Debtor States

By James Surowiecki*
The New Yorker, 12-4-2010

Another year, another crisis. If we spent last year worried that big banks were going to fail, the fear of the moment is that entire governments may go under. The anxieties about “sovereign debt” have been most acute in Europe, where the infelicitously named PIIGS countries—Portugal, Ireland, Italy, Greece, and Spain—have huge debt burdens, and where Greece in particular is in dire need of assistance. (It owes four hundred billion dollars, against an annual G.D.P. of around three hundred and forty billion and shrinking.) And now people are wondering if American state governments are headed for their own Greek tragedy. Last week, the Times suggested that the states could be plunged into a debt crisis, and the Wall Street Journal asked, “Who Will Default First: Greece or California?”

It’s not an outlandish question. Besides great climates and lovely beaches, California and Greece share a fondness for dysfunctional politics and feckless budgeting. While American states are typically required to balance their budgets annually, that hasn’t stopped them from amassing a pile of long-term debt by issuing municipal bonds. And, like Greece and other E.U. countries, states have used accounting legerdemain to under-report the amount they owe, even while accumulating huge, unfunded pension obligations. Just as a default by Greece (whose bonds are held by many big European banks) would have nasty ripple effects across the European economy, a state-government default would have all sorts of unpleasant consequences, as state bonds have traditionally been considered a thoroughly safe investment.

For all this, though, the comparison has been overblown. Our states’ debt burden, while sizable, is far more manageable than that of the PIIGS, which owe three times as much relative to G.D.P. as American state and local governments. And though states will certainly have to cut their budgets again this year, the cuts will be smaller (and therefore more politically palatable) than those of, say, Ireland, which is cutting government spending by almost nine per cent. Most important, the states have a fundamental advantage over euro-zone nations: they’re part of a country, not an ill-defined union, so they can count on help from the federal government.

Much of the assistance that the states get from Washington is close to automatic: in normal times, the government sends almost half a trillion dollars in aid (for everything from Medicaid to highways and education) directly to the states. And it can generally be counted on to step up its efforts in a crisis; last year’s stimulus sent more than a hundred and fifty billion dollars to state and local governments. There’s a long-standing tradition of this: one of the federal government’s first acts was to assume the debts that states had run up during the American Revolution. This meant that frugal states had to help pay the debts of profligate ones. But the assumption was that closing gaps between the states by some measure of redistribution was in the national interest. The theory is that we hang together in times of trouble lest we all end up hanging separately.

In the E.U., things are very different. For all the lip service paid to “Europe” as an entity, local interests consistently trump continental ones, as evidenced by the fact that it took Europe months to agree to help if Greece finds itself unable to finance its debts. Despite the large economic imbalances between the E.U.’s members, there are few tools for correcting them. The E.U. does have structural subsidies for weaker economies, but they’re quite small, and there is no obvious mechanism for channelling aid to countries that get in trouble. (Indeed, the E.U. constitution explicitly includes a “no bailout” clause.) Worse still, the single currency means that struggling countries like Greece and Portugal can’t devalue to boost exports and create jobs. Their only option is to slash budgets to the bone.

Countries like Greece and Ireland need to learn to live within their means, of course. But in the middle of a severe recession steep spending cuts and tax increases can be disastrous. The refusal of European countries (especially Germany) to bail out profligate neighbors, although perfectly understandable, has increased the chances that Europe as a whole will suffer a double-dip recession. In the U.S., by contrast, federal aid to the states softened the impact of the recession, allowing the economy to start growing again; while states still had to cut thirty-one billion in spending, the stimulus aid saved hundreds of thousands of jobs.

All this aid comes at a price, of course: it increases moral hazard, and it increases the national deficit. But the federal government is able to borrow money at exceptionally cheap rates, and, at a time like this, when the economy is still trying to find its feet, forcing states to cancel building projects and furlough teachers and policemen makes little economic sense. (Indeed, there’s a strong case to be made that more of the original stimulus package should have gone to state aid.) The European model would do more harm than good, as American history shows: in the early eighteen-forties, after the bursting of a credit bubble, many states found themselves in a debt crisis. The federal government refused to bail them out, and eight states defaulted—a move that cut off their access to credit and helped sink the economy deeper into depression. The U.S. did then what Europe is doing now, putting the interests of fiscally stronger states above the interests of the community as a whole. We seem to have learned our lesson. If Europe wants to be more than just Germany and a bunch of other countries, it should do the same.

*James Surowiecki has been a staff writer at The New Yorker since 2000. He writes The Financial Page.