Andrew Cuomo (Getty Images)
Jerry Brown (Getty Images)
Congress could face a fresh fiscal mess: a state — or a pack of ’em — calling for cash. The Republicans, newly in charge of the House, will be inclined to “just say no” and let markets punish the profligate. But it won’t work — and avoiding the question until then will only spread the disaster.
“We are facing bankruptcy on the part of practically every state and local government.” So said Felix Rohatyn last week.
A respected investment banker who shot to prominence when he helped Gov. Hugh Carey and the feds rescue New York City’s bondholders in 1975, Rohatyn overstates the case today. But at least he realizes that the problem isn’t just unrepentant “blue” states.
Sure, New York and California are bleeding cash heavily and running out of Band-Aids. But states with new “red” leadership may not fare better.
In New Jersey, Gov. Chris Christie gambled this spring by skipping a payment to the state’s near-broke pension fund to “balance” the budget. If the stock market is flying in a few months, investors may give him a pass. If not, they’ll want to see that money (and more) safely in the pension fund.
Bottom line: House leaders may expect Jerry Brown or Andrew Cuomo to call, but it could be a Republican star — one who needs money to change things, not to maintain the status quo.
And a crisis in one state would quickly bring economic catastrophe.
Bondholders trust their money to a state like California or New Jersey because they expect Washington to help out if needed — and not without reason. The feds have shown it to be true — in the New York City bailout, but also via the 2009-’10 stimulus, which gave states (and indirectly, their bondholders) cash without asking for any fiscal reforms in return.
The feds can’t change course quickly — no more than they could arbitrarily let Lehman Bros. fail in 2008 after standing behind big banks for years.
If the feds simply make it clear that a distressed state is on its own, investors around the country will worry about all such “safe” debt. Bond markets would stall (at best) for the weeks and months it took to do real analysis on who’s solvent and who’s not. States and local governments would find it nearly impossible to do even routine borrowing.
Muni-market turmoil would also prove contagious. US municipal debt now totals $2.8 trillion (up 18 percent since the housing bubble burst). Banks hold $220 billion — and money-market funds own $351 billion.
Remember, in September 2008, when a “safe as cash” money-market fund found itself with Lehman losses, the Treasury had to offer to guarantee all such funds to avoid an utter meltdown. In a muni crisis, Washington would likely have to do the same again. So the emergency would mean bailouts one way or another.
Even worries about a state default can harm the economy. Once banks start to fear paper losses from one source, they’ll look to reduce their exposure to other losses — by pulling back harder on lending to, say, small businesses.
None of which means that Congress should simply shower the states with more cash. What it needs to do is create some semblance of market discipline for borrowers and lenders — but gradually and openly.
First, it should be clear that any aid should come through elected government — not through, say, the Federal Reserve buying up municipal bonds. That way, state lenders won’t be expecting a back-channel bailout.
Second, it must ensure that any aid in the next couple years comes with strings (unlike the stimulus): In return for cash to pay the bills, states would have to wring long-term changes to future benefits from their unions and legislatures. They’d have to cut labor costs and fix work rules.
States would have the option to say no. But they probably wouldn’t — defaulting or slashing costs suddenly would hurt their localities too much.
Third, as the economy recovers, Congress should devise an orderly way for bondholders, too, to take losses in a future crisis. Absent a state-bankruptcy law that passes Supreme Court muster, the feds likely would have to let states access some sort of future fund — if bondholders then took losses according to a process explained long beforehand.
Figuring this out won’t be easy. German Chancellor Angela Merkel is prodding the rest of Europe to tackle similar problems — what to do about distressed debtors like Ireland and Greece, now and later?
But the worst thing to do is nothing. One day — maybe in January, maybe in 2015 — the problem will be too big to ignore.
Nicole Gelinas, a financial analyst, is a contributing editor to the Manhattan Institute’s City Journal.