Blue State Bailouts on the Horizon?

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Whenever we see risky and poorly thought-out ventures in the business world, the negative consequences of those ideas will usually be limited to the shareholders and investors in those companies. If a CEO makes a big gamble with a corporation’s business strategy and it blows up in her face, that’s bad news for people who invested in that company, but the rest of us aren’t generally on the hook.

The same is true even of government policies when they’re confined to a single city or state. San Francisco and Illinois may be doing some dumb stuff, but unless you live in either place, you’re probably safe. That is, unless there’s some kind of government bailout waiting for either set of actors. If the federal government is willing to step in and hand out taxpayer dollars to failing officials in cities and states, it creates just as much of a perverse incentive as when they bail out failed companies after bad investments. It just means we get more failed, reckless decision-making in the future.

Recently in The Wall Street Journal, editorial writer Allysia Finley warned that we may see a wave of blue city and blue state bailouts in the future as expensive public works projects and underfunded public employee pensions hit the skids. Finley writes:

More than a decade of near-zero [interest] rates allowed state and local governments to borrow cheaply. At the same time, the Fed’s quantitative easing inflated asset values and prompted pension funds chasing high returns to pile into riskier higher-yielding investments. Now that the music has stopped, the bills for years’ worth of monetary exuberance are coming due.

The balance-sheet risks for mismanaged states and municipalities have been hiding in plain sight just as they were at Silicon Valley Bank. Continued financial-market turmoil and a prolonged economic downturn could cause some pension funds to collapse and cities to declare bankruptcy. Taxpayers will invariably wind up on the hook for politicians’ bad financial bets.

I’ve been saying for a while that this is particularly a threat with government employee pensions in blue states. Large state pensions are leading the way when it comes to environmental, social, and governance (ESG) aligned investing. They’re eager to use the collective retirement nest eggs of millions of government workers to promote environmental policy, labor union activism, and diversity initiatives, all while, supposedly, maintaining healthy investment returns to future retirees. But it’s difficult enough to achieve the seven or eight percent return targets many pensions have set for themselves even when you’re only worrying about risk-adjusted returns. Add in an additional laundry list of progressive political goals and it becomes much more difficult. And that’s putting aside entirely the fact that many of the funds’ beneficiaries might not even agree with all of those goals in the first place.

So, if constricting a fund’s investing options by approaching allocation with an ESG lens leads to lower returns in the future, what will happen? Normally we would simply say “tough luck,” and expect the workers covered by those pensions to take the hit. At most, all of the taxpayers in a given state might be on the hook for a bailout of, for example, the state teachers union. But I suspect that when we eventually see underperforming ESG pension investments the underperformers will expect the feds – that is to say, all U.S. taxpayers – to shoulder the burden. Because in the view of ESG advocates, their investment decisions were virtuous and socially desirable. After all, they were merely following the lead of the Biden administration itself.

The argument will be that we can’t allow socially responsible investors to suffer just because their investments didn’t produce long-term profits – after all, what kind of message would that send to the socially responsible investing community? I predict that we will see investment managers and state politicians arguing that ESG-heavy pensions should get a bailout because they earned it with their good intentions. That’s not a good argument, of course, but that doesn’t mean that ESG fans won’t eventually make it. 

We also covered this topic on Episode 15 of the Free the Economy podcast. Listen here, starting at 1:01.