States: The New Strategic Defaulters
When we talk about a Greek default, the concern is that Greece is literally unable to pay its bills: more bonds come due than can be repaid in the current year, and nobody is willing to issue Greece new debt at an affordable interest rate. For this reason, any strategy to prevent default involves both austerity measures in Greece, to eliminate budget deficits; and loan guarantees from outside entities, which make it possible to roll over Greek debt.
Essentially, Greece faces simultaneous problems of solvency and liquidity. Greece can fix the solvency problem on its own, though not without considerable pain, by cutting spending and raising taxes. But those solvency measures will take some time to be effective, during which time outside help is needed to fix the liquidity issue.
As the bond yields of certain US states rise, especially Illinois and California, the comparisons to Greece have been obvious. But there is a key difference: state debt crises are almost entirely a matter of solvency. Because of the long-term nature of most state debts, states face little rollover risk and could even weather a complete loss of access to debt markets -- so long as they act to get their books into balance going forward.
States in fiscal turmoil have no significant need for a liquidity assist while they fix their solvency issues. In this sense, any default by a state would be a strategic default: it would reflect a decision by a state's government that default was the best option, not the only option.
Consider California, long the poster child for states in peril. As of October 2009, California had $67 billion in bonds outstanding, which is substantial: that equals roughly 4.4% of personal income in the state, compared to a national median of 2.5%. More distressingly, the state's unfunded pension and retiree health care obligations may add another half trillion in implicit debt.
But unlike Greece, California does not face a near-term need to pay these obligations or refinance them with willing lenders. The state's debt maturities are spread relatively evenly over the next 25 years, with just 17% coming due between this year and 2015. (Greek public debt is over 100% of GDP and 48% of it is due in 2015 or earlier).
There is no year in the next twenty when California will face more than $2.2 billion in debt maturities. Currently, the state is spending an affordable 0.1% of gross state product on debt interest. If lenders became unwilling to lend money to the state at an affordable rate (or at all), California could simply respond by retiring debt as it matures and issuing no new debt. This would require running a primary surplus (revenues minus non-interest spending) of just 0.2% of GSP. This is not an option for Greece.
It's true that in addition to needing to roll over long-term debt, states also rely on access to short-term borrowing markets to manage day-to-day finances. Loss of access to these markets would be an annoying hiccup.
But many states, especially Illinois, have demonstrated that there is an ugly-but-available strategy for managing short-term cash crunches without banks' help: delaying payments to vendors like Medicaid providers. A state that lost credit market access could use this strategy as a bridge to fiscal reforms that would turn the state cash flow positive, be they tax increases or spending cuts, without having to stop bond payments.
If states have the power to avoid defaults, why are the markets and pundits so nervous that they will default anyway? It's not that state lawmakers actually want to go into default. The problem is that certain incentives could push states into defaults that are fundamentally voluntary.
Ironically, states are paralyzed in part by the fact that they have several different routes to solvency. States do not face a Greek-like situation where a combination of painful spending cuts and tax increases are both necessary. They can avoid default by choosing among a menu of gap-closing measures.
In most cases, states could close their fiscal gaps with no tax increases at all, though the necessary spending-side changes might be painful. They also have options that are heavy on tax increases. Any of these options is preferable to default -- but there are good reasons to strongly prefer some over others.
In some states conservative legislators have blocked tax increases in favor of plans that borrow to delay closing fiscal gaps -- because they believe they can get a better deal closer to the crisis, that closes the gap entirely on the spending side. Similarly, public employee unions and their legislative allies have refused to give up generous wages and benefits, even though they cannot currently win support for the tax increases that would pay for them. They believe if they hold the line the state will eventually find the money somewhere.
This doesn't describe every state. But in some states (including Illinois and California) the Left and Right are playing a game of fiscal chicken, believing the other side will blink when the state gets to the fiscal brink.
And while these groups are playing a game against each other, they are also effectively colluding against the federal government. If the federal government will bail out a state that defaults on its bonds, then default may be a good fiscal strategy: it allows the state to engage in spending that will ultimately be paid for by taxpayers elsewhere.
The oddest part of this is that states are not legally allowed to go bankrupt. If states stop paying their bondholders, they will be sued in federal court and lose -- which should serve as a significant disincentive to default (and provide reassurance to lenders). However, a state default without bankruptcy would have unacceptable political and financial ramifications that could lead the feds to step in and make bondholders whole.
To stamp out this moral hazard, the federal government should act now to foster the expectation that it will not bail out failed states. One option would be to pass a law stating that the federal government will not assume state debts or lend money to states directly. This would include barring the Federal Reserve from buying state bonds.
Another, potentially more potent option would be to enact a law that would deprive any state that is in arrears on its bond payments of all federal grant funds -- including the federal components of Medicaid, welfare, highway and education funding. This would take bond default away from states as an option to conserve cash, as all states receive federal grants far in excess of their debt service costs.
If any state default would be a strategic default, aimed fundamentally at extracting bailout funds from the federal government, then the best defense is a change in laws to make that strategy a bad one. But the federal government will have to act before a state is actually defaulting for such a move to be effective.