What the Federal Debt Limit Has to do with States (and Not)

By :: July 22nd, 2011

Much has been written about how a failure to reach agreement on the federal debt limit would affect the economy and global financial markets.  Lately, attention has turned to state and local governments.  Moody’s warns that a federal credit downgrade would immediately lower ratings for 7,000 state and local issuances and possibly affect even some gold plated AAA states.   At the same time, backers of a federal balanced budget amendment point to states as an example where such rules have worked.

What’s going on?  Will a federal default doom state and local governments?   Are states the new model of fiscal probity?

First, it’s important to remember that although state tax receipts are picking up, states and localities are still climbing out of a revenue hole created by the Great Recession.  Meanwhile, federal stimulus funds have largely run out along with easy fixes like selling off assets, raiding special funds, and deferring obligations.  Against this backdrop, any federal action that cuts off revenue or increases costs is not helpful. 

Next, state and local governments are already feeling the brunt of “extraordinary measures” undertaken when the federal government hit its debt limit in May.  Back then, the U.S. government stopped issuing State and Local Government Securities.  Affectionately known as SLUGs, these securities allow state and local governments (much like mortgage holders) to refinance their debt without violating federal rules against arbitrage, or profiting from their tax-exempt bond authority. 

This is a headache, although hardly the end of the world.  State and local borrowers can still refinance, but they have to do it by assembling the right bundle of regular U.S. Treasuries, usually with the help of a paid financial advisor.

Now, if U.S. Treasuries were downgraded, all state and local debt refinanced in this manner would fall with it.  To be sure, these bonds represent only $130 billion out of a $2.95 trillion market.  However, this is small consolation for the pension funds, insurance companies, and other entities who purchased this debt once hailed as “just as safe” as U.S. Treasuries.

Of course, none of this will seem very important if we are in a double dip recession or global credit crunch.  As Moody’s notes, particularly at risk would be states dependent on federal contracts or salaries paid to federal workers as well as those with more variable rate debt.  But all states and cities are concerned about what will happen if tuition aid, Medicaid payments, and community development funds dry up when the federal spigot turns off.

In truth, no one knows what will happen after August 2nd.   It’s not clear whether and how the federal government would “prioritize payments,” and if so where states and localities would stack up against other claimants.

Originally posted at the Brookings Institution Up Front blog as part of an "Around the Halls" discussion on the debt limit.

 

7Comments

  1. Michael Bindner  ::  9:43 am on July 23rd, 2011:

    It won’t come to default, unless Moody’s et al reject the idea of a 14th Amendment solution. If they endorsed it – indeed if Obama endorsed it – it would put more pressure on the Congress to do a deal – since once this precident is made, the Congress loses leverage.

  2. Michael Bindner  ::  12:35 am on July 25th, 2011:

    That would actually be the big story of the week – Moody’s either endorsing the Constitutional Option or rejecting it. Either action would force Congress to act more quickly, although the rejection may upset the markets a bit. Still, such an upset ahead of an actual default might just give people the push they need. Acceptance tells Congress that they lose all leverage if they don’t act. Either way – if TPC has a relationship with Moody’s, now would be the time to get them to say something.

  3. Vince  ::  8:23 am on July 25th, 2011:

    WoW! A nice interpretation on the Federal Debt Limit. Nice article. Thanks for sharing.

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    One of the oldest forms of taxation in the US is that of buildings and land, commonly known as property tax. As a matter of fact, Property Tax Law was introduced first, even before the introduction of sales and income tax.

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