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The State of Illinois incurred deficits reaching nearly $15 billion in 2017, and those deficits are projected to double to $30 billion in 2018. Illinois has also accumulated hundreds of billions in unfunded liabilities in public sector pension and health-care plans. This has exposed local jurisdictions to the risk of default or bankruptcy. In response, Illinois has issued large bailouts, further weakening the finances of the state’s government. The courts have exacerbated this problem by ruling the Illinois Constitution mandates state bailouts for public sector pension and health plans.
Fiscal rules in Illinois have been ineffective in constraining deficits and debt. Illinois, like 48 other states, has a balanced budget provision in its state constitution. But, in recent years, the state legislature has failed to pass a budget at all — let alone one that would balance revenues and expenditures.
In April 2018, a constitutional amendment to cap the rate of growth in spending at the rate of growth in the state economy was introduced in Illinois’ legislature. A majority of Illinois state legislators have yet to show support for such a fiscal rule.
We question whether any fiscal rules could be effective in constraining deficits and debt in a failed state such as Illinois. The expectation is that the State of Illinois will continue to be dependent on federal bailouts, and local jurisdictions will continue to rely on state bailouts. The genesis of these expectations is found in the federal bailouts received during the 2008 financial crisis.
During the financial crisis, the federal government transferred hundreds of billions of dollars in direct and indirect aid to state and local governments. Much of this fiscal stimulus was off-budget. For example, the federal government subsidized debt issued by state governments as Build America Bonds (BABs). States issuing these bonds received a direct federal subsidy of 35 percent of their interest payment. State governments issued nearly $250 billion in BAB bonds in 2009 and 2010. This allowed the total debt issued by state and local governments to grow during the financial crisis.
A disproportionate share of this bailout money flowed to heavily indebted states, such as Illinois. Illinois made extensive use of federally subsidized debt in the form of BAB bonds. The direct impact of federal subsidies for bonds in Illinois was a sharp increase in deficits in 2009 and 2010, boosting total bonds outstanding to $25 billion. It should come as no surprise that these states have powerful public-sector unions lobbying for increased spending, even when that spending is financed with debt.
The national government’s bailout of state and local governments created even greater dependence on the federal government. Illinois is the worst-rated state in the municipal bond market, but many other states are also incurring unsustainable debt loads and unfunded liabilities in pension and health benefit programs for public employees. Perhaps most ominous is the legislation now pending in California that would shift liabilities of local governments and school districts to the state government.
These heavily indebted states seem to be in a race toward insolvency.
The federal bailout of state and local governments has had disincentive effects, too, similar to those accompanying bailouts in the financial industry. Anticipating bailouts, municipal governments have fewer incentives to impose effective fiscal rules or to pursue prudent fiscal policies. Banks and financial institutions continue to extend loans to failed states, anticipating that they will be bailed out by the federal government. When state and local governments receive bailouts, credit-rating agencies lump them together rather than assessing the riskiness of each jurisdiction in issuing debt. The inefficiency and misallocation of lending weakens the public finances of all jurisdictions participating in the bailout.
Earlier in U.S. history, bankruptcy law and a “no bailout” principle created the proper incentives for state and local governments. Bankruptcy laws provide for an orderly settlement of debts, and insolvency laws provide for a renegotiation of debts and unfunded liabilities. But states rarely file for bankruptcy; the last state to do so was Arkansas in the 1930s. Currently, federal bankruptcy law applies to local jurisdictions but not to states, and in states such as Illinois, municipal bankruptcy laws have been seriously weakened.
The failure of Illinois to address its growing debt crisis is often attributed to a divided legislature and gridlock in the budget process. But the more fundamental flaws responsible for the crisis are the absence of bankruptcy laws and no-bailout rules as well as a growing dependence of both the state and local governments on federal transfers and bailouts.
It has taken Illinois’ state and local governments half a century to accumulate unsustainable levels of debt and unfunded liabilities. Today, it is virtually inconceivable the elected officials in Illinois will be able to meet these financial obligations. Illinois cannot reverse 50 years of deterioration in dynamic credence capital by simply proposing a spending cap that will never be enacted, let alone be enforced.
Unfortunately, the best hope for a failed state such as Illinois is to let the state go bankrupt. With bankruptcy and a no-bailout rule in place, elected officials would again have an incentive to enact effective fiscal rules and pursue sustainable fiscal policy. Whether or not the judicial system could strengthen bankruptcy law and enact a no-bailout principle is an open question.
[Originally Posted at RealClearPolicy.com]