Feds might bail out U.S. cities and states
President Ford refused to help New York in 1975, a rejection immortalized as “drop dead.” Historically, the federal government hasn’t bailed out U.S. states and cities facing default. But the EU’s rescue of Greece and the exceptional depth of the recent recession just might change that. Two possible structures for bailouts are budget-avoiding federal guarantees and regulation-bending Federal Reserve bond purchases. Either way, politics may make rescues hard to resist.
Any such action would create huge controversy over constitutional principles of state sovereignty and responsibility. It would also create a potentially hazardous precedent. But that doesn’t make it impossible.
Sure, major direct transfers of cash to states or municipalities, beyond those in the 2009 stimulus package, would worsen federal finances and are thus unlikely. But federal guarantees of local debts would not immediately increase federal budget shortfalls. In fact, limited guarantees for non-federal infrastructure projects were considered as part of last year’s stimulus. A narrowly-defined guarantee program that extended to all states, but mostly helped a few, might avoid the political problems of directly bailing out just one state.
An alternative mechanism could be an extension of the Fed’s asset purchases to include state and municipal bonds. Currently the central bank does not have the power to do this for maturities of more than six months. But an approving Congress could remove that hurdle at a stroke, at least temporarily. That would distance the problem further from the federal budget, burying the risk in the Fed’s balance sheet — though of course it would amount to another form of money-printing, as is the case with the Fed’s existing programs to buy Treasuries and mortgage bonds.
In the end, whether decades of history are overturned may depend on the breadth of state and local financial problems. A guarantee or Fed purchase program to tackle a widespread danger of default could garner political support. Conversely, if default appeared confined to one large entity such as California — as with New York in 1975 — the politics would probably prevent any rescue. If troubled state and municipal governments are hoping they and their bond investors will get federal help, there is probably safety in numbers.