Fate of the States: The New Geography of American Prosperity (19 page)

When a municipality such as Stockton or San Bernardino declares bankruptcy, the largest and first-in-line creditors are state pension funds (though pensions’ first-in-line status is now being challenged by Stockton’s bond insurers). The irony of course is that it is the retiree obligations that forced these communities into bankruptcy. When San Jose residents voted to cut pension benefits in order to preserve basic social services, the city set a precedent that will be closely watched by other municipalities looking for a way out. Stockton is another potential precedent setter, as it is trying to use Chapter 9 to force bondholders to accept not only less interest but also a reduction in principal. Stockton is the first American city to try this since the 1930s, and what’s so scary to those in the municipal-bond community is that market insiders said something like this simply just couldn’t happen. Well, it’s happening.

There’s no right or wrong in all this. A government worker rightly feels entitled to the pension and benefits he or she was promised. A taxpayer rightly feels entitled to the essential social services like quality education, safe streets, clean water, and all the other things his tax dollars are supposed to support. The bondholder certainly believes he has the right to be paid back principal and interest in exchange for the municipality’s borrowing his investment dollars. It almost doesn’t matter whose claim is most worthy. Just as the private sector eventually realized that businesses could not survive unless radical changes were made to their retirement programs, the public sector is now slowly coming to the same conclusion. Once a state chooses to reform its pension plans, great improvements in fiscal health can be achieved. But the longer states wait to make changes, the greater risk there is that states will run out of money to pay their pensioners. There are a few basic ways to reform pensions, many of which have already been tested by states like Rhode Island. In 2012 Rhode Island took its funded-pension ratio from 48 percent to over 60 percent, reduced its unfunded liability by roughly $3 billion, and thereby saved the state over $4 billion over the next twenty years.
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Reforms were made with bipartisan support because both Democrats and Republicans understood that in order to save funding for public services, the state needed concessions from unions on pensions and cost-of-living adjustments for both current and future retirees. Rhode Island is a great success story, and more cities and states are following its lead.

The Way Forward

Back in December 2010 I was pilloried in the financial press when I went on
60 Minutes
and warned that there would be fifty to a hundred large municipal-bond defaults. A producer for the CBS news show had been hounding me for weeks, begging me to appear in a segment about the looming state and municipal budget crisis. Steve Kroft had already interviewed New Jersey governor Chris Christie and Illinois state comptroller Dan Hynes, and despite some initial misgivings, I agreed to speak with Kroft about all that was at stake economically. It was a wide-ranging interview. When he asked about municipal-bond defaults, I told him that they were coming and that investors would be wise to ignore conventional wisdom. “When individual investors look to people that are supposed to know better,” I told Kroft, “they’re patted on the head and told, ‘It’s not something you need to worry about.’ It’ll be something to worry about within the next twelve months.”
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Muni bond defaults did increase 400 percent in 2011, to $25 billion from $5 billion in 2010, according to the
Distressed Debt Securities
newsletter.
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But for the record, I never said those fifty to a hundred defaults would all happen in 2011, which was how my critics spun the story. Kroft had not even asked me for a time frame. He wanted to tell the story of the state and local budget crisis, and what I told him was that the crisis would become a big deal—“something to worry about”—within twelve months.

Twelve months after the
60 Minutes
story aired, I wasn’t the only one worrying. A headline from the December 20, 2010, issue of
Businessweek
blared: “New Govs Take Office Amid Historic Budget Crisis.”
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Time Magazine
, January 20, 2011: “Can Drastic Measures Save the Cash-Strapped States?”
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Associated Press, January 15, 2011: “Year Ahead Looms as Toughest Yet for State Budgets.”
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Bloomberg News
, January 19, 2011: “U.S. Mayors Say City Bond Defaults Likely Amid Strain.”
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A January 10, 2011
National Journal
story asked, “Is [California’s] budget crisis even solvable?”
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In December 2012 Detroit became the latest city to flirt with bankruptcy. Given the scope of Detroit’s fiscal problems—a $327 million deficit and $12 billion in accumulated debt
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—the city’s best hope is probably a state takeover and the appointment of an emergency manager. “It is likely the only option to avoid bankruptcy, as the city’s expenses continue to outpace revenue,” city council president Gary Brown wrote in an e-mail to constituents.
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The truth is, more municipalities are debating whether to follow the lead of Stockton, Mammoth Lakes, and San Bernardino and simply walk away from their financial debts in favor of maintaining police, firefighters, low student-to-teacher ratios, and the like. These are tough questions. How bad does it have to get for voters to stand up against the diminished public services they’re getting for their hard-earned tax dollars? When do people say “no more” to skyrocketing crime rates because the police force had to be cut in order to afford a retired chief’s $200,000-a-year pension? How long before taxpayers refuse to honor their obligations to the bond investors who loaned their communities money? At what point do Americans turn against their own teachers, police officers, and other public servants, arguing that an employee’s negotiated right to a generous pension simply cannot take precedence over safe streets or a child’s right to a quality education?

For some, defaulting may turn out to be the least bad option. It’s not unlike what happened in the housing market, when underwater homeowners dropped mortgage payments from the top to the bottom of their bill-paying priority list. Municipal bankruptcies, writes Michael Corkery of the
Wall Street Journal,
“are reminiscent of the strategic defaults seen during the financial crisis when many homeowners, overwhelmed with spiraling debts, mailed house keys to lenders and stopped paying their mortgages—a trend know as ‘jingle mail.’” The stigmas that once surrounded mortgage default and now municipal bankruptcy have faded. Even the rating agencies acknowledge they might have to change how they evaluate default risk for muni bonds. As the chief credit officer for public-sector ratings at Moody’s said, “As the stigma around bankruptcy erodes, we are revisiting our long held assumption about the willingness of some cities to repay debt.”
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Truth be told, that willingness was always in doubt. In 1994 Orange County became the largest municipal bankruptcy in U.S. history, and anyone who followed the Orange County story knew how little obligation voters felt toward general-obligation bondholders. Before the state stepped in with its bailout, James Lebenthal—founder of New York muni-bond firm Lebenthal & Co.—took a film crew with him to Orange County to interview locals about their perceived obligations to investors. Lebenthal said afterward that he was “distressed” to discover that most Orange County residents felt no moral obligation to approve a sales-tax hike in order to repay what was owed on the county’s debt. “I don’t know who will make up the deficit,” one woman told Lebenthal, “but I really don’t think it should be the citizens.”
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Defaults and bankruptcies are important stories, but they remain mere symptoms of and sideshows to something much bigger and more important. A geographic sea change is occurring in the United States, with economic power shifting away from longtime coastal strongholds—states still hung over from the housing bust—and toward the more “fiscally attractive” central corridor. These so-called flyover states contributed 25 percent of U.S. GDP in 2011, up from 23 percent in 1999. A two-percentage-point increase may not sound like a lot, but it’s huge—$300 billion in GDP.
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With such a large head start in the recovery, the central corridor should continue to drive the U.S. economy for years and even decades to come. Some of this has to do with the commodities boom and the fact that these states are embracing energy production at a time when states like California and New York are saying no. In fact, folks in other parts of the world would be glad if more U.S. states followed New York and California’s lead. “We Europeans are currently paying up to four or five times more for natural gas than the Americans,” said Harald Schwager, an executive board member for European chemical maker BASF. “Of course, that means increased competition for all the European manufacturing sites.” BASF’s solution: Invest more in the United States.
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Along with cheap energy, the central corridor is benefiting from the boom in agriculture. And while agriculture has historically been quite cyclical, demand for U.S. crops is stronger than ever. And more global too. Urbanization, modernization, and population growth in the third world have dramatically increased global food demand. In order to meet demand, U.S. grain exports are expected to increase 28 percent by 2021, according to the U.S. Department of Agriculture.
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The economic impact back home is already significant, as corn prices have soared from two dollars to seven dollars a bushel since 2006. A report from the Chicago Federal Reserve in August 2012 showed a 15 percent increase in farmland prices over the prior twelve months across Iowa, Illinois, Indiana, Wisconsin, and Michigan. A similar report from the Kansas City Fed showed a 26 percent gain. While agriculture these days employs a lot fewer people today than it did a hundred or even fifty years ago, higher land values do enrich communities and bolster consumer spending. “I’ll probably upgrade a couple tractors myself,” Minnesota farmer Gerald Tumbleson said back in 2007, when the corn boom first started to take off. “I’ll use a little more fertilizer this year too.”
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No wonder spending growth tracks 30 percent higher in the central corridor versus the coasts. Higher land prices and more consumer spending are good for state and local tax receipts too. It’s a virtuous circle: More jobs, more spending, and more housing demand beget a larger tax base and better public services—which attracts new jobs and pushes home prices ever higher.

Many towns and cities throughout the central corridor don’t have enough workers to fill all the available jobs. If they do, sometimes there’s no place to house them. Home prices in North Dakota are up 17 percent over the past five years, which is one of the highest in the nation but also reflective of the state’s severe housing shortage.
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Housing demand in North Dakota is being driven by the need for living quarters, not by easy credit or get-rich-quick speculation. “Man camps” and “tent camps” are being used as temporary housing for workers from Odessa, Texas, to Williston, North Dakota.
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Companies like Target Logistics that fill the temporary-housing void are fast becoming big business. The growth of companies like Target Logistics hints at a significant multiplier effect. More jobs and more people mean more demand for stores, movie theaters, restaurants, and, yes, banks. Bank consolidation will be most prolific in this region in coming years, as the growing credit needs of a booming economy create demand for superregional banks—none of which exist in the region today.

The cities and states of the central corridor will step up their investments in the kind of infrastructure most likely to attract business, and they’ll have the tax revenues to do it. Duluth, Minnesota, just finished construction on a new $78 million airport.
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Wichita Falls, Texas, has broken ground on a new $100 million terminal.
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And Texas recently opened a new $1.3 billion toll road connecting Austin and San Antonio.
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These are the kinds of investments likely to attract even more new businesses. The central-corridor states are better able to cut taxes too. As of January 2013 six of these states were considering cuts to state income-tax rates, and a seventh—Kansas—had dropped its top rate from 6.45 percent to 4.9 percent. In neighboring Missouri, Kansas’s aggressive tax cutting sparked fears of a westward jobs exodus. “I do think it’s hard to be anywhere near Kansas right now,” said Amy Blouin, executive director of the Missouri Budget Project, a St. Louis–based nonprofit group that analyzes state spending.
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For the housing-bust states there are no easy fixes. Budgets at every level of government are so strained that there can be no repeats of the bailouts Orange County received from the state of California in 1995 or New York City solicited from the federal government in 1975. The damage is done, but hope is not all lost. Since 2010 thirty-six new governors have been elected with broad mandates for change. Many of them probably didn’t realize how much of their terms would be shaped by triagelike budget decisions necessary to preserve the solvency of their state finances. Few of them could have imagined that they would have to tackle the politically toxic issues of deep budget cuts and pension reform. Fewer still likely realized that they would have to choose between honoring labor contracts and bond covenants and providing basic services to constituents. The key question all governors face is when to expend political capital for longer-term gains—gains that might not even be fully realized until after they’ve left office. Willingness or unwillingness to take political risks and make tough decisions increasingly will determine which states dig themselves out of their fiscal holes and which become the twenty-first-century economic heirs of Lowell, Detroit, and Mississippi.

Ultimately no amount of cost cutting or entitlement reform will be enough without a rebound in revenues, and new revenues will have to come from job creation. Job one for any governor or big-city mayor has to be attracting human capital and jobs that contribute to the tax base. Raising taxes to uncompetitive rates is simply not going to work because it’s just too easy these days for businesses and taxpayers to pick up stakes. Perhaps twenty years ago paying a big premium to live in California might have been reasonable—there’s the great weather, good schools, beaches, mountains, redwood forests, and on and on. But today that premium is just too high. Californians aren’t getting enough for their taxes and mortgage payments. With the money they save by moving out of state, they can afford ample vacations to Disneyland and Yosemite.

How can governors create more good jobs in a bad economy? One good example comes from North Carolina and its former governor Beverly Perdue. In 2009 Perdue used $13 million in ARRA money to launch the state’s JobsNOW “12 in 6” job-training program. Operated out of the state’s fifty-seven community colleges, the program aimed to provide up to six months of training in one of twelve different in-demand fields ranging from health care to manufacturing. A 2011 study by the North Carolina Community College System found that people who completed the course work increased their quarterly income by an average of $415. For those who chose health-care training, the increase was $700.
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Overall the state added eighty thousand new jobs and $16 billion in new investment during Perdue’s tenure. Other initiatives states should consider to restart job growth include opening up oil and gas production, passing right-to-work laws, and, whenever possible, cutting personal and corporate income taxes. There are legitimate political arguments to be made against all of these, but the simple reality is that states are engaged in a bare-knuckle fight for jobs and these happen to be the issues employers care about.

Winning back jobs for states and cities also means finally fixing the fiscal problems and making the tough decisions others had put off for years. There are solutions to the budget woes of the housing-bust states. The challenge is getting voters and unions to accept them. When it comes to state and municipal budgets, compromise has become a game of high-stakes chicken. Most elected officials want to avoid tough choices that in the near term might cost political support. That puts taxpayers at a disadvantage because public-employee unions are disinclined to compromise. Politicians have no explicit obligation to fight for the financial interests of taxpayers, but union leaders do have such a duty to their members. Take a look at the member handbook of the National Education Association, the big teachers’ union. One clearly articulated NEA goal is “to preserve and expand collective bargaining rights for education employees and to improve members’ compensation and benefits (including pension and health care benefits).”
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