Tuesday, August 10, 2010

Aid to states does not create moral hazard (unless it's done terribly)

As I've pointed out before, aid to states suffering from cyclical budget shortfalls is the best kind of stimulus: by directly saving jobs that would otherwise disappear, it is more certain to improve the employment picture than any other type of spending.

Yet many very intelligent commentators—even those who do support some kind of aid to states—seem to think that we run the risk of creating moral hazard by providing the money. Tyler Cowen, for instance, advocates helping states via federalizing Medicaid on the grounds that "as a one-time change it reduces the moral hazard problems from ongoing outright grants".

I don't understand how this is supposed to work. Granted, I can imagine how aid to states done badly would create moral hazard. If the amount each state receives depends in part on its financial difficulties, then you certainly get moral hazard; states have more of an incentive to run their finances into the ground in the hope of obtaining bailout money. But aid doesn't have to work that way to be effective. During a recession as deep and prolonged as this one, virtually every state is suffering from financial problems. At the margin, aid based on a simple metric like population would do a great deal of good without creating any moral hazard at all. And indeed, the tragically underfunded State Fiscal Stabilization Fund in the 2009 stimulus allocated funds to each state based almost entirely on population: 61% on school and college-aged population (5 to 24), and 39% on total population.

You might argue that since the decision to rescue states at all is a result of poor budgetary planning by the states, there are still some perverse incentives implicit in aid. Remember, however, that providing aid to states is a national decision. A single state's irresponsibility only improves its prospects to the extent that it makes some difference in the overall level of state budgetary problems in the US. Most states are too small for this to be relevant at all. Perhaps it's a minimal issue for California or Texas, but even then it could be eliminated entirely by including a small penalty for having a higher deficit than other states. (This would, of course, diminish the efficiency of the policy a little, as states that need aid the most would receive slightly less.) It could also be eliminated by making aid automatic in future recessions, conditional on a certain level of unemployment or decline in GDP.

Perhaps the possibility that federal aid will render stabilization funds unnecessary makes states less likely to accumulate them. Note, however, that if federal aid was automatic (or even highly likely) in bad economic times, this wouldn't be an issue; federal transfers would lower the need for stabilization funds, making smaller funds efficient. Inefficiency only arises when the federal response to recessions is inconsistent—in other words, the problem is policy uncertainty, not moral hazard.

Moreover, the notion that it is politically feasible for states to amass large stabilization funds strikes me as deeply naive. I'm not very old, but I've already seen the same story again and again: during boom times, every governor cuts taxes and increases spending, appearing to be a genius in the process. Especially with term limits, there just isn't much of an incentive to build an expensive stabilization fund that might have benefits down the road—not when compared to the outsize political returns from tax cuts or benefit hikes. I've rarely seen voters display much interest in holding state politicians accountable for solvency in the distant future.

In the end, the only model where I can imagine countercyclical aid to states causing adverse consequences is not an economic model—rather, it is a model of a dysfunctional political process, where states tend to accumulate wasteful spending that can only be purged through a budget crisis. The problem with this hypothesis is that it doesn't seem to match the real world. Maybe a little fiscal pain prods legislators to cut the fat from their budgets (and as long as aid doesn't balance the budget for every state, it will deliver that pain in the most egregious cases). Today, however, we're seeing cuts like massive teacher layoffs. That doesn't seem like "fat" to me, and it is tough to imagine why a recession should change the returns to a long-term investment like public education.

Meanwhile, massive cuts in state and local government jobs are the worst possible response to a lingering recession. I can't see any argument that justifies continued inaction.

1 comment:

Darf Ferrara said...

The model of a dysfunctional political process is actually known as public choice economics. It's true that aid to states doesn't have to create moral hazard, but unless it is carefully crafted it probably will.

Another issue is that you seem to be taking it for granted that public jobs are more important than private jobs.