What the Federal Debt Limit Has to Do with States (and Not)

Much has been written about how a failure to reach agreement on the federal debt limit would affect the economy and global financial markets. Lately, attention has turned to state and local governments. Moody’s warns that a federal credit downgrade would immediately lower ratings for 7,000 state and local issuances and possibly affect even some gold plated aaa states. At the same time, backers of a federal balanced budget amendment point to states as an example where such rules have worked.

What’s going on? will a federal default doom state and local governments? Are states the new model of fiscal probity? State tax receipts are picking up, states and localities are still climbing out of a revenue hole created by the Great Recession. Meanwhile, federal stimulus funds have largely run out along with easy fixes like selling off assets, raiding special funds, and deferring obligations. Against this backdrop, any federal action that cuts off revenue or increases costs is not helpful.

Next, state and local governments are already feeling the brunt of “extraordinary measures” undertaken when the federal government hit its debt limit in May. Back then, the U.S. government stopped issuing State and Local Government Securities. Affectionately known as SLUGs, these securities allow state and local governments (much like mortgage holders) to refinance their debt without violating federal rules against arbitrage, or profiting from their tax-exempt bond authority.

This is a headache, although hardly the end of the world. State and local borrowers can still refinance, but they have to do it by assembling the right bundle of regular U.S. Treasuries, usually with the help of a paid financial advisor.

Now, if U.S. Treasuries were downgraded, all state and local debt refinanced in this manner would fall with it. To be sure, these bonds represent only $130 billion out of a $2.95 trillion market. However, this is small consolation for the pension funds, insurance companies, and other entities who purchased this debt once hailed as “just as safe” as U.S. Treasuries.

Of course, none of this will seem very important if we are in a double dip recession or global credit crunch. As Moody’s notes, particularly at risk would be states dependent on federal contracts or salaries paid to federal workers as well as those with more variable rate debt. But all states and cities are concerned about what will happen if tuition aid, Medicaid payments, and community development funds dry up when the federal spigot turns off.

In truth, no one knows what will happen after August 2nd. It’s not clear whether and how the federal government would “prioritize payments,” and if so where states and localities would stack up against other claimants.

What about those state balanced budget amendments? Can they point to a solution? Unfortunately, there is less here than meets the eye.

Although frequently described as binding on all states except Vermont, most of these rules are forward looking, meaning that a governor must submit or a legislature must pass a balanced budget. More serious rules prevent a state from carrying a deficit over into the next fiscal year, but even they may be evaded through accounting gimmicks. Finally, there is a concern that these rules prevent states from responding to current conditions, thereby increasing rather than reducing economic volatility.

These concerns would be paramount at the federal level. We expect the federal government to respond to economic downturns, wars, natural disasters, and so forth. States are not the federal government.

The really bitter pill for states and localities is that even an agreement that averts default on August 2nd may be harmful if it cuts non-defense discretionary spending, Medicaid, and tax preferences for muni bonds or home mortgages. Still, given the magnitudes of risks involved, a deal is better than no deal.