Discipline with Lessons from U.S. Federalism
Lesson 2: Constitutional Regulations Require Clean Guidelines to Acceptable Local Behaviors
Constitutional regulation of central government transfers and tax assignment is possible, but clear constitutional guidelines as to what constitutes a valid spillover for national policy or a valid tax base for local revenues must be provided. The U.S. Constitution fails to provide the needed guidelines; as a consequence, local governments have found it possible to extract significant transfers in the form of inter- governmental grants and nonresident taxation. Efforts by the U.S.
Supreme Court to define a workable standard for what constitutes the valid domains of policy for national and local governments have proven ineffective given the limited constitutional guidance.29 Clear and workable definitions of economic spillovers and residential taxa- tion can be written and successfully enforced by courts or politically independent regulatory agencies. The recent experience of the European Union with the implementation of its new principle of sub- sidiarity provides direct evidence on the point (see Bermann 1994).30 Lesson 3: A Mature Banking System, Efficient Capital Markets, and a Well-Administered Fiscal System are Needed to Check Bailouts Efficient central government redistribution policies, a mature national banking system, and an integrated national capital market provide the institutional preconditions necessary to remove the temptation for central government bailouts. The heart of lesson 3 was taught early in U.S. fiscal history and by all accounts learned well by U.S. state and local governments: bailouts will not be forthcoming from a central gov-
ernment (or for municipal defaults, a state government) whose con- stituents are economically unaffected by the default (Yi0) and who are indifferent or actively hostile to the fate of citizens or bondholders of the defaulting government (vi£0). Whatever is the value of s—see lesson 4 below—the necessary condition for a tough central govern- ment that vi£ -Yi·swill then apply. The U.S. fiscal history and its four significant periods of defaults by state and local governments reveal the importance of these institutional preconditions for local fiscal efficiency. Throughout U.S. history, there have been only two direct bailouts of a state or local government by a responsible higher gov- ernment: the federal government bailout of Washington, D.C., in 1997, a case where Yi>0, and the current state bailout by New Jersey of its poorest city, Camden, a case where vi>0.
The first major wave of lower government defaults occurred during the 1840s, when eight states (Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, and Pennsylvania) and the Territory of Florida defaulted. The federal government’s response marked a his- torical turning point in its treatment of local fiscal crises.31 Legislative efforts by the eight defaulting states led by Representative William Cost Johnson of Maryland to secure a federal government bailout of their debts, offered as a logroll to relieve all states’ debts, was defeated in Congress. Johnson offered all the right arguments: default would stop the construction of important public works with significant interstate spillovers (Yi >0) while a bailout would relieve worthy state taxpay- ers of a heavy load of taxation (vi>0; Scott 1893). Opponents from the majority of fiscally sound states rejected both arguments, pointing out that the defaulted loans were for transportation projects or state banks providing only local economic benefits (Yi0) and that the state taxes needed to repay the debts would come largely come from the wealthy (nonmedian) landowners through property taxation (vi£0; Scott 1893).
The fact that almost 70 percent of the defaulted debt was held by sophisticated foreign investors (vi£0) and was not an important part of the portfolios of the large U.S. banks (Yi0) cooled any temptation for a bailout (English 1996). Importantly, opponents of a bailout stressed the strategic implications of such a policy; bailouts would signal an accommodating central government and encourage future deficits, defaults, and ultimately inefficient local governments.32Con- gress said no, and there have been no state defaults since.
The no-bailout position also has been adopted by U.S. states when confronted with defaults by their municipal governments. With the single exception of New Jersey’s current treatment of Camden, U.S.
states have also said no to bailouts. The first major test for the states came in the 1870s, and no states provided a bailout (Hillhouse 1936).
Most of the defaulting local debts were for local infrastructure projects designed to attract real estate developers or a railroad spur, with planned repayment tied to increases in property taxes on adjacent lands. When the projects failed, and many did, the local governments assumed direct responsibility for debt repayment. Almost all of this municipal debt was held by foreigners or out-of-state residents, and again the bulk of local taxes necessary to repay the debt would come from upper-income households (vi£0). All of the defaulting local proj- ects provided only narrow local benefits (Yi 0), in some instances extending no further than corrupt local politicians’ back pockets (see Hillhouse 1936). Like their federal counterparts from the 1840s, state legislators also appreciated the incentive for future fiscal problems that a bailout would create. The 1870 no-bailout decision was a first step toward controlling local fiscal excesses. To add credibility to a state’s future no-bailout position, all states passed regulations to limit the extent of local debt (usually to a fraction of local taxing capacity), and some states approved constitutional amendments prohibiting bailouts.33
The 1930s saw another wave of municipal defaults.34With the emer- gence of the automobile and the beginning of suburbanization in the 1920s came a new demand for public capital. The level of capital invest- ment by U.S. local governments roughly doubled from 1920 to 1930.
Virtually all of this investment was financed by general obligation bonds backed by the property tax base of the issuing communities. By 1932, debt service payments exceeded 15 percent of annual local spend- ing in fourteen states; nineteen more states had debt service burdens over 10 percent of annual local spending. Any significant downturn in tax base would threaten the ability of high-debt communities to meet their interest and principal obligations. The downturn came with the Great Depression of 1932, which placed new spending burdens on this shrinking tax base, for local governments still had the primary fiscal responsibility for services to low-income households and unemploy- ment relief. The result was an explosion of municipal defaults, rising from 678 local governments in default in 1932 to over 3,200 govern- ments in default by December 1935. In dollar terms, $2.4 billion, or $.16 of every dollar of outstanding local debt, was in default (see Hempel 1971). In contrast to the 1840s and the 1870s, the 1930s defaults were not limited to a few governments nor were they the result of obvious
fiscal mismanagement or corruption. The outstanding debt was now held by U.S. investors, and local taxes were being paid primarily by middle-income city residents. A state or federal bailout for the debt of these distressed municipalities must have been a tempting policy option.
There is no compelling evidence that a federal or state bailout was forthcoming. To be sure, from 1932 to 1940, federal and state assistance to the local public sector did increase above its historical trend, but the additional funds were never officially treated as a default relief program and, more important, were insufficient to make any contri- bution toward repaying the $2.4 billion in defaulted local debt. The depression reduced local property values by approximately 10 percent on average, leading to a fall in local tax revenues of $3.280 billion below their predepression trend over the period 1932–1940. Over those eight years, U.S. local governments managed to trim $1.409 billion from pro- jected predepression service spending, but these cuts still left a short- fall of $1.817 billion in the local budgets. The increase in federal and state aid filled this current-accounts fiscal gap, but not completely.
Additional aid above the 1932–1940 predepression trend totaled $1.890 billion, of which $.196 billion must be counted as federally required increases in local welfare spending. This left $1.694 billion in new federal and state aid to fill the $1.817 billion gap between local service spending and local taxes. Rather than providing new money to cover defaults, the increase in federal and state aid was not quite enough to close the local sector’s budget gap; the remaining $.123 billion short- fall had to be covered by additional local borrowing. In the end, it seems more reasonable to view the depression-related increase in federal and state assistance as local revenue insurance in the face of an economic disaster rather than a fiscal bailout in response to strategic local deficits.35
The reluctance of the federal government to bail out local govern- ments in deficit distress continues to this day, best symbolized by President Ford’s response to New York City’s request for federal assis- tance following its 1974–1975 default: “Ford to City: Drop Dead,” said the New York Daily Newsheadline.36In the most recent fiscal crises in Philadelphia (1990), Bridgeport (1991), Miami (1996), Orange County (1996), and Camden (2000), federal bailouts have never even been raised as options. There is no evidence of significant national spillovers from these (near) defaults (Yi0),37and while Camden is a poor city with median household incomes approximately half the national
median (the other distressed cities have median incomes near or greater than the national median), there are other equally poor U.S.
cities not in fiscal distress. Further, Camden is located within one of the nation’s richest states and, constitutionally at least, remains the fiscal responsibility of New Jersey. It is difficult to imagine how national redistribution politics might single out this one city for special federal relief; at the federal level, at least, vi0 seems reasonable.
The federal bailout of Washington, D.C. has been the one exception to the rule of no federal assistance. The reason for this bailout lies in the city’s unique fiscal and political position as the nation’s capital.
First, without a supervising state, Washington has been given financial responsibility for the usual state functions of courts, prisons, trans- portation, and health care for the poor. These services entail significant public spillovers and are typically financed at the wider level of the state. In the case of Washington, D.C., however, local taxes provide most of the needed funding and do so in an economic environment where business and middle-class residential tax bases are highly mobile. The consequence has been a steady erosion of the city’s tax base over time (see O’Cleireacain 1997). Second, as the nation’s capital, Washington provides a unique national service as the political and his- torical center of the country. Local services such as crime control and sanitation provide national benefits as a significant number of city’s
“residents” are national or international visitors. While there is little redistributive reason to bail out either the taxpayers or the bondhold- ers of Washington, D.C.—the city’s median income equals the national median income (thus, vi0)—there are good spillover reasons that the federal government might offer such support (Yi >0). In effect, local politicians held hostage national politicians through their monopoly control over a unique, nationally valued local public good: safe, clean streets in our nation’s capital. The city got a federal bailout estimated to be worth an additional $600 million per year in federal government assistance. Local politicians, however, lost policy control over impor- tant public services to a federally appointed control board.38
Today, U.S. state governments continue to follow a no-bailout policy when confronted with local defaults, again with only one important exception: Camden. For the New York City, Philadelphia, Bridgeport, Miami, and Orange County defaults, no new state monies were pro- vided to repay bondholders or supplement local tax revenues. At the time of default, the debts of each locality were widely held, and city services provided only local benefits—thus, Yi0. The median-income household in New York City, Philadelphia, and Orange County earned
as much as or more than the state’s median household—thus, vi0 for these cities. The typical resident of Bridgeport and Miami was poorer than their state’s median household, but the earnings gap of 30 percent was apparently not sufficient to warrant significant state fiscal relief.
What the states did offer were loan guarantees to allow the city access to short-term borrowing (New York, Philadelphia, Bridgeport, Miami), accelerated grants payments in return for lower future payments (New York City), or permission to spend already allocated state capital grants on current services (Orange County). New Jersey’s bailout of Camden has been the one exception to the rule. The median Camden resident earns only the national poverty level for a family of four ($17,000), earn- ings that are about 40 percent of what the median New Jersey house- hold earns. The city’s crime rate is the highest in the state, and the public schools are the worst performing. Poor city residents cannot afford to exit to any neighboring community. The state has responded with new monies sufficient to fund fully the city’s debts and most of city services for the foreseeable future, largely motivated by a desire to ensure minimal public services to the city’s residents and children.39
A primary lesson from this fiscal history is that central governments can resist the political and economic need for local government bailouts if the appropriate market and fiscal institutions are in place to mini- mize economic spillovers (Yi 0) and adverse distributional conse- quences (vi 0) from a local government default. The required institutions include a mature national banking system or diversified holdings of local public debt, integrated national capital markets, and a system of centrally financed taxes and transfers targeted to deserv- ing poor households. Only in the recent cases of Washington, D.C. and Camden is there any evidence of significant bailouts. Both bailouts can be rationalized as a failure to establish the needed market or fiscal insti- tutions. In the case of Washington, D.C. local officials exploited their monopoly control over an important national public good: a safe, clean national capital. In the case of Camden, local officials successfully exploited the redistributive preferences of the state’s relatively wealthy median income household. When appropriate market and fiscal insti- tutions are in place, however, central government bailouts can be prevented.
Lesson 4: A Constitutional Bankruptcy Standard Requiring Local