Funny Muni

Megan has been making her case for allowing the perennially fiscally stressed state of California to default on its debt, should it come to that. It wouldn't be fun, she says (and really, it wouldn't), but saving California would eliminate the possibility of real reform of the state's budget process, which is absolutely necessary. It would also open up a giant can of moral hazard worms, which would wriggle their way through the mud of state and local budgets around the country. End metaphor.

This seems like a good time to quote Warren Buffett, who recently discussed this issue with shareholders, writing:

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let's go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds - virtually all uninsured - were heavily held by the city's wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city's fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York's citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city's bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to "share" in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

He was making the point that Berkshire was pricing insurance based on a world with few muni defaults, but adding insurance to that world would change default probabilities -- making Berkshire more exposed than it had anticipated. But a similar point applies to a government guarantee. It may seem like a relatively cheap solution, since states don't find themselves in these situations very often. But the effect of an guarantee, explicit or implicit, would be to increase reckless borrowing and reduce attempts to fix messes at the local level. Suddenly you have a world where the feds either need to exert a lot more control over state budgets or where feds will be routinely shelling out on behalf of local and state borrowers. Or, as Megan says:

But once the treasury has bailed out a single state, there will be a strongly implied guarantee on all such debt.  So you don't give them the keys to the vaults, but you do leave a window open, point out where the money's kept, and casually mention that you've given the armed guards the week off.

I don't see how the government can make a credible committment not to bail out various localities who overspend, if it's already done so.  And if that's the case, there's no way to avoid the moral hazard, so we might as well go ahead and offer the explicit guarantee in exchange for some sort of say in how the money is procured and spent.

Farewell, Federalism . . . we hardly knew ye...

Here's the thing -- I don't think the government can avoid saving California this time.