California gubernatorial adviser David Crane's remarks (see below, Financial Markets Won't Fix Pensions) give us the straightforward approach to the inter-relationship between state debt, pensions and other obligations, which I call the 'first dollar' argument (that is, that bond covenants require states and municipalities to hand over to bondholders the first dollar in tax revenues, making defaults unlikely). However, I can't help thinking this view ignores how debt crises actually occur. They are not simply fiscal problems, but fiscal and political problems that often result from a loss of confidence by investors long before a government actually reaches the point that it runs out of money to pay bondholders. That loss of confidence can produce a cascading series of events that makes default more likely even when tax revenues are adequate to pay off bondholders.
Crane, for instance, talks about how rising pension and benefits costs will likely force steep cuts in vital services long before a state like California defaults on its debt. But if you look at the turmoil caused by sovereign credit crises (and our states are sovereign entities for the purpose of their debt), at some point steep cutbacks in services (or even the prospect of cutbacks) produce a tremendous political reaction that begins a momentum in favor of requiring that debt holders take a haircut too, in order that they share in the pain. It doesn't help bondholders that they are perceived as 'wealthy' individuals or (even worse) big financial institutions who are being paid back in full at the expense of poorer constituencies who are seeing their benefits and services reduced.
If you accept the notion of the item below on Gov.Kulongoski that state governments are in for a big 'reset' because their budgets are structurally out of balance, California's failure to produce any meaningful budget reform means it has little to rely on but tax increases and further budget cutbacks to keep paying its bills. How long will that go on? Gov. Arnold has already gone back to the state legislature looking to cut several billion dollars out of the current state budget (less than two months after it was passed) because of the state's fiscal situation, and the governor is targeting further cuts in services. How many more mid-year fiscal adjustments will the state be forced to make this fiscal year, and what are the options beyond continuing to cut services?
I think Crane also ignores the interplay between state and municipal finances, which is so important a part of the fiscal landscape of states. As states come under fiscal pressure, they not only cut back on services, they cut aid to localities, increasing the budget problems at the municipal level. At the same time, quasi state agencies which have issued debt backed by specific revenue sources also get into trouble in a sustained difficult economic environment.
It's very likely that a state debt crisis could begin at the municipal level, where a large number of localities find themselves in extreme fiscal distress. A few key municipal defaults in a state will prompt investors to run for the hills, not just for the paper from those municipalities, but from issuers throughout the state. Let's remember, for instance, that New York City's fiscal crisis began when a quasi government state agency, the Urban Development Corp., defaulted on its debt, which prompted investors, who were well aware of the Gotham's growing debt but had continued to buy its paper, to finally say, 'no more' because now the prospect of default was no longer theoretical. Once investors stopped allowing the city to roll over its debt, it was curtains.
Municipalities are in some ways more vulnerable than a state to high employee compensation costs because their budgets are proportionally more devoted to these costs. One can envision continuing cutbacks in core services (especially public safety and education) which prompts a call for 'no more' among taxpayers of more and more California municipalities. How many will look at the example of a Vallejo, which is only now exiting bankruptcy with lower employee costs and some measure of debt relief, and wonder if that isn't for them, too? As this story notes, "Vallejo can only afford to set aside $5 million for creditors holding roughly $50 million of the city's debt." How much more of an appetite for that will investors have?
What may occur, in other words, is a more extreme version of market discipline than Crane expects. No, mere bond downgrades won't rattle investors. But a domino effect-- in which a number of different kinds of California issuers lower down the pecking order than Sacramento get into trouble with their debt--will rattle investors, who will focus on the lack of reform, including pension and benefit reform, and the unsustainable nature of budgets around the state, including in Sacramento itself.
There is a scenario, in short, where bond vigilantes may play a bigger role in reforming California pensions (and perhaps those of other states), than Crane's remarks suggest.
Crane, for instance, talks about how rising pension and benefits costs will likely force steep cuts in vital services long before a state like California defaults on its debt. But if you look at the turmoil caused by sovereign credit crises (and our states are sovereign entities for the purpose of their debt), at some point steep cutbacks in services (or even the prospect of cutbacks) produce a tremendous political reaction that begins a momentum in favor of requiring that debt holders take a haircut too, in order that they share in the pain. It doesn't help bondholders that they are perceived as 'wealthy' individuals or (even worse) big financial institutions who are being paid back in full at the expense of poorer constituencies who are seeing their benefits and services reduced.
If you accept the notion of the item below on Gov.Kulongoski that state governments are in for a big 'reset' because their budgets are structurally out of balance, California's failure to produce any meaningful budget reform means it has little to rely on but tax increases and further budget cutbacks to keep paying its bills. How long will that go on? Gov. Arnold has already gone back to the state legislature looking to cut several billion dollars out of the current state budget (less than two months after it was passed) because of the state's fiscal situation, and the governor is targeting further cuts in services. How many more mid-year fiscal adjustments will the state be forced to make this fiscal year, and what are the options beyond continuing to cut services?
I think Crane also ignores the interplay between state and municipal finances, which is so important a part of the fiscal landscape of states. As states come under fiscal pressure, they not only cut back on services, they cut aid to localities, increasing the budget problems at the municipal level. At the same time, quasi state agencies which have issued debt backed by specific revenue sources also get into trouble in a sustained difficult economic environment.
It's very likely that a state debt crisis could begin at the municipal level, where a large number of localities find themselves in extreme fiscal distress. A few key municipal defaults in a state will prompt investors to run for the hills, not just for the paper from those municipalities, but from issuers throughout the state. Let's remember, for instance, that New York City's fiscal crisis began when a quasi government state agency, the Urban Development Corp., defaulted on its debt, which prompted investors, who were well aware of the Gotham's growing debt but had continued to buy its paper, to finally say, 'no more' because now the prospect of default was no longer theoretical. Once investors stopped allowing the city to roll over its debt, it was curtains.
Municipalities are in some ways more vulnerable than a state to high employee compensation costs because their budgets are proportionally more devoted to these costs. One can envision continuing cutbacks in core services (especially public safety and education) which prompts a call for 'no more' among taxpayers of more and more California municipalities. How many will look at the example of a Vallejo, which is only now exiting bankruptcy with lower employee costs and some measure of debt relief, and wonder if that isn't for them, too? As this story notes, "Vallejo can only afford to set aside $5 million for creditors holding roughly $50 million of the city's debt." How much more of an appetite for that will investors have?
What may occur, in other words, is a more extreme version of market discipline than Crane expects. No, mere bond downgrades won't rattle investors. But a domino effect-- in which a number of different kinds of California issuers lower down the pecking order than Sacramento get into trouble with their debt--will rattle investors, who will focus on the lack of reform, including pension and benefit reform, and the unsustainable nature of budgets around the state, including in Sacramento itself.
There is a scenario, in short, where bond vigilantes may play a bigger role in reforming California pensions (and perhaps those of other states), than Crane's remarks suggest.
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