Build America Bonds: As Warren Buffett Suggests, a Dangerous Trap for the Feds

The Senate is currently wrangling over whether to extend the Build America Bonds program. This move is a potentially dangerous step into fiscal folly -- one that deserves a closer look than it's currently getting, though I suspect Warren Buffett is already on the case.

Build America Bonds were created as part of the stimulus package in early 2009 to reliquify the municipal bond market. Instead of making the bonds tax-free, the federal government would subsidize a portion of the interest payments made by states and localities -- a step that jump-started the market to the tune of tens of billions of dollars. The Treasury Department has wanted to do this for years because tax-free bonds cost the federal government more in lost revenues than their subsidized cousins. That's a fair argument to extend the program, but there are others against it that haven't gotten a fair hearing. (Some Republicans oppose an extension, but it's not clear they want to do much more than whack President Obama politically.) The main issue in my mind: the threat to fiscal federalism.

We have fiscal federalism -- i.e. states manage their own budgets -- for the same reason we have political federalism in this country: to ensure robust experimentation with what works and what does not. (Take a look at California to see what does not work.) Justice Louis Brandeis famously called states the "laboratories of democracy," that that is a quality that has served this country well.

For a look at what happens when the federal government starts subsididizing state and local bonds, take a look at Texas. The Lone Star State is wrangling with the feds over tax bills, and to get some leverage, the Treasury has withheld interest subsidies to Texas on the bonds. (Florida is staying away from the bond program as a result.) I have no idea who's right in this fight, but the fact is, Washington has a new weapon to use against states on fiscal matters.

States are understandably worried about that. It's not hard to imagine that Washington will have other demands in exchange for interest subsidies in the future. After all, the reason we have a nationwide drinking age of 21 is because the feds threatened to withhold highway construction money from states unless they did so. I'll bet no one thought of that when President Dwight Eisenhower came up with the idea of an interstate highway system.

But there's a reason the feds ought to think twice here as well. Richard Ciccarone, a munibond expert at McDonnell Investment Management, told me this about Build America Bonds a few months ago, and it is ringing more true now:

Once you get the federal government in th business of subsidizing debt service, you increase the pressure to provide a bailout if there is a problem. It's a small crack in the door but it is a crack that threatens federalism as we know it. It erodes the self-reliance of [state and] municipal governments. And they are bound to shift from more conservatives to more liberal spending policies.

Build America Bonds were a great idea when the economy was on the edge of a cliff. Now that the economy is back from the abyss, they are -- at the very least -- something honorable people can disagree about. If you want stimulus, there are definitely better ways.

Image from examined via Flickr Related:

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