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Letting States Default is Very Dangerous Thinking

There’s a growing narrative that states should be allowed to default if they can’t fund their spending needs during the pandemic. Let me be very clear about this:


Get the message? Let me explain.

During the Euro crisis I explained the important difference between the European Monetary Union (EMU) and the USA. The Euro had a series of rolling crises coming out of the financial crisis and they experienced depression-like growth in many countries. Overall, their recovery was much weaker than the recovery in the USA. The primary reason for this is that the member countries in the EMU do not have access to a federal treasury that helps them remain solvent.

This is crucial to understand why the US monetary system works and Europe remains somewhat dysfunctional. In the USA the states operate balanced budget mandates over time. But state governments are not businesses, that is, they don’t engage in necessarily positive net present value operations. It’s hard to make money putting out fires and keeping the peace. So they end up being cash flow negative across long periods of time. Also, like Europe, we all use the same currency, but a bottle of wine doesn’t cost the same in Biloxi as it does in NYC. So there are inherent trade imbalances between the states. And because we all use the same currency these trade imbalances don’t work themselves out via the foreign exchange markets. So poor states can find themselves in perpetual states of imbalance versus rich states in the same way that Greece finds itself at a perpetual trade disadvantage to Germany. So someone has to step in to fill the void over time.

The states fill this fiscal void by getting federal aid. The federal government grants hundreds of billions of dollars every year to states thereby indirectly helping them to fund their overall budgets. Every state in the USA balances their budget in the long-term because the federal government’s budget is unbalanced. And the federal government can run an unbalanced budget because they leverage the enormous productive capacity of the world’s largest economy.¹

Europe doesn’t have this arrangement in place. So the countries in the EMU, which are the equivalent of states in the USA’s system, have occasionally encountered solvency issues. Eventually the European Central Bank imposed implicit backstops so the EMU didn’t experience any solvencies. But it took the Central Bank’s intervention to stop things from really spiraling out of control in Europe.

So, just to reiterate, the states need federal funding across time because the balanced budget amendment rules and trade imbalances make it difficult for them to remain solvent entirely on their own. This is a good thing! It helps the states remain somewhat disciplined when budgeting, but it also helps them avoid the risk of insolvency and the mass economic hysteria that would inevitably result. And we all benefit from a stable currency union that doesn’t have periodic blow ups.

But let’s also be clear about the unusual nature of this event. Some people keep demanding their pound of flesh from “irresponsible” individuals, corporate America, colleges and now states. I get it in the case of a large public for profit entity like an airline. But why would we voluntarily decide to stop funding public services during the pandemic? Why would we even consider making it more difficult for New York to fight the pandemic and service basic public needs? Is this the entity that deserves to be sacrificed in the name of your “free market” narrative?

Also, can we stop referring to this as a “rainy day”? This isn’t a rainy day. It’s a category 5 hurricane hitting the entire globe. And no, no one plans for a complete sudden stop in the economy so stop blaming individuals, firms and states for not having prepared for a 100 year storm.

Further, to people concerned about the free market and the economy – why would we risk a huge state like New York defaulting? If you think Lehman Bros defaulting was a problem then wait until one of the largest states in the country defaults. And for what? All because some politicians misunderstood the inherent nature of state budgeting while they extract their pound of flesh?

This is crazy talk. Just stop it. This isn’t the time for the blame game and political partisanship. If there was ever a time for the UNITED states to act united then this is it.

¹ – It’s interesting to note that blue states tend to be less dependent on federal funding than red states even though it is often red state Republicans that politicize this issue. But this really isn’t a partisan issue. ALL of the states benefit from the United aspect of the USA so let’s stop playing political games and start helping each other out.