Why States Are in Trouble – Five Reasons

If you listen to MSNBC and FOX news on TV, you hear two very different stories about the state budgets. According to FOX, the states are in danger of bankruptcy. The situation is dire. We must DO SOMETHING NOW! According to MSNBC, at least when it comes to Wisconsin, Rachel Maddow and others will tell you that there is no state budget problem.

Who’s right? NEITHER!

(1) State pension funds followed banks into the same boat

Many state pension funds did the same thing that banks did. They did not keep sufficient capital reserves on hand to cover big emergencies. According to the Financial Times, Investment losses hit public sector pensions” in the first two months of 2009, US “state and municipal pension plans lost 9 per cent of their value” of more than $2 trillion dollars. By January of 2010, a  FT headline “US public pensions ‘facing $2,000bn [$2 trillion] shortfall‘.” Some US pension funds even speculated on commercial real estate deals just like the banks who are now failing did.

Interestingly enough, Wisconsin was not one of those states. On November 1, 2010, Wisconsin was one of only two states to score 100% on its capital-reserves safety-rating among the 50 state pension funds.

Investments made by many state pension funds “went south” during the financial crisis. A particular case in point is Calpers, the state pension fund for California. In 2007 Calpers made a deal with Lennar, one of the biggest construction companies in the US, if not the world, to buy land to be developed in LA and other parts of Southern California. When the crisis hit, Lennar decided not develop the sites, leaving Calpers and a holding company stuck with the bulk of the now-worthless land.

Pension funds, including state and local pension funds, are called “institutional investors”. Like banks, these institutional investors – pension funds, mutual funds, private colleges, local governments, and other large institutions – invest billions of dollars in order to do their job of paying out money they’ve promised to their clients.

Pension funds are suffering now because too many of them made rosy projections about how much money they would be bringing in. Overall, many pension funds are in trouble because they made bad forecasts about the markets. But unlike banks and large corporations, there will be no bailout funds for states from the federal government.

Like many regional and community banks, pension funds are struggling to stay afloat. Some states are now looking into whether they can abandon their pension funds and replace them with 401K plans. Given the fact that the WSJ reported 60% of the aged 60 to 62 are far short of being able to retire on their Social Security and 401K plans now, abandoning pubic employee pensions will be likely to become one more disaster that the next generation of Americans will have to deal with.

(2) State governments did not foresee the financial crisis

Even the Wall Street Journal says in its article Budget Battles Roil Straitened States: What Went Wrong, “The budget woes in most states result from a cascade of events largely triggered by the recession of 2007-2009. The downturn meant declining tax revenue as workers were laid off and spent less.” State governments, like the rest of us, never foresaw a job market with ten percent unemployment.

Fumbled revenue forecasts also seriously impacted state income tax revenues. States like California who have capped property taxes are even further handicapped. Only sales taxes remain to be raised when revenue from other kinds of taxes drop or are capped. This is indeed what is happening with county sales taxes rising to over 10% in some places.

Sales taxes, of course, hit the poorest people in the state because in California they pay sales taxes on food. Sales-tax increases are particularly hard on workers who need to commute to work. And they affect industries, retail businesses, and agribusiness who need gas and oil to run equipment or use raw materials that go up in price because of taxes – sales taxes.

(3) State governments did not anticipate the loss of federal funds

With Republicans attacking federal government spending in earnest, states will not get the federal tax funds they have relied on in the past. The federal government is cutting back on subsidies to the states, Some state governments have begun refusing federal funds. Those states will soon suffer the most from lack of infrastructure, education, and services.

Those states may also lose industry and jobs to states who are able and willing to provide the highways, rail services, training and other support needed by large American and foreign companies. Large corporations often “shop among states” for the best place to locate their businesses. Tax cuts alone won’t serve to make them locate in a state.

Many larger companies have begun complaining about the limited amount of visas available for hiring foreign workers. They say that they need foreign workers because Americans are not well-enough-educated  to do the jobs they need to fill. Yet here we are, with many states cutting education to the bone.

(4) States rely on the bond market to borrow funds.

Just as companies issue corporate bonds, states issue municipal bonds when they need funds. Bonds are loans. They need to be repaid by a certain time. States are now in a position of borrowing when their ability to repay (due to tax losses) is low. As a result, buyers of bonds worry about whether they will be repaid by the states. Because of that worry, states have to offer of a higher interest rates to get reluctant bond-buyers to part with their money for a state’s bond.

So, now we have a situation where companies, who are sitting on wads of cash, can easily raise even more cash, some of it from the US government and state tax cuts to business, and the rest from selling corporate bonds at unusually low rates of interest (thanks to the Fed’s holding interest rates low).

In order to make their bonds attractive to buyers, states, trying to compete in the overall bond market that includes corporate bonds, have relied on tax exemptions given to municipal bond holders. At a certain point, even tax exemptions on states’ bonds may not be enough incentive.

Predictions are being made by economists such as Nouriel Roubini about the possible failure of some municipal bonds. Many of these may be smaller local bonds. But all this spells trouble. In the future states may find few takers for bonds once considered stodgy, but are now increasingly considered risky.

(5) States are now not responding rationally to the financial crisis.

If you were suddenly confronted by a number of bills you didn’t expect; the rates on your credit card(s) were raised; and your credit rating was in danger of being significantly reduced; would you go to your boss and say you wanted to work fewer hours and earn less pay? And then give your kids bigger allowances? Of course not! But that is what many states are doing.

Many states are slicing their own income by proposing to extend tax cuts, give new tax cuts, cap property tax rates, and to stop trying to collect delinquent taxes. Taxes are the main form of government income. Without income, a government cannot pay its bills. Nor can it do what it is supposed to do for citizens.

State and federal deficits are simply the “balance on their credit cards”. Yes, there is a problem with that balance. Because of the financial crisis, the balance is getting too high for some of the states. That means the credit rating of the states could be downgraded. And that means governments’ costs of borrowing will go up further, causing a spiral into further debt.

The writing is on the wall. Democrats who say there’s no problem with the budget(s) are dead wrong. But Republicans who say the threat is dire and imminent are wrong too.

The reason that the federal government is in crisis right now is that Congress set a limit (by law) on how much it could spend. It’s as if you decided you wouldn’t run up a credit card debt of more than $5,000 maximum on a card with a $25,000 credit limit. It’s not as if you have maxed out your card, or you couldn’t spend more if you had to.

What’s really pushing the states into crises right now is the insistence that the public sector, which has incurred huge amounts of debt as a result of investing in private sector deals which went bad during the financial crisis should spend more money, in the form of tax breaks, on the private sector.

The top tier of the private sector is doing just fine right now. US companies are sitting on 1.4 trillion dollars in cash. Even small-cap corporations are doing well now. It is local businesses, the self-employed, and the American worker who aren’t doing well. According to David Cay Johnston, author of the book, Free Lunch How the Wealthiest Americans Enrich Themselves at Government Expense and Stick You With The Bill, American workers’ wages have risen only $300 or less on average since 1980! Pensions of public employees will obviously be reduced too or converted to inferior 401 K plans because state pension mangers did not foresee the possible outcomes of the financial crisis.

Having no more workers at the bottom of the private sector left to squeeze for profits, state governments are now bleeding the the public sector even more in order to continue subsidizing the richest parts of the private sector through corporate tax cuts, property tax caps, and drastic cuts to federal and state programs to catch tax evaders and make them pay up. Even the poorest of all, Medicaid recipients, are being squeezed to death.

All this leaves only one question. Who will be left to pay the piper next?