I’ve gotten a few questions via email about what I mean by ‘a bailout for the states’. ‘bailout’ covers a lot of ground so I think it’s fair to address.
What I mean by ‘a bailout’ is that the federal government is not going to sit by and let California, or Illinois on New York simply default on its debt and push all those unionized civil servants out onto the unemployment lines. They will not see the prisons thrown open - the guards all dismissed, or allow the state to descend into anarchy. When the money runs out they will be involved in the process of what comes next, and use their influence and power to help smooth the transition from where those states start, to where they end.
What form the ‘bailout’ actually takes will be subject to negotiation. The unions (employees), the politicians, the debt holders and the pensioners will all be involved in the discussion. There is no doubt in my mind that the state government will be far smaller after the negotiation than in will be before it. The unions won’t like that, but taxes can’t realistically go as high as they would need to make up the shortfall.
Taxation is really a model – the numbers aren’t absolute. As the rate rises the revenue rises but there is a diminishing return. And eventually increasing the rate simply reduces the economic activity and doesn’t generate more tax revenue. The states that are in the most trouble are all near the higher end of the Laffer curve, so there will be no more tax revenue for them. Government cuts will be in the offing, and civil servants will be expected to take some pain.
There is also little doubt in my mind that the debt holders will have to take a haircut. The financial markets and pensioners won’t like that, but if there isn’t enough money to pay employees, then there certainly isn’t enough to give the bond holders 100 cents on the dollar. But the capital markets will prevent the decision makers from forcing all the pain on the bondholders because that would lead to contagion and another collapse.
In that regard, if things look to go really badly, the Fed will act as a stopgap. They’ll buy up whatever debt they feel is necessary to preserve the present liquidity level (better described in this case as the leverage multiple) of the broader markets, using their balance sheet to prevent a liquidity collapse. They’ll buy however much of the debt is required to keep the crisis from spreading. In that way, the US taxpayer will be on the hook for all of it, at some level. No one will be presenting a bill to them at this point – but they will be guaranteeing the broader system. And that is the real ‘crisis moment’.
At that point, the finances of the state will be taken away from legislature, and be addressed by the courts. Hopefully that will mean that grownups will finally be in charge, but you never really know because there is a small legal hiccup in the whole thing. The problem is that states don’t presently have the facility for managing a bankruptcy. As an example, at present there is no way for them to legally cut pension payments at all. Under current law they are on the hook for 100% of all promised payments.
That won’t happen though because the money has to come from somewhere. If the pensioners are to be made 100% whole then the State’s Bonds will be forced to default. And since the pension holds those bonds and the bonds of other entities which will lose value along with a State default, the pension value will collapse. So they can either negotiate something with the bondholders where the pain is shared, or they can force the bondholders to take the hit alone, and be the very next in line to suffer. The people who run pensions aren’t that stupid.
The place where the Feds will be forced to step in is in the gaps between projections and results. No one, for instance will be able to give a clear idea of actual tax revenue when the state emerges from its crisis. Much of the mathematics of the welfare state is circular. Paychecks are issued to state employees, who are then taxed, and the resources used to hire more employees, who are taxed, and the resources used for more… etc. The effect of all of that can be estimated, but with so much of the State’s future revenue and expenses up in the air, forecasting cumulative economic activity will be sketchy and uncertain. The Federal government will be asked to give assurances to stakeholders to make up any shortfalls and to convince risk takers to stay in the game.
The country as a whole is also a stake holder in the future of a state like California or Illinois. A healthy vibrant California for example, is as much an asset to the country as its present incarnation is a liability. So the question is: what’s something like that worth to you? Surely it’s worth something, and in the process of negotiation, we’re going to find out exactly what that is. That’s the amount I would expect the US taxpayer to inevitably be on the hook for. But the alternative isn't likely because it's not really in our interests to let New york, California or Illinois sink.
The thing that concerns me most is that the people on the left in this argument are factually wrong about how economics works. The things they believe (or at least the things they say they believe) simply aren’t so. They ignore the contradictions of their positions and the way their worldview always seems to require some ‘external asset’ to feed the system. Redistribution of wealth doesn’t lead to greater economic growth, it leads to less. And when we reach this point in the process, a view like that will no longer be a viable talking point.
If they come to the table like Howard Dean - all talking points and no logic or reason to support it, then the global markets will rightly lose confidence in our ability to act like adults. That will be what turns an orderly if somewhat weakening dollar into a hyper-inflating dollar. Like I’ve said before, the only real way for us to avoid the abyss is for the economic education of the American left to outpace our fiscal descent. It’s time for the boomer left to finally grow up and face reality. It really can’t be put off or avoided any longer.
One last comment - a Bailout for the State Pensions would essentially be the same as a bailout for the states since under present law, there is no way for the states to forgo their commitment to the pension system. My understanding is that if the pensions run out of money to make payments, the state is legally obligate to make the difference up from tax revenue. The unions will see that enforced in court so that kind of event will simply put us back at the top of this post. It will follow the same path from there.
2 comments:
Tom,
You are probably right about what will happen. What concerns me are the specifics and the new moral hazard that will be created.
For example, let's say that California needs to be bailed out to the tune of $100 billion. I fully expect that, after much blah blah about firemen who went into burning buildings, and widows who will have to eat dog food on their reduced pension, the unions and the bondholders will each take a 25% haircut, and Ben Bernanke will then "finance" the rest on the backs of my childen.
We won't get the systemic changes we need, such as outlawing public sector unions, so we will play this same song in another 40 years.
PS Have you read This Time Is Different: Eight Centuries of Financial Folly?
Yeah, I’m hearing that issue of the moral hazard raised a lot…I don’t dispute it. Keep in mind, I’m not endorsing any of this – all I’m saying is that this is how I think it will play out. And since the real moral hazard will be in how many concessions are given to the unions, I can’t really say how that will go. It’s a political issue, and I’m not any better and handicapping politics than anyone else.
The fact is though, even at its best there will be tons of pain to spread around. And for all the ‘talk’, the market is the place we will need to work to avoid contagion. If the other unions or pensioners get upset, no one will really care. But if we have a run on treasuries then we may be kissing the entire western economy goodbye. All that infantile talk we’ve been hearing from Obama and the left through all of this about ‘making the rich bankers pay instead of the working man’ won’t fly when it comes down to that. They’ll be in the deep water then – and if they screw around like children the global markets will eat them all alive.
The unions and the unionized pensioners may end up getting lots of concessions, but they will be giving up a ton too – especially compared to their current, totally unsustainable position. I’m convinced that if you asked them after the fact whether they were winners they’d say ‘absolutely not’ and probably be really angry about how it’s all played out. Remember, they are the ones holding the view that’s most divorced from reality. They’ll hate any deal they get because it will have to be based on coping with the facts.
So don’t go assuming that we’re all going to end up their slaves. By the time the whole mess is done I wouldn’t be at all surprised if unionizing the civil service is illegal, and our labor laws have been changed to totally geld the unions in the private sector. The media is just waking up to this story. When America sees what they’ve been getting away with there’s no way they’ll look good enough to sustain their position.
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