Stop profligate states before they sap the Fed

As we know, even the most ill wind blows somebody good. In the case of the coronavirus pandemic, that life-threatening disease became a life raft for states and localities that had spent themselves into deep holes of budget deficits and accumulated debt. A panicked federal government flooded states with stimulus cash (or, as I prefer to think of it, Monopoly money), which, as it turned out, was even more than many could get rid of at their wastrel worst.

This bailout, along with the long period of absurdly low interest rates engineered by the Federal Reserve, masked the immense burdens the spendthrift states have taken on and the likelihood that, like trust fund children, they will eventually seek rescuing them from their own profligacy. Note that in the past week, California’s projected 2024-25 budget deficit of $58 billion was revised upward, to $73 billion.

I have taken comfort in the past from the nation’s wisely constituted federal structure and said silent words of thanks to Oliver Ellsworth and Roger Sherman, architects of the Connecticut Compromise as the Constitution was being drafted in 1787. By establishing in Congress an upper house with equal representation for each state, that bargain erected a barrier to the plundering of the small by the large, or, as they say today, the “marginalized” states by the more populous or powerful.

It’s hard today to imagine senators from the 40 more sensibly managed states voting to take the spendthrifts off the hook for years of excess and pandering to government unions. They would be placing their constituents in the same sucker role that President Joe Biden’s student debt “forgiveness” (the correct term is “transfer”) plan would have placed those Americans into who repaid their loans.

So it has seemed safe to assume that the next time a destitute California or Illinois trots out some sophistry about a “dynamic partnership” in which the rest of the nation saves it from its own fiscal folly, the door to the vault would be barred.

Alarmingly, though, among its several precedents, the pandemic panic gave birth to a little-noticed action that could open a back door to the bailout vault. In April 2020, for the first time, the Federal Reserve announced it was willing to buy the debt of state and local governments. Among the multitude of “emergency” measures being launched at the time, the action attracted little notice. Even some of the veteran Fed watchers whom I consulted about the topic were unaware that this line had been crossed.

Previously, the central bank had been leery of venturing into local financing policy that inevitably becomes embroiled in politics. During the deep recession a decade before, the Fed chairman at the time, Ben Bernanke, had testified to Congress that “we have no expectation or intention to get involved in state and local finance.” He, or someone, could have added that the Fed’s authority to do so at all is constitutionally dubious.

Fortunately, uptake of the new facility was limited to two likely suspects: the state of Illinois and New York’s Metropolitan Transportation Authority. They borrowed a total of $6.6 billion before the window was closed at the end of 2020. But once a panhandler has been offered a meal at a back door, one can expect them to knock again.

There was some $1.2 trillion of state debt outstanding, as of 2021. Almost half was in six states, led by New York’s $170 billion and California’s $144 billion, rivaled on a per capita basis by Connecticut, Hawaii, Illinois, Massachusetts and New Jersey. Illinois already has nearly achieved junk bond ratings, but others are contending for that distinction.

These borrowings were run up to cover operating deficits and capital spending; the massively underfunded pension promises that these jurisdictions have made to their past and present employees are a separate, even less manageable problem. The day will come when, assuming a congressional bailout looks like a nonstarter, they muster their power elites and government union cronies to pressure the Fed to buy new bonds at a price the market will not pay.

The situation calls for an intervention. Congress should enact a prohibition on the Fed buying state and municipal bonds now — before the supplicants begin banging on the bank’s door.

The Fed might privately welcome the handcuffs on a “stop us before we kill again” basis. It might prove a needless precaution, but the pandemic reminded us of the virtue of vaccination. Let’s request a booster.