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Debt: The Shame of Cities and States

Saturday, October 1, 2011

A century ago, america’s states and cities faced a crisis in government. A number of commonwealths — California, New York, New Jersey, Wisconsin, and Illinois conspicuous among them — as well as cities across the land labored under the heavy weight of costly and corrupt misrule. This state of affairs was generally blamed on an unholy triple alliance of large corporations (“the trusts”) and other business interests, party bosses and machines, and compliant legislators and officials. Lincoln Steffens, the most prominent muckraking journalist of the day, scathingly described the results in influential magazine articles, gathered together in his 1906 books The Shame of the Cities and The Struggle for Self-Government.

Since then the clock of time has completed a circuit of 100 years and more, and the nation’s states and municipalities again face a crisis in government. A number of commonwealths — yes, California, New York, New Jersey, Wisconsin, and Illinois still conspicuous among them — as well as a number of counties and cities, labor under a heavy weight of debt, deficits, and future obligations. This state of affairs is generally blamed on an Iron Triangle of public employee unions, compliant governors and legislators, and a complaisant electorate.

The current crisis is the product not of contracts, graft, and patronage — the mother’s milk of early-20th-century state and local politics — but of sweetheart salary, pension, and health insurance deals secured by public employee unions: the mother’s milk of early-21st-century politics. The parlous state of American state and local government circa 1900 may properly be seen as a consequence of the in many other respects admirable rise of a democratic party politics over the course of the preceding century. The fiscal-deficit crisis of the past several years may properly be seen as a consequence of the in many other respects admirable rise of the welfare state.

Progressivism, the movement that rose in reaction to state and local malfeasance a century or so ago, was defined by the dictates of party politics; the clash of social, ideological, and economic interest groups; and the federalism of American government. It both reflected and reinforced the growing legitimacy of the administrative and social welfare state, and a rising discontent with boss-machine-party politics.

There are signs that a reaction is taking shape comparable in its scale and impact to progressivism but this time aimed at the excesses rather than the insufficiencies of American government. A hundred years ago a generation of governors undertook (with varying degrees of intensity) to combat the unsavory corporate-political machine combines of their time. Among the more conspicuous were Republicans Robert La Follette in Wisconsin, Hiram Johnson in California, Theodore Roosevelt and Charles Evans Hughes in New York, and Democratic Woodrow Wilson in New Jersey. Their counterparts today focus, with varying degrees of intensity, on the fiscal consequences of overgenerous pension and health care arrangements for public employees. Among them: Republicans Scott Walker in Wisconsin, Chris Christie in New Jersey, and Mitch Daniels in Indiana, and Democrats Jerry Brown in California and Andrew Cuomo in New York.

Insofar as they see themselves engaged in an effort to change policies that stem from an abuse of government power and threaten the well-being of the polity, they are very much the descendants of their counterparts a century and more ago. They are contesting the spend-and-tax conventional wisdom of past decades, much as their progressive equivalents took on the reigning assumptions of Gilded Age machine politics.

The crisis

The core problem is the massive, rapidly growing fiscal burden of current debt and future obligations spawned by public employee pensions and health care. It has become a touchstone public issue. In June 2011, the Hoover Institution’s David Brady and Michael McConnell convened a State and Municipal Fiscal Default Workshop, designed to subject the crisis to concentrated, expert examination. Participants included leading bankruptcy and contract law-school professors, political scientists and historians, and a number of professionals who manage state and local government finance.

The crisis stems from the rise of pension and health care provisions for public employees. In the past, these were commonly seen as fringe benefits. Today they are most often regarded as entitlements. There is a wealth of political and governmental meaning in that verbal shift.

The United States was long notable for its failure to provide such benefits for employees of any sort, private or public. They were more common in Europe, the product of old feudal and new socialist influence. As in so much modern American history, the Great Depression and the Second World War was the great divide. Widespread private-pension and health care coverage came with the war. In the decades after 1945, these provisions grew from inexpensive fringe benefits to ever more costly entitlements in the public as well as the private sector. Out of this emerged the present crisis.

The debt crisis stems from the rise of pension and health care provisions for public employees.

Social Security required the pension recipient, the employer, and the state to contribute to what was defined as a form of paid-for insurance: and hence a vested interest. Wartime wage freezes, tax breaks, and the need to woo scarce workers spurred companies to make entitlements part of their employment contracts, and postwar growth and prosperity, favorable tax breaks, and powerful unions turned them into normal  components of employment.

But private sector unions steadily shrank in size and clout during the late 20th century. By the early 2000s, only about eight percent of the private workforce was unionized. When, in the 1980s, the prevailing defined benefit pension plans began to pose a fiduciary threat, firms began to switch to defined contribution plans. The change was helped along by the creation of 401(k) pension plans, the decline of private employee unions, increasing employee mobility, and a mutual fund industry that has been called the sales force of the defined contribution revolution. And when the cost of health care rose steeply with the introduction of Medicare/Medicaid, government bore the brunt of the increase.

The public sector was another story. State and local public employee unions won collective bargaining rights in the late 1950s and early 1960s. As their membership grew to 40 percent of the public workforce, so did their political clout. Public sector union leaders, much like party bosses in an earlier time, secured benefits for their constituents and thus added to their political power.

The result was a coral-like growth of ever-sweeter employment, health care, and pension provisions, extracted from acquiescent governors and legislators in return for financial support and union members helping in elections. Some 88 percent of public sector workers still had defined benefit pensions in the first decade of the 21st century, compared to about eighteen percent in the private sector. By 2008 there was an estimated $3.35 trillion gap between the states’ resources and their pension and health care commitments. Many towns, cities, and school districts were committed to wages and benefits consuming 70 to 80 percent of their budgets. The complexity of the system, along with popular and media disinterest, contributed to the growing overhang. Then the financial collapse of late 2008 and the consequent recession turned a future threat into a current crisis.

The response

As with any major issue in American life, the polity’s response to the fiscal crisis takes a variety of forms: legal, governmental, political. The Hoover workshop focused on the default-bankruptcy option: so far, more potential than pervasive. The relevance of default and its close relation to bankruptcy are heightened by the rampant growth of current debt and future obligations, and by the specter of sovereign default looming over several European nations.

One of the workshop’s concerns was the legal status of default. Our progressive predecessors had to deal with the then-prevailing view of the Constitution as a check on the active state and a safeguard of the sanctity of contract. A strikingly similar condition exists today, and poses a question: How to deal with the contractual and other safeguards that encase public employee pension and health care entitlements?

These guarantees can claim a high degree of legal sanctity. But there is little in American law, and life, that is immune to challenge, as the dismantling of legalized racial discrimination so vividly demonstrated. Finley Peter Dunne’s progressive-era comic character Mr. Dooley observed that what looks like a stone wall to the ordinary man is an arch to the lawyer.

In Home Building & Loan Association v. Blaisdell (1934), the Supreme Court, with an opinion written by the far-from-radical Chief Justice Charles Evans Hughes, upheld a state law that delayed the enforcement of home and farm foreclosures. The Great Depression was the setting for this blow to the sanctity of contract and boost to the police power of the states, and conservatives then and since have criticized the decision. But they seem ready now to accept comparable fixes to the growing state and local fiscal crisis. The states’ police power to assure the health, safety, and welfare of the people fits more readily into the present tenor of constitutional law than does a strict interpretation of the sanctity of contract.

How to prevent default and bankruptcy figured more largely in the workshop than did their potential consequences. This reflected the historical reality that default (to say nothing of bankruptcy) by states or municipalities is a Black Swan in the annals of American public finance: notable when it happens because it happens so rarely.

The only conspicuous outbreak of state default (there is no instance of state bankruptcy) came in the 1840s, when eight commonwealths and a territory chose not to pay the interest or principal on their canal and railroad bonds. The consequence of this action was minimized by several factors. The bondholders were overwhelmingly foreign, and primarily British, which hardly added to the unpopularity of the states’ action. The Eleventh Amendment prevented foreign bondholders from suing for recovery in the federal courts. And most of the defaulting states eventually met their obligations.

The relevance of default and its close relation to bankruptcy are heightened by the rampant growth of debt and future obligations.

Nevertheless the states have been notably reluctant to have recourse to default. Why? However temporary, there are likely costs in the form of more difficult, and more expensive, access to the credit market. Modern state indebtedness is much more likely to include a substantial in-state creditor base, with consequent political pressure to avoid default. And a vastly expanded, and more activist, national government suggests that the prospect of bailout from above is commensurately greater.

While state default has not recurred since the 1840s, default by cities and thousands of other minor civil divisions is not infrequent. During the Great Depression more than 2,000 towns, counties, and cities went into default. More than fifty counties fell in arrears on debt retirement in the 1980s and 1990s. And the current perfect storm of a depressed economy and rising government obligations makes default a clear and present danger. Yet the prevailing view of the Hoover workshop participants was that the threat of default, like the threat of bankruptcy, had its chief value in its sobering impact on the interested parties: unions, employees, officials, voters.

Bankruptcy has long been a familiar feature in American commercial law. Congress passed a series of short-lived laws in the 19th century, in response to economic downturns. A more permanent federal law of bankruptcy came into being in 1898. In accord with the widespread national belief in the social utility of encouraging a new start after a setback, modern American bankruptcy law, more than in other nations, favors debtor survival and restoration over creditor recovery.

The widespread assumption was that the Eleventh Amendment, which prohibits suits against a state by citizens of different commonwealths, made state bankruptcy a constitutional nonstarter. But the Depression, and the default of so many lesser civil divisions, induced Congress to add Chapter 9, which enabled local governments to declare insolvency, to the bankruptcy code. The Supreme Court at first found this to be beyond the constitutional pale. In its late New Deal reincarnation as an enabler of rather than an obstacle to active government, it accepted a revised version of the law.

But municipal bankruptcy has been a rarely adopted way out of fiscal crisis since the Depression. In 1991, a federal court held that Bridgeport, Connecticut, had not sufficiently demonstrated its insolvency, and rejected the city’s bankruptcy filing.

Would state bankruptcy today turn out to be an effective way of getting the parties to take up compromise?

The recent bankruptcy of Vallejo, California, is notable for its uniqueness. Rob Stout, that city’s financial director at the time, reported to the workshop on his experience. Its cost ($11 million in lawyers’ fees alone) was not trivial, nor was the length and difficulty of the negotiations to secure the consent of the unions and other interested parties. Still, Stout thought it beneficial in making the parties more amenable to compromise.

Advocates of state bankruptcy fasten on this advantage, and question the widely held belief that it is unconstitutional. Federalism is not a zero-sum game, as the debate over jurisdiction in the realms of immigration and marriage demonstrate. Penn Law Professor and Hoover workshop participant David Skeel is a prominent advocate of state bankruptcy, and the idea has won the support of politicians Jeb Bush and Newt Gingrich.

The most germane historical analogue involves corporate, not personal, insolvency. This was the outburst of railroad receiverships in the late 19th century. A sixth of the nation’s railroad mileage was in receivership in 1893. The federal judges overseeing the process turned out to be not taskmasters, but benign collaborators to the stricken lines. Court-appointed receivers almost always came from the previous management, however culpable it may have been. And when railroad unions threatened to strike, the federal judges crafted a new and effective form of labor injunction.

Would state bankruptcy today turn out to be an effective way of getting the parties — public employee unions and their members, politicians, taxpayers — to give up deadlock and take up compromise? Would these judges, thrust into the sensitive role of deciding on matters of state taxation, borrowing, and spending, stir up fresh torrents of political and ideological controversy? Or would the overseeing (often elected) state judges, with their own pensions to worry about, serve the interests of their political bedfellows? And what would be the effect of a state’s bankruptcy on bond markets and the cost of its ensuing debt?

The historical record (such as it is) is not encouraging. Railroad receiverships provided rich fodder to populist and progressive critics. There is small reason to think that state bankruptcy today would have a less politically destabilizing effect.

There is a record of other ways of dealing with a budgetary-fiscal crisis. Ours is, after all, a political culture in which the desire to constrain government is as deeply embedded as the readiness to savor the goodies it can provide. Sinking funds in the 19th century were designed to limits the states’ spending capacity. State financial control boards that oversee (and check) the expenditure of municipalities might be more widely applied. Off-budget enterprises can be a way of obscuring a state’s budgetary obligations. The states’ police power can as readily be used to justify budgetary cutbacks as to justify budgetary largesse.

But as the workshop discussion wore on, it appeared that the implicit, and increasingly the explicit, bottom line was that the current crisis and its resolution fit into the classic setting of American public issues: That is, resolution lay primarily in the interplay of politics and public policy.

The Madisonian moment

The most relevant framework of the political dimension of the fiscal-budgetary crisis was provided by Founder James Madison: That public policy was best served by a broad rather than a narrow spectrum of competing interests; and that political compromises emerging from the interplay of interests and the facts on the ground was the best route to a viable resolution.

How well does the state-municipality fiscal crisis fit this framework? Surely the multitude-of-interests condition is very much present, and growing. Consider this list (far from exhaustive) of interests currently at play:

  • States versus states: e.g., Indiana and Wisconsin wooing employers from tax-upping Illinois; Arizona, Nevada, and Utah doing the same to California.
  • States versus municipalities: the recent Massachusetts Senate vote to curtail the collective bargaining power of public employee unions was due in part to the concern of legislators that the cities and towns they represented would pay for pensions and health care with teacher, police, and fireman jobs.
  • Employees versus retirees: the potential conflict between resources aimed at Medicare/Medicaid and resources aimed at salaries and pensions.
  • Private versus public workers: widespread and growing resentment by workers in the private sector, whose pensions tend to be based on the less fruitful defined contribution system, of those in the public sector, whose pensions consist overwhelmingly of the more favorable defined benefits system. This advantage is compounded by smaller or no public employee contributions compared to their private counterparts, sweetheart arrangements such as topping-up the final year’s salary on which the defined benefit pension often is based, and in some cases risibly early retirement ages.
  • Tension between the pension-holding upper half of the population and the nonpensioned lower half.
  • Taxation versus economic growth: conflict between those in the public sector and their liberal supporters, who seek the greater social welfare that relies on greater tax revenue, and those in the private sector and their business-conservative supporters, who seek the economic growth that derives from a more favorable (lower-taxed) state environment.
  • Short-term versus long-term agendas: e.g., political incumbents enamored of the benefits that the immediate distribution of benefits can bring to them, versus challengers attracted by the negative electoral effect of reduced spending on those incumbents; or the claims of current job-and-pension holders against those still on the ladder, or seeking to get on it.
  • Intrastate strife: teachers, policemen, firemen, and other public employees jousting over fixed or declining expenditure.

This Madisonian play of interests is unfolding in a variety of states and their idiosyncratic political cultures.

Illinois and Connecticut have been inclined to tackle their fiscal problems by favoring revenue enhancement (higher taxes) over supply-side management (cutting entitlements). At the beginning of 2011, Illinois Democratic Governor Pat Quinn faced a $13 billion deficit, half as large as the general fund budget. With a solidly Democratic legislature behind him, he secured a set of fixes that ranged from heavy borrowing to more casinos, and most notably a 75 percent increase in the state income tax, from 3 percent to 5.25 percent. This was followed by a budget for the new fiscal year that reduced state expenditures by a far-from-urgency-driven 1.5 percent.

The distance in time to the next election, and the fact that departing Democratic members could vote for new taxes without political cost, help explain this unusual outcome, achieved just before a new, less-Democratic-dominated legislature took office. But the game is far from over. The systemic sources of the state’s financial hole — unsustainable pension and health care commitments, a still-struggling state economy — are very much present. And there is tension between Governor Quinn and House Speaker and Illinois State Party Chair Michael J. Madigan, who is arguably the most powerful Democrat in the state and is inclined to appeal to the growing public sense that cuts in spending are inescapable.

Connecticut’s Democratic governor conjoined tax increases with substantial spending cuts and state employee union concessions on benefit cuts. But while a majority of the state’s workers approved, there was enough opposition from the unions (most notably afscme) to scotch the deal. As of mid-summer, attempts to patch up a compromise continued. The governor threatened large-scale layoffs, the unions hung tough. But the political class remained hopeful: “I just see there’s a deal there. There’s got to be a deal there,” the speaker of the House plaintively observed.

Other Democratic states march to different drummers. Andrew Cuomo of New York and Jerry Brown of California are sons of former governors, and ran similar campaigns in which their awareness of their state’s financial troubles and a readiness to take on public employees’ entitlements were front and center. Yet differences between their states’ political cultures and their political personalities have so far rendered different results.

The California story, which figured prominently in the Hoover workshop, has captured national attention. This is due to its size and importance. If any state can be said to be modern America writ small, this is it.

Illinois is the most prominent example of a state still under the sway of the old Democratic machine politics; California is least subject to that traditional template. Its politics is highly personal, driven by the media, television, and advocacy groups. Its politics is strongly influenced by those classic progressive-era instruments of direct democracy (tempered by special interests and big money): the initiative, the referendum, and the occasional recall.

In essence, California’s fiscal crisis is much like those of other states: a hard-to-support burden of pension, health care, and other commitments to public employees, combined with a strong popular resistance to revenue enhancement. Current Governor Jerry Brown, in the course of his long political career no slouch at embodying conflicting popular positions, has responded to the fiscal crisis with a mix of budgetary belt-tightening and taxation bucket-dipping. He hoped to deal with half the shortfall by budget cuts, and half by a five-year extension of a cluster of supposedly temporary taxes currently on the books. The legislature’s response was a budget bill that Brown found inadequate, and he vetoed it. That action won a round of applause from the far from Democratic-leaning Hoover workshop participants. But soon after he changed his mind, and agreed to a budget replete with the short-term stop-gaps and without the tax extensions to which he had committed himself.

Cuomo, meanwhile, came up with a balanced budget that had few gimmicks and no new taxes. Brown was unable to get needed Republican support for his initial program. Cuomo, in a state with more of the old, traditional politics, got the gop support he needed. The Wall Street Journal summed it up: “Cuomo Is Sailing and Brown Becalmed.”

There are a number of other differentiating factors. California’s deficit as a percentage of the budget is larger than New York’s; the rise and fall in its revenue intake is greater. And environmentalism has a much more conspicuous place in the Golden State than the Empire State. The bottom line is that the endless variety of political culture, economic situation, and leadership capacity makes for varying responses to the same systemic problem: deficits born of entitlement commitments that exceed revenue capacity.

There is a third category to be considered: Republican-led states. Mitch Daniels in Indiana, Chris Christie in New Jersey, Scott Walker in Wisconsin, and John Kasich in Ohio have pushed similar agendas of deficit reduction, constraints on public employee unions, and resistance to business-discouraging tax hikes. Again, their political fortunes have varied, depending on a complex mix of each state’s political culture and the governors’ political skills and opportunities. Daniels and Christie have been the most successful, Walker the most beleaguered, Kasich somewhere in between. A critical mass of willing student cannon fodder, union stridency, and a state tradition of political progressivism is by far the strongest in Wisconsin; less so in Ohio; least so in Indiana and New Jersey. New Jersey, like New York, has strong local political leaders, who have backed Cuomo and Christie in fighting rising labor costs. Indeed, Cuomo has spoken of Christie’s policies as a model.

The future: Does it work?

Muckraker lincoln steffens famously reported after a 1921 visit to the Soviet Union: “I have been over into the future, and it works.” What about the future of the fiscal/budgetary crisis engulfing so many of America’s states and cities? Will they be able to cope? If so, how? Or to put it another way: As units of government, do they still work?

One thing seems clear: None of the devices previously employed to contain state and local debt — default and bankruptcy (the major topics of the Hoover workshop), sinking funds, review boards, off-budget enterprises, judicial loosening of contract sanctity — offer the hope of a solution. Some or all might be useful; none is a panacea, or likely to be widely adopted.

The answer — if answer there be — appears, instead, to reside in the hoariest of American political realities: the Madisonian play of interests, the political equivalent of Adam Smith’s vision of social good emerging from the pursuit of private gain. And there is the no less venerable tradition of American federalism. The idea that states (and, by implication, municipalities) can, through the fecundity of their differing political cultures and socioeconomic conditions, act as the laboratories of democracy that Justice Brandeis said they were, is alive and well. Already they are showing considerable adaptability, in contrast to the rigidities of the response of the president and Congress to the national fiscal crisis. And one advantage of Madisonian politics is that time usually works for rather than against a resolution.

Is this a form of policymaking at odds with the strongly national, highly ideological governing model so favored nowadays by advocacy groups and the media? One can only hope so.

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