The Debt Trap, Part (2): The Unaffordable We-Don’t-Care Act

Yesterday’s post, on the seemingly unstoppable growth of federal transfer payments to state and local governments, ended on a question: what happens when both parties to the transaction, the states and the feds confront unsustainable commitments? The brilliant answer our federalism has produced: make yet more unsustainable commitments. Why?

Start with an iron law of federalism: in any federal system, junior governments will undertax, overspend, and gamble on a federal bailout. (Jonathan Rodden’s splendid book on Hamilton’s Paradox is a great introduction. If you have the stomach.) When they do, only two remedies are available to deal with the situation and, prospectively, to deter the conduct:

  • Let wayward states go bust. Historically, that’s been the American way. States defaulted in the early 1840s and again after Reconstruction; in the 1930s, Arkansas earned the singular distinction of defaulting for a third time. The feds didn’t blink.
  • Bail them out, while making the remedy so costly that potential offenders will think twice. That’s the Merkel-Schaeuble EU: drum offenders through a back-breaking austerity program and run their governments from the Reichskanzlei for a few years. That’ll teach the next guy (unless he’s French).

The dilemma of our federalism is that neither of these reponses is available. Option (1) requires a strict segregation of state and federal revenues and spending, as we did in the pre-New Deal era. Once a big federal transfer state incentivizes states to tax and spend themselves to the brink of ruin, “drop dead” ceases to be a viable political response. Option (2) is foreclosed as a constitutional matter.

Now what? For well over a decade, the dominant response has been to enact state bailouts under different names and without admitting that that’s what we are doing.

Unsurprisingly, some bailout measures were temporary responses to the financial crisis that began in 2008. For example, the federal government created Build America Bonds, effectively subsidizing some $115 billion newly issued municipal bonds at a 35 percent rate. For another example, the 2009 “Stimulus” provided hundreds of billions to state and local government for “shovel-ready” infrastructure projects and to prop up the government employment market.

The real action, however, has been under Medicaid—the biggest and most generous transfer program and, consequently, the chief contributor to the states’ fiscal woes. Under the Clinton administration, Congress enacted a childrens’ health insurance program (“CHIP”) that allowed states to re-assign Medicaid-covered children from that overburdened program into the yet-more generously funded CHIP program. Similarly, under the first Bush administration, Congress enacted a prescription drug benefit that allowed states to transfer “dual-covered” elderly’s prescription costs from Medicaid to the wholly federal Medicare program, thus producing (despite a federal “clawback” provision) substantial Medicaid savings for states. The 2009 Stimulus contained a temporary increase of the Medicaid funding formula (“FMAP”). All those de facto bailouts, however, pale in comparison to Obamacare.

  • Obamacare provides for a massive expansion of Medicaid, sweeping in some 16 million currently uninsured individuals. Under Medicaid’s current FMAP, the feds pay between 50 and 83 percent of the states’ costs. In contrast, they will pay 100 percent of the costs for the “newly enrolleds.” The ratio will gradually decline to 90 percent by 2019. Even so, Obamacare will add at most 2 or 3 percent to the Medicaid costs that the states would have incurred in any event. For most states, moreover, Obamacare means a substantial increase of the average FMAP. Texas, for example, will see its match increase from roughly 60 to 70 percent.
  • For uninsured individuals outside Medicaid’s ambit and and for small businesses, the act envisions the establishment of state-run, federally superintended “health benefit exchanges.” (In states that fail to establish such exchanges, the U.S. Department of Health and Human Services [HHS] will do so directly.) The federal government will provide substantial subsidies for insurance obtained through—but not outside—an exchange. And wouldn’t you know: states will be able to tranfer hundreds of thousands of current and former employees and the their health care expenses from state-funded programs into the exchanges (or, for some groups, into the expanded Medicaid). The magnitude of this effect will depend on HHS regulations. State politicians will lobby aggressively for transfer-facilitating rules, and HHS will be hospitable to their entreaties. It needs the states, both to provide political support for a widely unpopular statute and to make the unwieldy exchanges work as well as they will.

Obamacare isn’t a centralist assault on federalism. Rather, it doubles down on our federalism’s debilities: yet more debt-financed spending, yet more warped incentives, yet another bailout. That reckless maneuver, aided and abetted by the states (who were for Obamacare before some of them were against it), will collapse under its own weight of debts and dysfunction. To borrow a phrase: it was never “built to last,” and never meant to last. Our federalism has reached its outer limits.

Next stop, this coming Monday: Argentina.