States Could Face Debt Crisis Soon

Although much focus has been placed on the federal debt, many states also have significant debts which they have been trying to hide through a range of measures. As these debts and obligations continue to grow, many states are resorting to more and creative, and desperate, measures to make required payments, which could ultimately lead to a downward spiral in their financial strength. See the following article from Expected Returns.

The head-in-the-sand brand of economics has permeated every aspect of government as a historic debt crisis approaches. It is the convergence of private and public debt- both at the Federal and State level- that distinguishes this debt crisis from the more mundane kind. In predictable fashion, faced with insurmountable budget holes, states are resorting to accounting gimics that would make Arthur Anderson blush.

From the New York Times, State Debt Woes Grow Too Big to Camouflage:

California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes, and armies of retired public workers who are counting on benefits that are proving harder and harder to pay.

And states are responding in sometimes desperate ways, raising concerns that they, too, could face a debt crisis.

New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million.

Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.

In an ordinary debt crisis, there are any number of entities available to bail out guilty parties. In the current debt crisis, the level of indebtedness is unheard of, the scope of the debt is boundless, and the political will to tackle the debt is non-existent.

Economists often point to the debt to GDP ratio of 120% following World War II to justify current levels of debt. They argue that in comparison, debt to GDP levels approaching 100% are reasonable. However, these economists are missing one key point. Back then, we owed the debt to ourselves; today, the debt is largely held by foreigners. In economic parlance, this is called a transfer of wealth.

When foreigners own so much of our debt, they can wield the economic "nuclear option" and dictate domestic economic policy. We are already seeing this dynamic play out in the direct MBS purchases by our government precipitated by political pressure from foreign holders of our debt. This brings up important questions of sovereignty. Post-World War I Germany comes to mind as an economy brought down by onerous debt levels and an economic system subject to the will of foreign agents.

This isn't just theory- the debt crisis is having real, measurable effects on jobs. Illinois plans to lay off as many as 20,000 teachers, and New York City is cutting its police force. Don't be fooled- the cuts in the public sector will accelerate as this is a secular trend.
Underfunded Liabilities

Some economists think the last straw for states and cities will be debt hidden in their pension obligations.

Pensions are debts, too, after all, paid over time just like bonds. But states do not disclose how much they owe retirees when they disclose their bonded debt, and state officials steadfastly oppose valuing their pensions at market rates.

Joshua Rauh, an economist at Northwestern University, and Robert Novy-Marx of the University of Chicago, recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion.

After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders.

“When you see that, you recognize that states are in trouble even more than we recognize,” Mr. Rauh said.

The pension crisis, and by extension the debt crisis, will intensify if the General Accounting Standards Board, or GASB, is successful in changing accounting rules to force unfunded pension obligations onto the balance sheet. Some of the more pertinent proposed changes include adjustments of pension fund discount rates and a shortening of the amortization period. This would be a stark change from the sleight-of-hand accounting that is the standard in America.

For example, the Federal government regularly raids Social Security funds and replaces them with "special-issue" government securities. These government securities are different from government bonds in that they can not be sold to foreigners. In effect, the government is issuing an IOU to itself, to be repayed at an undetermined date in the future. And here's the kicker: These securities are considered assets on the annual Social Security trust fund reports in what can only be described as voodoo accounting. Surely if you or me tried to engage in such a con game, we would be locked up in jail or a mental institute. But alas, this is the kind of accounting bs that goes on regularly in government.

Now back to the pension crisis. There are significant and dire consequences to states' budgets that proposed GASB accounting changes would bring. First of all, if states were forced to report unfunded liabilities, there would be debt downgrades across the board, which would raise the costs of servicing debt. Second of all, if discount rates used to calculate future obligations were to change from the industry standard of 8% to more realistic levels, pension obligations would effectively increase close to a trillion dollars. And finally, the amortizing of liabilities over a shorter period of time would increase current expenses. All of these factors push the timetable of a major crisis forward.

The likely response of state governments with their backs against the wall will be to take on bigger risks with taxpayer money. Think Lehman. Think Bear Stearns. Think bubble. States will turn to derivatives to mask balance sheet disasters. These kind of crises never end well. As the government's balance sheet implodes, gold will explode. The rocket launch in gold will be shocking.

This post has been republished from Moses Kim's blog, Expected Returns.