Taxpayers Lose Most When Munis Fluctuate
Near panic in the market for municipal bonds has prompted talk of a coming Armageddon in state and local finance, with predictions of major bankruptcies and even a proposal to allow states, whose debt has been a safe haven for many investors for decades, to seek the protection of Chapter 9.
But the real losers in this game will not be traditional muni investors. That's because most big municipal issuers in America, despite their budget woes, do not face an imminent liquidity crisis of the sort that is likely to prompt massive defaults. Instead, these issuers have built up significant long-term obligations that legislators are now under increasing pressure (including pressure from the market) to deal with after having ignored them for years. The result is likely to be what I call the Illinois solution: some service cuts, moderate concessions from unions and big tax increases which politicians will justify in part by saying, ‘the market made me do it.'
Although there is little doubt that states and cities face their most serious budget crunch in decades, some of the talk about massive defaults comes from mixing up two sets of issues, namely government's short-term fiscal problems and the long-term obligations of states and municipalities, including their bond debt and pension liabilities. To say that state and municipal politicians in many places have made too many promises they probably can't keep is not the same as saying their governments are about to run out of money to pay their most essential debts tomorrow, or next week or even later this year.
One reason for this confusion is the hyperbolic way in which everyone from politicians to advocacy groups to journalists and fiscal analysts talk about budget deficits. We calculate deficits, for instance, in a way that overstates the problem by comparing tax collections to the projected growth of government spending, not to actual spending, which is less. Advocates regularly describe small cuts to programs as ‘devastating' even when the funding for these programs has grown consistently for years. They also describe services that government didn't even provide a decade ago as somehow now ‘essential.' Politicians invoke laws that mandate spending, like legislation requiring minimum levels of aid to schools or gold-standard health benefits for employees, as a reason why it's impossible to control budgets, even though state legislators have it in their power to rescind these laws. The result is a budget picture that looks dire in part because of all the things that politicians won't touch until they are utterly forced to touch them.
In government, even what looks like a liquidity crisis is often something else entirely. Over the past two years, for instance, a number of states, notably California and Illinois, have at one point or another stopped paying their bills. In the private sector, when a company starts falling behind in its payments to vendors in this way, it's an immediate red flag and often a prelude to a bankruptcy filing. But in government unpaid bills are sometimes just another budget maneuver, a way of pushing bills into the next fiscal year to make this year's budget growth appear smaller.
Faced with a cash crunch a government, especially a big government like a state, can do many things a private business can't, including forcibly raising revenues through tax hikes to avoid defaulting. And while tax hikes may damage the long-term competitiveness of the state or city, they're likely to do just fine as a source of enough short-term revenues to avoid a default.
One result of mixing up the issue of states' long-term obligations with their short-term budget deficits is to overestimate the impact that pension and bond debt has on today's budgets. California, for instance, has significant long-term government worker pension liabilities, estimated by some at a whopping $500 billion. The impact of the state's pension costs on its annual budget has grown rapidly, from less than $1 billion a decade ago to more than $4 billion today.
But California's total spending is $127 billion and its budget deficit is estimated at $25 billion, so pension debt isn't its biggest problem right now. Yes, California has to deal with these pensions obligations soon, because their annual cost is increasing rapidly and crowding out other obligations. But those costs aren't about to drive the state into insolvency imminently.
To understand this dynamic is to appreciate why the growing talk of bankruptcy for states or big city governments is so risky for taxpayers. Any bankruptcy judge looking over pension and municipal debt obligations will quickly understand that they are long-term liabilities that a government can address over time by a combination of cost savings and by devoting more revenues to paying them off every year. Maybe a bankruptcy deal would include giving bondholders and union members the proverbial fiscal haircut, but taxpayers would almost certainly be on the hook for significantly higher contributions, too.
So far, at least one governor, Chris Christie, is trying to deal with both his state's long-term obligations and its short term deficit without raising taxes. It's a worthwhile effort. But New Jersey's politicians (and voters) have dug themselves such a deep hole that there is also no quick fix. The state still has problems balancing its budget even though it is not making contributions to its pension system, which require another $3 billion a year in revenues that the state doesn't have. Illinois is in similar shape.
Of course, there's always the chance that some unanticipated, ‘black swan' event could prompt a real liquidity crisis, perhaps by further rattling the muni markets and prompting a flight from the debt of those states and municipalities that have been most irresponsible. It is perhaps because Illinois legislators finally saw how jittery the muni market was about their budget that they finally decided to act earlier this month.
But absent any such unanticipated event, the real risk right now is not to bondholders from some massive series of defaults. It is instead to taxpayers who are about to take it on the chin.