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Doomsayers Predicting State-Municipal Defaults

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If you have a taste for gloom and disasters, then you will enjoy predictions of the coming default by states and municipalities across America on their heretofore sacred municipal bonds, the munis so beloved of retirees and pension funds. These bonds are the way local and state governments financed building the Interstate Highway system, schools, sewer plants, power grids, civic centers, every kind of infrastructure that underpins the modern way of life. Because these income investments were considered safe and were tax-free, they fill millions of retirement funds around the world, but now the sponsoring governments are on the brink of bankruptcy, almost at the point where they have run out of various fancy Enron-style bookkeeping tricks to conceal that fact, and observers say the next option is to default on paying the interest.  Says Frederick Sheehan, a muni bond analyst:

“This gradual deterioration of municipal finances has quickened over the past several months. Spending is rising and revenue is collapsing. Funding gaps have been disguised by accounting gimmicks.”

Says Arthur Levitt, Former Chairman of the SEC:

“Fraud in the municipal market and incompetence, which in some ways is worse than fraud, has never been greater.”

We all recall how Governor Schwarzenegger of California recently paid state bills with I.O.Us, drawing on future tax receipts. Some other examples, according to various investment newsletters:

*Arizona plans to sell and lease-back its State House and Senate buildings, in an attempt to raise a one-time cash influx not unlike Virginia Governor McDonnell’s plan to sell off state-owned liquor stores

*Colorado Springs has let one-third of its street lights go dark, sold police helicopters on e-Bay, and stopped all street paving

*States from Kansas to Hawaii have considered bills to cut the 5-day school week to four, or to cancel entire grade-years altogether

*Los Angeles wants every city agency except Fire and Police to cut back to a 3-day week

*Harrisburg, Pennsylvania (state capital) has already skipped its 2010 debt payments, and its debt is now considered “high risk junk” by Moody’s (the same rating agency which continued to rate AIG and derivatives AAA right up to the crash on Wall Street, so make of this what you will).

The consensus is that as many as 48 American states are very close to bankruptcy… a train wreck in slow motion which may have been a long time coming but is, especially according to conservatives and committed Free Market analysts, inevitable. The obvious trigger is that expenses have continued to rise but revenues have collapsed—- no surprise when total real unemployment is around 18+ percent (including those who have been discouraged and quit looking, and those who have been reduced to part-time low-wage jobs), real estate values have plummeted (with commercial real estate just beginning its own serious downturn), sales tax receipts are down, and the stock market, despite wild volatility, has pretty much flat-lined (when it hasn’t continued its bear market downtrend) so that state and local pension funds now have a deficit estimated to be well over $3.2 trillion.

What will happen next? The Big Money and Wall Street are quietly unloading their store of municipal bonds, but innocent small investors are unwarned and, as always, they are the ones who will suffer when the defaults begin.  This has actually happened before, mostly during the last downleg of the Great Depression, when many, many defaults on munis occurred. The answer then was to raise taxes at both state and national level, but times are different today. If states tried to raise taxes as they did in the ’30’s, it would almost certainly abort our fragile recovery and throw us into a greater recession. Moreover, it is hard to imagine today’s politicians ruthlessly cutting out  entitlements (look at the riots in Greece over just such cuts)—- most electeds will not have the political will. Therefore, it is quite possible even many Republicans would join Democrats in Congress to authorize a bailout, and such a bailout would dwarf every previous bailout…. i.e., the Fed would print fiat money out of thin air at a pace that would make Alan Greenspan’s bubbles look anemic.

As you know, most Free Market economic theorists deeply believe we, as a nation and as a global economy, are careening toward runaway inflation; and they believe such an enormous bailout will inevitably produce hyper-inflation on the order of Germany in the 1920’s, unraveling our society in the process.

This belief is at the foundation of the conservative-Tea Party hysteria over reducing the deficit. Indeed, I believe the Republicans, based on this scenario, are doing everything they can to make a double-dip recession and hyper-inflation into a self-fulfilling prophecy by doing such things as refusing to extend unemployment benefits or add to the deficit in any way.  It seems as if the Republicans want the economy to stall out so they win in November and, if states begin defaulting next year, also win in 2012—- sounds like their business plan for America. It is their contention that reckless spending on lavish entitlements got the states in trouble, rather than the reckless greed of Wall Street and its meltdown.

Some economists have said that, Yes, we need to bring our deficit under control (and are careful to distinguish between the budget deficit and the national debt, something the instant experts of the Tea Party do not do); but they also caution against immediately trying to stop all deficit spending, or cutting entitlements, or raising taxes on the middle class because that in itself will surely kill the recovery. This is exactly what happened in 1937 when FDR listened to conservatives, stopped his deficit-financing of New Deal programs, and thus brought about a second downward spiral in the Great Depression, a depression finally ameliorated by the massive deficit spending of World War II.

The Republicans and Wall Street have gone out of their way to demonize everything Keynesian, and deficit spending is Keynesianism personified. The only problem is, deficit spending works when it comes to stopping a self-feeding depression. It works no matter how much the Free Marketeers of Friedman economics keep saying it does not. We would be further out of our current recession if the Free Marketeers in Congress had not prevented passage of a bigger stimulus package, and not then hamstrung any other real stimulus programs Obama wanted, mostly with self-righteous remarks about curbing “the deficit.” Even some conservative economists are now warning against smothering the recovery with foolish constraints on deficit spending at this moment. They agree, we should create a plan to reduce the deficit, but should not implement it until the recovery is more firmly underway…. even if it means temporarily adding a little more to the deficit.

Where does this leave us with the predicted defaults by soon-to-be-bankrupt states? Well,

*First, the situation is not uniformly dire—- it has been said that the perpetually gloomy soothsayers have foretold five of the last two recessions (that is, they may exaggerate a little bit—- in order to sell their newsletters and investment advice, perhaps?).

*Second, the feds bailed out the bondholders in the Wall Street meltdown, so why not an arrangement to help the states stretch out and meet their obligations to these mighty bondholders, and otherwise give them some kind of assistance—- the stimulus money saved the states in 2009-10, after all. Of course, this rescue will happen only if the Republicans are not in charge in Congress.  And,

*Third, if we cut military spending and re-instituted some of the former taxes on the super-wealthy, there would be a lot of money available for other things, now wouldn’t there?  

  • are allowed to expire next year.  Trickle-down economics has never worked and never will.

  • Cato the Elder

    I’d tell you that what the bond crowd is doing is a bit more nefarious than what you suppose.

    You see, when you can create the perception that the issuer is close to insolvency you manipulate yields higher. At that point, they back up the truck and buy high yielding debt.  Then, you angrily bang your fist on the table for austerity, because if you can then drive rates down that increases the value of the paper you already own.

    Think it doesn’t happen like that?  Let’s rewind to the beginning of Eurozone crisis. Pim(p)co was all over CNBC driving up rates across Europe by talking about a “ring of fire” and that the world was going to default. In doing so they were able to accumulate around a trillion dollars in sovereign debt at sky high rates.  Then, this same crowd turns around and pushes the ECB for a bailout so that their paper gets insured with other people’s money. No, lo and behold, they’ve fired up a PR campaign to crack the austerity whip because (wait for it) the debt they just bought will approximately double in value if they can engineer a deflationary low-rate environment.  

    What you’re seeing is the same people setting up the muni market for a similar assault.  

  • Teddy Goodson

    who chose not to comment here, but sent me an e-mail, permitting me to post the comment here (my emphasis added), as follows:

    “I agree with you on your theory that the Republicans are hoping to make things worse so they can blame Obama. I would go even further and say that whatever properity we have had for the last 10 years (and maybe beyond) has been based on smoke and mirror economics. That is, by over leveraging the banks and creating false weath through speculation and outsourcing manufacturing.

    The only people making money on outsourced goods are the international corporations. That money does not go directly into the American economy except as a few mansions, cars, and expensive vacations. The middle class is disappearing because there has been less and less real wealth as opposed to the appearance of wealth. At present, the financial industry (industry?) is 1/3rd of our economy. That is 1/3rd of the economy which produces nothing of real value in the society. This so-called wealth is based on make believe money.

    In short, the country never had close to the wealth we thought over the last 15 years. Now that the smoke has cleared we are left looking in the mirror at the ugly image of our true economic predicament. We are just not a rich a country as we thought we were. In fact, we are in really bad shape.”

    This comment goes pretty well with that of Cato the Elder, above. It seems obvious that the Wall Street and Big Money did not siphon off enough wealth in the meltdown, but have decided the poor average suckers still have a bit of treasure left that they can squeeze out of us.

    What would happen if we told the bond holders to get lost? Would that in the long run (or even in the short run) be any worse than what we are already going through? Phhttt!

  • TomPaine

    MATTHEWS: OK. Let’s talk about the progressive income tax. Would you like to replace it?

    BARBER: Absolutely. I would love to replace it with the fair tax.

    MATTHEWS: And you would like to get rid of the 16th Amendment to the Constitution, which created it back in 1913, get rid of the whole thing?

    BARBER: Absolutely. I think it’s — it’s counterproductive to our economy.

    (CROSSTALK)

    MATTHEWS: OK. Sure. You want to get rid of the income tax, period, not just the progressive income tax, but any kind of direct tax, income tax, is that right, and go to an indirect tax, some sort of ad valorem, VAT kind of tax? That’s what you want to do?

    BARBER: I think the science is there, the data is there to show that a consumption-based tax is far more productive for a society and far more fair.

    MATTHEWS: OK. OK. We get rid of the income tax, period.

    What interests — or, rather, what sales tax rate on top — here in D.C. we pay 8 percent. What would you add to that for — as a national sales tax? What percentage of sales?

    BARBER: No, you wouldn’t be adding any tax.

    The fair tax is a replacement for all the embedded tax that’s estimated to be in the products and goods and services that we have already because of our current income tax.

    (CROSSTALK)

    MATTHEWS: We have sales taxes all around the country, sir. In addition to the current sales tax we have in other states — you can’t stop states from having sales taxes, so in addition to the sales tax, you would have a national sales tax, right?

    BARBER: Correct.

    MATTHEWS: OK. What rate?

    BARBER: It wouldn’t be in addition. It would be replacing the product and service. It would be a replacement of the taxes that are already there. And you can’t — the local locations would have to take care of their own tax.

    MATTHEWS: You would get rid of the sales tax in localities?

    BARBER: You would get rid of Social Security, capital gains.

    MATTHEWS: No, no, no.

    (CROSSTALK)

    BARBER: You would get rid of Medicare and Medicaid. You would get rid of the death tax.

    (CROSSTALK)

    MATTHEWS: Would you answer the question?

    What do you do about sales taxes in states like Pennsylvania, Washington, D.C.? All across the country, states have sales taxes. Would you get rid of those? And how can you do that constitutionally, denying the right of states to pay for their expenses? How would you do that legally or constitutionally?

    BARBER: You wouldn’t — you wouldn’t necessarily do that. The states would have to choose in what way they want to tax on their own. That’s their sovereign right.

    (CROSSTALK)

    MATTHEWS: Well, they have. They have sales — OK.

    (CROSSTALK)

    BARBER: But I think they would follow the national standard.

    MATTHEWS: Right. Everybody listening knows what’s going on here. You’re not answering the question.

    You want a national sales tax. What rate of taxation do you want in that sales tax?

    BARBER: The estimated tax that’s already embedded in the goods is 23 percent. You would get rid of the embedded tax, replace it with the fair tax, and the states would then have to choose how they want to tax beyond that.

    (CROSSTALK)

    MATTHEWS: Well, in the states that I live in, it’s about 8 percent. So we’re adding 23 percent. So we would have a 31 percent sales tax. What would you apply that to? Food, clothing?

    BARBER: Well, you keep saying add. You would not — again, you would not be adding a tax, Chris. You’re putting words in my mouth.