As Illinois lawmakers wrestle with a $13 billion budget deficit – the equivalent of half the overall budget for the year – they are finding that simply keeping up with the interest payments on the debt is an onerous task. This year’s price tag: a crippling penalty of more than a half-billion dollars on debt issued in 2010.
Nevada, California and Texas are struggling with deficits as large as 44 percent, 29 percent and 32 percent, respectively, and these and other states will feel the impact of rising borrowing costs. So far, the solutions from both Democratic and Republican governors, including proposals for sharp cuts in government workers' benefits and a scaling back of bargaining rights, have sparked protests in Wisconsin and Ohio.
Beyond the grim implications for cash-strapped states, this scenario offers a preview of the pain that might befall the federal government if investors in U.S. Treasuries start to demand a premium because of uncertainty over the federal fiscal situation. Already, the Obama administration's budget proposal for 2012 projects that interest payments on the national debt will quadruple over the next decade, from $207 billion in 2011to $844 billion in 2021. Interest on debt held by the public is estimated to climb from 7.7 percent of total federal outlays in 2011, to 15.8 percent in 2016. If interest rates rise, those debt costs will climb even higher.
"If we don’t get a handle on our fiscal situation, investors will grow more nervous and demand a higher interest rate to buy our debt," said Mark Zandi, chief economist at Moody's Economy.com. "That, combined with deficits, will start to gobble up our budget and resources and ultimately will swamp us, much like rising interest payments swamped a number of European countries."
For sure, the U.S. government has more flexibility to manage its fiscal situation than the states because it can print money and run a deficit. Treasury securities remain the world's safe harbor investment, in spite of a $1.6 trillion U.S. deficit. In contrast, most states are legally bound to balance their budgets. Still, there are enough similarities that the woes of the state governments may predict the path ahead for the federal government.
"There are parallel situations because politicians at both levels of the government have irresponsibly pushed costs forward with Social Security and Medicare, making promises they can't keep," said Chris Edwards, director of tax policy studies at the Cato Institute. "State governments have done the same thing."
The coming year is shaping up to be the most difficult ever for U.S. states, which are predicting budget shortfalls totaling $125 billion as federal stimulus efforts expire before tax revenues recover from the economic downturn, according to the Center on Budget and Policy Priorities. "In a normal recession, it takes a couple of years for state revenues to rebound. This one is worse than usual," said Elizabeth McNichol, a senior fellow at the center.
"If you look at the credit default swap market, it's clear there's some nervousness in municipal markets about the possibility of state defaults," said Joshua Rauh, an associate finance professor at Northwestern University's Kellogg School of Management. One big concern: the $3 trillion in unfunded state and local pension liabilities.
The cost of insurance for Illinois' credit is comparable to that of Spain, Lithuania and Iceland. "Of all markets around the world, there are only 15 where there are levels that are higher than this," Rauh said. "There clearly is some worry in municipal markets about state and local finance."
Illinois will pay 20.9 percent more than better-rated municipal borrowers on the $9.6 billion of bonds the state sold in 2010, according to an analysis by the Civic Federation. The state's taxable bonds sold at yields from 5.5 to 7.5 percent.
State governments are facing a confluence of unfortunate events that add to their deficits: slow recovery from recession and the expiration of federal stimulus programs such as the Build America Bonds, which let states and localities borrow in the taxable market, said Gabriel Petek, a Standard & Poor's analyst. Build America Bonds benefitted municipal bond issuers in two ways: by giving them access to a new set of investors and also by shrinking the supply in the tax-exempt market, which tends to increase demand for their existing debt.
"State governments are under pretty intense fiscal pressure," Petek said, noting that reserve funds have been drained and other stop-gap measures exhausted. "State governments employed many one-time measures in hopes that the economy would recover. A lot of those temporary measures are reaching their expiration."
Most states still have sound credit quality and are unlikely to default, Petek noted. In contrast to countries like Greece, where a crisis of confidence left no willing investors, most states pay down their debt steadily over 30 years and aren't as dependent on short-term borrowing. Still the perception of instability by itself can lead to higher interest rates.
States with Projected FY2012 Gaps | |||
State (Top 10) | FY2012 Projected Shortfall | Shortfall as Percent of FY2011 Budget | |
1. Nevada | $1.5 billion | 45.2% | |
2. Illinois | $15 billion | 44.9% | |
3. New Jersey | $10.5 billion | 37.4% | |
4. Texas | $13.4 billion | 31.5% | |
5. California | $25.4 billion | 29.3% | |
6. Oregon | $1.8 billion | 25.0% | |
7. Minnesota | $3.9 billion | 24.5% | |
8. Louisiana | $1.7 billion | 22.0% | |
9. Connecticut | $3.7 billion | 20.8% | |
10. North Carolina | $3.8 billion | 20.0% | |
"If [deficits] are causing concern or consternation among investors, that alone may drive up the cost of borrowing even though the actual ability of the governments to repay the debt is not as constrained as the budget situation might suggest," Petek said. Standard & Poor's is keeping a close eye on the states' cash and liquidity management to make sure they have enough cash on hand for debt service.
For now, the federal government will continue to enjoy low borrowing costs, with 10-year notes costing the government only about a 3.5 percent interest rate. China is happy to keep buying Treasury bonds to fund the trade deficit, Rauh said. "For the time being, they are pleased to keep loaning us money so we can buy their goods," he said. "The question is what happens if and when China develops enough domestic demand for the goods they produce that they don't have to be as reliant on the U.S. That's the point at which one would be worried about issues with the Treasury market."
Like most states, the federal government isn't likely to default on its debt, projected to reach $10.9 billion in fiscal 2011. The real danger is that it will inflate its way out of the problem. Indeed, Zandi believes that it will take a sharp increase in interest rates before federal officials make the hard choices needed to reduce the deficit in the medium and long term.
"At some point, late 2013 or so, interest costs are going to rise rapidly," he predicted. "I don't think policymakers are going to be able to make the changes necessary without a push from global investors. They won't be able to connect the dots in the minds of the American people that if we don't make these hard choices, we’ll go down a path that would be much worse."
Related Links:
The Governor Who Cut His State Down to Size (The Wall Street Journal)
AIG Says Risk Rose on Munis; Defaults May Limit Liquidity (Bloomberg)
Amid Cuomo’s Medicaid Cuts, Health Care Workers’ Union Shapes a Victory (The New York Times)
