Here's the rough draft of an op-ed I'm working on:

Appearing recently on ABC’s “This Week,” Senate Minority Leader Mitch McConnell suggested that stimulus funds for the states take the form of loans rather than grants. "It will make them spend it more wisely," McConnell said. "The states that didn't need it at all wouldn't take any."

Since, alas, some sort of aid to states seems to be a foregone conclusion, Sen. McConnell’s approach may have merit. Indeed, one refinement of Sen. McConnell’s proposal—tying the interest rate on the loans to state thriftiness or lack thereof—might provide a useful antidote to state profligacy.

Many states have rapidly increased their spending in recent years. Delaware, for example, increased its spending by 21.4%, some 5.3% per year, above the rate of inflation and population growth over the 2003-2007 period. (Spending growth equal to inflation plus population growth yields constant real spending per capita.) In the same four years, my state, Georgia, increased its spending by some 10.9% (or 2.7% per year) above inflation and population growth. Other states with rapid spending increases include Hawaii, Massachusetts, and Indiana.

By contrast, some states have maintained commendable fiscal discipline in recent years. Texas and South Carolina, states with governors who have publicly stated they do not want federal aid, have both held spending growth below inflation plus population growth. Oregon, Washington, and Connecticut have even more impressive records of controlling spending. And the most fiscally conservative state over the past four years is West Virginia which decreased spending by a whopping 22.7% below inflation and population growth.

In order to avoid moral hazard—encouraging states to grow spending in anticipation that Uncle Sam will bail them out come the next cyclical downturn—aid to states should reflect states’ fiscal discipline in recent years. Sen. McConnell’s loan idea can accomplish this objective by tying states’ interest rates to their rate of spending growth.

Here’s how such a scheme might work. Interest rates could be based on five year Treasury notes which currently carry an interest rate around 2%. States that kept their spending at or below the rates of population growth and inflation could borrow at the 2%. States with more rapid spending growth would pay interest rates equal to 2% plus their rate of spending above population growth and inflation. Delaware, for example, would pay 7.3% to borrow and Georgia’s interest rate would be 4.7%.

An additional improvement over simply sending funds to states would be to tie the bailout funds--be they grants or loans--to states' adoption of meaningful tax and spending limitations. Such limits could slow increases in state spending when economic growth returns and mitigate the boom/bust cycle in state fiscal policy.

Although there would be a few details to be resolved (perhaps tweaking the interest rate formula for Louisiana and Mississippi which had large increases in spending in the aftermath of Katrina), providing state aid in the form of loans with interest rates tied to fiscal discipline ameliorates the moral hazard created by federal grants to states, rewards well managed states, and acts as a disincentive for irresponsible spending growth.

Note: The spending reduction for WV strikes me as implausibly large so I'm taking another look at the Census data.