Lending Federal Dollars to States Will Bankrupt Us All

By 07/09/2010

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Katy, bar the door—before this wacky idea gets out.

University law professors have a knack for dreaming up ever-more-far-fetched ideas, so no one should pay any attention to the latest one–except for the fact that its potential political appeal makes it downright dangerous.  Christopher Edley, dean of the law school at the University of California, Berkeley, has proposed that the U. S. government stimulate the economy by loaning money to near-bankrupt state governments.

Edley is concerned that states are “managing huge budget crises” by “cutting spending and raising taxes.” Edley, like all other Keynesian liberals, believes such responsible actions simply undermine “the federal stimulus.”

So in Edley’s world, any state that has gone on a financial bender–Illinois, California, New York, you name it—should be encouraged to borrow as much as it wants to cover those massive state bills state taxpayers don’t want to pay.

If the Edley law ever gets passed, it’ll be “happy hour” for the teachers, janitors and other school district employees collecting rising salaries and generous pensions–even while private sector workers are desperate to hang on to their jobs.  Education expenditures can continue to rise unimpeded, because everyone will be reassured that they come with no additional taxes. The state government will simply borrow the money from their friends in Washington.  Cities and towns can get in on the action as well, because nothing prevents states from passing on the borrowed money to lower levels of government.

But in the long run, Edley’s law would wreck the system of federalism we have had for the past two centuries and more.  The American federal system—with states and localities playing a strong, independent role in the governance of the country—has always had a fiscal system that has kept states and cities responsible, so they do not spend beyond their means.  For two centuries, the bond market has reminded states that interest rates rise when they, like the  Greeks, the Spanish, and the Italians, spend many more dollars than they collect in tax revenues. When states and cities can’t keep their houses in order in good times, they suffer in bad ones. Because the discipline of the bond market works so effectively, states and localities have generally had both the autonomy and the responsibility that makes for good government.

Once the federal government promises to bail out irresponsible states with federal loans, there is nothing left at the state level to keep the spenders under control. It will be no longer “tax and spend” but “spend and no tax,” a vastly more popular political slogan.

What’s worse, Congress will have no incentive to keep “loans” to states and cities from accelerating in the same way Fannie Mae loans did.  None of the Edley loans to states made by the federal government will count against the national deficit any more than Fannie Mae loans did—until the agency went belly up.

Indeed, under the Edley plan, Congress will have still another way to spend money without it ever contributing to the country’s vast annual deficits. Take Medicaid as an example of how this can work.  Congress can ask states to pay more of the Medicaid bills, then “loan” the money to the states to cover the cost. Congress is spending the money, but none of that expenditure ever appears on the federal accounts—until, of course, things grow hopelessly out of control.

Edley, of course, creates some imaginary safeguards, such as requiring loans to be promptly paid when good times return. But, of course, any future Congress can extend repayment deadlines. In the meantime, everyone can pretend, as Edley already is, that the cost to the federal government is “nothing.”  He explains, blithely, “there would be zero risk of default, and a guarantee of full repayment plus interest.”

Katy, please, please bar the door.

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