Could California Really Default?
After Standard & Poor's downgraded California's bond rating yet again earlier this month, Gov. Arnold Schwarzenegger and members of his administration sounded practically schizophrenic, on the one hand warning the legislature that the state had to get its fiscal house in order while simultaneously deriding the notion that California would ever fail to pay its obligations.
The ever-colorful Terminator had the harshest message for the bond market: How could you rate the state's bonds as no better than some African nation's? Echoing the remarks of the state's treasurer, who said last year that nothing short of nuclear war would prompt the state to default, Schwarzenegger pointed out in the Wall Street Journal that the state "has never, ever defaulted on its debts." Defenders of the state even opined that some of the budgetary criticism of it was unwarranted and politically motivated, not based on economic and fiscal reality.
Watching all of this unfold, I couldn't help thinking how little some of us have learned in the last few years, and I wondered whether investors were taken in by these assurances. What struck me in particular was the extent to which the Governor's bluster, his treasurer's assurances, and the defenders of California ignored the complex nature of government finance and the way that municipal defaults unfold when they do occur. There may be good reasons why California won't default, but neither the state nor its defenders are addressing them sufficiently.
Let's start with this simple, broad observation that if there is one thing that we should all have learned in the last few years, it is to be extremely skeptical of any salesmen of financial products (this includes state officials hawking and defending munis) who assure us that because something has never happened before it will never happen. Our entire financial system was brought to its knees by underwriters and salesmen on Wall Street, by sophisticated investors around the world, and government regulators who all averred that there were sufficient protections against systemic risk simply because the system had never melted down in the precise way that it ultimately did. Amid such assurances it was easy for the supporters of Fannie Mae and Freddie Mac to scoff at the notion that either could fail because they had never failed, and scandalously easy for their supporters to dismiss criticisms of these institutions as politically motivated, just as California supporters now dismiss worries about its credit rating as partisan politics.
If there is something else investors have learned the hard way, it is that protections, including "insurance," are only as good as the entity or entities backing them. As part of their assurances to investors, California's officials argue that there are protections in the state's constitutions and covenants which make bondholders among the first to be paid in any financial crisis. The cynic in me wonders if these covenants are as solid as, say, the senior position that General Motors' bondholders thought they had before the federal government sent them to the back of the line when it bailed out the giant auto maker and in one fell swoop upset decades of bankruptcy precedents.
But there is a more important point here, which is that assurances to bondholders about their place in the pecking order ignore the reality of how municipal default can unfold over time, especially when politicians seem unwilling or unable to fix their government's fiscal woes. To understand what I mean it's worth looking at the whopping New York City default in the mid-1970s. Like California, New York spent years building up a spending regime that went beyond its resources, built on locked-in costs like employee pensions and municipal debt obligations that are not so easily cut or deferred, and which ultimately left city leaders with the politically unpopular choice of cutting services sharply or reneging on their other obligations.
Like California, New York addressed these problems initially by rolling them over into future years with accounting gimmicks and mounting borrowing that did nothing to fix the underlying, structural nature of the problem. When the end came, it was not because the city could not meet some single big debt payment. Rather, it was when officials recognized that enough investors had fled the city's debt instruments that New York could no longer float even short-term financing notes, the sort of borrowing that many governments engage in to smooth over the cycles in tax collections and other revenue streams that make paying bills tough.
One reason these investors had fled new issues, of course, is because munis are supposed to be conservative investments that offer only a modest return to their holders in exchange for being able to sleep peacefully at night. A loss of confidence in this market doesn't occur quickly but is a long-term process, and politicians can exacerbate the uncertainty when their rhetoric becomes more and more bombastic and their assurances steadily more unrealistic, something that's now becoming commonplace among California officials.
After this latest downgrade, for instance, one argument advanced by the state's officials is that it would never stiff bondholders because they are (by the very nature of tax-exempt investments) California residents. This argument is so politically naïve that any savvy investor should see right through it. For one thing, when a budget crunch gets so severe that bondholders start to worry about their investments, it usually means that politicians are facing the choice between paying off a government's senior obligations and cutting services to the bone. Yes, the state's bondholders might be citizens, but under budget duress they will inevitably be characterized (rightly or wrongly) as rich citizens whose demands for payment are being made at the expense of those getting their programs and services cut.
Investors also can't be reassured by the actions and pronouncements of Schwarzenegger who, even as he browbeats the legislature for not acting responsibly, is looking desperately for a bailout from the feds. He's even resurrected the tired, specious argument that California deserves a handout because it sends more money to Washington than it gets in return, a claim advanced for years by so-called balance of payments studies that the late Senator Daniel Patrick Moynihan sponsored.
But even Moynihan realized after years of analyzing this problem that the biggest cause of the deficit between some states and Washington was not federal spending, but taxation. Californians (and residents of other states with such a deficit like New York) pay so much more to the feds in taxes than their states get back in spending because our progressive system of taxation taps more of their incomes. And as Moynihan came to understand, those states that sent more to Washington were in large part responsible for creating and maintaining the very system of taxation that fleeced them. After all, Californians voted strongly for President Obama, whose next budget will sharply raise the country's two top income tax rates, thereby further exacerbating the balance of payments deficit between California and Washington. Sorry, Arnold, but you don't get to complain about a system your voters have been instrumental in perpetuating.
Of course, what the Governor wants is not lower federal taxes but more money coming this way from Washington. And yet, there is absolutely no basis for the rest of us to assume that a state which has acted irresponsibly with its own money will be any more responsible with more of it from Washington.
Still, Arnold's hectoring is certainly going to make things uncomfortable for the Obama administration, which has lots of political allies in California and will come under further pressure to bail out the Golden State. The problem for the administration is that it senses that anger everywhere else is rising against California, which is viewed as the author of its own problems, even as New York City was of its.
No doubt Washington will first try to help surreptitiously, as it did last year when it granted states the right to issue federally subsidized, taxable Build America Bonds, which my colleague Nicole Gelinas called a "backdoor bailout" of California because the state rushed out so much debt under the program. As Nicole explained about this flood of taxable federally backed paper from the Golden State, "If California's usual debt purchasers - tax-exempt investors - are saturated, maybe that's a sign that the state should dial back on its borrowing. Instead, the feds have given it an end-run around normal market signals," which California gladly took advantage of.
California legislators might make a better case for more federal aid if they showed some progress in solving their long-term structural problems by trimming public pensions (including their own) back to levels more consistent with the private sector, by attempting to resurrect parts of their private economy smothered by special interests (like the formerly glorious agricultural economy of the Central Valley being destroyed by environmental extremism), and by seeking to refocus some of the state's enormous government spending on infrastructure projects that secure the future, as the state once did.
Or legislators could continue kissing off the problem and allow us to test the notion of whether our biggest state could, in fact, ever default.