Red States, Blue States, and Zombie States
Over the past two decades, most states have experienced debt fatigue, allowing debt to increase to levels that exposes them to default. When the ratio of debt to personal income exceeds 10 percent, states risk default on their debt. In our research we designed new fiscal rules called “debt brakes” that can constrain the growth in spending and restore sustainable levels of debt. We explore the potential impact of the debt brakes in the different states.
States have responded to the risk of default quite differently; we distinguish between red states, blue states, and Zombie states.
Red states are states that have not experienced debt fatigue. These states consistently pursue prudent fiscal policies designed to maintain sustainable debt levels. Texas, for example, has consistently pursued prudent fiscal policies. While the debt/personal income ratio has been rising in Texas, it is still well below the debt tolerance level. Some red states, such as Florida and Utah, experienced an increase in the debt/personal income ratio above the debt tolerance level, but responded with prudent fiscal policies to restore sustainable debt levels.
If red states had enacted the proposed debt brakes, this would have would have constrained the growth in spending and maintained debt/personal income ratios below the debt tolerance level over the past two decades. Enacting the debt brakes today in red states would assure that the debt/personal income ratio is maintained below the debt tolerance level in the forecast period.
Blue states are states that have experienced debt fatigue, failing to pursue the prudent fiscal policies required for sustainable debt levels. States such as Colorado and Kansas experienced a sharp increase in the debt/personal income ratio during the financial crisis in 2008, and during the coronavirus pandemic. The debt/personal income ratio increased above the debt tolerance level and is projected to continue to increase in the forecast period.
Enacting the proposed debt brakes in blue states would have constrained the growth in spending and maintained the debt/personal income ratio below the debt tolerance level over the past two decades. Enacting the debt brakes today would allow blue states to reduce and maintain the debt/personal income ratio below the debt tolerance level over the forecast period.
Zombie states are states where debt fatigue set in many years ago. These states have consistently pursed imprudent fiscal policies, resulting in unsustainable debt levels. In states such as Illinois and Connecticut, the debt/ personal income ratio has been above the debt tolerance level for two decades and is projected to continue to increase over the forecast period.
While these states also experienced a sharp increase in debt during the financial crisis and coronavirus pandemic, most of the debt is simply due to debt fatigue. Zombie states failed to respond to rising debt levels with more prudent fiscal policies. The major source of the increased debt is unfunded liabilities in state pension and other post-employment benefit plans. Politicians in Zombie states promised public employees improved benefits without paying for them.
Enacting the proposed debt brakes in Zombie states would result in more prudent fiscal policies. But, even with the debt brakes in place, the debt/personal income ratios would have remained above the debt tolerance level, exposing them to debt default. Enacting the debt brakes today would begin to reduce the debt/personal income ratio; but it would take several decades to reduce that ratio below the debt tolerance level.
Debt fatigue in Zombie states exposes them to a high risk of default on their debt. This is reflected in poor bond ratings. Illinois, for example, must now pay a significantly higher interest rate on bonds compared to other states. This is a vicious cycle in which higher interest costs contributes to unsustainable debt levels.
Zombie states have not defaulted on their bonds because of federal bailouts. During the economic shocks experienced over the past two decades, the capital markets for bonds issued by states such as Illinois shut down.
But the federal government stepped in with bailouts to rescue the Zombie states, subsidizing and guaranteeing their bonds. This year the Federal Reserve has allowed the states to designate municipal governments and public enterprises to access emergency lending directly. Without these federal bailouts, Zombie states would have defaulted on their debt.
This reliance on federal bailouts creates all the wrong incentives in the states. State and local governments anticipating federal bailouts do not have much incentive to enact more effective fiscal rules, or purse prudent fiscal policies. Credit agency rating of state bonds is distorted by this dependence on federal bailouts. Financial institutions extend credit to the states, shifting risk of default to taxpayers.
Zombie states anticipate yet another bailout when the next economic crisis hits. Like Frankenstein, they expect to be jolted back to life with an infusion of federal dollars. But this Ponzi scheme in which the federal government borrows money to bailout bankrupt state governments can’t last forever. Federal bailout of the states has helped drive federal debt to unsustainable levels.