The States and Too Big to Fail

Bloomberg reports:

U.S. House members are returning to Washington from summer recess to act on a $26 billion plan to aid cash-strapped state governments.

The U.S. government has a long history (see pp. 57-60) of refusing to bailout profligate state governments. It dates all the way back to the 1840s when eight state governments (and one territory) came to Congress with hats in hand: Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, Pennsylvania, and the territory of Florida all wanted a federal bailout of their debts. Representatives from fiscally responsible states would have none of it and an important precedent was established. There have been no state defaults since.

Today’s action is not a full state bailout (as far as I know, none of the states are threatening bankruptcy just yet), but the federal assertion that the states are too big to fail does mean that they will face a significantly softer budget constraint tomorrow than they did yesterday. That is: the states have a weaker incentive to be fiscally responsible.

How might we expect the states to behave in this post-bailout world? 

In recent research, Alexander Fink and Thomas Stratmann of George Mason University shed some light on the question. It would be nice to just compare the performance of states that receive federal aid with that of states that do not. But the states that receive federal aid are not random. In all likelihood, they are probably mismanaged to begin with (or perhaps poorer to begin with). In any case, a simple analysis of those that receive aid may not tell us much about the bailout effect itself.

Fink and Stratmann untangle this causal relationship, however, with a clever technique. They look at the German upper chamber, where different states enjoy different levels of political influence. Because political influence makes a state more likely to receive a bailout and because it is unrelated to the states’ underlying fiscal management, this allows Fink and Stratmann to test for the impact of the bailout without accidentally picking up other influences. What do they find?

States with a softer budget constraint [i.e., greater expectation that the German national government will bail them out], have higher deficits and debts and receive more bailout funds.

Furthermore:

The larger the expectation of a bailout, the higher the amount spent in a number of spending categories, and special interests are most likely to benefit from this additional spending. We also find that bailout expectations lead to less efficient state government service provision. 

One wonders if Congress is doing the states any favors.

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