple of years old, but we'll be like, "Here it is."

David Schleicher: Yeah, absolutely. The book starts with an example, like a thought experiment. What would happen if Chicago and Illinois declared they were going to default at one moment? Illinois has made some progress in recent years, the city of Chicago, and the really jurisdiction is not so much, I wonder very much about the recent election in Chicago and its effect on the potential for fiscal crisis.

Allison Schrager: As I said, I don't know why anyone can say everything's fine. In that vein, you sort of lay out different ways we should deal with the certain principles. But as you point out that first state municipalities do have to take a hard look at their behavior that's causing financial duress. But you say, "First we must address what you call the political crises of states and cities." What are you talking about?

David Schleicher: Yeah, I have a whole variety of ways the federal government should approach offering bailouts, creating systems for default like bankruptcy and for encouraging us that are in ways they could do it better. But as I note in the book, I quote the movie War Games, "It's a strange game. The only way to win is not to play." The optimal way for us to address state local fiscal crises is not to have them. The best way not to have them is to have a particularly responsive state and local democracy. That is to say, if voters have to take into consideration the costs and benefits of spending really through an effective mechanism, democracy, we might imagine we'd have fewer fiscal crises. One of the big challenges we face when you study states and cities is the realization that states and cities, particularly outside of executive elections are barely democratic at all.

What do I mean by that? Ask yourself, do you know who your state and local officials are? Do you know who your county commissioner is? Do you know who your city counselor is? Do you know who your state legislator is? Do you know who the sheriff of your county is? The answer for almost all people is not now. As a result, people in state and local elections mostly vote for whatever party they favor at the national level. That makes sense, so there's some correlation between the issue spaces, and it's like not crazy if you don't know anything to just vote, whether "Do you like Biden or do you like Trump? I'm going to vote for the people in that person's party." But the effect of this is that almost nothing that state and local officials and state and local legislatures do has any effect on whether they're elected or not, outside of their ability to get elected in extremely low turnout, activist-driven primaries.

As a result, the state and local politics is dominated by interest groups. They can take it to a variety of forms, whether it's homeowners’ groups or businesses or public employee unions or whatever else. But there's very little mass politics, that is to say the kind of politics that's makes politics more efficient for taxpayers. Or let's do ordinary things that people want or that ordinary people can access, because there's so little accountability for state local officials to get things right.

Again, executives stand outside of this, too little people often do know who the mayor of their city or governor of their state is. As a result, we sometimes see out-party mayors and governors. You see like a Charlie Baker in Massachusetts or Andy Beshear in Kentucky. This is a result of those people being famous people who can then leverage their fame to become party brands unto themselves and get votes in that way. But absent that, state and local democracy just doesn't work very well. There's a result it gets captured by people who just want more from the government right now, but aren't going to pay for it themselves.

Allison Schrager: Do you think this is getting worse? Everyone's saying that people are becoming more aware of national politics and less aware of local politics either because of problems with the media industry and local news, or just sort of the intrigue that's happening.

David Schleicher: Oh, it is definitely getting worse. First off, declining local newspapers has had a really big effect on split-ticket voting, for instance. That's pretty clear. Declining local newspapers has a direct effect on borrowing costs. When a local newspaper closes the jurisdiction in which it's located, borrowing costs increase because lenders know that no one is watching the store. There's going to be waste and all sorts of things happening afterwards, but also national polarization makes this worse. It's the extent that the other party is full of complete and total villains in your eyes. It really doesn't matter to you whether they're wasting a lot money here and there in the state and local budget, because they're villains. The extent that we have such great inter-party enmity at the national level, and we kind of organize ourselves around teams of Democrats and teams of Republicans and have a tribal attitude towards politics, it makes state and local accountability extremely difficult.

Allison Schrager: We've got more moral hazard and less accountability?

David Schleicher: Well, we definitely have less accountability. We have a little more moral hazard for sure. Yeah, that's basically right.

Allison Schrager: Oh, so I hate to say it, but it sounds like something bad has to happen for people to really heed this message.

David Schleicher: Yeah, the sad thing about American politics is that we said that about almost everything, every issue, we just wait until a crisis and we'll solve it. I will say that the pandemic is kind of a positive. A crisis happened and we actually across some dimensions dealt with the economic impacts, I don't know, decently well. I don't know. You may disagree because we have the kind of inflation problems that have followed. But by international comparisons it seems like okay enough. We did muddle through. But in this context specifically, we do have both a long-run democratic crisis in states and cities and a particular problem created by maybe a failure to take advantage of the opportunity created by the fiscal space created by the federal aid at the moment in states and cities. It is, while things are okay now, I do agree that they are a bit perilous going forward.

Allison Schrager: Well, I guess it's similar to how I think about pandemic economic policy, which I think definitely if you compare it to say other calamities was better in that people didn't starve and fewer businesses failed than needed to. But we just didn't know where to stop. We just had to take it to 90 and probably we should have taken it to 50, and now we have this inflation and whatever nastiness is going to come through it. But we didn't have to, we could have spared a lot of economic pain and not done that.

David Schleicher: We took it to 90 with state and local aid. One of the big ways in which we took it to 90 was the state and local aid provisions of the ARP, which were just enormous. They were just giant buckets of money. It was pretty unnecessary, I think, at the time. If we could take that bit back, I think we probably would, not the CARES Act aid, which I think actually should have come with a few fewer conditions. But the ARP aid was really quite a lot and it came with very few conditions and the courts have stripped out the only conditions that were imposed on it. Now, it really is just a kind of a free lunch.

Allison Schrager: I guess maybe now the future is just all these little mini crises to remind us that we do go too far from time to time.

David Schleicher: It is what it is. I always joke with my wife, who I mentioned earlier, is Canadian. I always describe America as a country of high variants. It's like we do some things great, we do them terribly. It is surely the case that in this case we do both.

Allison Schrager: Thank you so much. I really think everyone should read your book and I don't say that often, and you should read it now, while we have time to think carefully about these things. But if not, read it when the next state or municipality has problems. Because I always thought inflation wouldn't come back. The other thing I've always worried about are state municipal financial stress.

David Schleicher: Yeah, absolutely. The 1970s can come back if the inflation chooses anything. The ‘70s never go away forever. State and local fiscal crises may come back at the same time, soon after inflation.

Allison Schrager: Totally. It's like we keep building things on a fault line and because we don't have an earthquake, we're like, "This is a totally reasonable thing to do."

David Schleicher: Yeah. Next thing you know, we'll all be wearing bell bottoms and disco will come back. It's really a dark future of that.

Allison Schrager: Well, if they read your book, they might spare us this problem.

David Schleicher: Let's hope. Let's hope

Allison Schrager: That's all we have. In a Bad State will be released in June. Give it to all your friends who should care more about what's going on at the state and local level. It's available on Amazon, and you can find David @ProfSchleich on Twitter. You can find City Journal on Twitter @CityJournal and on Instagram at cityjournal_mi. As always, if you like what you heard, please give us a five-star rating on iTunes. David, thank you so much for joining. This has been so fun.

David Schleicher: Thank you so much for having me.

Photo: Aslan Alphan/iStock

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