A New Generation of Zombie State and Local Governments
By Barry Poulson (February, 2021)
Massive extension of federal aid and credit is creating a new generation of zombie state and local governments. The magnitude of federal aid extended to state and local governments in response to the financial crisis in 2008 and the coronavirus pandemic in 2020 is unprecedented in U.S. history.
The George W. Bush Administration responded to the 2008 financial crisis by enacting the Emergency Economic Stabilization Act. The Bush bailout was followed in 2009 by a more ambitious bailout by the Obama Administration, the $830 billion American Recovery and Reinvestment Act (ARRA), (Congressional Budget Office 2009). The fiscal stimulus was used to subsidize state and local governments to address fiscal stress during the Great Recession.
Much of the stimulus funding during the Obama administration was off budget. For example, the federal government subsidized the debt issued by state governments as Build America Bonds (BABs) (Puentes at al. 2013). States issuing these bonds received a direct federal subsidy of 35 percent of their interest payment. State governments issued early $250 billion in BAB bonds in
2009 and 2010. A disproportionate share of this bailout money flowed to heavily indebted states, such as Illinois. Illinois made extensive use of federally subsidized debt in the form of BAB bonds. The direct impact of federal subsidies for bonds in Illinois was a sharp increase in state debt in 2009 and 2010, boosting total bonds outstanding to $25 billion (Merrifield and Poulson, 2018a, 2020).
Normalization of fiscal and monetary policy was long delayed following the financial crisis in 2008. It was not until 2019 that the Fed made a formal commitment to normalize monetary policy (Federal Reserve 2019). After years of financial market repression the Fed made a commitment to return the federal funds rate to something close to real market rates. “Effective October 15, 2019, the Federal Open Market Committee directs the Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 1-3/4 to 2 percent”. But before the Fed made much progress in normalizing monetary policy the coronavirus pandemic triggered a new era of fiscal stimulus and monetary easing.
The federal government responded to the coronavirus pandemic in 2020 with a series of stimulus packages. The Committee for a Responsible Federal Budget (2021a) provides a breakdown of this stimulus funding. The Response and Relief Act allocated about $4 trillion for COVID relief. They estimate that $935 billion went toward small business loans and grants, and $345 billion was allocated to various forms of state and local aid. State and local governments also benefitted from funding for education, health care, transportation, and other spending. President Biden has proposed an additional $1.9 trillion COVID Response package. That legislation includes $350 billion in aid to state and local governments (Committee for a Responsible Federal Budget, 2021b).
During the coronavirus pandemic the Federal Reserve reduced interest rates by buying bonds, and committed to keeping short term interest rates close to zero through 2023. Chairman Powell provided further reassurance to investors by committing the Fed to continue these policies until the economy makes “substantial further progress” in achieving target inflation of 2 percent, and full employment. The Fed has revised the definition of maximum employment as a ‘broad and inclusive
target”. The focus on maximum employment is an important shift from the historical emphasis on inflation targeting (Powell 2021).
In response to the coronavirus pandemic the Federal Reserve has for the first time begun lending directly to state and local governments (Pew Charitable Trusts 2020; Cox 2020; Wall Street Journal 2020). The Fed created the Municipal Liquidity Facility (MLF) to extend credit to selected local governments. This decision was triggered by a spike in interest rates on municipal bonds in March and April 2020. The MLF was authorized to purchase up to $500 billion in short term notes. States, cities, and counties could borrow up to 20 percent of their fiscal year 2017 own source revenues. The purpose of the lending facility was to help governments manage cash flow pressures, and offset revenue shortfalls and increased costs linked to the pandemic.
It is not surprising that Illinois was the first state to participate in the MLF Program, selling $1.2 billion in bonds. The Metropolitan Transportation Authority (MTA) in New York sold $450 in notes to the MLF. New Jersey plans to borrow $4.5 billion in FY2021, using the MLF Program. Hawaii has also expressed interest in the MLF Program. The interest rate charged on these loans depends upon the borrowers’ credit rating. S&P bond ratings suggest that these states will pay a relatively high interest rate compared to more credit worthy states (Pew Charitable Trusts 2020; Cox 2020; Wall Street Journal 2020).
The direct lending program established by the MLF has been attractive thus far to the least creditworthy state and local borrowers. With stabilization of interest rates, the private credit market has been more attractive to more credit worthy state and local governments. However, the new lending facility has set an important precedent for bailing out state and local governments. While originally created to meet short term credit needs, there is discussion of extending the facility to extend longer term credit to state and local governments. Thus, the MLF could become an important lender of last resort, keeping a new generation of zombie state and local governments afloat (Pew Charitable Trusts 2020; Cox 2020; Wall Street Journal 2020).
The bailout of state and local governments had disincentive effects, similar to that accompanying bailouts in the financial industry. Anticipating bailouts, municipal governments have less incentive to impose fiscal rules, and to pursue prudent fiscal policies. When municipalities receive bailouts, credit rating agencies lump them together, rather than assessing the riskiness of each jurisdiction in issuing debt. The inefficiency and misallocation of lending to municipal governments weakens the public finances of all jurisdictions participating in the bailout, including state as well as local jurisdictions.
For two decades the federal government has failed to normalize macroeconomic policy, and there is little evidence that it will do so in the near future. These macro-policy failures set the stage for a new generation of zombie governments.
The Intuition behind Zombie state and local government
As in the case of zombie enterprises, a zombie government is defined as one that is insolvent, i.e. unable to meet financial obligations in full and on time. But the concept of insolvency in state and local government is more complex.
One approach to insolvency is based on a mathematical proposition. If the rate of economic growth exceeds the rate of interest, debt can grow without limit. This concept of insolvency has been applied to the federal government, where debt now exceeds gross domestic product (GDP). Keynesians argue that even if total debt grows to some multiple of GDP this is not a problem as long as economic growth exceeds the rate of interest. The flaw in this Keynesian view is that higher levels of debt impact both the rate of economic growth, and the rate of interest. Indeed, the Congressional Budget Office (2020) projects that as the ratio of debt to GDP continues to increase in the long term this will be accompanied by higher interest rates, and retardation in the rate of economic growth. The CBO also points out that printing more money that leads to hyperinflation is not a solution to our debt crisis.
An alternative approach to insolvency is suggested by the literature on what is referred to as the market discipline hypothesis (Jaffee and Russell 1976; Stiglitz and Weiss 1981; Eaton and Gersovitz 1981; Bishop et al. 1989; Bayoumi et al 1995). An important proposition in this approach is a nonlinear relationship between yields and debt levels. Yields may not rise smoothly with increases in the debt levels. Yields may rise gradually at first, but eventually yields increase in a steep nonlinear way, and at some point credit markets respond by denying borrowers credit.
If the relationship between yield and debt levels is nonlinear, it is possible to estimate the level of debt at which a state defaults. The literature on interest rates and state bonds indicates that the probability of default is also affected by cyclical factors, and constitutional constraints on borrowing (Liu and Thakor 1984).
Bayoumi et al. (1995), for example, find strong evidence for a nonlinear relationship between yields and debt for U.S. states, consistent with the market discipline hypothesis. They find that the yield on state debt increases by 23 basis points per percentage point increase in debt levels, but, at debt levels one standard deviation above the mean, the increase in yields rises to more than 35 basis points. They estimate that credit is rationed at debt levels about 25 basis points above the highest debt levels in their sample of states. The supply of credit to U.S. states is steep because of rising default premia. In their preferred equation the maximum debt level at which credit is constrained is 8-9 percent of gross state product.
It is important to note that Bayoumi et al. (1995) find that constitutional rules to constrain debt significantly reduce the cost of borrowing in the states. They estimate a 50 basis point decrease in the cost of credit in states with effective constitutions debt limits.
When individuals and private firms become insolvent they may face legal sanctions or be forced into bankruptcy. When governments become insolvent they do not face the same legal sanctions imposed on private firms. Throughout most of our history both state and local governments faced legal sanctions that could force them into bankruptcy. However, during the great Depression, the federal government enacted new laws that established bankruptcy procedures for municipal governments, but not for state governments. Since then state governments have resolved their financial obligations without the threat of bankruptcy. Since there is no threat of restructuring or exit, there is more incentive for state governments to take on the credit extended by or guaranteed by the federal government (Mitchell 2021; Horpedahl 2021).
The Empirical Evidence for Zombie State and Local Governments.
Theoretically we can measure the incidence of zombie governments using the same measures we use for zombie enterprises. A narrow measure of state debt would compare general obligation bonds issued with the interest cost on those bonds. However, general obligation bonds now comprise a small share of total state debt. A large share of state debt is ‘off budget’ in the form of revenue bonds, certificates of participation, enterprise bonds, and other obligations. The most rapid growth in state debt in recent years is in the form of unfunded liabilities in state pension and Other Post Employment Benefit (OPEB) obligations (Poulson and Hall 2011; American Legislative Exchange Council 2018).
The bailout of state bonds has a long history in the U.S. As noted, states have not been subject to bankruptcy proceedings since the Great Depression. In response to the collapse in state bond markets during both the financial crisis and the coronavirus pandemic, the federal government provided hundreds of billions of dollars in support of these markets. For these reasons the yields and ratings for state bonds are less accurate measures of the credit conditions, i.e. risk of default, on these bonds.
The following table provides data on state bond ratings by S&P Global Ratings. Only ten states received a rating less than investment grade (AA), Alaska, California, Connecticut, Illinois, Kansas, Kentucky, Louisiana, New Jersey, Pennsylvania, and West Virginia. Only two states, New Jersey and Illinois received a junk bond rating (BBB). The change in state bond ratings in fall 2020 reflects the impact of the federal bailout during the coronavirus pandemic. In three states the ratings improved, New York, Vermont, and Pennsylvania. In one state, New Jersey, the state bonds were downgraded.
The stability and in some cases improvement in state bond ratings in 2020 is surprising given the magnitude of the recession experienced in that year. The decrease in output and employment in 2020 was comparable to that during the Great Depression, when a number of states defaulted on their bonds. In the absence of federal bailouts in 2020 we would expect default rates on state bonds comparable to that during the Great Depression.
U.S. State Ratings and Outlooks: Current List
Recent Rating Actions
|New York||AA+/Negative||AA+/Stable||Dec. 11, 2020|
|Vermont||AA+/Negative||AA+/Stable||Nov. 10, 2020|
|New Jersey||BBB+/Stable||A-/Negative||Nov. 6, 2020|
|Pennsylvania||A+/Negative||A+/Stable||Sept. 1, 2020|
S&P Global Ratings’ U.S. State Ratings
|Ratings as of Dec. 11, 2020|
|Colorado (ICR)||New Mexico|
|Florida||AAA||Stable||North Dakota (ICR)||AA+||Stable|
|Indiana (ICR)||Rhode Island|
|Iowa (ICR)||AAA||Stable||South Carolina||AA+||Stable|
|Kansas (ICR)||AA-||Stable||South Dakota (ICR)||AAA||Stable|
Note: U.S. State Ratings and Outlooks: Current List, S&P Global Ratings. ICR-Issuer credit rating. All other ratings are for the state’s general obligation debt. Ratings for other debt issued by the state will vary based on the security backing the bonds.
The bailout of municipal bonds by the Federal Reserve is a recent phenomenon. In response to the coronavirus pandemic, the Fed for the first time bought bonds directly from selected municipal governments (Pew Charitable Trusts 2020; Cox 2020; Wall Street Journal 2020). As noted, municipal governments are subject to bankruptcy proceedings when they default on their debt. For these reasons the yields and ratings on municipal bonds are a more accurate measure of the credit conditions, i.e. risk of default on those bonds, compared to state bond issues. Some municipal bonds are backed by the state government. Thus municipal bond yields (interest rates) may provide insight into credit conditions at both the local and state level.
The following chart shows the 20 Bond GO Index based on an average of certain general obligation municipal bond maturing in 20 years. It highlights the spread in yields for bonds with rating grades Aa, A, and Baa maturing in the 20th year.
Note: The graph sets forth information relating to municipal bond yields (interest rates) trends. Based on “The Bond Buyer 20-Bond GO Index”. The 20-Bond GO Index is based on an average of certain general obligation municipal bonds maturing in 20 years and having an average rating equivalent of Moody’s Aa2 and Standard & Poor’s AA. The graph compares yields for high, average, and low rated municipal bonds over the last decade. WM Financial Strategies.
The chart reveals a downward trend in the yields for all municipal bonds, and convergence in the yields of higher rated and lower rated bonds over the past decade. The financial crisis in 2008, and the coronavirus pandemic in 2020 are both marked by a sharp discontinuous increase in the spread of yields for these bonds. In both of these economic shocks the spread in yields increased between 200 and 250 basis points. The impact of federal bailouts in both of these economic shocks was a decrease in average yields for all municipal bonds and a convergence of yields between higher rates and lower rated bonds. Even after this convergence, however, the difference in yields between the highest and lowest rate bonds exceeded 150 basis points. Prior to 2008 the spread in yield between the higher rated and lower rated bonds was generally less than 30 basis points.
The following chart compares yields on the 20-bond buyer index, and that on 20 year Treasury bonds for 1998-2021. The long downward trend in yields covers the past two decades. Over the first decade there is evidence of convergence in the yields on municipal bonds and treasuries. But over the last decade the difference in yields increased roughly 100 basis points. The divergence in yields was especially sharp in response to the financial crisis in 2008, when the yield differential increased to about 300 basis points.
Note: The graph sets forth information relating to municipal bond yields (interest rates) trends. Based on “The Bond Buyer 20-Bond GO Index”. The 20-Bond GO Index is based on an average of certain general obligation municipal bonds maturing in 20 years and having an average rating equivalent of Moody’s Aa2 and Standard & Poor’s AA. The graph compares yields for the 20-Bond GO Index with yields on 20-year US Treasury Bonds, over the last two decades. WM Financial Strategies.
The financial crisis in 2008 and the coronavirus pandemic in 2020 revealed the wide disparities between jurisdictions pursuing prudent and profligate fiscal policies. However, federal bailouts have now triggered a race to the bottom in the municipal bond market. Negative real interest rates are distorting prices in this market. The average yield on U.S. junk bonds has fallen to below 4 percent for the first time. Increased demand for higher yielding junk bonds has made it cheaper than ever for state and local governments to borrow. The spreads between municipal junk bonds and higher rated bonds are at an all-time low (Wall Street Journal 2021a, 2021b).
Illinois, for example, has accumulated hundreds of billions in debt and unfunded liabilities in public sector pension and health care plans. The state has also assumed liabilities incurred in Chicago and other highly indebted local jurisdictions. The subsidies received by the state and local governments in Illinois from the fiscal stimulus most likely enabled them to pay bills and avoid bankruptcy. But the negative side of these government bailouts are the disincentive effects. The state of Illinois and the city of Chicago continue to kick the crisis in their pension system down the road, rather than enact reforms required to make the plans actuarially sound. Debts and unfunded liabilities continued to pile up making state and local government in Illinois even more vulnerable. There is a high probability that these pension plans will default on their obligations billion (Merrifield and Poulson, 2018a, 2021; Brodsky, 2020).
Bonds issued by Chicago schools reveal the recent distortions in the municipal bond market. Prior to the coronavirus pandemic Chicago schools issued bonds with an 8.5 percent yield, 580 basis points above the yield on investment grade (AAA) municipal bonds. In January 2021 Chicago schools issued bonds with a yield of 2.24 percent, only about 100 basis points above investment grade municipal bonds. Prior to the coronavirus pandemic rising labor and pension costs pushed Chicago schools toward bankruptcy, and there was some question whether they would even have access to the municipal bond market. But federal bailouts have kept this zombie afloat. Chicago public schools benefitted from the $900 billion relief bill, and the Biden administration has promised even more relief of public schools in the new relief bill introduced in Congress in 2021(Wall Street Journal 2021a, 2021b). .
The new race to the bottom is also evident in the market for pension obligation bonds. Prior to the financial crisis in 2008 municipal government issued these bonds to cover shortfalls in the pension funds. Taxpayers were then hit with the burden of paying for these bonds as well as rising labor and pension costs. Zombies issuing these bonds were revealed during the financial crisis. Detroit, and Stockton and San Bernardino, California reneged on their pension obligation debt in bankruptcy. But, pension obligation bonds are again in demand, more than doubling in 2020. Most pension obligation bonds are issue in Illinois and California, but municipalities such as Tucson, Flagstaff, and Pinal County Arizona have also issued these bonds to cover shortfalls in their pension plans(Wall Street Journal 2021a)..
State bailouts of municipal governments weaken the creditworthiness of both the state and local government. The best example of this is the state of Connecticut, where unfunded liabilities in state pension and OPEB obligations total more than $35 billion. Municipal governments and school districts across the state have become increasingly dependent on state bailouts (Merrifield and Poulson 2018b).
In 2018 Connecticut lawmakers froze state aid to municipal governments because legislators failed to pass a budget. Due to Connecticut’s bleak fiscal status, Standard & Poor’s downgraded the state’s general obligation bonds rating, citing the state’s responsibility for the city of Hartford’s $540 million debt. A special commission on the debt crisis recommended fiscal discipline measures designed to constrain debt and put fiscal policy back on a sustainable path. State legislators issued
bonds that year that include covenants imposing a “debt brake.” The newly issued bonds provide funding for school construction projects and distribute grants to municipal governments and special districts. The covenants limit state borrowing to no more than $2 billion per year. Bond authorizations may not exceed 1.6 times the amount of general tax receipts. State spending is limited to 98-100 percent of revenues and cannot grow faster than inflation. Excess reserves above the spending limit must be placed in a rainy-day fund. Moreover, the state cannot change the formula for the debt limit for five years. The debt ceiling can only be breached if the governor were to declare an emergency and three-fifths of both chambers of the state legislature were to vote to increase the cap (Merrifield and Poulson 2018b).
The market response to this bond issue in Connecticut was quite remarkable. The state received orders for three times the amount of bonds issued. Oversubscription of the bonds allowed the state to negotiate lower interest rates, significantly reducing the debt service costs. The “debt brake” obligation encouraged passage of a state budget that would eliminate deficits and set aside more than half a billion dollars for the rainy-day fund (Merrifield and Poulson 2018b).
The experience in Connecticut reveals that state bailouts are a moral hazard. If state bailouts are available, local governments have little incentive to limit debt. This means credit rating agencies artificially inflate local government bond ratings because they anticipate state bailouts. This causes banks and financial institutions to not perform due diligence in buying the bonds because they know taxpayers will ultimately pay the price if the bonds go bust.
By imposing a “debt brake,” Connecticut was able to constrain state debt. Ultimately, this kept the state afloat because of bond market disciplinary forces. If Connecticut fails to enforce the debt ceiling and spending caps, bond rating agencies will downgrade ratings and increase interest rates, thus fueling a state debt spiral.
Connecticut avoided debt crisis, and municipal bankruptcy in 2018, but it is not clear that the state will be able to do so in the long term. Municipal governments and school districts continue to demand bailouts from the state. The state has again turned to the federal government for transfers and subsidies, in response to the coronavirus pandemic, just as it did during the Great Recession. Although no state has declared bankruptcy since the Great Depression, it is difficult to see how states such as Connecticut that are carrying massive debt loads can stay afloat in the long term without fundamental reforms in their fiscal policy. For the “debt brake” to be successful, Connecticut must impose a no-bailout principle and require local jurisdictions to be financially independent.
The experience in Connecticut reveals that one must be cautious in drawing inferences about insolvency based on the data for bond yields. During recent major economic shocks the market for municipal and state bonds virtually disappeared. The federal bailouts in response to these economic shocks allowed them to not only issue bonds, but to expand that issue over the course of the business cycle. Even with the federal bailouts, however, some state and municipal governments continue to issue bonds below investment grade. The yield and ratings for these bond issues suggest the magnitude of zombie state and local governments.
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