Moral hazard in a modern federation

Abstract

Arguments against providing fiscal aid to state governments usually rely on a simplistic moral hazard argument: supporting states through a cyclical downturn encourages them to overspend. This argument undergirds the policy recommendations made by the mainstream literature on Fiscal Federalism. I argue that these accounts are predicated on a misunderstanding of what it means to be an agent with respect to one’s budget over the business cycle. Basic corporate finance theory teaches us that in order to have control over the relative movement of income and expenditure in the current period, one must be able to design one’s own capital structure. US State governments are institutionally and constitutionally prevented from designing their own capital structures, and as such, cannot be judged to have budgetary agency across the business cycle. I show that the moral hazard problem presented in the fiscal finance literature is ill-posed, and obscures a second, more important problem of moral hazard. Namely, that politicians at the federal level reap the political rewards of pursuing austerity at the state level while remaining insulated from any political, economic, or social costs or responsibility. This second moral hazard problem admits of a simple solution: trigger-based fiscal aid to state governments.

JEL CODES:

• H7
• H77
• E62
• H39
• H61
• H63