Adair Turner's account of financial markets is insightful but misunderstands the role of the state in creating financial crises.
Last week (April 24), I schlepped to Virginia Tech to deliver a talk on “Our Colossal Debt Versus the Constitution,” as part of the Virginia Tech Pamplin College of Business BB&T Speakers Series on Capitalism. Previous speakers include John Allison (formerly BB&T’s Chairman and CEO, who initiated this program); James M. Buchanan; and Robert Samuelson. What I’m doing in that company and in front of a large crowd of finance guys, I don’t really know; but I greatly enjoyed the event.
The slightly abbreviated text appears below, with apologies for the inordinate length of this post. Faithful followers of this blog will find little new. But it’s a convenient summary of points made earlier on this blog and elsewhere, and maybe there’s a fresh thought here or there.
OUR COLOSSAL DEBT AND THE CONSTITUTION
The topic may strike you as odd. Debt is depressing, and it is being managed (more or less) by people who think about interest rates and trade balances, not legal rules. The Constitution, in contrast, is about moral uplift and about God, guns, and gays. What has that got to do with the public debt?
Nothing, if you listen to our public debate. Primarily, the debate is about economics—budget projections, tax rates, entitlement costs, and the Fed’s bond transactions and interest rates (the “return-free rate of risk,” as it is affectionately known). Secondarily, the debate is about politics. On one analysis, our politics and especially our parties are too ideological and divided to get a handle on the debt spiral. On a different analysis, our politics actually rests on an enormously broad and firm public consensus: let’s have a really big transfer state, and not pay for it. Either way, the debt looks yet more depressing. But you are still nowhere near the Constitution.
Still: I hope to persuade you that the topic is worth thinking about. Start at the “debt” end of the strange juxtaposition: at some level, in some setting, public debt spells the ruin of nations and the collapse of constitutions. If you doubt it, take a look at Europe’s crumbling constitutional experiment. Then, start at the “Constitution” end: this country started out under a mountain of debt. Payments on the national debt amounted to over 40 percent of federal revenues. Bond obligations, including IOUs issued to soldiers in General Washington’s army, were mostly junk. The Constitution was written to fix that problem (among others). So the intersection marks a whole range of intriguing and important questions. I intend to explore some of them.
The Debt and the Constitution
Our public debt is much, much larger than the “headline,” publicly held debt of $16-plus trillion. Add intergovernmental debts, agency debt, state and local debts, and unfunded long-term obligations for Medicare, Medicaid, and Social Security: you’re in uncharted territory. Everyone knows that the accumulation of debt is “unsustainable.” But I’d like to draw your attention to two further aspects of the picture.
First, contrary to all tenets of public finance, we aren’t racking up debt to finance war or infrastructure investment. The picture is one of debt financed consumption. We are simply borrowing from future generations.
Second, the obligations can no longer be redeemed in full: they are simply too large. We can inflate some of them away, which is a form of slow-motion default. Or, we can abrogate promises made for Medicare, Medicaid and Social Security, but that would have to be on a scale not even Paul Ryan has contemplated or proposed. There are other variations on the theme. One way or the other, though, the debts will not be paid, because they cannot be paid.
Now, the brilliant segue: does the Constitution say anything about this? One could start on a rhetorical point (actually, a pretty good one): what the Constitution’s Preamble promises future generations—“Posterity”—is “the Blessings of Liberty,” not a mountain of debt. But the Constitution has more specific things to say about debt:
Art. VI Sec. 1. All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation.
You see something similar in a provision enacted after America’s Second Founding, in 1868:
Am. XIV Sec. 4 The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.
These, obviously, were war debts. And what the provisions say is: these were our wars, and these are our debts; and we intend to pay them (except not to secessionists and slaveholders). From those constitutional commitments to consumption-driven debts we don’t intend to pay is quite a distance.
So debt was very much on the Founders’ minds. And yet, the Constitution is curiously silent on how to deal with it. For example, there is no constitutional debt limit and no balanced budget requirement. The Constitution does speak to the Founders fear that states would borrow recklessly, debase the currency, and renege on their obligations:
Art. I Sec. 10 Cl. 1. No State shall … coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in payment of Debt; [or] pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts.
As for the federal government, though, there is very little beyond this:
Art. I Sec. 8. The Congress shall have power
1. To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defense and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.
2. To borrow Money on the credit of the United States;
5. To coin Money …
This actually tells us two things about debt.
First, the power to tax American citizens directly is the central response to the Articles of Confederation, under which Congress had to requisition taxes from states. That system had produced a feckless government and a pile of unpayable debts. If you want to solve that problem, the Founders argued, you have to enhance the central government’s tax capacity. You must enable it to tax citizens directly, and that power must extend to every conceivable asset and transaction. As my kids would say, that is way harsh.
(The founders readily admitted that; but even after 225 years, their teaching doesn’t seem to sink in. You may remember the Supreme Court’s decision in the “Obamacare” cases: Congress, Chief Justice Roberts said, can tax you even for “inactivity”—your failure to buy health insurance. How can that be? Because the Constitution specifically authorizes it. The ultimate tax on inactivity—on your mere existence—is a head tax; and Article I Section 9 plainly implies that Congress may lay such taxes in proportion to the census.)
Second, the power to borrow is a legislative power. In Britain, it had belonged to the executive, with disastrous results. Here, it belongs to Congress, as we learn anew with every debate over the debt ceiling.
But that’s it. Curiously, the power to borrow, like the power to tax, comes with no substantive limit. (For good measure, that’s also true of the power to coin money: it encompasses the power to print it.) If we’re so worried about debt, and insolvency, and the easy way out (inflation, or “the rage for paper money,” as the Founders called it), why is there no substantive constitutional limit—a balanced budget requirement, for example; or financial stability criteria, of the sort you find in the European Treaties?
The short answer is that the Founders did not believe in “parchment barriers.” Constitutional limitations will work only if they are “self-enforcing,” as political economists now say—if they are embedded in a structure of separated powers that creates checks and balances and makes ambition counteract ambition.
But what exactly is it about the structure that blocks the accumulation of debt—and why does it appear to be failing us now? The question is too big for a single hour. So allow me to take a piece of it: the federal structure, and the intractable debts of state and local governments. Periodically, that $8 trillion problem shows up in the headlines: Detroit is in receivership. Stockton is in bankruptcy. Illinois and California are staring at a wall of debt and are paying contractors in scrip. About $5 trillion of the debt consists of underfunded pension and other post-employment benefit obligations. Even prosperous Virginia can balance its budget only by not funding its pension system. All that, mind you, after several years of economic recovery.
The distress may look like a distraction from the acute condition of our national accounts. Think about it, though: practically all the things you come in contact with—education, police, fire protection, transportation, health services—are provided by state and local governments. The disrepair of those institutions is a very large piece of the puzzle. It’s also a terrific illustration of our theme.
The Commitment Against Bailouts
Any federal system that couples centralized monetary and tax authority with decentralized borrowing and spending authority will have to confront moral hazard—that is, the danger that states will borrow and spend on the central government’s implied credit. The European Treaties prohibit such behavior, and they contain supposedly ironclad prohibitions against bailouts. But that has not worked very well. Parchment barriers never do, as the Founders understood.
In the end, only two principal strategies can check moral hazard: (1) “hierarchical” controls, meaning central controls on, and timely interventions in, local governments’ spending and borrowing authority; or (2) “market” controls, meaning the enforcement of fiscal discipline through the ordinary operation of private debt markets. That strategy, in turn, requires a credible commitment against central bailouts, lest state governments borrow—and creditors lend—on the central authority’s credit.
By design, our Constitution does not envision hierarchical controls: the President cannot fire a governor or remove a spendthrift legislature. So it’s down to market controls, and those will work only with a credible, firm commitment against bailouts.
Here again, one is struck by the Constitution’s deafening silence. Nothing in the Constitution establishes an anti-bailout principle. Nothing bars states from borrowing themselves into ruin (although they must pay their debts in real money), and nothing bars the federal government from paying the states’ debts, sua sponte or upon the states’ request. Thus, the stage seems set for irresponsible state bets on federal assistance. The scenario seems particularly likely because constitutional government in the United States started with a bailout—the assumption of the states’ Revolutionary War debts. And yet, a credible commitment against bailouts has historically been one of the most distinctive and salutary features of American federalism. Its force and structural origins are illustrated by the federal government’s “drop dead” stance in the first serious test between 1837 and 1843.
In the Antebellum Era, states competed aggressively in providing infrastructure (such as roads, harbors, and especially canals), often through a system of tax-free finance. State-chartered banks and internal improvement corporations sold debt instruments, very often to European investors. Those schemes sailed into trouble after a sharp deflation beginning in 1837. By 1840, banks collapsed and the bottom dropped out of the speculative land market that had supported the borrowing spree. In 1841–42, several states defaulted. British and Dutch investors pressured the United States government for intervention, arguing (probably with some justice) that they had extended funds in reliance on the credit of the United States. In 1842, the United States was entirely cut off from international credit. Charles Dickens’s Christmas Carol alludes to the debacle: Scrooge in his nightmare fears that his possessions have turned into “a mere U.S. security.”
Plans for a federal bailout surfaced as early as 1839, but they never materialized. A committee proposal for federal debt assumption was never even put to a vote in Congress. The outcome was a very happy one. Lenders at home and abroad took the losses, but the credit markets soon resumed their operation, as they always do. Many states adopted constitutional prohibitions against tax-free finance. And the government’s “drop dead” stance helped to create a firm, lasting expectation among investors and politicians that the federal government will refuse bailout demands.
What explains the resilience? It wasn’t a lack of popular demand, and it wasn’t that Congress lacked the money. (The tariff produced more revenue than Congress knew what to do with, and insolvent states would have been a fine place to park the cash.) The reasons, rather, have to do with two factors: constitutional structure, and political sectionalism.
The structural reason is the constitutional feature I mentioned earlier: the Constitution’s silence. Virtually all modern federal constitutions contain a “fiscal constitution”—that is, a mandate and a distribution formula for the distribution of federal tax receipts to subordinate governments. Our Constitution does not prohibit federal transfer payments, including payments in relief of debt. However, it does not mandate such payments, either, and it contains no distribution formula. In the 1840s, the lack of a baseline deprived debt relievers of a focal point and, hence, prevented them from bargaining toward a political consensus. The assumption debate was not about what distribution would be “fair” relative to a known baseline; it was about what the appropriate distribution baseline ought to be. Especially for an institutional system that demands considerably more than a simple majority in a single political body for purposes of legislation, that is usually too much to handle.
The severe impediment to debt relief become insurmountable when politics is driven, as it has been for much of our history, by sectionalism—that is, a divide among states that is too deep to be overcome through normal political logrolling and compromise. The antebellum divide, of course, was slavery. Everyone knew where the money for a bailout would come from: the tariff, which the South loathed. And the debate over the distribution of federal funds raised the awkward questions of whether slaves should count for that purpose (as they did then for purposes of direct taxation and for representation). There was no way of bridging the divide; and so the center held.
Transfer Payments and Public Debt
The 1837–43 experience illustrates the genius of our constitutional arrangements, and it reinforced the credibility of those arrangements. But it also suggests the contingent nature of the anti-bailout commitment, and there are reasons to doubt whether the commitment still holds.
The need to obtain concurrent majorities in two houses, plus presidential approval, will ordinarily block debt relief, especially under sectional conditions. The obstacles, however, can be overcome in times of crisis and unusual political consensus. We had two such periods in the twentieth century: the New Deal, and the Great Society of the mid-1960s. Both periods produced momentous changes in our politics and institutional architecture. Among those changes is an innovation that was virtually unheard of in the nineteenth century and a controversial rarity until the 1930s: large-scale, systematic transfers of federal funds to state and local governments. In venues from poverty relief to unemployment insurance to infrastructure, the New Deal found funding formulas and institutional techniques to overcome obstacles to transfer programs. Sectionalism remained sufficiently potent to block transfer programs in policy domains where federal involvement would have threatened the racial caste structure in the South, especially education. Those obstacles were eventually overcome in the 1960s, with the creation of federal education programs and Medicaid under the Great Society.
Transfers remained relatively modest until the early 1960s, and a large portion was devoted to the national highway program and other infrastructure investments. But with the onset of the Great Society, transfer payments exploded, to the current level of over $600 billion each year. Overwhelmingly, the new programs funded not infrastructure but services and consumption, from education to medical benefits. The single largest contributor has been Medicaid, which now accounts for over 45 percent of all federal transfer payments to states. For present purposes, let me three quick points.
First: the programs created by the New Deal and the Great Society of course had substantive policy ambitions. But they also had a strong flavor of debt relief. States were in severe distress after the Depression, and one of them defaulted. (That was Arkansas, the only state to accomplish the feat three times in our history.) But we did not bail out Arkansas; instead, we sent aid to all states. There is an important lesson here for the present: We have never bailed out individual states, and we never will. In that sense, newspaper talk about Illinois or California as “the next Greece” is misguided. However, debt relief for all states, in the guise of federal funding programs, is a very distinct and disturbing prospect; more in a moment.
Second: the dynamic of federal transfer programs is not “on and off”; it is “on and ever upward.” (The Reagan era is the only exception ever, and it proved temporary.) Let me mention two of the many intractable reasons. One, transfers produce stubborn fiscal illusions. Suppose that state taxpayers would refuse to pay $100 for some redistributive program. Then suppose that the federal government offers to chip in $50 for every $50 spent by the state on that same program: taxpayers may well support the scheme, failing to recognize that the federal government’s share is also their tax responsibility. And two, a state that declines to participate in a federal grant program would leave federal dollars—including its own citizens’ federal tax dollars—on the table. That is not going to happen. Thus, every state ends up with a level of spending that no state would adopt on its own.
The third and crucial point for our purposes is that federal transfer programs produce acute moral hazard: they prompt states to overspend in anticipation of greater federal largesse. In relatively flush times, expanding federally funded programs looks relatively cheap. In recessions, when fiscal constraints force budget cutbacks, demand for many federally funded services will tend to rise—and cuts in those services look prohibitively expensive. The more generous the program, the more expensive the cuts: it will require a two, three, or four dollar cut in Medicaid to save a single dollar in state tax revenue. State officials recognize the dire long-term consequences of federal funding. However , they rarely look beyond the next election cycle, and so they aggressively seek federal funding even if the long-term fiscal consequences are known to be ruinous.
At the same time, the programs weaken Washington’s commitment against bailouts. You no longer have to negotiate a distributional baseline: the programs already contain it. And once that problem is overcome, the system feeds on itself. Every Congressman and Senator knows that Medicaid—the most generous federal program, and therefore the program most likely to erode state budget discipline—is the principal source of the states’ budget problems. The natural response, though, is not to cut back. It is: we broke it; we own it; let’s help—especially in times of crisis. Of course, that makes the problem worse: if you give states 80 cents on the Medicaid dollar instead of 60, they’ll spend yet more on that program, not less. But that’s hard to explain, and even harder to resist.
Back to the subject: debt and the Constitution’s federalism. The “ debt” part is the $5 trillion in pension and health benefit obligations. There’s no doubt that those debts have been fueled by federal transfer payments. Teachers, administrators, nurses, college and (yes) law school professors, and other public professions owe their numbers and their sometimes extravagant benefits to federally incentivized programs. States operate under balanced budget provisions and the watchful eyes of the bond markets, so they can’t run large deficits. But they can hide the true costs by underfunding their pension and benefit programs, and that is what they have done. Those debts can’t be paid, regardless of what the economy does and what reforms particular states may undertake. Illinois’ pension funds will go insolvent in 2016; New Jersey and California are close behind.
The constitutional questions aren’t far behind, either. For example, legal scholars are debating whether we could put an insolvent state through a bankruptcy proceeding. But the larger constitutional question is the one I suggested earlier: is the precommitment against bailouts still credible—or will the next financial crisis bring us a European scenario of sovereign bailouts?
The bond markets don’t seem to think so. The spreads between state bonds are very considerable, and they widen in crisis times. (There is actually a negative contagion effect: when California’s borrowing costs go up, Virginia’s go down.) That would not happen if creditors were gambling on a federal bailout. And at some level, the muni markets are right: there won’t be any direct bailouts.
In part, that has to do with a piece of good fortune—the decentralized nature of the debt market. When sovereign debts are owed to and leveraged by big, “systemically important” financial institutions, no central government can credibly commit to a no-bailout policy. This, in a nutshell, has been the problem for the E.U., where sovereign debt is mostly held by big banks. Should one of them go under, it might take the entire financial system along for a brutal ride. If California had a bank that loaded up on the state’s debt and then leveraged it, the United States might in fact be in Europe’s position. Mercifully, however, only one of the United States (North Dakota) has a state bank, and U.S. state and municipal obligations are overwhelmingly owed to individual bondholders and bond funds. If those debts go bad, bondholders and retirees—and probably some funds with big bets on the wrong side of the market—will have to take a haircut. That would be unfortunate, but it would not threaten the financial system. So the central government can keep lenders guessing.
In other part, the precommitment lasts on account of the structural constitutional features I have mentioned. There is simply no way for the federal government to re-capitalize and restructure individual states. Debt relief would have to be global, and even that remains difficult.
Or does it?
Federal transfers drive state overspending, which prompts debt relief under any other name, which prompts yet more state overspending. And in recent decades, the spiral has accelerated. For example, the American Recovery and Reinvestment Act (“ARRA”), better known as the 2009 “Stimulus” bill, provided some $223 billion to state and local governments. Roughly half of the amount was dedicated to program- and project-specific transfers, principally for the purpose of closing state budget gaps and of propping up the government employment market. The biggest bailout measure to date, though, is one you wouldn’t suspect: the Patient Protection Act, aka Obamacare. The act will pay cooperating states 100 percent for expanding Medicaid. In other words, cooperating states marginal costs are close to zero, and their average Medicaid cost will drop. In addition, the health care “exchanges” that are to begin operation next year will allow states to dump hundreds of thousands of employees, whose benefits are currently paid by state and local governments, into federally funded programs. This is why the states were for Obamacare before some of them were against it.
As you know, though, many states are still against the act, and are refusing to cooperate. That signals a sea change in American politics, or rather two. One, it signals a resurgence of sectional politics, on a scale we have not seen in a half-century. The non-cooperating states are “deep red,” and their resistance to Obamacare is part of a larger pattern of resistance on issues from global warming to labor policy. Our politics is reverting to its historical and constitutional norm, and that will have consequences.
Two, state governments—including those that are cooperating—no longer trust the federal government’s promises. Congress will make good on those promises with what? In the post-World War II era, escalating transfer payments were partially financed through inflation: Washington made good on its promises to states in cheaper dollars. In the 1990s, the payment stream was financed through the “peace dividend.” Since then, it has been purely debt-financed. That cannot go on.
What happens when the music stops? Who will take the haircut? I don’t know the answer. But I do know that the questions will be deeper than that. We will have to re-think the wisdom of an Executive Government that operates effectively without judicial or legislative constraint, purely by dealmaking. We will argue about a nominally independent central bank that fine-tunes not only the currency but also the stock markets, and which bankrolls a dissolute government and in the process expropriates fixed-income investors. And we will re-examine and hopefully reform a federal system that fosters fiscal illusions and excess spending at all levels of government.
In a sentence: our debts problems will become constitutional problems. They always have been.