The Looming State Budget Crisis

States and local governments cannot rely on the Federal Reserve to print money. As they face financial difficulties not seen since the 1930s, this is significant. We see the consequence of this difference on display daily in the sovereign bond market; the United States and the United Kingdom have exceptionally low long-term interest rates despite large budget gaps while equally large budget gaps in Spain and Greece have been rewarded with crisis.

Last night 60 Minutes broadcast a must-see segment highlighting the state and local government crisis to come with pointed commentary from Meredith Whitney, the bank analysts and financial advisor, and Chris Christie, the Republican governor of New Jersey. The story they tell is very complicated involving numerous topics: jobs, stimulus, budget deficits, pensions, unions, municipal bonds and even bailouts or double dip.  The 13 minute video is below followed by a few comments.

Credit Writedowns has been writing about this problem for some time. See our posts under the tag "local government". One of the first posts in March 2008 titled "State and local governments: budget cuts likely" outlined how revenue shortfalls due to the housing bust would mandate budget cuts for states where balanced budget mandates are the rule, not the exception.

The question then becomes: what can we expect as taxpayers in terms of services for our hard-earned tax dollars? Charles Hugh Smith has an excellent blog on this very topic. My understanding is that much of the State and local budget is mandated and hard to cut. Therefore, cuts will occur in areas of greatest leverage: infrastructure — both human and transportation. It is a safe bet that we will get less in infrastructure and education, in particular. After incidents like the Minneapolis bridge collapse, we all know that our governments have continued to under-invest in infrastructure despite boom times. Now that revenue for local and state governments has fallen, it is to be expected that infrastructure projects will be even less likely going forward.

I expect many municipalities to enter bankruptcy. Others will be forced to make major cuts to stay viable and avoid bankruptcies. So, a likely outgrowth of the housing bubble is a decaying infrastructure and poor education. For those of us who can think of historical parallels, the United Kingdom after World War II is an apt one. There, decades-long under-investment after the crippling war left the country’s roadways and education system in a shambles from which it is still recovering over 60 years later. It wasn’t called the ‘Sick Man of Europe’ for nothing.

Also see "Are munis the next shoe to drop?" from April 2010 based on a post by Rick Bookstaber. Regarding risks in the muni market, I think Rick has this right. Federal stimulus has put the day of reckoning off and QE3 using municipal bonds may well do as well. But eventually, the cuts – and the defaults – are coming.

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