" The Global Debt Crisis is a brilliant advance on the central peril of modern democracy.
Peterson and Nadler and their colleagues show, in lucid detail, that the American and
European debt crises grew from within our federal systems of layered sovereigntyand that the way out requires strengthening, not weakening, our federal structures. Readers will learn how federalism and financial markets can fortify democratic accountability at every level and how centralizing debt can jeopardize both solvency and democracy. This is first-rate scholarship with political punch."Christopher DeMuth, former president of the American Enterprise Institute
The Global Debt Crisis: Haunting U.S. and European Federalismby Paul E. Peterson
Debt crises have placed strains not only on the European Union's nascent federal system but also on the federal system in the United States. Old confrontations over fiscal responsibility are being renewed, often in a more virulent form, in places as far flung as Detroit, Michigan, and Valencia, Spain, to say nothing of Greece and Cyprus. Increasing the complexity… See more details below
Debt crises have placed strains not only on the European Union's nascent federal system but also on the federal system in the United States. Old confrontations over fiscal responsibility are being renewed, often in a more virulent form, in places as far flung as Detroit, Michigan, and Valencia, Spain, to say nothing of Greece and Cyprus. Increasing the complexity of the issue has been public sector collective bargaining, now a component of most federal systems.
The attendant political controversies have become the debate of a generation. Paul
Peterson and Daniel Nadler have assembled experts from both sides of the Atlantic to break down the structural flaws in federal systems of government that have led to economic and political turmoil. Proposed solutions offer ways to preserve and restore vibrant federal systems that meet the needs of communities struggling for survival in an increasingly unified global economy.
Contributors: Andrew G. Biggs (American Enterprise Institute); César Colino (National Distance Education University, Madrid); Eloísa del Pino (Instituto de Políticas y Bienes Públicos, Madrid); Henrik Enderlein (Hertie School of Governance, Berlin); Cory Koedel
(University of Missouri); Carlos Xabel Lastra-Anadón (Harvard University); Daniel Nadler (Harvard University); Shawn Ni (University of Missouri); Amy Nugent (Government of Ontario, Canada); James Pearce (Mowat Centre, University of Toronto,
Canada); Paul E. Peterson (Harvard University); Michael Podgursky (University of Missouri); Jason Richwine (Washington, D.C.); Jonathan Rodden (Stanford Uni versity); Daniel Shoag (Harvard University); Richard Simeon (University of Toronto, Canada); Camillo von Müller (University of St. Gallen, Switzerland, and Leuphana University, Germany); Daniel Ziblatt (Harvard University)
" The Global Debt Crisis is a brilliant advance on the central peril of modern democracy.
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The Global Debt Crisis
Haunting U.S. and European Federalism
By Paul E. Peterson, Daniel Nadler
Brookings Institution PressCopyright © 2014 THE BROOKINGS INSTITUTION
All rights reserved.
Federalism's Emerging Fiscal Crisis
No pecuniary consideration is more urgent, than the regular redemption and discharge of the public debt: on none can delay be more injurious, or an economy of time more valuable.
—George Washington, message to the House of Representatives, December 3, 1793
It is well understood that defaults, bankruptcies, and fluctuations in interest rates are shaped by business cycles, banking management, and financial engineering. However, credit risk among the lower tiers of government within a federal system also has political determinants and political consequences. Without downplaying the importance of economic conditions and technical considerations, this volume focuses on the political realities that affect the capacity of subnational governments to survive global financial crises. The material explored here serves as a reminder that the founding social science was called political economy and that visionaries from Adam Smith and David Ricardo to John Keynes, Milton Friedman, and Friedrich Hayek all considered themselves as much students of the subject identified by the first part of the term as students of that identified by the second.
Such students of political economy have never been as necessary as they are today. As the title of this book suggests, we are in the midst of a global debt crisis. Economists at the International Monetary Fund (IMF) suggest that the public debt of the ten leading developed nations will rise from 78 percent of GDP in 2007 to 114 percent by 2014. These governments, including those in the United States and in many European nations, will by then owe around $50,000 for every one of their citizens. That translates into more than $10 trillion of extra debt accumulated in less than ten years. The governments of rich nations have never borrowed so much in peacetime, and their massive debts will likely shape the world economy for decades to come. If current trends continue unchecked, demographic pressures combined with political paralysis will send the combined public debt of the largest developed economies toward 200 percent of their GDP by 2030. As if the 2008 recession did not do enough to overturn national and subnational balance sheets, a far longer-term and less cyclical fiscal crunch is currently in the making: the pension and health-care costs of a rapidly graying population. By 2050 a third of the developed world's population will be over 60 years of age, and economists estimate that this "demographic bill" is likely to be ten times larger than the recession's fiscal costs. Politicians in most industrialized nations have failed to confront these fiscal and demographic forces. The debt that they are accumulating portends an even greater financial catastrophe than the one that the international community is still struggling to survive. And so it is that leading economists are now beginning to acknowledge the resurgence of the venerable, if old-fashioned, field of political economy. In an era that until recently was defined by quantitative economics—derivatives, default swaps, and other exotic forms of financial engineering—the quaint field of political economy is seeing a rebirth among leading economists as the lens through which the present global crisis must be viewed to be understood. In 2013, a U.S. Federal Reserve Bank president, Eric Rosengren, criticized a widely circulated and fairly conventional economic model of sovereign credit risk for its oversimplification of the subject and its "parsimoniousness," especially the extent to which it "omitted" what Rosengren called the "political determinants of risk premiums." In a sign of just how far the pendulum has recently swung back to the political origins of the field of economics, Rosengren—a leading monetary specialist who, like most of his central bank colleagues, usually exhibits the putatively clinical nonpartisanship of his profession—openly observed, "One frequently sees that credit default rates spike around elections, and that countries that are politically destabilized have difficulty generating the political will to address problems."
The notion that "political will" is as important as economic capacity in dealing with a crisis, though intuitive to students of political economy, is an important warning coming from a top U.S. central banker and one that may presage the reunification of the fields of politics and economics. Even more strikingly, Rosengren specifies a promising first candidate for close inspection in the realliance of political science and economics, one that also happens to be the overarching subject of this volume—fiscal federalism:
Another political variable that might be relevant [to credit risk] is a variable that captures whether there is stable fiscal federalism in a country. For example in Spain, debt and banking problems have been exacerbated by the reality of regions that were autonomous but not necessarily fiscally responsible. A variable that might capture this impact is state and local government debt to GDP.
Echoing those comments, Federal Reserve governor Jerome H. Powell observed, on the same day:
Many advanced economies are in an extended period of slow growth and high deficits, and face long-term fiscal pressures from aging populations. Terribly difficult fiscal adjustments lie ahead. Although there is still time to make them, delay will sharply increase the pain of adjustment. The time to act is now. In my view, the problem is not principally one of economics or fiscal policy; it is one of governance. The real threat to the fiscal standing of the United States is that of inaction caused by a long period of political polarization and dysfunction. That would be a self-inflicted wound. And that is a problem that can't be derived from the traditional fiscal metrics [emphasis added].
This volume takes Powell's remarks as its point of departure.
Tales from Three Cities
While by now virtually everyone has come to understand that Greece, Ireland, Portugal, and Spain have, in some form or another, defaulted on their sovereign debts, the U.S. cities of Stockton, Vallejo, and Central Falls initially attracted far less attention. For decades, municipal bankruptcies were rare occurrences in the massive $3.7 trillion U.S. municipal bond market. Mostly limited to utilities and over-budget public projects, they were handled in isolation, rarely touched whole cities—let alone states—and posed few deeper questions regarding the political-economic structure of the nation as a whole. Quite apart from the events in Detroit, seven U.S. cities, towns, and counties have filed for bankruptcy since 2010. Prior to that year, no large municipality had failed to fully repay its principal debt since the Great Depression, when about 4,000 municipalities defaulted—including about forty that never fully repaid their debt. But the modern trend of ultimate municipal creditworthiness might be changing, with several cities and counties having recently attempted to pass on losses to either bondholders or higher tiers of government. Alternatively, they may need to alter their contractual commitments to their employees. While each of the U.S. cities, towns, and counties that have filed for bankruptcy since 2010 has approached insolvency in different ways, the overall options available and the choices that each has made in dealing with the specter of bankruptcy provide a window into some of the broader national and international themes addressed by this volume.
Stockton's 2012 bankruptcy made it the largest U.S. city in history to declare bankruptcy. At its bankruptcy hearing, the municipal government faced a $26 million annual deficit and had incurred a debt of as much as $1 billion—substantial for a city of 290,000. Stockton's choices were emblematic: either public sector employees or bondholders must take the brunt of the cuts. As the authors in this volume argue, which group Stockton chooses will have implications beyond the city itself; the consequences of its choice will reverberate across America's federalist structure as a whole.
In the summer of 2012, Stockton indicated that it might try to impose substantial losses on lenders as well as public employees in order to spread losses across both types of creditors. Since at least 1981 and possibly as far back as the 1930s, no U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due, according to Bloomberg. But as Stockton city manager Bob Deis told city council members at a June 26, 2012, hearing, "We're trying to spread the pain, unfortunately, to others besides employees." Punishing bondholders has generally been unsuccessful at the municipal level: of the forty-three municipal bankruptcies filed since 1981, thirty-three were either dismissed by a judge or failed to win a court ruling discharging their debt. Court records for the remaining ten do not list the disposition. According to Bloomberg, those cases ended with a cut in the principal owed to lenders. Some cities have avoided trying to force investors to take a loss in court or outside of it since most market analysts have thought that the bond market would punish any future borrowing with higher interest rates or possibly by locking a defaulting municipality out of credit markets entirely. But the fear of credit market discipline is changing. For example, in 2013 Detroit asked both bondholders and pensioners to accept less than the amount originally contracted.
Central Falls, Rhode Island
Central Falls may be the municipality that has been most successful in extracting itself from its debt crisis—and it did so without burning its bridges to the bond market. In September 2012, it won court permission to exit bankruptcy status by repaying bondholders in full (including even their legal costs) while cutting municipal workers' pensions (by as much as 55 percent, including an additional requirement that pensioners pay 20 percent of their health-care costs until they turn 65 years of age). The court ruling ended a storm of controversy following the passage of a state law, signed by Governor Lincoln Chafee in 2012, that gave investors a lien on the city's tax and general revenue. Following the court's ruling that Central Falls can protect bondholders while forcing its employees to take cuts, the president of one of the Central Falls public sector unions said: "We've been pilfered and beaten down ... we didn't have the power, the money, to fight it."
Stockton and Central Falls can be ignored as exceptional instances, but the fiscal collapse in Detroit in the summer of 2013 is vastly more portentous. The nearly $20 billion bankruptcy suit that the city filed in federal court was the inevitable consequence of economic, social, and political trends only slightly more immediate and advanced than those undermining the fiscal well-being of Philadelphia, Chicago, Cleveland, Milwaukee, and many other U.S. central cities. Business and industry are moving to U.S. suburbs, ex-urbs, and rural areas and to countries across the globe. The quality of public services is deteriorating even as per capita costs are rising. Public officials are promising public sector employees health and pension benefits without putting aside the necessary resources to cover the costs. Taxes have been raised to levels that scare entrepreneurs into choosing more promising locations. Detroit's bankruptcy case can be expected to twist and turn as law, politics, and the fiscal reality on the ground are taken into account over the course of the litigation. All that can be said with certainty is that the competing demands of creditors and pensioners will take years to sort out.
The Fiscal Crisis of the U.S. States
The charged emotions surrounding Detroit's municipal bankruptcy and the city's and the unions' radically departing views on which party should bear the brunt of the cuts—the workers or the bondholders—are emblematic of every current sovereign and subsovereign fiscal solvency crisis, from the streets of Central Falls to the streets of central Athens, from the protests in Vallejo, California, to the protests in Valencia, Spain. The same difficult choices that Stockton and Vallejo, Jefferson County, and Central Falls have faced are confronting governments at the state and even national levels, with major consequences for the intergovernmental structure of the two largest and most important federations in the world: the European Union and the United States.
For the first time since the Great Depression, multiple U.S. states might find themselves unable to pay their employees or their bondholders, effectively going bankrupt (for our extended discussion, see chapter 2). As early as March 2010, the Wall Street Journal asked, "Who Will Default First: Greece or California?" (the answer was Greece), and in testimony before the Congressional Financial Crisis Inquiry Commission, investor Warren Buffett—who then owned more than $4 billion of state and local debt—stated that the federal government may ultimately be compelled to bail out states.
If the failure of commercial banks posed a "systemic risk" in 2008, it will be difficult to argue that the U.S. states are not "too big to fail" in 2013: state and local governments represent more than 12 percent of the nation's GDP and more than 15 percent of its employment. Millions of public employees stand to lose their jobs if the federal government does not step in. The municipal bond market is more than $3 trillion in size, and state and local governments use it to finance their schools, highways, and other projects. More than two-thirds of outstanding state and local debt is held by small investors and public institutions. Should states require a bailout by the federal government in 2013, it would likely rival the 2008 bailout of the U.S. banking system. Every day the pressure builds: in the summer of 2011, $160 billion in federal stimulus money—given to states and local governments during the financial crisis to keep them afloat—ran out. The average U.S. state budget faced a roughly 20 percent deficit in 2011, with states like New Jersey and Illinois projecting 40 percent and 50 percent shortfalls, respectively.
Arguments are already being made against such bailouts, ranging from the problem of moral hazard to the fact that it would likely change forever the face of American federalism—which historically considered the fiscal autonomy and independence of states as a defining feature of the federal system. Unprecedented alternatives are being sought: the New York Times reported in January 2011 that lawmakers were looking for ways to circumvent existing constitutional jurisprudence in order to allow states to declare bankruptcy. (They currently cannot.)
That sovereign entities may be at risk of default in the coming decades is well understood. It is not just Greece, Ireland, Portugal, Spain, and Italy whose debt situations have become a matter of urgent concern. According to Fred Bergstrom, even the United States has allowed itself to be placed at undue risk, as the net foreign debt of the U. S. central government, in the absence of corrective measures, is projected to rise within the next twenty years from about $14 trillion dollars in 2012 (more than 65 percent of GDP) to $50 trillion, or more than 140 percent of GDP—a level "far above any conceivably sustainable position." As dramatic as those numbers are, they understate the looming crisis, for they do not include the sovereign debts of the fifty states of the union, which currently amount to more than $1 trillion, or about 7 percent of GDP. Nor do they take into account the value of the unfunded liabilities faced by public sector pension plans: although they are officially estimated at $438 billion by the states themselves, they could in fact be as high as $3 trillion, or about 20 percent of GDP.
Excerpted from The Global Debt Crisis by Paul E. Peterson, Daniel Nadler. Copyright © 2014 THE BROOKINGS INSTITUTION. Excerpted by permission of Brookings Institution Press.
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