Wednesday, 21 September 2011

Who Will Look After Little Brother?

One potential debt crisis that has escaped our attention so far this year is that of the US States. An interesting feature of the American political system is that the political sub-units – the US States – enjoy a greater deal of fiscal freedom than many political sub-units elsewhere in the developed world. Whilst US State governments follow a more integrated monetary policy, which tends to reflect a national agenda, they also have the ability to pursue a more independent fiscal policy.

To this extent, the US system is comparable to the Eurozone. We must not follow the analogy too far because the American States are different to the Eurozone nations in that they have more of a common heritage, a common language, and a tradition of openness within a broader economy than the EU has yet to develop. And yet, we cannot but help to think in terms of California having a GDP similar to Italy, or Wisconsin the size of Ireland, and so on. It is instructive to do so when considering the issue of potential monetary instability.

The average fiscal deficit to GDP ratio in the Eurozone is about 4.2%. This average hides a wide dispersion of results, from a Greek deficit of about 10.0% of GDP to a German deficit of about 1.7% of GDP. The situation in America is slightly different. The estimate for US Federal debt is about 9.0%, which is in the ball park in comparison with some of the Eurozone nations. However, the average State debt is about 16.5% of State GDP, which is a figure that makes Greece appear to be fiscally prudent. There is some debate about the accuracy of these figures (State GDP is very hard to measure in a fluid and open economy such as the US), and we have to remember that there is also a political agenda to their estimation. Additionally, there is also a greater deal of dispersion around this mean, from Wyoming (with a deficit of about 6% of State GDP) to Massachusetts (with a deficit of about 25% of State GDP).

If we believe that the US State deficits and the US Federal deficit are additive, that would imply total public debt in the US of about 25%. This seems rather large to us, and suggests that an element of double counting has crept into the estimations. Nonetheless, we are comfortable with the conclusion that US States deficits are worse than those of the Eurozone nations, and that there is a greater variation of experience with the deficits of the US States. All of this remains hidden by the US Dollar being the world reserve currency. Just as the weaker Eurozone nations have hidden behind the collective strength of the Euro, so the US States have hidden behind the US Dollar being the world reserve currency. This has kept down the cost of borrowing for US States and has made funds more readily available than the fiscal environment would otherwise have offered without this feature.

Looking into the future, one wonders how long this will last. If the US credit rating suffers further deterioration, then there may well come a point where the position of the US States is re-evaluated in the bond markets. Just as the more vulnerable Eurozone nations have suffered the scrutiny of the bond markets, so could the weaker US States, such as Michigan or California. If that were to happen, then rather unfortunate consequences could result. In thinking about what could happen next, we have found the case of the near bankruptcy of New York City in the 1970s to be instructive.

The relative fiscal independence of the US States means just that – they are responsible for themselves. If their finances were to come under pressure, then there is no automatic mechanism whereby the Federal government would have to bail them out. If the Federal government took a position of moral hazard – that those who made the mess have to clear it up – then it is quite likely that the State governments would respond by increasing revenues (charges as well as taxes) wherever possible, along with the more likely policy of cutting back expenditure very hard. Even today, it is not entirely unknown for the staff in some States to be paid in IOUs, which are redeemed for cash by a credit union or bank. We could well see a lot more of this. It is at this point that one of the great strengths of the US economy becomes one of its weaknesses.

Although there is some migration between nations in the EU, by and large, European populations are having to bear fiscal austerity. The tax base is relatively stable and the pain of spending cuts is simply endured. This is not so in the US. Given the open nature of the US economy, given the fluidity of its labour market, and given the relative homogeneity of the population, it is far easier to move house. Often to a different State. It is relatively easy to move from fiscally imprudent New York to fiscally prudent Connecticut – you would simply be moving further up the commuter line. This feature creates an instability to the State finances. It is generally the case that the tax base is highly mobile (and will pack up and leave if taxes are seen as too high), whilst the spending base tends to be immobile. The tax base moves out, whilst the spending base stays put. For a State under pressure, this will make the situation worse.

In this future, if it came to pass, the Federal government would have to bail out the State, much as it eventually had to with New York City in the 1970s. Not because it has to, but because it is in its interest to do so. The cost of such bail outs would be truly staggering, and we can see why the Federal government is reluctant to contemplate it. This completes the circle, because a failure to contemplate the downside of the finances of the US States may well lead to a further downgrading of the US by the ratings agencies.

Most visions of the financial future do not account for adequately the inherent instability that the US State finances could contribute to the global monetary system. We feel that this is a mistake. We fear that the realisation of this weakness could lead to a sudden correction in valuations that itself could become a destabilising factor. Then we will all be wondering who will look after the little brother.


© The European Futures Observatory 2011

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