Public finances

Can pay, won't pay

America’s most profligate states do not owe as much, proportionately, as Greece. But their politics are just as problematic

Washington, dc

THE state of Illinois has a rather crude way of coping with its ballooning budget deficit. It stops paying bills. Already, it has failed to pay more than $5 billion-worth. State legislators are paying their own office rent to avoid eviction. Schools and public universities are having their budgets cut.

Illinois owes Shore Community Services, a non-profit agency in suburban Chicago, some $1.6m for services to the mentally disabled. The agency has had to lay off a dozen staff. Jerry Gulley, the executive director, says his outfit’s line of credit could be exhausted soon. The bank will not accept the state’s IOUs as collateral. “That’s how sad it is,” shrugs Mr Gulley.

Comparisons between incontinent American states and Greece are all the rage. Though this is an exaggeration, credit-default-swap spreads, which measure investors’ expectations of default, are wider for some American states than they are for some of the euro zone’s other peripheral economies (see chart).

There are other similarities. Like members of the euro zone, American states may not declare bankruptcy, cannot be sued by creditors and, thanks to America’s federal structure, cannot be forced to behave by a higher level of government. They also do not issue their own currency, so inflating away their debt is not an option. And, like many European governments, state legislatures and governors are reluctant to impose the necessary pain. The Illinois legislature recently passed a budget for the next fiscal year, starting on July 1st, which leaves a $13 billion deficit to be closed.

The parallels with Europe are unfair, though only up to a point. American state and local debt last year was $2.4 trillion, about 16% of gdp. But most of that debt is issued by local governments or state agencies and has specific assets or fees, such as road tolls, earmarked for paying it back. Even in the weakest states, debt that needs to be paid out of general tax revenue was under 5% of GDP last year. Greece’s was 115%. The numbers for deficits show an even greater contrast. California’s deficit, assuming the state fails to close it, would equal only 1% of its GDP, compared with 14% for Greece and 9% for Portugal last year.

Greece and Portugal do not have separate federal and state governments, however. So a fairer comparison would take account of gross American federal debt, which currently stands at 85% of GDP. This underlines the fact that most of America’s debt problem is federal not local. The consequence is that, because states’ refinancing requirements are relatively low compared with their tax revenues, no state faces an imminent liquidity crisis. California’s treasurer, Bill Lockyer, is fond of saying that California will not default unless there is thermonuclear war.

It was not always that way. From 1841 to 1842, in the wake of a series of financial panics and recessions, eight states and Florida (then a territory) defaulted. John Wallis of the University of Maryland says that this first series of defaults led states to set up strong constitutional barriers to debt accumulation. States now commonly require either a referendum or a supermajority vote of the legislature to issue a general obligation bond (one not backed by earmarked revenues). All states, except tiny Vermont, now require their annual operating budgets to be balanced, which limits the racking up of debt over time. Many state constitutions also enforce repayment of debt. In California, for example, only schools can be paid ahead of bondholders. This is one reason that state defaults are so rare; the last was by Arkansas in 1933. In 1975, New York state passed a moratorium on servicing New York City debt unless its holders agreed to a restructuring. The next year the state’s court of appeals ruled it unconstitutional.

Still, the prospect of default is not quite as remote as these comforting comparisons suggest. That New York even tried to force a restructuring on creditors, albeit New York City’s, illustrates that the threat of default is primarily not economic, but political. With revenue plummeting, legislatures and governors are often unable to agree on spending cuts or higher taxes to narrow the gap. California’s dysfunctional politics are a big reason why Moody’s rates California only a few notches above junk. “This is the seventh-largest economy in the world—it’s not an ability-to-pay issue,” says Robert Kurtter of Moody’s.

States are also finding ways round the constitutional barriers to borrowing. New York needs voters to approve any general-obligation bond; so, since 2002, it has relied on bonds backed by personal income-tax revenues which don’t require that approval. In January Illinois issued $3.5 billion in bonds to fund its pension payments, and may issue a similar amount in the coming fiscal year, though pension obligations are clearly an operating expense.

Most troubling of all is the squeeze budgets are facing from their unfunded obligations for civil-service retirement pension and health benefits. The Pew Centre on the States, a research organisation, put these at $1 trillion in 2008. In a report, Joshua Rauh and Robert Novy-Marx, finance professors at Northwestern University and the University of Chicago respectively, note that these liabilities are coming due at an alarming rate. By 2018 Illinois will be paying $14 billion a year in benefits, equal to more than a third of the state’s revenue, compared with $6.5 billion now. Mr Rauh says bondholders should worry because several state constitutions, including those of Illinois and New York, make state pensions senior to bond debt.

Still, the assumption of many investors is that the federal government would never let a state default. It might allow an isolated case, but if a default looked like the start of a wave, the federal government would surely blink—just as Europe did when confronted by Greece.