Will states soon begin defaulting on their debts, with further negative implications for localities and U.S. metropolitan areas?
More people are beginning to ask that question, and it's a natural one given the genuinely disturbing state budget conditions my group has been anatomizing out West in California, Arizona, and Nevada and that others have described elsewhere.
These conditions—which find states like Arizona and California contending with both massive "cyclical" and "structural" shortfalls that amount to 33 and 21 percent, respectively, of annual stable expenditures—are truly hard to conceive of. But as it happens default is becoming more thinkable.
Credit analysts think about default risks all the time, and in the third quarter of last year rated the chances of Illinois and California defaulting in the next five years at about one in five, a bit lower than the chance for Iraq and Romania but a bit higher than for Latvia and Hungary. (My colleague Jonathan Rothwell will elaborate soon).
And then there is history to consider. As Dennis Berman recently wrote in the Wall Street Journal, state defaults on debts are not only thinkable in the United States but have a specific—albeit somewhat distant—history that is not irrelevant to the present situation.
To show this Berman sets the way-back machine to the year 1841, when a now-forgotten depression pushed eight states "and a desolate territory called Florida" into full default.
What happened back then? Then, as in this decade, land values soared and states funded new expenditures on roads and canals. Then as now, it all went bust, "bringing down banks and state governments with them" as Berman writes. After that, the eight states—fearful that their action might preclude ever borrowing in Europe again—bit the bullet and began defaulting. What happened then? Investors dumped state bonds, yields on them soared, Congress refused to intervene with a bailout, and eventually the crisis eased. Most of the states eventually paid off their debts and changed their laws, as Berman writes, "to safeguard their finances" and so "make U.S. states some of the world's best credits." But even so there were lasting consequences of the episode as U.S. states would pay interest rates a percentage point higher than Canadian issuers for the rest of the 19th century.
So, will it happen again? The problems in a California or Illinois or Michigan are so enormous that journalists have begun asking the question while some budget watchers have been debating default or bankruptcy. Nevertheless, when I asked our colleague Matthew Murray of the University of Tennessee, the lead author of our new paper, about state deficits, he said he found it highly unlikely that states would default at this time.
Writes Matt: “I think it is highly unlikely at this time that states would default, it would be such a calamitous event. If the economy continues to grow the states will be able to piece things together. However, it will be many, many years of fiscal adjustment bringing general fund budgets back into alignment and addressing pensions and other long-term obligations. I think the greater risk is municipal and/or special district default, but even if that takes place it will be limited rather than pervasive. All speculation on my part, but I just do not see states going down with a defaults. The states have too much to lose in terms of borrowing costs and business climate to risk a major default. And of course there are the political consequences for those who would allow default to happen. What is going on in Europe has much to do with lenders and potential lenders who are pushing up interest rates on public debt; we are not seeing a market response like that at all in the U.S., and even California can sell bonds in the current environment without paying a significant premium.”
And yet, Matt’s view is hardly complacent. Even if states manage to muddle through their current cyclical budget crisis, massive “structural” problems remain that are compounded by a pension-payment gap of another $1 trillion, according to the Pew Center on the States. Very clearly, excruciating budget finance choices will persist long after the current yawning cyclical gaps are closed. Look for the unprecedented times and the forced end of business-as-usual, with radical restructurings absolutely necessary.
One scenario recently “gamed out” at a New York conference with former Treasury Sec. Robert Rubin on the panel: The federal government helps a state make an imminent bond payment in 2013 but only in exchange for strict conditions including an oversight authority that would essentially take budget decisions out of the state’s hand.
Sounds like fun, huh?