Why do cities and states find themselves in fiscal holes? Economist Robert Inman joins Allison Schrager to discuss the roots of municipal debt crises, the post-Covid balance sheets across the U.S., and the need for disciplined local governance.
Allison Schrager: Welcome to Risk Talking, a podcast about economics. I'm your host, Allison Schrager, and today we'll be joined by Robert Inman. He is the Richard King Mellon Professor Emeritus of Finance at Penn's Wharton School and a research associate at the National Bureau of Economic Research. He studies public finance and has conducted research into the design and impact of fiscal policies with an emphasis on fiscal federalism. Today, he joins us to discuss the uses and abuses of government debt, particularly at the state and local level. Robert, thank you so much for joining us.
Robert Inman: Oh, you're welcome, Allison. Happy to be here.
Allison Schrager: Hey, thanks. I think it’s especially timely too, because I think state and local finances are really the big story that no one's talking about. I recall before the pandemic we kept hearing doom-and-doom stories about various cities or states that were in serious fiscal trouble. And then the pandemic happened, and it seems like that conversation just went away. I mean, what happened? How would you assess a lot of states’ fiscal health right now?
Robert Inman: Well, I think two things happened, one bad and one good, at least if you're a governor or mayor. The pandemic itself really did have a very significant adverse effect on city and state finances. The issue, not surprisingly was, of course, lots of people were driven out of the labor force because of the illness, but also market activity went way down. We were in modes of stay at home, no shopping, people working from home. The implication was that there simply wasn't the economic activity that had existed in the post-Great Recession era, and the economy took a pretty significant nose dive beginning in 2020.
The second part of the story, and the story that every state and local official loves to talk about, is the federal government stepped in with a great deal of money. The CARES Act initially in March of 2020, followed up by a supplemental act in December of 2020, and then again followed up with a major spending of the American Recovery Act in March of '21. This put a great deal of money into the state and local sector, and in many instances proved to be a larger sum than the actual revenue losses that the states and cities might have suffered because of the pandemic.
The pandemic obviously was not a pleasant experience, but from the point of view of state and local budgets, just looking at the numbers, with the federal expenditures, it has to be considered a net plus.
Allison Schrager: I mean, are they still in that position? I was just reading how California ended up in this huge net plus, but now they're actually in debt again because of I guess some quirks about the various propositions that have been passed over the years.
Robert Inman: Right. The other issue, of course, is what happened to the net plus. From my point of view, I would've hoped that would've found its home in something called a rainy day fund, namely it's temporarily extra money. The right thing to do with such an influx would be to save it in anticipation of future downturns. The result, however, has been really quite the opposite in many instances. It has been to favor tax cuts, and now we're back into a regular economy looking at potential continued slowdown, not recession yet, but slowdown, which is going to slow down tax revenues.
It was a downturn, a significant upward blip. The blip was returned to taxpayers. And now at least from the budgetary point of view, we're back into a flat downturn experience.
Allison Schrager: Reading your research, a lot of things really jumped out at me that I think are super relevant to be thinking about right now, particularly your anatomy of the fiscal urban crisis. Philadelphia—I actually had forgotten about this because I was quite young at the time—had a fiscal emergency in the early '90s when lenders and guarantors refused to lend the city its needed funding. I feel like a similar thing happened in Detroit or Puerto Rico, where these disasters seem to come out of nowhere. What leads up to that, and do you think some places are now really in danger of these sorts of things happening again?
Robert Inman: I think the cause of it is really, and not shockingly, focusing on today and forgetting about tomorrow. From a politician's point of view, the votes are today, not tomorrow. The temptation is to give back any excess in either any budgetary upturn, give it back in increased services or in reduced taxation that keeps the voters happy and gives me a shot at reelection. This was certainly the story in Philadelphia prior to the 1990s, and clearly the story in Puerto Rico. The implication, of course, is deficits exist and deficits then are funded oftentimes by short-term borrowing.
You get into a situation where these short-term debts used to fill holes in the immediate period. These short-term debts accumulate until eventually the bond market says no. And that's certainly what happened in Philadelphia, happened in Detroit and also in Puerto Rico.
Allison Schrager: I mean, what causes the bond market to say no? Is there some event? Does debt get to a certain level?
Robert Inman: It's the latter. Imagine we're in a Ponzi scheme, Allison, and that's essentially what's going on here. The bond market reaches the point where they go, wait a minute, maybe we're the end of the Ponzi scheme. We don't feel it's either prudent to lend or useful to lend in the sense of maybe stimulating city growth, neither prudent nor useful to lend. If we do lend, there's a significant risk that we won't be repaid. And that's exactly what happened. Philadelphia went to the bond market. The backstory is, of course, high spending, low taxes, and a recession of 1990.
But the city went to the bond market asking for its usual loan of $105 million to tide it over the course of the fiscal year. When the bond market took a look at the budget really in a careful way and for the first time seriously, they found an additional $250 million shortfall on a $2 billion budget, a 10 percent shortfall. Their reaction was, wait a minute, if we lend you guys money, what's the chance that we're going to get repaid our $105 million in short-term borrowing when there's going to be a $250 million dollar hole in the budget with lots of other demands? Their basic attitude was, let's back away from this. That's also clearly what happened in Puerto Rico and also in Detroit.
The bond market rides along as long as its lenders feel their bonds will be repaid. But the next lender eventually says, "Wait a minute, I'm suspecting that my bonds will be the ones that don't get repaid," and therefore they don't lend. In all three instances, you hit the wall where the accumulated short-term debts of prior years suddenly begin to loom large as a share of the budget and the obligation seems to suggest that future lending might be low on the priority list.
Allison Schrager: I mean, speaking about whether or not they get paid, when I think of a sovereign debt crisis or a state and municipal debt crisis, I usually think of there being three stakeholders. There are the bond holders, the pensioners, and then there are the other citizens who rely on government services like libraries and schools. Who generally gets paid first? Who's senior there?
Robert Inman: From a legal point of view, it'll be the contractors. Detroit put all three players on the table and said, "Who do we want to give our money to?" Essentially what happened in bankruptcy was a negotiation process between the three, between current residents, public employees and particular retirees, and bond holders. The court typically will then try and do a balancing act. No one of the three will actually bear the largest burden. The court will try and do an equitable division of the obligations. It's a pie that ideally would've been $1, is now 80 cents. The question is, who's going to lose the 20 cents?
In the Detroit case, it turned out that the bond holders were actually the most significant losers in this instance. The pensioners got a significant cut in their pensions; rather than getting a dollar on a dollar, they were getting 90 cents on the dollar. The taxpayers and citizens were in many ways bailed out by state money. The state came in and filled the hole in the budget to keep basic public services ongoing. You can imagine the politics of this. Streetlights go out, crime goes up, the state says, "What should we do?"
And the answer is turn the streetlights back on. The state has been responsive in the case of Detroit to the basic needs. To elaborate a little bit, this was also true in Philadelphia and it was also true from the federal government's assistance for Puerto Rico. An outside government is the one who will typically fill the gap between taxpayers and resident need and the original status quo, and then the bond markets and the pensioners are the ones who will end up dividing up the losses.
Allison Schrager: I mean, despite all of this, in some ways, the U.S. system isn't so bad. It's generally regarded as an example of a well-managed federal fiscal system, especially when you compare it to, say, Argentina and Brazil, where their local governments get in even more trouble. What are the best institutional features that promote responsible local budgeting?
Robert Inman: Well, I would say two things. One, in fact, if you want to cut to the heart of the matter, is a populous that pays attention to what the government is doing. The question then is, how do we get the populous to pay attention? The answer for me is in many ways the capital markets, the bond markets are important, at least at the local level, big cities, Detroit and Philadelphia, its folks who own property, who have a close vested interest both in property taxes and in services that are going to enhance the value of their property.
If services go down or taxes go up, either of those outcomes is going to reduce the value of my home. And as a consequence, I'm going to be paying pretty close attention to how the budgeting is being done. I think the big plus that the American Federalist Institution has over those, say, in Argentina or Brazil is property ownership. Property voters have invested interest in the outcome of the public finance, and they pay attention to the outcomes of public finance. That to me has been a big, big plus for the US system as a whole.
Allison Schrager: Although you have written about how we can make that more transparent, I think a lot of people as well are certainly taken by surprise when they're in a state or municipality that runs into fiscal trouble. I mean, how can we do better?
Robert Inman: Well, I think it's got to be two things. One is making sure the data as to how the budget is doing is actually clear. That residents understand it. And then secondly, residents care about it. Back to property owners, they care. Now, the question is how to help property owners understand what the budget is actually doing. This is not an easy task. And the question is, are there institutions that can help that? There are things like comptrollers. I'll say this, in the case of Philadelphia, we have a comptroller, and the comptroller takes great delight, in fact, the current comptroller who is running for mayor, takes great delight in pointing out the budgetary shortfalls of its previous administration.
You need a watchdog, either an elected watchdog or an appointed watchdog, who is going to pay attention to the budgetary implications. The other thing is, budgets are incredibly complicated. If you just think about all the little parts in any city or state budget, they're moving. There's a pension fund. There's enterprise funds. There's the general fund. There's the capital fund. All of these funds are ways of squirreling away money or spending money without paying attention to the implication to the overall budget.
You need somebody who's going to stand back, look at the whole budget and say, "While you're doing fine on the current account budget, I noticed that you sold a lot of assets to pay for the current accounts. That's reduced your capital budget. Similarly, you've underfunded your pension fund. That's helped the current account, but it's made your pension budget move into deficit." You need somebody who's going to look at all the different budgetary components, convey that information in a clear and comprehensive way, and then have voters who are going to pay attention to it.
Allison Schrager: I mean, I've always followed the public pension issues, even the numbers they give when they talk about their liabilities is controversial. I mean, the issue I think a lot of financial economists have with public sector pensions is they discount their liabilities at an expected rate of return, which gives the pensions effectively no incentive to account for risk. Because the more risky your investments are, the higher expected return, the less money it looks like you owe.
But when I've talked to people at the Governmental Accounting Standards Board about these accounting standards, they're always like, well, it's really hard just to get them to comply at all. We don't really have a lot of room to change things. I mean, do you think there's any way we could have, as I said, better standards, more transparency? Would the states be open to that?
Robert Inman: Well, your point's absolutely right, and the issue is getting the right discount rate. The one that you'd want to use is a risk-free rate that is going to pay attention to the long-run interests of the taxpayers. That could be a Treasury rate or something maybe slightly higher than the Treasury rate. The consequence of picking a high interest rate, as you imply, is when you do your discounting, you get a much lower liability attached to it and a much higher estimated return from the assets that you hold.
Things look better from that point of view than they might from the point of view of a homeowner or a taxpayer who's looking at things over a longer period of horizon and is looking at things that are going to be much less risky given their own investment choices. You want to have a low interest rate. I think we've gone a long way in publicizing, thanks to some very good research by colleagues at Stanford, gone a long way to publicizing what the implications of this high interest rate are. I do think that certainly the public officials understand what the implications are.
Whether the average voter understands it or not is a more subtle question. But I think getting the issue out there and discussed is crucial. I think the comment of your conversation with the GASB colleague is to suggest that there's no incentive for them to change, no incentive for them to pick a lower interest rate. That raises the question, maybe we should regulate these things. From the point of view of cities, that puts the burden on the state. And from the point of view of states, that puts the burden on the federal government.
There's another layer to this. There's the voting political control over budgets, and then there's the second alternative, a regulatory control over budgets.
Allison Schrager: Well, if we are going in the direction of regulatory control, or maybe even taking that to a federal level, I mean, it's always seemed to me certainly following state and municipal bankruptcies and particularly around pension issues, that the federal government was quite adamant about showing that they would not support or they would not bail out states and municipalities. Whether or not they actually do it is a different question. But there were fairly significant bailouts during the pandemic. Do you think that was seen as a one-time thing or a new regime where states and municipalities can count on fiscal and federal support?
Robert Inman: I don't know how to answer that. I think the American Reinvestment and Recovery Act was another major contribution to the budgets of state and local governments. Again, on this round on the COVID and the American Recovery Act, two big ones. What's the typical horizon of a state or local official? I don't know, maybe 15, 20 years? You've been in office since 2010. Anytime you've been in trouble, you've gotten federal money. The question to my mind is, do they have any reason to think that's going to stop? Right now, I think the answer is maybe no. We were very fortunate back when I was just starting out in all of this, when Gerald Ford basically said to New York City, "You're not getting any money."
That was a really important signal to the state and local sector. It was a statement by the federal government that we're not in the business of bailing out cities, in this case New York, that have gotten themselves into fiscal difficulties. And that signal has stuck. The Philadelphia crisis, the Detroit crisis both had money attached to them from the state in helping the city manage things, but it was in terms of loans. The loans had a decent interest rate attached to them, which the city had to pay. And in all instances, the loans had priority over any other government spending.
There was a designated tax that went immediately to the repayment of state loans and then the city could go into doing its regular budgeting. I think the issue is now I think the bailout question. I think your question is absolutely spot on. What are the expectations of state and local officials? My sense is they are pretty confident that there's going to be aid for them if they get in trouble. And that only creates, as you probably suspect, an incentive to be a bad budgeter. That's maybe where we're headed.
Allison Schrager: I was just even reading a history of the Fed over the last five years, and I wasn't even paying attention, because I would have been horrified that there's even big calls for the Fed to be a lender of last resort to states and cities, which I didn't even know was part of the conversation.
Robert Inman: The municipal liquidity legislation that came out in 2020, it actually turned out to be a pretty good piece of legislation, but the Federal Reserve was given the right to lend money to state and local governments. They did do the right thing, which include a significant risk premium attached to the loans. The consequence was not many, just a few places ended up taking advantage of the borrowing. I think New Jersey was one. But it did operate as a pretty significant backstop for the market, gave the market some security and allowed interest rates to move back downward after a significant blip in the summer of 2020.
But I think this is an issue. I don't think the Fed's going to get into this game in a serious way. Certainly my colleagues at the Fed would think it's a bad idea, but I think Congress finds it very tempting to want to use their budgetary powers to fill gaps at the state and local level.
Allison Schrager: I mean, do you think the status quo is sustainable? Right now it seems like the unions in particular have been getting a lot of pushback for pushing states and cities to pay for contracts with no real limit to what they're going to be spending. I mean, do you think something has to change there?
Robert Inman: I think it'll be city by city and state by state. But as a general comment, I do think we're in a situation now where there's a sense if any one city or any one state gets into trouble, a bailout from the federal government is not likely. In the same way that Ford said to New York, "Sorry, no help." But I think if a major state, the State of New York or California, got into serious trouble or a group of major cities got into trouble, as we've experienced with Covid, I think a bailout becomes very, very likely.
The incentives of Congress, of elected representatives are, one, to deliver services and, in instances, cash to their constituents. They need a majority vote. Therefore, they're going to need a lot of other people interested in delivering cash. There's never a big scarcity of that. Congress is always under the temptation to want to structure a bailout. The question is, what can limit those temptations? I think good presidential leadership will be essential on this point.
Allison Schrager: You think we're past the days of the “New York: Drop Dead?” Next time it's going to be, here's your check?
Robert Inman: Yeah, I suspect we're there.
Allison Schrager: I guess Covid was an extraordinary event, but it does seem like that might have been a turning point, particularly for some municipalities, certainly before we're getting to the point where they could barely govern, like Syracuse or Modesto. I mean, how does it get that bad?
Robert Inman: Well, I think it's just both the places you mentioned have essentially flat- to- declining economies. In that environment, there's going to be very little buildup of any kind of reserves or having a tax base that's very sensitive to an upswing in the economy as sales or income taxes. If you're living on property taxes, you're going to be in real trouble, I think, in declining areas. Your tax base is going down. Your revenues are going down. In many instances, I'm going to guess, both Modesto and Syracuse have got rising service needs in terms of education and policing. It's going to create great pressure on the budgets, a temptation to fill those pressure holes with debt.
Debt accumulates, and then we're going to have trouble. If Syracuse is alone or Modesto is alone, I think they'll live alone. They'll rise or fall on their own. But if there's anything like another significant recession or this one drags on and on and on, there's going to be a lot of low-growth cities and low-growth states that are going to be under budgetary pressure. The temptation, as we've seen, is to go to Washington to look for help.
Allison Schrager: I almost wonder if, honestly, it goes back to the financial crisis that once it was seen that you should bail out banks, I think it felt like everyone should be bailed out to be fair, and particularly, you said, if you have a declining city.
Robert Inman: There's a distinction to be made, I think, here. The banking crisis, if the banks go under, the economy goes under. I think the bailout of the banks was in many... I think the issue was putting in additional safeguards to make sure this doesn't happen. But the bailouts of the banks was, they went into some really bad investments. The investments went south, threatening the ability of banks to function in their primary roles as lenders to business. That would have been a significant consequence to the economy.
Having states go down, all of them, yeah, sure. But having ten of them go down, the states in industrial Midwest and so forth have real trouble, it's not obvious that a national bailout is going to happen. I think the politics is going to be the combination of the politics and the economics, but I think the banking crisis was in some ways a special one that we all had a vested interest in making sure it didn't happen.
Allison Schrager: I mean, looking forward, the state did have this great gift coming out of the pandemic of surpluses. I mean, can you think of any state that's used a rainy day fund, refunded a pension, or are they pretty much all back to where they were before?
Robert Inman: Well, I think the rainy day fund has gone up in several of the states. The Illinoises and New Jerseys have not, but the Colorados have and the Texases have.
Allison Schrager: The states that were growing?
Robert Inman: Yeah, that's exactly right. That's exactly right. They've been able to put the excess into savings accounts. An interesting example, which was an article in The Times the other day, was Mississippi got a lot of Covid money, but they couldn't spend it because they couldn't hire the people that the money was meant to hire. They're sitting on a significant pool of funds, I think it was $80 to $100 million, that according to the rules of the program, they needed to spend on healthcare facilities, which if they could hire people they would've spent it. But they couldn't hire people.
As a consequence, that money is going to end up going back to Washington. Maybe that's not so bad. But the issue is something that economists like to call fungibility. You can move money around in little boxes. Very likely to my mind that there's money sitting in Mississippi, but I suspect some of that money found its way into other parts of the state budget.
Allison Schrager: Well, unfortunately, that's all we have time for. But I think we're definitely going to see how this plays out. I think state and local finance definitely does not get the attention it deserves, but of all the issues we obsess over, it probably has the biggest impact on our day-to-day lives.
Robert Inman: I think that's certainly true.
Allison Schrager: I'm so glad you are here to talk to us and shed light on something people really need to care a lot more about. Thank you so much for joining us. You can find City Journal on Twitter at @CityJournal or Instagram at @cityjournal_mi, and we'll link to Professor Inman's work in the description. I highly suggest you check it out. And as always, if you like what you heard on this podcast, please give us a five-star rating on iTunes. Robert, thank you so much for joining.
Robert Inman: You're most welcome. Take care.