Spotlight on the States: Federal Default Edition

Jul 22, 2011

Pew's Center on the States has an interesting new report with a different angle on how breaking through the debt ceiling and defaulting would affect our economy. Most accounts of the disastrous effects of a technical default focus on interest rates and on the private sector; however Pew's report focuses on the potential effects on state and local budgets and their ability to borrow.

Nearly all state and local governments are required to balance their budgets, so the purpose of municipal bonds is to finance capital projects like building schools and fixing roads, rather than to cover shortfalls. Since interest rates on these bonds are closely tied to Treasury securities, a federal default that increases federal interest rates would affect municipal bonds as well. Federal default would make investors more jittery about all government debt, including municipal debt. As the report says:

Moody’s Investors Service recently announced that if the federal government loses its AAA grade, the agency would downgrade at least 7,000 top-rated municipal credits and $130 billion in municipal debt directly linked to the United States—including mortgage-backed bonds secured by the federal government or by agencies such as Fannie Mae and Freddie Mac.

Obviously, downgrades at any level would make it more difficult to borrow and would force states and localities to hold off needed infrastructure projects. Right now, Moody's has threatened five states with downgrades--Maryland, New Mexico, South Carolina, Tennessee and Virginia--so they would certainly be vulnerable.

But, the effects are not limited to the municipal bond markets. As one can imagine, interruption of the numerous transfers that the federal government makes to states and localities would be a logistical and budgetary nightmare. Payments for Medicaid, unemployment insurance, and a whole host of block grants could potentially be reduced or delayed if Treasury is forced to prioritize payments. For example:

Take tuition aid: The academic year begins in August, and the federal government owes $10.4 billion in tuition assistance for that month. States have slashed higher education budgets four years in a row, and colleges could have a hard time accommodating students whose federally subsidized loans are late.

These delayed payments might also make it hard for governments to operate, since they have figured federal payments into their budgets for this fiscal year. States with cash flow issues might have to seek loans from banks in order to cover their expenses. Certainly, states would have to scramble to keep their finances in order and to try to provide services in as even a manner as possible.

Other effects from default would hurt the budget and open up new deficits for the current fiscal year. If checks to federal government employees or other benefits are delayed or not made, it would hurt state revenue from income and sales taxes. Also, more broadly, a default's impact on economic growth and unemployment would also contribute to new deficits in the current fiscal year. The combination of these effects would force state lawmakers to revisit their current year budgets. Considering the acrimony that has accompanied many state budget debates already, this is not an attractive prospect.

Clearly, a federal default would be a nightmare for the whole country, whether you're talking about the private or the public sector. We have to avoid a technical default on the federal debt. Hopefully, the Gang of Six plan or other negotiations will provide a path out of this potential scenario.