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Wall Street Journal

 

The Coming Local Government Credit Crunch

March 10, 2009

By Nicole Gelinas

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Federal crowd-out and inflation risk will make it hard for states and cities to borrow.

President Barack Obama's $3.6 trillion budget designates $36 billion for transportation infrastructure. State governors and legislatures should spend that money wisely -- and even more importantly, they should use the remaining $229 billion they're getting in stimulus money to put their fiscal houses in order. If they don't, they risk burdening their constituents with devastating taxes in the near future.

Local and state governments face such peril in part because the federal government is about to saturate the market for U.S.-based debt -- including debt issued by municipalities -- as it props up failed financial institutions and distributes stimulus money. The federal government could overwhelm the credit markets. In the third quarter of 2008 alone, the amount of federal-government debt surged by 39%. This was "the largest quarterly growth rate recorded," the Federal Reserve recently reported.

It likely will get worse. Treasury debt held by investors around the world is slated to surge by 98% between now and 2013. That's overwhelming even in a growing market.

It's easy to see how such issuance could engulf demand for other types of private and public borrowing here and around the world. Even if the appetite for total credit-market debt were to increase as dramatically as it did over the past five years -- highly unlikely -- the federal government would be on pace to soak up 22% of that new demand. (The federal government's share before 2008 was just 10%.) In a stagnant or shrinking credit market, private and municipal borrowers would have to fight very hard with Uncle Sam to get attention.

It's also quite possible that demand for U.S.-based debt will shrink overall as China, for one, invests more money domestically with its own stimulus plan. Plus, at some point, global markets are going to worry that if the U.S. can find no more lenders, we won't be able to shrink our debt burden without devaluing our currency.

Lower demand in an oversaturated market -- plus the risk of inflation -- means higher Treasury rates, which will push interest rates up for everyone, including corporations and municipalities.

If that happens, healthy corporate borrowers might have some flexibility. Multinationals with operations elsewhere and heavy exporters have some choice, however limited, to borrow in other currencies and pay the debt back with revenue generated in those currencies.

Municipal borrowers, on the other hand, are stuck with dollars. Though their investors get huge tax exemptions, those benefits might be overwhelmed by two factors.

The first is that global wealth, particularly in high-net-worth, debt-dependent states like New York and California, continues to be destroyed. So there may be less demand for tax-sheltered securities.

The second is that if the stimulus retards recovery rather than speeding it up, more municipalities will be at real risk of default. That's dangerous, because right now municipalities are among a few classes of borrowers without a quasi-explicit guarantee from the federal government.

If investors decide to demand such a guarantee as municipal finances continue to deteriorate, the government may have a harder time assuaging their fears. The bailout boat is already sinking under the weight of AIG; it may not have room for Arnold Schwarzenegger.

Unfortunately, the stimulus bill will quite possibly retard recovery. The bill encourages yet more spending on education and health care rather than on public works that would improve private-sector productivity.

Governors should take these risks seriously. Instead, a few, including New York Gov. David Paterson, have called on the federal government to do more of what it shouldn't: spend scarce federal resources to bail out failed municipal-bond insurers.

What Mr. Paterson and his colleagues should do is shout to Washington that reckless federal borrowing hurts the ability of cities, towns and states to borrow, and thus infringes on their own sovereignty. At home, the governors should ensure that they're getting the biggest bang for every stimulus buck by investing in the right public infrastructure, like faster mass transit for productive urban centers.

It's a golden hour for governors to make good decisions -- finally -- about how to spend finite money. If they don't, they may pay for their own, and the federal government's, bad decisions over and over again.

Original Source: http://online.wsj.com/article/SB123672996312089009.html

 

 
 
 

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