‘The shakiness of this company is a tragedy for Rhode Island,” Governor Lincoln Chafee said Wednesday about 38 Studios. “Shakiness” was an understatement. The next day, Curt Schilling’s troubled video game studio, which the state lured from Massachusetts with a $75 million loan guarantee, abruptly laid off its entire staff.
Yet the problem isn’t just that Schilling’s company has apparently run out of cash. It’s that Rhode Island put itself in a position where the failure of one specific mid-size firm would be a tragedy for the state. Whenever any state gets into the “economic development” business — that is, handing out favors to individually selected firms — it is playing venture capitalist with taxpayer dollars. But while real venture capitalists know that many investments fail, Rhode Island doesn’t appear to have planned for anything other than success.
Rhode Island compounded this error in a couple of ways. The 38 Studios investment dwarfed everything else in the state’s economic development portfolio — indeed, the state expanded a $50 million economic development fund to $125 million in order to be able to do the deal — meaning a failure would be a major burden for taxpayers.
And the state’s Economic Development Corporation, which oversaw the deal, appears to have been asleep. As state Treasurer Gina Raimondo pointed out, companies don’t run out of money overnight. How was there no advance warning that this was coming?
Regardless, the state has now left itself with nothing but bad options. Rhode Island politicians are discussing two of them — letting 38 Studios fold and paying off the bondholders, or giving the company more money in hopes that the company will succeed if given time to finish its next game release. But a third option should be seriously considered: defaulting on the loan guarantee.
The state did not finance 38 Studios directly. Instead, bonds were issued to finance the company, and the state offered a “moral obligation” of repayment if 38 Studios went under. This moral obligation is not legally binding. If the studio folds, the state legislature will have to vote on whether to appropriate money to pay off the bondholders.
Generally, states should perform on their moral obligations. But Rhode Island’s government has more moral obligations than it can possibly service. The state still struggles under a huge unfunded public employee pension obligation, even after a major set of pension reforms last year, which will freeze cost of living adjustments for current retirees for as long as 15 years.
Surely, the state had a moral obligation to pay those pension benefits in full. If it couldn’t afford to meet that obligation, how can it afford to appropriate the nearly $100 million that it will take to pay off the 38 Studios bondholders with interest? A default will surely make it difficult for Rhode Island to issue more moral obligation bonds— but if that means no more 38 Studios-style deals, so much the better.
In the future, Rhode Island could resolve to get better at the economic development business, making more diverse investments and watching them more closely. But is there any reason to think the state would ever be good at business investing? You can see the learning curve now, with Governor Chafee and Curt Schilling publicly debating whether 38 Studios’ first release, “Kingdoms of Amalur: Reckoning,” was a flop. Chafee says it was (and that it’s a reason not to give the studio more money), while Schilling says it wasn’t. But why should the governor of Rhode Island need to have a professional opinion on which video games are hits?
Instead of fixing its economic development program, Rhode Island should get out of venture capital entirely, instead focusing on policies that improve its business climate overall. A bond default would leave nearly $100 million in extra funds to either cut taxes or improve public services in Rhode Island. Other savings can come from reforms to public-employee benefits and from eliminating other wasteful corporate welfare.
Reforms like these aren’t sexy — and they don’t allow politicians to cut a ribbon and take credit for creating a few dozen specific jobs. But they are a solid foundation for long-run economic growth, and they won’t ever leave Rhode Island dependent on the sales of one video game.
Josh Barro blogs about fiscal and economic policy for Forbes.com.