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The Scary Future of Municipal Bankruptcy - California Leads the Way

California's municipal governments are systemically set up to be financial disasters. But there are ways out.

In California, the names of the latest victims are well known. San Bernardino, Stockton and Mammoth Lakes all filed for bankruptcy within the last few weeks. And Vallejo emerged from Chapter 9 protection just last year. The questions appear to be "Why all in California?" and "Who will be next?"

Although California's problems are extreme, the state is hardly alone in financial difficulties. Towns and counties in Alabama, Illinois, Michigan, New Jersey, New Hampshire, New York, Pennsylvania and Rhode Island are all having trouble meeting their financial obligations. If these conditions continue to spread, the United States will be facing a crippling debt crisis at the state and local levels, which is where Americans receive much of what matters for their quality of life.

This was a central point in a report released July 17 by the State Budget Crisis Task Force headed by former Federal Reserve Chairman Paul Volcker and former New York Lt. Gov. Richard Ravitch.

Simply put, in the aftermath of the financial crisis emanating from Wall Street, the federal financial mess is bleeding over into state budgets in profound ways, adding enormous costs to already overburdened state coffers. That spillover, in conjunction with broader national crises in finance and healthcare, is overwhelming state and federal finances.

California has added challenges that make the problem even trickier. It must maintain massive education, infrastructure and prison programs with limited ability to raise money. The prison expenditures are particularly onerous. The state prison population is more than 160,000, and Sacramento spends roughly $50,000 annually to house each inmate. Not surprisingly, California has the costliest prison system in the country.

Despite the protests of powerful interest groups in the corrections business, California cannot afford to continue to crowd out other essential services to pay that group so handsomely. The state government must act now to overcome the prison interests' lucrative campaign contributions to legislators — and outsize influence — and bring that sector back into line.

Additionally, local governments are limited in the amount of revenue they can raise by notoriously strict property tax caps set by Proposition 13. The state's capacity to raise money also is hindered by its stagnant political system, which sets up the dynamic in which the only answers to an economic shock or shortfall are to vigorously restrict services or sell them off. Too many elements of California's budget are protected by legislative decree or political muscle to allow balanced decisions in times of distress.

Taken together, California's state and local governments are systemically set up to be financial disasters. That's why California is an outlier nationally in the fiscal crunch and why it has become ground zero for municipal debt crises and bankruptcies. California is a prosperous state. It is the political constraints that are crippling it.

But other states, like New York and Illinois, should pay attention. If they don't take action, the extremes of California will ultimately become a reality in those states too.

So what can be done? We can start by asking why the Federal Reserve cannot refinance municipalities to preserve essential services at interest rates comparable to what it gave to rescue the insolvent banks that created this mess. And it is high time officials moved boldly to force the banks to break off the chain of disastrous swap contracts that have cost local authorities and states so much money.

Another key point to keep in mind is the importance of strong regulatory policies. In a world in which financial institutions can receive zero-interest loans from the Federal Reserve and then lend out the capital at much higher interest rates, the opportunities for financial mischief are plentiful.