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Global financial markets have been rocked in recent weeks by fears of a Greek government default on its debt. If a country like Greece is allowed to default, how could a similar fate be avoided in Spain, Portugal, or even Ireland given their budget deficits and debt-to-GDP ratios?
Such a domino effect would put the future of any euro-denominated asset at risk because of the high degree of financial integration across the EMU. The “contagion” from a Greek default could plunge much of the Eurozone’s banking system into insolvency. Although unsustainable fiscal policy serves as the genesis of the crisis in Athens, its trigger has been the realization among investors that the financial architecture across the Eurozone is unprepared to cope with a string of sovereign bankruptcies.
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Shifting to the other side of the Atlantic – could the bleak budget picture at the state level spark a similar crisis here? Is this even a fair comparison?
Obviously, states – like the Eurozone members – don’t have their own individual currencies to devalue during a budget crisis. It’s also not simply whether California, Nevada, or Arizona’s deficit and gross debt compare with those of Greece, but how financial markets would deal with a state default and to what extent the political culture in these state capitols can be counted on to avert such an outcome.
All this uncertainty is why analysts who believe the U.S. “sand states” are immune from a similar solvency crisis are deluding themselves. The table below, from a recent CBO report, provides a glimpse of state deficits as a percentage of general fund expenditures.
Based on the most recent expenditure data from the National Association of State Budget Officers, the CBO estimate implies that California’s deficit is $37.5 billion (the official estimate is “more than $20 billion’”). Measured relative to California’s $1.9 trillion GDP, the deficit is trivial (2%) and hence nothing to worry about, some argue. Even more compelling is the level of California’s outstanding debt: only about 7% of GDP, which provides more than enough capacity to add to the debt. Yet, if these amounts are so trivial, why is California counting on an $8 billion federal bailout to meet its obligations? Moreover, well over one-third of the $829 billion 2009 stimulus was directed to state and local governments. Additional calls for bailout funds so soon after the distribution of hundreds of billions of dollars in state aid should make the skeptics at least a little curious about what’s going on.
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In the United States, the capacity of states to raise funds is limited by a federal government that already consumes one-fifth of the country’s economy. While EMU members are generally not burdened by fiscal policy set from Brussels, there are limits to the steps U.S. states can take to balance their budgets. Moreover, states have “capital budgets” in addition to their general funds that borrow to finance infrastructure. According to Federal Reserve data (page 68), there is $2.3 trillion in outstanding municipal debt. In addition, roughly $400 billion in municipal securities are issued by government authorities on behalf of qualified nongovernmental entities such as hospitals, private colleges, and some private companies. As shown in the table above, when one compares outstanding municipal debt to net state outlays, the ratio is roughly similar to that for the federal government, which no one believes is in sound financial condition.
The historic default rate on municipal bonds is exceedingly low – aside from aberrations like Cleveland, the only municipal bonds that default are those that are issued but not guaranteed by states and localities. But this low default rate is also what makes the ramifications of default so great – financial firms have aggregated exposure to states through bond insurance and muni swaps that is difficult to quantify. Seemingly esoteric issues like municipalities’ collateral posting requirements on derivatives transactions could loom large in a crisis. S&P gives states higher credit ratings if their derivatives counterparty lightens up collateral requirements. Banks have played along with this arrangement, willing to sacrifice the protection afforded by collateral since default was so improbable. But just as with Greece, the need to hedge these exposures in the credit markets is what causes spreads to increase. This spread widening is then what leads to more speculation about default, which causes spreads to increase further and feeds the crisis.
However the Greek situation is resolved, it is a reminder that financial panics are not just about specific debt-to-income ratios, but investor sentiment and the financial system’s ability to absorb a default. As more investors become aware of their exposure to the unthinkable, they take actions to hedge that risk. This leads to greater awareness of the risks, an erosion of confidence among counterparties, and the potential for the kind of “run on the bank” that ultimately did in Bear Stearns and Lehman Brothers.
Unless U.S. states get serious about reducing their deficits, the conditions for crisis will remain.
Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush.