State and Local Government: The Fiscal Crisis—Posner

In my post of August 29 of this year—“Is the Federal Government Broke?”—I pointed out that a realistic assessment of the federal government’s finances, conducted in the first issue of a Morgan Stanley newsletter called Sovereign Subjects (published on August 25), and modeled on the kind of assessment required of private companies, concluded that the federal government probably is insolvent. A firm is insolvent when its liabilities exceed its assets. The major asset of the federal government is its taxing power, which is some fraction of Gross Domestic Product. Its liabilities include bonds and other contractual debt, entitlements such as social security and Medicare, and government services such as maintenance of highways and national defense. The so-called “entitlements” are not really contractual obligations because Congress can reduce or eliminate them, and likewise government services; but the political resistance to reducing let alone eliminating them could be as strong as the resistance to “restructuring” (a euphemism for defaulting on) government debt. And the taxing power is limited, not only by political opposition but also by the negative effect of heavy taxation on incentives to work and to invest, and by other economic distortions that heavy taxation creates.

Not that the federal government could be forced to declare bankruptcy. In a bankruptcy, the assets of the bankrupt firm are sold and the proceeds distributed among the creditors, or the creditors’ claims are converted to equity and the creditors thus become the firm’s owners, the shareholders being wiped out. Neither of these things can happen to the federal government. If it refuses to pay its contractual creditors—the individuals, firms and other private institutions, and foreign countries, that own Treasury securities or other federal debt—or if inflates the currency in order to reduce its real debt burden, it will find it difficult to borrow in the future without having to pay a very high interest rate, which will further deepen the federal government’s insolvency. Inflation and default are only short-term measures for staving off financial disaster.

The federal government has at present a very large and growing deficit, and few ideas for reducing it that command widespread support. Many of our state and local governments also have huge deficits—Illinois, California, and New York are insolvent by the methodology of the Morgan Stanley study, and doubtless other states and a number of cities as well—but their fiscal situation is, I believe, less dire than that of the federal government.

Start with cities. Cities unlike states or the federal government can be forced to declare bankruptcy, and their assets can be sold to satisfy creditors. Cities (also towns, villages, and other municipal entities) often have income-producing assets attractive to creditors in bankruptcy. But it would be such a blow to municipal pride for a city to go broke and see its most valuable assets seized to pay its creditors, and would wreak such havoc on its ability to borrow in the future at reasonable interest rates, that city governments will do almost anything to avoid bankruptcy; and there is much they can do without encountering insuperable political opposition. Cities do not provide many entitlements. Rather, their costs are heavily concentrated in salaries and benefits of city employees, and these costs can be cut by salary reductions, reductions in pension and other benefit contributions, and layoffs. Infrastructure costs, such as road maintenance, can usually be reduced as well (by what is euphemistically referred to as “deferred maintenance”); and sales and property taxes can be raised to help close a gap between revenue and expenditures. Cities suffer but they cope.

The situation of the states differs in one crucial respect from that of municipalities: they cannot declare bankruptcy. And unlike the federal government, they cannot use inflation or devaluation to get out of a fiscal hole because they are not permitted to issue their own currency. In fact their situation is very similar to that of the nations of the eurozone. And we have seen that the eurozone nations that have been hardest hit by the economic crisis, notably Greece, Ireland, Portugal, and Spain, have taken effective and in some instances draconian measures to cut their costs, including entitlement costs. They have no choice, because they can’t borrow money at affordable interest rates if creditors consider them insolvent or verging on insolvency.

Our states are in a similar but better position because, unlike the eurozone countries, they do not provide elaborate entitlements. Social security and Medicare, the two biggest U.S. entitlement programs, are entirely federal. Medicaid is shared, but a state could if it wanted abandon Medicaid. State expenditures are heavily concentrated on roads, higher education, and prisons, and expenditures on such services can be reduced, and state taxes raised, with limited political resistance because of the absence of alternatives. Nor do the states or cities bear the heavy costs of national security borne by the federal government, with its $700 billion annual defense budget.

The economic downturn caused a sharp decline in state tax revenues, which have been running about 12 percent below their pre-downturn levels. The result has been an aggregate state budget gap for fiscal 2011 of $130 billion and an estimated gap of $140 billion for fiscal 2012. About a third of these gaps will be filled by federal stimulus money. (These statistics are from Elizabeth McNicholl et al., “States Continue to Feel Recession’s Impact,” http://www.cbpp.org/cms/?fa=view&id=711.) That is not an ideal solution because it merely shifts debt from the state to the federal ledger. (See John B. Taylor, “A Zero Stimulus Impact,” Dec. 9, 2010, http://misunderstoodfinance.blogspot.com/2010/12/zero-stimulus-impact.html.) And it still leaves big gaps in state budgets. But rather than running up huge deficits, as the federal government has been doing, the states have managed to close the budget gap for 2011 by a combination of raising taxes and reducing expenditures, and they will do so for 2012 as well—they have no choice. They are lucky not to! Because the federal government is not expected to default, it can borrow both from Americans and from foreigners at low interest rates, and so can continue to postpone the day of reckoning at which it will have to cut its expenditures. There is no similar confidence in state or city bonds. States and cities cannot long postpone the day of reckoning. The analogy of Greece and Ireland is compelling. 

When times are good, low tax rates generate large public revenues, which politicians spend to make themselves popular. The result is waste, which can be cut in an economic downturn without inflicting unbearable political pain. Taxes can be raised as well, because the politicians can tell the people—and the people will believe them—that unlike the federal government they cannot use deficit spending to enable tax and expenditure rates to remain unchanged. 

What is true and disturbing is that the weakness of government compared to private corporate accounting standards (the need for reform of government accounting is acute) fosters profligacy and makes adjustments to fiscal reality unnecessarily abrupt and painful. An illustrative problem for both state and cities is what might be called “indirect bankruptcy.” I refer by that term to the sale of assets to obtain money for current expenditures. It is illustrated by the sale in the last few years by Chicago of two major income-producing City-owned assets: the Chicago Skyway and the system of parking fees and fines. The assets were sold for their market value, which is to say the present value of the earnings that they are anticipated to generate over their useful life. The City should have invested the proceeds of the sales in assets expected to generate a similar (ideally a higher) net income stream. Instead the City dissipated the proceeds on paying current expenses, nevertheless running up huge deficits with now less future income to pay them down. 

Another example of bad government accounting at the state level is excessive pensions and other benefits for public employees. By assuming unrealistically that the value of a pension fund will increase at an annual rate of 8 percent, states are able to “fund” generous public pensions at low annual expenditure, since a contribution that compounds at 8 percent grows very rapidly. Still, public pensions can be renegotiated, or even defaulted, and the political pain is limited because public employees are not a dominant political bloc—in part because their high wages and especially their generous pension and medical benefits have made them unpopular in a period in which private employees are struggling—and because the generous federal entitlements buffer the pain to individuals of reduction in state and local expenditures. 

At the local level, there is concern that many cities and other municipalities leave many of their liabilities off their books, and this concern has led to a fall in the price of municipal bonds (and hence an increase in the interest rates that municipalities have to pay on new bond issues). The financial situation of the municipalities may be more dire than that of the states, and the result may be a wave of municipal bankruptcies. 

The fiscal situation of state and local government is serious from a macroeconomic standpoint because it adds to the nation’s overall debt load, a load shared among individuals, families, cities, states, troubled businesses, and the federal government. This heavy debt load, by limiting the money available for consumption and production, is retarding the economic recovery and thus contributing to the continued high rate of employment. Nevertheless the fiscal situation of state and local government seems more manageable than that of the federal government.

Comments

[corwin]

Per usual,I learn from this site.Still, I don't see any ideas of how to avoid the crisis. I declined to interview for a job (I'm a physician) in the Chicago area -in spite of generous wages and a good work environment,because I can't decide if there's enough stability (I'm a physician.)
And, I believe CALPERS projects an annual growth rate of 12% -with taxpayers liable for the difference between projected and actual growth.

[GreeceRUS]

The government, not only in the US, but in the Western World in general, will have to sooner or later default on its obligations i.e. its entitlements. The weaker players are already going under in Europe.

The production dis-incentives and complacency afforded by the Welfare State, is fundamentally incompatible with the growth rates needed to finance its entitlements, as promised by Hope and Change. Higher prosperity based on decreased incentives to produce is as much af a pipe dream as a perpetual motion machine generating energy out of nothing. Sorry to remind that it simply does not exist!

[GreeceRUS]

“Still, public pensions can be renegotiated, or even defaulted, and the political pain is limited because public employees are not a dominant political bloc”

Exactly, but,
In Greece where public employees HAVE become a dominant political block, such re-negotiation has been out of the question. Anyone proposing such an action is immediately marginalized as an extremist. Even now under the threat of a bankruptcy that will inflict pain reaching food shortage levels and a generation of decline, the Greek public still vehemently resists such cuts. The situation mathematically leads to a death spiral, as a desperate public refuses to let go of the very government promises that created the predicament in the first place. At the same time, competent people, rationally and justifiably, become unwilling to produce to feed a government beast poised to confiscate a major portion of their efforts.

In the US, as an increasing number of people abandon the private sector to become public unionized employees, this very same Grecian “Point of No Return” is now approaching. The existential difference is that for the US there is simply no entity in this world even remotely capable of bailing out a failing America. So, in my view, exactly because there is no backstop, the US scale will tip abruptly, potentially unleashing a crisis that will make 2008-10 look like a walk in the park. I do not see a 20% support Tea Party capable of altering the course of things. More than a hope, the Tea Party is simply the last gasp of a once prosperous nation now facing the precipice of an intense vicious cycle of decline. Anyone doubting that such a cycle exists should consider how the American people elected Obama to correct Bush’s mistakes. The margin of economic freedom that the US once enjoyed compared to the rest of the world is gone (in part because the US stalled, in part because other countries with 3+ billion citizens liberalized some) so the point of no return may have already been crossed. I think that the 2008 election WAS the endgame of American prosperity.

[Galliano jewellery]

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Thanks for this short and informative post.

[Jack]

A major problem in CA, as Warren Buffet pointed out in his very brief role as Gov Arnie's financial adviser is that of Prop 13. The problem is that residential and commercial properties are only reassessed when SOLD, so many property owners pay little more than the tax bill of the late 70's when the Jarvis bill was adopted.

There was, as is always the case for poor public policy, a noble intent of protecting oldsters of the era from the effects of rapidly escalating property values and the related high taxes. CA was flush with $5 billion surplus under the tight-fisted government of the same Jerry Brown just re-elected.......... so "who needs property taxes?"

Today the problem is that of having been in place so long that it has a large number who have long benefited and have become stakeholders unwilling to modify Prop 13. It's nearly the perfect "don't tax me, don't tax thee, tax the guy behind the tree" policy in which new buyers pay vastly more for a twin of the long held property next door.

The effects of such a poor policy goes well beyond the overall loss of tax receipts and obvious inequities of one home owner paying many times the tax of his next door neighbor.

In commercial R/E complex "deals" are put together such that a tax reassessment event is avoided.

Also much of CA is a transportation nightmare with costly "freeways" gridlocked in both directions morning, noon and evening. It would be interesting to study how many who have retired and might like to move closer to the beach, golf course, or smaller town but who instead hang on for the substantial tax break, while newer, younger working folk are forced to "go further out" where property prices (and the newbie tax premium) are lower......... and add to the constant congestion with a time consuming, energy wasting, commute.

Voting patterns too are likely distorted with those paying very little in taxes favoring expenditures that will be inequitably paid by the newbies.

CA's problems would suggest that a reform and general phase out of Prop 13 become and immediate priority. It would be simple to offer a tax exemption on the first $150 (or some other amount) as is done here in Anchorage for those over 65 and gradually meld the remaining taxes into a common rate.

A brief article concludes:
"How the Golden State Got Tarnished"

"A more permanent, homegrown solution to California's woes (and it may take a state constitutional convention to get it) would require the state to eliminate the two-thirds threshold for enacting taxes, to repeal Proposition 13's freeze on the value of commercial properties (some of which are still assessed at their 1978 levels) and to end the process of ballot-box budgeting through the initiative process, which is now more dominated by monied interests than the legislature ever was. In Washington, the Age of Reagan may have shuddered to an inglorious end, but we also need action from state governments -- and Sacramento in particular -- to move us toward a more sustainable economic future."

http://www.washingtonpost.com/wp-dyn/content/article/2009/05/27/AR2009052702904.html

CA's shortfall of $20 billion does seem a large number and cutting is surely to be part of the process, but with 35 million people and perhaps 15 million households the average cost per household would be $1300 per average household it's hardly "Greece".

Even as proper values have fallen, the wealthy state has $4.4 trillion in property value, some $300,000 per household, though that includes commercial. Closing the entire $20bn gap could be done from property taxers alone for 1/2 of one percent of value. Many states would love such a "problem". Reforming Prop 13 would be a good place to start, though ha! the likelihood among CA's perpetually adolescent voters seems slim! Maybe a celebrity will come, wave a magic wand and make it all go away.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Value of California's properties falls 1.8% to $4.4 trillion
Forty-eight of California's 58 counties saw totals fall this year — nine by more than 5%, the state Board of Equalization reported. The total value fell 2.4% in 2009.
September 02, 2010|By Marc Lifsher, Los Angeles Times

Reporting from Sacramento — The Golden State's real estate market lost a bit more of its luster as the total value of California's properties fell for the second year in a row — and for the second time since records were first kept in 1933 at the depths of the Great Depression.

The value of all types of properties fell 1.8% this year to $4.4 trillion, the California Board of Equalization reported Thursday. The total value fell 2.4% last year.

[no equity short sale]

you are giving good information about state and local government to the people.

[garage]

The consequences of such a poor principle proceeds well after the general decrease of levy acknowledgments and conspicuous inequities of one dwelling proprietor giving numerous times the levy of his next doorway neighbor.

[Jimbino]

In your list of Federal government assets, you neglect the national parks and forests, which could be sold off to pay down the deficit. They are poorly run and among the most racist of Amerikan institutions, seldom showing a black, brown or red face in attendance. And they can't even improve threatened species like the American bison as well as Ted Turner does.

[Jack]

Jimbino? Would you FAVOR selling off the national heritage of our parks?? Mebbe divvy 'em up and add some profit centers? McD's? Lease a bit out to Disney?

As for your demographic observations they don't coincide with my own; any back up data? Also, do you suspect you might be confusing economic strata with race? It does take a few discretionary bucks to take the family on vacation -- another reason that the current "all for the rich" policies are not serving us well and will result in further economic decline.

Irrefutable equation: In an economy 70% dependent on consumer spending -- Flat and declining wages for most = Flat and declining demand. Adjust for 10% unemployment and you've a glide path to destruction.

[Jack]

"Greece?" Interesting......... theory:

"In the US, as an increasing number of people abandon the private sector to become public unionized employees, this very same Grecian “Point of No Return” is now approaching."

Hmmm, folks working, or even unemployed, in the private sector just wake up one day and say "Hey.... I think I want to be a teacher, cop or refuse collector?"

Have you even wondered about growth of the public sector being related to more demand from the citizenry? CA for example spends VASTLY more on locking many more folks up for MUCH longer terms than they did a decade or more ago. Have you considered that functions such as teaching, policing, refuse collection/recycling, court operations, have not benefited from the labor saving-job diminishing productivity gains of the private sector?

Have you thought, any? about public sector jobs being more technical and complex than those of a couple decades ago? Zoning issues in more crowded cities? Traffic engineers and environmental problem solvers?

CA teachers, whose 5 plus years of education and continuing education perform an intense and crucial task earn $50K or so, a figure much less than similar education and effort would earn them in most private sector jobs and leaves them with the problem of not qualifying even to purchase a home in most areas of CA.

While it's ever worthwhile to work at making the public sector more efficient, keep in mind that pounding down wages in a nation 70% dependent on consumer spending tends to depress consumption by a like amount.

Ha! I'm longing for the day when Posner-Becker or anyone else here considers pounding down the "compensation" and "performance bonuses" of our topmost gleaners and compares what they carve off to that which they, arguable? produce. What IS going on when CEO's have gone from 30 times worker pay to over 400 times today? Have those able and willing to do such jobs become that scarce???

[KrugmanForDummies]

I think the government should mandate a 30% yearly wage increase for everyone making less than 200K, for the next 10-20 years. Also mandate employer guaranteed healthcare, employer guaranteed education and employer guaranteed defined benefit retirement at 60 with full healthcare coverage.

Sure, that may not quite give producers incentives to produce more (invent, innovate, increase efficiency) but sure everyone would have more money and thus consume more. Another government mandate would impose price controls so that producers do not automatically translate increased demand from the extra income and benefits into higher prices.

Bottom line, less incentives to produce at work, more complacency about production, but at the same time more consumption. More wealth, less effort. The miracle of macro-economics!

[Jack]

Krugs? Not bad! But can I ask a couple questions? Since ALL of the productivity gains for 25 years have accrued to the topmost tiers, how much do you think this (recently lazy?) cabal needs to "have incentive?" Further? if monetary incentives are so powerful could you hazard a guess as to how our economy might light off were SOME of the productivity gains middle and lower income folk helped create found its way to their paycheck?

Question #2: If we KNOW that it takes $18/hr to maintain the most minimal independent living std in must of our nation, but many wages range from min wage to $10 - $15 with no benefits.. who should subsidize the difference? Does such a host of subsidies benefit capitalism and guide scarce resources to their best use?

Q #3 Germany, as one example, has a somewhat better "SS" than does the US, dating from the late 1800's, and has a fine H/C open to all, while in this "richest of nations" we are dumped into Medicare which is being spurned by many doctors. Is this great?

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[KrugmanForDummies]

Finally Jack, someone who understands what the key to American excellence is.
Compared to Germany, the US has had horrible governance, monopolized by a cabal of plutocrats, as you very well point out. The only reason that the US has become more prosperous than Germany is the sheer superior competence of the average, albeit hapless and exploited, American individual. The overwhelming evidence is that, whether it comes to science, math, language or any other measurable competencies, the average American is so much more competent than the average German. Every international comparison statistic puts the average American right on the top, when it comes to measuring individual competence. The comparison is also clear to anyone who has met average Americans and average Germans, as well as other Europeans. So, were it not for the pernicious effect of dog eat dog capitalism depressing the final outcome, Americans would be twice as wealthy as they are now and their wealth margin over the rest of the world even wider. There’s just something so unique about these A m e r i c a n P e o p l e that just makes them destined to excellence. Introduction of social-democracy in America will be the definitive key to fully unlocking this human asset into one worldwide truly invincible combination. Think Americans are on top of the world now? Just wait till they adopt Social Democracy; competitors will have no chance. The main history written about the beginning of the 21st century will be one of how America adopted social-democracy and left the rest of the world in the dust.

[KrugmanForDummies]

Of course, the social justice that us progressives strive for should be international, otherwise it becomes hypocritical. We simply cannot harvest 35-40% from the income of a privileged, most productive, American minority and give it to teachers making 50K per year, when there are 1 billion people in the world that live on $2K per year. The 20th century has been the American century and wealth has been overwhelmingly and disproportionately accumulated by a privileged 5% of the world population living in a nation called United States.

The 50K/year American teacher is still in the top 5% of the privileged, by worldwide standards, and his/her wealth and standard of living has also largely been built on the backs and sweat of a working third world. Why is the American teacher rewarded 50k and the Sri Lankan 2k per year? It is only fare that we impose an additional 35% international tax on all those privileged, by worldwide standards, Americans making more than 2-3 times the average worldwide income (i.e. any American making more than ~15K/year) and redistribute that wealth worldwide to truly needy men women and children. The American teacher’s family does not need a 1400 sqf apartment and 3 cars, however modest. An 800sqf dwelling and one car per family will do just fine; that would actually be a lucky dream for most people on this planet.

As members of a caring and compassionate movement we simply cannot morally defend not applying these principles of social justice to every man woman and child on this planet - not just Americans. Consistent with that spirit is the fact that the Nobel price of economics awarded to great progressive thinkers such as my mentor, Paul Krugman, is an international award.

So let’s strive for a just 70% tax on the American rich (35% federal + 35% world tax), ramping down to 35% for teachers making 50K/year (they only pay the world tax after all the federal deductions and credits) and down to a modest 30% for those making around 30K (international tax only) who, by international standards, are still members of an exclusive privileged group of Americans which have accumulated disproportionate wealth in this past century and are earning 4-5x the average worldwide income.

Why should Americans resist such just redistribution? After all, we all know, money does not bring happiness. Even the 50K American teacher’s standard of living is greedy and frivolous by international standards. Why should 0.3 billion Americans (5% of the world population) hoard 30% of the worldwide income? A 6x time ratio! The additional modest 30-40% international tax is the only morally defensible route towards some remote sense of justice, and all Americans should support it.

[KrugmanForDummies]

Hey, Kruggy, get your hands off our rich! The wealth of these people is ours! Ours to supplement our American (yes AMERICAN) middle incomes, not to feed homeless in Manchuria Mato Grosso and Uttar Pradesh.

Our rich folk money, is there for my daughter to get a $12,000/year education by our 50K/year teacher rather than an $6,000/year education, not to send 25 girls to school in your Sri Lankan school with the 2K/year teacher. And it’s there for my daughter’s school to build a pool and football field on 20 acres, not to buy books and pencils for children in Mato Grosso. And yes, our rich folk money is to be used to give me enough supplemental Social Security income to buy my daughter an iPhone, not to feed the homeless in Manchuria and Uttar Pradesh.

So thanks but we’ll keep the money. Yes we can!

[Jack]

KFD: Perhaps adjusting your tongue in cheek first paragraphs for PPP, (purchasing power parity) would make it more palatable. But it IS creative to pit our underpaid teachers against the poor of the world so as to help make some sort of "case" for pounding down wages of our working folk.

Not sure why you're miffed by your daughter's school having athletic facilities in an era when sports workers are knocking down some of the highest corporate and individual salaries, and the arts, music, theater and film remain a solid source of export income for us. Even you mentor, Krugman and our distinguished profs here brought back a couple hundred grand from Stockholm.

[Chris]

I agree with the physician who posted above that there is just no way to estimate the potential liabilities of this crisis. It is really something to say that the solvency of the government is the forefront of my mind when thinking about if I should move. There is just so much uncertainty about the possible outcomes here. There are fifty different legal regimes which will deal with this issue as it arises. No doubt it will take time for solutions to emerge legislatively and still more time for those laws to be litigated in the courts. Posner's assertion that a state can simply default assumes that the state is a much more cohesive entity than it actually is.

[karen millen]

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[Gordon Longhouse]

Sorry for the late post. Been on holidays.

Posner's suggestion that public accounting needs to be improved has considerable merit in my opinion.

It has almost become a fetish here in Australia that all deficits at any time are bad and ought to be gotten rid of no matter what.

The result of this attitude and the use of -what is essentially- cash accounting is that infrastructure spending in years of surplus is restricted, as assets expected to last for decades are required to be paid for with cash.

A government ought to be able to purchase a fleet of fighter jets with an expected life span of 20 years financing 80% of the purchase price with 15 year debt and still be considered to be in surplus if current receipts exceed current expenditure. As it is, using lemonade stand accounting, it is considered to be in deficit.

Finally turning to Jack's discussion of California. Taxes must fall on one of three factors of production: labour, capital or land. Capital is very mobile and hard to reach even for national governments leading to its preferential tax treatment everywhere. Labour is becoming more mobile which leaves land.

Land is everywhere the preferred factor for sub-national units such as states and cities because taxes on land are nearly impossible to avoid. Land owners depend upon state based title systems to certify their ownership and this dependency lives them open to taxation.

Through Proposition 13, California cut itself off at the knees in respect of land taxation living it labour and capital as its only sources of revenue. Good luck being a sub-national taxing these factors in the internet age. It is hard enough as a national entity.

The solution for us in Australia was to impose a VAT at a national level and distribute the proceeds (less cost of collection) to the states (you don't want to be there when the pie is divided up). This seems to be working.

[supra tk society]

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[supra tk society]

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