State and Local Debt Bombs Ticking Throughout US Heartland

Monday, 02 Aug 2010 08:34 PM

By David A. Patten

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The 50 states have racked up a record $2.4 trillion in bond debt during the economic downturn — the highest level of state and local indebtedness in history, economic analysts warn.

State and local bond debts now consume 22 percent of the nation’s annual gross domestic product (GDP) — a bigger slice of the economic pie than ever before, according to Manhattan Institute senior fellow and City Journal senior editor Steven Malanga.

Based on an analysis of federal data on state indebtedness, Malanga calculates that state and local debt has skyrocketed from 12 percent of GDP in 1980, to 15 percent of GDP in 2000, to an estimated 22 percent in 2010. That’s the highest it has ever been, and those figures do not include the estimated $3 trillion in state and local pension obligations.

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The municipal bond debt that cities, counties, and states accumulate often is used to pay for major infrastructure projects: toll roads, airports, bridges, water and sewage treatment plants. But too much debt can drain more money from federal coffers, when members of Congress act to stave off the massive layoffs that can occur when states try to balance their budgets.

The stimulus bill provides a classic example of the interaction of state and federal budgets. The Congressional Budget Office (CBO) revised the bill's original tab of $787 billion upward by nearly 10 percent in January 2010, pegging the new cost at $862 billion. The bill contains more than $160 billion in direct aid to states, much of it to stave off layoffs in law enforcement and education.

Ironically, it also contained an inducement for states to take on even more municipal bond debt by creating a new classification of municipal bond called Build America bonds. Unlike regular bonds, Build America bonds are not tax free. But they have a good yield and the federal government subsidizes about 35 percent of the interest cost. State and local governments have added more than $118 billion in debt from this one instrument since the stimulus bill was passed in February 2009.

How much more record debt international markets will tolerate is an open question. Municipal bond debt tends to be sold domestically, while many of the largest consumers of federal debt are foreign nations such as China.

On Thursday, the CBO warned that the federal debt as a percentage of GDP has jumped 36 percent in just three years. And greater spending on Social Security and Medicare as the population ages is expected to pressure those numbers even higher.

CBO chief Douglas Elmendorf warned: “Unless policymakers restrain the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches, growing budget deficits will cause debt to rise to unsupportable levels.”

But Elmendorf’s report does not address skyrocketing state and local debt. Adding those obligations to the federal deficit suggests the overall public debt picture in the United States is far grimmer than previously recognized.

As Wall Street Journal columnist Daniel Henninger recently observed: “Americans, staring at fiscal crevasses opening across Europe, have to decide if they also wish to spend the next 50 years laboring mainly to produce tax revenue to pay for public workers' pensions and other public promises. The private sector would exist for the public sector.”

Moreover, unlike in previous recessions, prospects that federal and state governments can grow their way out of debt as the economy expands do not appear bright in the months ahead.

On Friday, the Commerce Department reported that the nation’s economic growth was unexpectedly low in the second quarter, just 2.4 percent. That level of growth, top economists say, is so sluggish that the unemployment rate, which had settled back down to 9.5 percent, is expected to resume its upward climb and probably will cross the 10 percent mark by December.

Those declining economic conditions on the national level have battered state tax revenues.

For a host of reasons, federal and state debts are quite different. The federal government can essentially print its money, while the states cannot. But a good argument can be made that federal and state indebtedness should be tallied to give a more accurate estimate of U.S. debt.

Many European countries, Malanga says, do not have state-level debt to contend with. That means rosy comparisons to U.S. debt levels, which shows some European nations carrying much more debt as a percentage of their GDP, may be deceptive.

"If you follow Milton Friedman's prescription that debt is just future taxes that has to be collected,” Malanga tells Newsmax, “then you probably should add the municipal [bond] debt. Because one way or another, it is going to have to be paid off, just like the federal debt has to be paid."

Brian Riedl, lead budget analyst for The Heritage Foundation, agrees that spiraling state and city debt can have an important impact on the nation’s overall economy.

"Examining only the federal government's debt provides only a partial picture of the nation's finances. The federal government, state governments, and local governments are all borrowing from the same pool of savings,” Riedl tells Newsmax. “Therefore they all have a large combined effect on the economy and interest rates.

“In the long term,” he adds, “all of this debt at all levels of government is going to have to be repaid by the same 300 million Americans' taxes, regardless of whether the check is ultimately written by the state and local government themselves, or through a federal bailout, or whatever arrangement is enacted."

The skyrocketing indebtedness is the latest sign the 50 states are on a collision course with chronic budget woes — often because of the very stimulus policies intended to rescue them from the Great Recession, some experts say.

That chilling analysis, supported by several leading economists, is forcing governors and state legislators around the country to consider that a stunning possibility: As bad as their budget problems have been so far, things may be getting worse.

Part of the problem is that President Obama's stimulus spigot is beginning to squeak shut. States received $60 million to help them pay for education and Medicaid last year. This year, that number drops to $36 million.

That reduced flow of federal dollars is revealing the daunting circumstances many states still face: lingering unemployment, repeated revenue shortages, and pension and benefit commitments that appear to be unsustainable.

"Washington has made things much worse for states because our nation has moved so far away from sound economics," "Rich States, Poor States" co-author Jonathan Williams says in the August issue of Newsmax magazine.

"Unfortunately," Williams adds, "the Obama administration is talking about sticking it to big business more than they are, making the U.S. a less competitive place for capital. And believe it or not, without capital you don't grow jobs."

"Rich States, Poor States" is an economic-competitiveness ranking of the states published by the American Legislative Exchange Council.


Although experts disagree over what's causing the rising flood of red ink that is bleeding from state budgets, they do agree things will probably get worse before they get better. Without full employment, states’ hopes of meeting their obligations and paying down their bond debt are dim, experts say.

Williams says many states hurt themselves by raising taxes and shifting the burden to higher wage earners. Such policies, he says, overlook the fact that states essentially compete with each other.

"You cannot build a Berlin wall around your state border to keep the most successful people in," Williams says in the exclusive interview with Newsmax. "If you raise taxes high enough, believe it or not, people actually do leave.

"In 'Rich States, Poor States' we find that the migration trends are just astounding: People vote with their feet, and they vote very strongly against high taxes and high regulatory burdens," says Williams.

In other words, people move to states with less burdensome tax policies.

In addition to predatory taxes, Williams and his two co-authors, the noted economists Arthur B. Laffer and Stephen Moore of The Wall Street Journal, blame several other factors for states' persistent economic woes. Among them:
  • Massive pension liabilities. While private-sector employers have been shifting workers onto 401(k) plans, most of the nation's 20 million state and local government workers remain on pension plans. States have more than $360 billion of unfunded pension liabilities. The worst offender is Illinois, whose pension system is funded at only 46.1 percent. Private-sector plans funded below 65 percent are considered in critical condition.
  • A serious spending hangover. State budgets grew too rapidly during the boom years, they say. From 1997 to 2007, Arizona, Nevada, Wyoming, Florida, and California — all states hit hard by the recession — increased state and local spending by more than 50 percent. Arizona's public spending led the pack, jumping a stunning 73 percent.
  • The "stimulus curse." The $63 billion that Congress doled out to states for education and Medicaid last year enabled state legislators to put off the worst of the financial reckoning. With stimulus aid dropping to $36 billion for 2011, according to the Center on Budget and Policy Priorities, states now face drastic belt tightening.
The analysis gives four examples of how not to govern a state: California, Michigan, New Jersey and New York.

California has the 46th-worst economic outlook, the study says. New Jersey is No. 48, and New York places dead last at No. 50.

Michigan is No. 26, despite powerful unions and the auto-sector downturn.
"We call it the California, Michigan, New Jersey, and New York disease," the authors write. "Increase taxes, let the unions run amok, punitively regulate businesses — and watch the jobs disappear."

Williams remains pessimistic that states can bank on a hiring boom anytime soon to help them get back in the black. He says states are at a fiscal crossroads, and must take serious fiscal steps now to become more competitive.

The Manhattan Institute’s Malanga tells Newsmax that in some ways state-level debt is more difficult to address than debt on the federal level. The federal government can benefits from Medicare and Social Security, for example, to help those programs remain solvent. But states often have no such flexibility.

“The way many state pension funds are conceived, oftentimes the obligations are put into legislation, or even sometimes into the very state constitution,” he tells Newsmax. “Those benefits in many cases can't be cut, or those payments can't be voided, without serious legal implications.”



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