Tied to the Mast: Connecticut Imposes a ‘Debt Brake’

Published July 12, 2018

In Homer’s Odyssey, sailors are lured to the rocky shores of an island by an irresistible siren song. To prevent his ship from succumbing to the song, Odysseus orders his sailors to fill their ears with wax and tie him to the ship’s mast.

Like Odysseus, Connecticut lawmakers are trying to prevent the ship of state from crashing into bankruptcy. Connecticut’s unfunded liabilities have reached a staggering $35 billion. Municipal governments and school districts across the Constitution State have become increasingly dependent on state bailouts.

As a harbinger of possible economic turmoil, lawmakers froze state aid to municipal governments because legislators failed to pass a budget. Due to Connecticut’s bleak fiscal status, Standard & Poor’s downgraded the state’s general obligation bonds rating, citing the state’s responsibility for the city of Hartford’s $540 million debt. A special commission on the debt crisis recommended fiscal discipline measures designed to constrain debt and put fiscal policy back on a sustainable path.

Just as Odysseus protected his sailors from the siren song rather than rely on willpower, Connecticut lawmakers are finally attempting to protect state residents from reckless government spending. State legislators issued bonds this year that include covenants imposing a “debt brake.” The newly issued bonds will provide funding for school construction projects and distribute grants to municipal governments and special districts.

Thankfully, the covenants limit state borrowing to no more than $2 billion per year. Bond authorizations may not exceed 1.6 times the amount of general tax receipts. State spending is limited to 98-100 percent of revenues and cannot grow faster than inflation. Excess reserves above the spending limit must be placed in a rainy-day fund. Moreover, the state cannot change the formula for the debt limit for five years. The debt ceiling can only be breached if the governor were to declare an emergency and three-fifths of both chambers of the state legislature were to vote to increase the cap.

The market response to this bond issue was quite remarkable. The state received orders for three times the amount of bonds issued. Oversubscription of the bonds allowed the state to negotiate lower interest rates, significantly reducing the debt service costs. The “debt brake” obligation encouraged passage of a state budget that would eliminate deficits and set aside more than half a billion dollars for the rainy-day fund.

Critics worry about a rainy day and that the state may now lack the power to bail out local jurisdictions in case of a recession or revenue shortfall. What these opponents fail to acknowledge is that state bailouts are a moral hazard. If state bailouts are available, local governments have little incentive to limit debt. This means credit rating agencies artificially inflate local government bond ratings because they anticipate state bailouts. This causes banks and financial institutions to not perform due diligence in buying the bonds because they know taxpayers will ultimately pay the price if the bonds go bust.

By imposing a “debt brake,” Connecticut is docking state debt. For the state debt to remain at bay, Connecticut must incorporate the “debt brake.” Ultimately, this will keep the state afloat because of bond market disciplinary forces. If Connecticut fails to enforce the debt ceiling and spending caps, bond rating agencies will downgrade ratings and increase interest rates, thus fueling a state debt spiral.

Connecticut may have avoided imminent municipal bankruptcy, but the real test will come in the next recession. Should this occur, municipal governments and school districts will demand more bailouts from the state. Unfortunately, the state will likely turn to the federal government for transfers and subsidies, as several states did during the Great Recession. Although no state has declared bankruptcy since the Great Depression, it is difficult to fathom how states carrying massive debt loads can stay afloat without fundamental reforms in their fiscal policy.

By tying themselves to the mast of a “debt brake,” legislators are sending a clear message that the state can no longer afford to bail out municipal governments and school districts. For the “debt brake” to be successful the state must impose a no-bailout principle and require local jurisdictions to be financially independent.

Other states and the federal government will be watching the Connecticut situation closely. If Connecticut’s fiscal discipline reforms are successful, similar debt, tax, and spending limits will likely be enacted in several states. We have argued for a Fiscal Responsibility Council and a deficit/debt brake at the national level, too. Perhaps President Trump should ask Congress to put wax in their ears and tie him to the mast of our federal deficit/debt brake reform to ensure the United States does not crash on the rocky shores of overspending.

[Originally Published at the Washington Examiner]