The Next Financial Crisis?

If the latest potential financial fiasco blows up one can only shudder at the thought of what the repercussions will be. As The New York Times reports, many analysts who predicted the subprime mortgage crisis are warning of another impending meltdown, only this time it’s not the work of Wall Street, but rather of state and local governments besieged by unsustainable debt.

Many municipalities have resorted to underhanded methods of obtaining money to pay for basic services. Illinois, for example, after struggling to honor obligations to pay its pension funds, borrowed $10 billion in 2003 to invest in those pension funds. The recession, however, damaged the transaction, leaving the state facing the same problem, only with the added burden of paying interest on its investment. In response Illinois has essentially resorted to the same tactic (borrowing more money to pump into pension funds and selling pension bonds) in the hopes that this time it will work.

It appears that most state and local governments are simply deferring payments and hiding debt obligations by removing liabilities from their balance sheets in a manner reminiscent of Wall Street’s handling of CDO’s and credit default swaps. According to The Times, New York has “delayed payments to vendors and local governments because they had too little cash on hand… California paid vendors with i.o.u’s last year,” and Gov. Chris Christie of New Jersey “deferred paying the $3.1 billion that was due to the pension funds this year.

Such actions make it difficult to determine how large the debts really are, though analysts know enough to estimate that several trillions are owed collectively.

This is potentially a huge problem because states can sustain themselves only by borrowing, and analysts fear that lenders may refuse to lend to/buy bonds from particularly weak municipalities. Once this happens, all state and local governments could be engulfed by a massive, Europe-like crisis in which credit becomes unmanageably expensive, causing chaos—there would be no money for health care programs, schools, transportation, police…

There are already chilling signs that the situation is beginning to unravel. Although government bonds are widely considered extremely safe to invest in since municipal bankruptcies and defaults are extremely rare, The Times explains that “last month, mutual funds that invest in municipal bonds reported a big sell-off— a bigger one-week sell-off, in fact, than they had when the financial markets melted down in 2008.” And equally ominous: “hedge funds are already seeking out ways to place bets against the debts of some states.”

Obama’s stimulus package has temporarily mitigated the devastation by pumping cash into state and local governments. Indeed, the federal government has increased its share of state budgets to one third, up from a quarter in 2008, according to The Times. Even so, many draconian cuts have been made: Arizona’s new death panel program, in which Gov. Brewer has mercilessly slashed funding for certain Medicaid-covered transplants, is going to kill over 90 people; Newark fired 13% of its police force last week; and Idaho has made it much harder for people to apply for food stamps by shuttering almost a third of its Department of Health and Welfare offices.

With stimulus money slated to run out next year and a stubbornly depressed economy, it appears likely that matters will deteriorate even further. The frightening fact is that even if unemployment were to return to normal levels sometime soon the debt crisis would not abate. Unless lawmakers devise a plan to tackle the crisis before it’s too late.

This seems unlikely, however, because the problem was created by chronic irresponsible and timid governing characterized by a pervasive unwillingness to raise taxes or slash spending. Harrisburg, the capital of Pennsylvania, for example, has considered bankruptcy over raising taxes to meet its $68 billion obligations. And the Republicans voted into office last month will certainly not raise taxes and likely won’t enact any serious spending cuts, especially considering that the first such idea they proposed consisted of doing away with a program that has already expired.

If the looming crisis blows up, it’ll be very interesting to see how the federal government responds and how the public reacts. Would Obama and the Fed bail out state and local governments? If so, which ones?

Most important, though, any vestigial faith in government would be completely shattered. One wonders if the system can handle such a scenario, especially in the aftermath of the sub-prime mortgage meltdown. The American people have steadily lost confidence in government and authority since Watergate, and it feels as if we’re
approaching a tipping point: there is no public enemy number one these days—is it the federal government, state and local governments, Wall Street, the media, the Federal Reserve, the SEC, Republicans, Democrats, the NSA, TSA, the CIA, Bush, Obama? Take your pick.

It feels as though we can’t trust anyone to behave responsibly. The sub-prime mortgage crisis proved that free markets cannot regulate themselves. An obvious response is for the government to impose strict regulations such as the Glass-Steagall Act. But the looming debt crisis poses a disturbing question. If government cannot manage its budgets responsibly how can it be relied upon to monitor systemically important financial institutions?

The truth is that these fiascos underscore the notion that both unfettered free markets and over-reliance on socialist policies are unsustainable. The trick is recognizing that capitalism requires elements of socialism for its survival (if we gut Medicare, for example, what happens to all the senior citizens who can’t afford health care?) and vice versa (no free market means little to no innovation). Once we accept this we stand a better chance at striking a proper balance and can seek ways to curb the excesses of Wall Street and out-of-control government debt.

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