The Moral Hazard of a State Bailout

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May 20 2009, 12:22 pm by Megan McArdle

If the government does bail out the muni bond market, how should it go about things? The initial assumption is that they'll only guarantee existing debt. Otherwise, it would be like handing the keys to the treasury to every mayor, county board, and state legislature, and telling them to go to town.

But once the treasury has bailed out a single state, there will be a strongly implied guarantee on all such debt. So you don't give them the keys to the vaults, but you do leave a window open, point out where the money's kept, and casually mention that you've given the armed guards the week off.

I don't see how the government can make a credible committment not to bail out various localities who overspend, if it's already done so. And if that's the case, there's no way to avoid the moral hazard, so we might as well go ahead and offer the explicit guarantee in exchange for some sort of say in how the money is procured and spent.

Farewell, Federalism . . . we hardly knew ye

Comments (1)

Nelson Alexander May 20, 2009 2:55 PM

We need a more comprehensive approach.

It is beginning to be clear that the total amount of the various paper claims written in dollar units on the future labor of all Americans exceeds several generations, assuming we can find something to produce and export.

Geithner, et al, are doing what bankers must do with slacking creditors. They are managing a slow, painful debt workout of the United States of America. But it is simply too piecemeal.

We need to have the bankers and financial managers get together. With a little balance sheet consolidation they can then tell us how many trillions we owe them and what sort of time frame they had in mind. Once the consolidation is done it will be more apparent that the claims are held by a reasonably small number of people. Probably about .05 percent of the population. The ones who refer to themselves publicly as "The Capital Markets." As in the old maxim, "We must restore the confidence of the Capital Markets!"

Once we can clearly see who these creditors are and how much all of us owe them, including what is owed by our children and our grandchildren, then finding solutions should be much easier.

Admittedly, the solutions might be violent and might not be what the creditors had in mind. But it would really be better for all to get this misunderstanding cleared up quickly and democratically, nicht wahr?