The Debt Demon
Have states and localities borrowed too much?
A new wave of negative thinking is abroad in the land, a fear that state and local governments have piled up more debt than they can pay off, and that there will be a cascade of defaults, such as occurred in the Great Depression of the 1930s.
Such thinking posits two things: First, the dire economic and financial conditions of the 1930s are about to be repeated. Second, we haven’t learned much about forestalling a surge in defaults by state and local governments. Neither of those propositions is true.
Let’s start with the 1930s. During that decade, one state and hundreds of local governments -- representing about 15 percent of outstanding state and local debt -- experienced a default. Individual bond issues that embodied actual monetary default (money that is late and not paid in full as promised) represented 7 percent of total outstanding debt. Of that amount, the ultimate monetary loss came to only 0.5 percent of the total debt. That’s because governments, after delays and refinancing, actually paid back 99.5 percent of the principal and interest that was due -- an extraordinary recovery rate.
Since then, default rates on municipal securities, especially tax-supported debt, have been trivial -- and there are multiple reasons for that. Local governments, which represented most of the government sector’s pre-Depression spending and taxing, are no longer the isolated, self-dependent entities they were in the early 20th century. Also, governments in the late 1920s and early 1930s relied heavily on short-term borrowing, so they were susceptible to rollover risk as the banks that lent them money either could not or refused to renew short-term loans. It’s no wonder the banking crisis from 1931 to 1933 coincided with the sharp peak in municipal defaults.
Today, state and local debt is much less of a burden on both the national economy and governments’ current revenues. In the late 1920s, state and local debt equaled 17 percent of the gross domestic product (GDP) and rapidly rose to 30 percent in the early 1930s. In contrast, in the late 2000s, such debt equaled 14 percent of the GDP. Accordingly, in the late 1920s to early 1930s, state and local debt was equal to two and a half times their annual current revenues. In 2008, total municipal debt outstanding was one times annual revenues.
Additionally, revenue collection is more stable than it was 70 years ago. Modern revenue systems stress withholding at source (including taxes embodied in mortgage payments) and collecting at time of transactions (sales and excise taxes). While delinquency on property taxes skyrocketed to 25 percent in the early 1930s, delinquency rates the past few years -- despite mortgage foreclosures -- have increased only slightly from about 1 to 2 percent in the largest cities. That’s because of mortgage insurance restrictions that require property taxes be paid in order for the foreclosing entity to keep the title to the property.
The makeup of bond issuers is also different today. States with larger and more diversified revenue sources than localities, are much larger players. In the late 1920s, state government revenues represented only 23 percent of the sector’s total revenues; in 2008, it was 61 percent.
Thanks to structural and policy changes that grew out of the 1930s, the nation’s banking system is much less inclined to the rapid, widespread failures that would lead to municipal defaults. This was just demonstrated during the recent Great Recession of 2007-2009, where extraordinary steps were taken quickly to maintain liquidity in the payments system.
The Great Recession was a severe test of the financial system. It bent but did not break. Yes, states and localities now face fiscal stress. But they are not nearly as indebted as in the 1930s, nor do they have heavy annual debt service burdens. Painful adjustments are being made by these governments, but there is not the sudden unrestrained downward spiral in income and prices that occurred in the 1930s. Some hard lessons have been learned.