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Will Bailing Out the States Tank the Dollar?

by John Rubino on November 3, 2010 · 26 comments

Back in 2006 Meredith Whitney was an obscure Wall Street analyst who bit the hand that fed her by declaring housing a bubble and the big banks a disaster. This took guts, both because analysts who dis their research universe tend to lose access and/or their job,  and because the overwhelming consensus, from Alan Greenspan on down, held that things were fine, home ownership was good, and big banks were rock-solid.

Whitney was right, they were wrong, and since then she’s used her considerable cred to keep hammering away at the illusion of a recovering US financial system. Her current target is state and local finances, which, she says, are far worse than the mainstream realizes.  In today’s Wall Street Journal she lays out this thesis and asserts that a federal bailout isn’t coming — it’s already here.

I intended to post a few excerpts, but couldn’t find a single paragraph that didn’t contain something useful. So here’s the whole thing:

State Bailouts? They’ve Already Begun

Bond subsidies and transfers have allowed states to avoid making tough decisions. It won’t last.

The threat posed by the state fiscal crisis in the U.S. is vastly underestimated and under-appreciated—because even today too few people understand how states have been managing their finances.

A clear example of this took place in Manhattan last week at the Economist magazine’s Buttonwood Conference, where a panel role-played the federal government’s response to a near default of the hypothetical state of New Jefferson. After various deliberations and simulated threats from the Chinese government, the panel reluctantly voted to grant New Jefferson an emergency bailout of $1.5 billion to cover the state’s debt payment.

What this panel and so many other investors fail to appreciate is that state bailouts have already begun. Over 20% of California’s debt issuance during 2009 and over 30% of its debt issuance in 2010 to date has been subsidized by the federal government in a program known as Build America Bonds. Under the program, the U.S. Treasury covers 35% of the interest paid by the bonds. Arguably, without this program the interest cost of bonds for some states would have reached prohibitive levels.

California is not alone: Over 30% of Illinois’s debt and over 40% of Nevada’s debt issued since 2009 has also been subsidized with these bonds. These states might have already reached some type of tipping point had the federal program not been in place.

Beyond debt subsidies, general federal government transfers to states now stand at the highest levels on record. Traditionally, state revenues were primarily comprised of sales, personal and corporate income taxes. Over the years, however, federal government transfers have subsidized business-as-usual state spending not covered by state tax collections. Today, more than 28% of state funding comes from federal government transfers, the highest contribution on record.

These transfers have made states dependent on federal assistance. New York, for example, spent in excess of 250% of its tax receipts over the last decade. The largest 15 states by GDP spent on average over 220% of their tax receipts. Clearly, states have been spending at unsustainable levels without facing immediate consequences due to federal transfer payments and other temporary factors.

At the same time, local governments now rely on state government transfers for 33% of their funding. Thus, when a state finds itself in a financial bind, it has the option of saving itself before saving one of its local municipalities. Pennsylvania recently assisted the state capital, Harrisburg, in the form of a one-time “advance” payment—but there are hundreds of towns like Harrisburg that will also need assistance. These one-time fixes fail to address the real structural problems facing so many states and municipalities.

State budgets are likely to experience their second consecutive year with deficits of close to $200 billion. The root of the problem is simple: State governments have spent recklessly and unsustainably. Rainy-day funds are depleted, pension-fund contributions are already at record lows, and almost all of the major federal government subsidy programs will run out in June 2011.

Until now, the states have been able to evade the need to rein in spending largely because the federal government enabled them to do so through record high federal allocations, and by creative accounting that put off funding well over a trillion dollars of state-employee pension and other retirement obligations.

The level of complacency around this issue is alarming. Most assume, as last week’s Buttonwood panel did, that the federal government will simply come to the rescue of the states without appreciating the immensity of the cumulative state-budget gaps. I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a federal response. Solutions attempted in piecemeal fashion, as we’ve seen thus far, would amount to constantly putting out recurring fires.

Rather than waiting for more federal intervention, states need to make their own hard decisions and not kick the can down the road. How will taxpayers from fiscally conservative states like Texas or Nebraska feel about bailing out threadbare Illinois or California? Let’s hope we never have to find out.

Some thoughts:

  • When you add up state and local pension liabilities, operating fund deficits and outstanding muni bonds,  the bailout numbers become Fannie/Freddiesque. We’re talking several trillion dollars up front, with no end in sight because states will use federal money to avoid the kinds of changes that would bring them back into a semblance of balance.
  • The size of this ongoing federal commitment will be obscured in the official announcements — as it is now — but analysts like Whitney will see through the lies and publish real numbers. So eventually the markets will understand that Washington, just a few years after nationalizing the mortgage market, has taken on another several trillion dollars of junk paper from the states.
  • The global markets, already worried about the viability of the dollar as a reserve asset, will really start to sweat. The question is how they’ll react to this latest assault on their collective balance sheet. Foreign central banks and risk-averse investors are starting to resemble battered spouses, putting up with pretty much anything from the US because they have nowhere else to go. But even this kind of pathological patience has to have a limit, and if a bailout of California and Illinois is the final straw, then the game changes from fiscal crisis to currency crisis.
  • Geoff

    Hmmm…bet on fiscal restraint and the free market being supported by Congress?

    Or assume that Congress gives gifts like TARP-2 to Warren Buffett, free mortgages from Fannie and Freddie to the public, and bails out every municipality, county and state that can’t live within its means?

    Hmmm…well, think I’m buying more gold and moving to the countryside before the debt riots start.

    • Rachael

      Let’s be neighbors…..I’m on my way…..

  • Keith Carr

    There is a day of reckoning coming and this is happening because the people who really control everything have been planning and executing all the steps along the way to make it so. Nothing happens by accident least of all the global financial situation which is a shambles and it will not get better by design. Beware and prepare…

  • Dr. Death

    Thanks for kicking over this rock, but the roaches flee the light as quickly as illusions. The key word in this great article is “currency”. Like the European Union, there is no state currency to compete with the greenback. Gold is the quiet school master of currencies. When she raises her head, it’s time for the kids to settle down. She is now whipping her paddle out of her desk drawer, but the spoiled brats will take down their greenback ringleader. Honor the schoolmaster; buy her and those currencies which honor her.

    • ehswan

      Not gold, but silver will save the day.

  • Brad Thrasher

    Still think that QE2 will help more the states and get us out of this recession.
    Gold is good but give the Fed a chance for us baby boomers.
    Thrasher

  • Pingback: State Pension kills U.S. Dollar | Icliks Incoming

  • Bruce C.

    I think the fact that Californians re-elected Boxer and Brown is proof of one of two possibilities: that most people don’t realize how dire and unsustainable their state’s finances are, OR, that most people don’t care because the gravy train continues, and probably because of B & B.

    I suppose Whitney, like just about every other opinion writer in the Journal, wants to sound even-minded and intellectual by writing things like, “Rather than waiting for more federal intervention, states need to make their own hard decisions and not kick the can down the road.” How stupid sounding. Why should the states do that? Or, rather, why should any ONE state do that? State discipline will not protect them from Federal profligacy (e.g., a dollar crisis), so why bother. Besides, all of these numbers and percentages are without context. So some states are getting a third of their deficits paid by the Fed government. Is that a lot? So what will two-thirds be? State budget deficits are nearly $200 billion a year – is that alot? (Let’s see, that’s less than two months of QE II, so far.)

    Speaking of QE II, The FED is in fact enabling the Federal government to “kick the can down the road” too. As above, so below. Notice that not one politician is compaining about more QE. Better to die with lots of dollars than with none, just in case. (Master: “Why should government spending be curtailed?” Grasshopper: “Because interest rates will rise and consume all income.” Master: “So then more income will be forthcoming. You do not yet understand the nature and source of fiat money! Your task is to imagine the largest number that you can, and then double it.”)

    • James Woroble Jr

      There’s an even more likely possibility… voter fraud involving ineligible participants and / or electronic rigging.

      Remember the quote of that commie extraordinaire, ‘Uncle Joe’ Stalin, whose socio-political prodigy now rule our nation…“It is enough that the people know there was an election. The people who cast the votes decide nothing. The people who count the votes decide everything.”

      • Brad Thrasher

        As one who actually lives in California, Brown and Boxer won simply because the proven records of Whitman and Fiorina was to ship jobs overseas while pocketing or should i say pursing 100’s of millions personally. The closest thing Carly found to an issue was a hot mic condescending comment about Senator Boxer’s hair.

        Of course it didn’t hurt that Whitman referred to Brown’s term as governor, “California’s golden years.” Never mind that firing her undocumented housekeeper of nine years and advocating for her deportation tended to conflict with vast majority of Californians sense of fairness.

        We are thankful for the reported $300 million Meg & Carly spent on their campaigns here in California. Has your side got anymore like them? ;)

        I understand it’s incomprehensible for many but corporatism just doesn’t sell here anymore. You need to appreciate, we gave the nation Ronald Reagan and the tax revolt. Each of which gave rise to the borrow and spend fiscal policy and deregulation that led to this current FUBAR.

        In other words we Californians are looking for solutions other than the failed policies of the past, without regard as to whether those failed policies be championed by Democrats or Republicans.

        • Schweizer40

          You Californians are killing all reason, exporting all but green jobs and dying on the vine. Don’t expect us Texans to bail you idiots out. Won’t happen! I say let China have California for the nations debt. It would solve alot of problems.

        • Pal

          I do not want to sound like I am defending bad ideas by either part but pull your head out. Since since is less tax the problem. The problem is uncontrolled government spending. You have to be pretty non-smart to intimate that cutting taxes is the problem. STOP SPENDING MONEY YOU DON”T HAVE

  • http://allgoodfun.net/ John Swinburne

    The system we have gotten along with for the past hundred plus years isn’t sustainable — its past the use-by. Obviously! Vested interests continue to apply band-aids and props in vain hope. Time to think outside the square and devise a new one. And that’s not going to happen is it! Only from the ashes of unprecedented human pain and ecological destruction will the surviving remnants necessitate, and bring it into being. It seems to be human nature to act from a crisis necesssity level, rather than an inciteful proactive evolutionary action.

  • archivesDave

    Hmmmm…
    Very interesting!…
    But according to Walter Burien , many states have been keeping double books and have hidden surpluses.
    I wonder what the REAL facts are.

  • big jones

    Bruce C. dude. I ditto you to the max.

  • Donald

    Thanks for a fantastic article John. In New York state, 99.99% of the people are oblivious to the state deficit in the budget, pension and healthcare. We get fed bailouts, state bond bailouts, and even take from the pension fund which is underfunded to begin with. I’m afraid all the present and past government workers will be bailed out at a huge cost to everyone else. Public unions are killing us and they nobody knows it. They control the lawmakers and the lawmakers control the law. It is similar to a communist party state.

  • Dave

    It’s true, Washington will never adopt an austerity plan that amounts to much, only one that sounds good to the average voter whose attention span is 8 seconds.
    Serious inflation is now etched in stone, maybe something worse…
    Having gold (since 2006), food, guns, ammo and a water well, I sleep like a baby.

    • Just Observing

      Me too. Dave.

    • Claude Michaut

      Dave, the funniest comment of them all !!!

  • http://www.zachaus.com josef zack

    I live in NY, on Long Island. I must be part of he 00.01% who knows fully well, about he NYS deficit. In Suffolk County, the budget is also out of control. And in the Town of Southampton, the budget is Black Comedy at its worse.

    I have studied this for some time now.

    What few if any people don’t understand, is while California has given all of the Press about its lack of fiscal responsibility, (with Nevada having the dubious fame of being second by way of observation and Press comments), New York is just behind California and is in the same fiscal condition, (if not worse).

    Well the Democrats swept the state again; not that I put any stock in political parties any more …

    I expect a gross acceleration towards fiscal collapse for New York, well before the 2012 elections.

    I believe, IMHO, that sometime in late 2011 (Q3 or Q4?), the Federal Government will not be able to enable deficit budgets for ALL of the states. This very well may be the Black Swan event that pushes the US$ over the edge, into currency collapse.

    I guess I’ll just have to wait and see how this upcoming tragedy plays out.

    That the US$ collapse is inevitable, should be no surprise to anyone, who has endeavored to follow the white collar crime, which has been passed of as banking business, government taxing & spending, manipulation of the precious metals exchanges, the grand mortgage crime scheme, and of the like.

    All of the above mentioned malfeasance, crime and stupidity is just coming all together now. It is slightly more obvious to those who have, heretofore have been consciously ignorant of selfsame.

  • Jan

    Would you think that possibly the Federal Government is putting the States into debt to prevent Nullification? Seems to me that it would be a lot harder for a State to go against Federal policy and new laws if they owed their very existence fiscally to that same entity.

  • Agent P

    “As one who actually lives in California, Brown and Boxer won simply because the proven records of Whitman and Fiorina was to ship jobs overseas while pocketing or should i say pursing 100′s of millions personally.”

    Uh, not quite.

    The (2) Incumbent, Career Politicians (B & B), won because for lack of a better word, California voters are Stupid – Supremely so, and collectively speaking, certainly not individually speaking. How else does the state find itself where it is at, without many years – nay, Decades of voters voting themselves ‘largesse’ and falling for the tired, old worn out politics of envy and class warfare?

    As an excellent Bay Area talk show host (Lee Rodgers) once said way back in 1993, this state (Ca) would have to collapse under the weight of its own profligacy before true reform would take stage. We are not there yet, but will be in due course. And it will not end nicely for the citizens of the state, nor its recently Re-Elected and Re-heated politicians.

  • silverbug

    Yes and let’s not forget foreclosure gate, This $6 trillion dollar debacle is not going away either. We are simply doomed becuase no one in DC knows what to do. They are all lawyers not economist. If there is a grandioso plan to pay the DEBT off please let me us know how. Otherewise carry on with debasement. State pension’s are loaded with MBS the very assets that you can not sell nor foreclose on. What worth do they have?

  • erik

    Interesting conversation. I would propose that even precious metals won’t save you!
    I’ll propose the most outlandish scheme. We left the gold standard for the same reason we are in this mess. Deficite spending. The reality is that its the U.S.’s turn to lower its currency and gain the competitve advantage of lower wage cost. Yes that will come at a cost. We will lose the status of being the worlds reserve currency. The real question is weather the member nations of the IMF let us do it. Will China allow the U.S. to mach them in cost competativeness? I doubt it. So what’s next? I propose an alternative to the gold standard (there is not enough supply for the worlds currencies) ….. Carbon. All it takes is for legislation to turn cap-and-trade from a tax then to a form of acceptable currency standard. They have allready convinced the worlds children that without controls on carbon all is lost.

  • DavidN

    We are past broke. I really expect some kind of world war out of this. There doesn’t seem to be any nice way to settle debts between nations anymore. The dollar or any fiat currency has no intrinsic value if more can be minted at will. Most nations are short of real assets, like oil, minerals and food.

    Maybe if we went back to barter between nations it would force some responsibility on government and people. This isn’t going to be easy for most people. I always knew I would have to work until I died of old age, but most people I know believed they would have some ease at the end of life.

  • joel

    Eric, there is absolutely enough gold to cover the world’s currency. Gold simply must be revalued to it true worth, and dollars deflated. See FOFOA.com for info on the concept of freegold, where all currencies float against a floating value of gold, not a fixed value of old.


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