Jamie Dimon, Chairman of JP Morgan Chase caused quite a stir in the investment community when he warned American investors should be more worried about the risk of default of the State of California than of Greece’s current debt woes. Dimon told investors at the bank’s annual meeting that, “there could be contagion” if a state the size of California, the biggest of the United States, had problems making debt repayments. “Greece itself would not be an issue for this company, nor would any other country,” said Mr. Dimon. “We don’t really foresee the European Union coming apart.” (1)
As a temporary California resident, I was aware of California’s budget shortfalls but wanted to find out why the state was in so much trouble. The latest report on the Gross Domestic Product (GDP) of the United States for the last quarter of 2009 grew by a revised second estimate of 5.9 percent. (2) Why should state and local governments have fiscal woes when the federal government is growing at such a brisk pace?
The short answer is revenue is down and expenses like unemployment compensation are up. States and local governments get revenue from state income tax on individuals and corporations, sales tax, property tax, death and gift tax, and various other licensing and transfer fees. High unemployment equals less people paying state income tax. Sales taxes are flat or growing at rates less than projected as individuals cut back on spending. Property tax collections have decreased in many markets nationwide as county tax assessors have reassessed property values to reflect the depreciation in home values. In summary, state and local governments are hurting for income in ways they never would have imagined in 2007.
The stimulus package Congress voted on a year ago to stimulate the economy has primarily gone to buoy financially troubled states. The state extensions of unemployment insurance are federally funded. Stimulus cash has allowed state governments to prevent or delay letting go public employees under their jurisdiction. As the federal funding of states dries up in 2011, the gap between obligations and revenue will widen.
The Center on Budget and Policy Priorities projects that an increasing number of states will struggle to balance their budget in 2010. The total budget shortfall for all states in the fiscal year could reach $196 billion or 29 percent of the state’s budget – the largest gap on record. Revenue gaps for 2011 will continue, leading to a combined budget shortfall of $375 billion. (3)
Boiling this scenario down to a household, imagine taking home income of $100,000 on expenses of $129,000. You need to borrow $29,000 to make ends meet. Now blow this scenario back up again to include all fifty states in aggregate and the gravity of the combined budget shortfall becomes painfully clear. After a few years of living like this, you would consider bankruptcy to remedy the situation as your total debt exceeded your total assets. State governments do not have the luxury of this option.
Media outlets in the states of Arizona, California and Illinois have cried our states will go bankrupt if we do not solve our fiscal problems. The headlines have overlooked one pertinent fact. States cannot legally file bankruptcy. Chapter 9 bankruptcy is for municipalities like Vallejo, California, which filed bankruptcy in 2008 because it could not afford its pension obligation. (4)
However, states can default on their bond obligations. In the 1841, the state of Mississippi defaulted on a bond issued on its behalf by the Planters Bank in 1833. The bonds were never paid. If one of our fifty states defaulted on its obligation in 2010, in the near term, it is unlikely the Obama administration would allow that state to stiff the bondholders. The political implications would outweigh fiscal realities and the federal life-preserver would land on the front steps of the afflicted states’ capital building.
The financial implications of default would cause the states bond rating to flirt with junk status and make the possibility of borrowing additional money prohibitively expensive. The dilemma might effectively freeze all state business but the essentials until a viable strategy is enacted. I see the miss-guided masses marching on the streets demanding their personal bailout benefits.
Defaulting on debt obligations is the nuclear option, state and local jurisdictions make up budget shortfalls by raising taxes and fees and cutting services. The majority of services we receive as citizens come from our state and local governments, not the federal government. As the revenue or income that states receive decline, the state needs to reduce the amount of money it spends. The cuts in spending may show up as layoffs or reductions in salary for state workers such as schoolteachers. Many medical and health professionals as well as state police and highway maintenance personnel are other state employees who are affected by fiscal contractions. Lower and middle-income workers are disproportionately affected when local and state municipalities cut services and raise taxes.
Shifting gears and going national, the GDP growth in large part resulted from the federal governments stimulus spending. State governments do not have the luxury of printing money through the Federal Reserve and monetizing the newly created debt as the United States Treasury Department does. The federal government creates money when a commercial bank like Goldman Sachs borrows money from the Federal Reserve at .25% and uses the money to purchase Treasury Bills paying three or four percent interest, presto change, money is created out of thin air. The resulting increase in the GDP was not a result of organic growth from expansion in the private sector but a further escalation of the federal deficit.
At the city and county level, pay and benefits consume the majority of local budgets. Bloated pensions will be the downfall for cities all over the country. Vallejo California filed bankruptcy in 2009 to get out of paying retroactive pension boosts. Bankruptcy hurts all concerned. City employees are laid off, budgets are trimmed and the hit to the cities credit rating makes borrowing money for infrastructure and building improvements much more expensive.(5) According to the Pew Center state pensions are underfunded by almost $1 trillion. (6) Can you say bailout!
The Dirty Little Secret
In the 2000’s before the Great Recession money managers in small municipalities wore many hats including managing the pension fund. Riding into town on the white horse was the investment advisor of a prominent investment bank promising returns 2 or 3 percent higher if the money manager only invested a portion of the pension fund into an exotic security backed by so-called quality mortgages. The exchange was similar to a high school aged kid telling a third grader I will give you three baseball cards for the Alex Rodriguez rookie card in your collection. The over matched third grader said three for one, of course I will trade, are you crazy? The pension manager, like the third grader, said of course, the county employees and pensioners will not believe I got them such a good deal. We all know how that exchange turned out for the pensioners and their municipal money manager.
Do not ask me how things will turn out; my crystal ball is clouded over. Things do not look brighter on the horizon. Taking positive GDP figures and letting your guard down is an act of willful ignorance or self-deception at best. Taking your financial future into your own hands is the prudent course. In this bloggers opinion, rising revenue in concert with reduction of national debt would be a good start. Everything else is smoke and mirrors.
Have a nice day!
(2) http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
(3) http://www.cbpp.org/cms/index.cfm?fa=view&id=711
(4) http://www.iddmagazine.com/news/189081-1.html
(5) http://money.cnn.com/2008/06/02/pf/retirement/vallejo.moneymag/index.htm
Credit This! 
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