Narrator: Imagine the Governor of Illinois and the Mayor of Chicago holding a desperate joint press conference. They announce their governments are "flat broke," on the verge of defaulting on their debts. In Chicago, schools close as teachers protest massive layoffs. In the state capital, small business owners fear economic collapse. On cable news, a Texas senator declares, "Why should my constituents pay for Chicago’s mistakes?" while the President’s economic advisor warns that forcing brutal budget cuts could trigger a national depression. The Secretary of the Treasury adds that a default would shatter the bond market, halting infrastructure projects across the country. This is the impossible scenario at the heart of state and local budget crises.

In his book, In a Bad State: Responding to State and Local Budget Crises, author and law professor David Schleicher argues that this is not just a hypothetical nightmare. It is a recurring, structural problem in American governance. He reveals that when a state or city faces financial collapse, the federal government is trapped in a "trilemma," forced to choose between three conflicting goals, where achieving any two means sacrificing the third.

Narrator: At the core of Schleicher's analysis is a powerful framework he calls the fiscal federalism trilemma. When a state or city is in crisis, federal officials want to achieve three things simultaneously. First, they want to avoid the macroeconomic and social harm caused by austerity—the brutal spending cuts and tax hikes that can turn a recession into a depression. Second, they want to prevent "moral hazard," the risk that bailing out a government will encourage it and others to be fiscally irresponsible in the future. Third, they want to preserve the ability of states and cities to borrow money for crucial infrastructure projects, which requires keeping the municipal bond market stable and ensuring creditors get paid.

The problem, Schleicher argues, is that the federal government can only ever achieve two of these three goals. This forces an agonizing choice. A bailout prevents economic harm and keeps the bond market healthy, but it creates moral hazard. Forcing austerity avoids moral hazard and protects creditors, but it inflicts immense economic pain. Allowing a default also avoids moral hazard by punishing lenders, but it can cripple a government's ability to borrow for decades and potentially destabilize the entire bond market. There is no perfect answer, only a choice of which poison to drink.

Narrator: This trilemma is not a new phenomenon. Schleicher takes the reader on a historical journey to show how the federal government has swung between different responses over time. The nation’s very first major fiscal crisis set the stage. After the Revolutionary War, Alexander Hamilton famously had the federal government assume all state debts. This was a classic bailout. It stabilized the young nation's economy and strengthened its credit, allowing states to invest. However, it also created moral hazard, setting an expectation that the federal government would back state debt.

Just a few decades later, in the 1840s, the pendulum swung in the opposite direction. After a boom in canal-building fueled by reckless borrowing, eight states and the territory of Florida defaulted on their debts. This time, Congress refused to intervene. The decision was praised for instilling fiscal discipline—states subsequently wrote balanced-budget requirements into their constitutions. But the cost was severe. The defaulting states were locked out of credit markets for decades, dramatically hindering their economic development and ability to build infrastructure. These two episodes perfectly illustrate the trade-offs at the heart of the trilemma.

Narrator: Schleicher reveals that federal fiscal policy isn't just made in Congress or the White House; it has often been shaped by the Supreme Court. In the late 19th century, a wave of defaults swept across cities and counties that had issued bonds to finance the railroad boom. When local politicians, under pressure from taxpayers, tried to escape these debts, the Supreme Court intervened forcefully. In a series of aggressive rulings, the Court sided with bondholders, compelling cities to raise taxes and cut services to pay what they owed.

This judicial activism imposed painful austerity on local communities, worsening recessions. However, it also created ironclad confidence in the municipal bond market. The result was an unprecedented boom in urban infrastructure, as cities like Chicago and New York were able to borrow vast sums to build the bridges, sewers, and water systems that made them world-class metropolises. In a stunning reversal just a few years later, the Court took the opposite approach with Southern states that wanted to repudiate debts from the Reconstruction era. By creating the modern doctrine of sovereign immunity, the Court protected these states from their creditors. This provided short-term relief but, just as in the 1840s, crippled their ability to borrow and invest for generations.

Narrator: As the 20th century progressed, federal responses became more complex, moving away from all-or-nothing choices toward mixed solutions. The 1975 fiscal crisis in New York City is a prime example. Initially, President Gerald Ford refused to help, leading to the infamous headline, "Ford to City: Drop Dead." But behind the scenes, a more nuanced solution was taking shape. New York State imposed an emergency control board to enforce austerity, and it created the Municipal Assistance Corporation (MAC) to issue new bonds backed by dedicated city revenues. Bondholders were forced to accept losses. Only after the city and state had taken these painful steps did the federal government step in with conditional loans.

This "balanced" approach, combining elements of austerity, default, and a limited bailout, became a model for future crises. We see echoes of it in the 2013 bankruptcy of Detroit, where a state-appointed emergency manager imposed cuts, bondholders and pensioners took losses, and a "Grand Bargain" funded by philanthropies and the state acted as a non-federal bailout. This modern approach acknowledges the trilemma and attempts to manage it by spreading the pain, rather than letting one group bear the entire burden.

Narrator: Schleicher concludes not by picking a "correct" response to the trilemma, but by offering four principles to design better policies, no matter which path is chosen. 1. Prudence: Federal policy should encourage states and cities to prevent crises in the first place. For example, federal aid could be conditioned on states adopting more transparent accounting standards that prevent them from hiding debt through financial gimmicks. 2. Balance: Responses should mix elements of bailouts, austerity, and defaults to avoid the extreme harms of any single approach. 3. Spreading: When a regional crisis affects multiple overlapping governments—like the state of Illinois, Cook County, and the City of Chicago, which are all deeply indebted—federal tools should encourage a solution that spreads the sacrifices across all of them, rather than bailing out one while another collapses. 4. Resilience: The federal system should be strengthened against shocks. This includes reforming zoning laws to help people move from declining regions to booming ones and improving the efficiency of infrastructure spending. One of Schleicher's boldest proposals is to create a formal bankruptcy process for states, similar to the Chapter 9 process for cities, to provide an orderly way to handle an otherwise chaotic default.

Narrator: The single most important takeaway from In a Bad State is that there are no easy answers to state and local fiscal crises. The trilemma of avoiding economic harm, preventing moral hazard, and preserving investment is an iron law of fiscal federalism. Any politician who promises a painless solution is either naive or dishonest. The book's true power lies in its clear-eyed acceptance of this reality, shifting the conversation from a futile search for a perfect fix to a more practical question: How can we manage these inevitable trade-offs more intelligently and equitably?

Schleicher's work challenges us to recognize that these are not just technical debates about finance; they are deeply political and human struggles over who bears the cost of failure. When a city goes broke, will it be the taxpayers, the bondholders, or the public employees who pay the price? The book provides a vital framework for navigating these painful choices, urging policymakers to build a system that is not only more stable but also more just.