The biggest problem for state and local governments is how pension costs are crowding out other budget items. Consider the California cities of San Diego and San Jose. In San Diego expenses for the city’s retirement fund increased from $43 million in 1999 to $231 million in 2012 and now comprise the equivalent of 20 percent of the general-fund budget. However, even as the city budget grows, San Diego is actually lowering its current payroll, with the total city workforce down 14 percent since 2005.24 In San Jose the city’s pension expense increased from $73 million in 2001 to $245 million in 2012.25 The latest payment is equal to 27 percent of the city’s general-fund budget, which is the same percentage by which San Jose has downsized its workforce over the past decade. As both of these cities work through a tough economy and an even worse housing market, the retirement-benefits problem looms larger, even for traditionally prounion Democrat lawmakers. San Jose mayor Chuck Reed, a Democrat, called reforming pensions “my number one priority because it’s the biggest problem we face. It’s a problem that threatens our ability to remain a city and provide services to our people.”26 San Diego’s Republican mayor Jerry Sanders took a similar tack: “If we continued to have hugely escalating pension costs every year,” he told Governing magazine, “we simply could not sustain any level of service in the city of San Diego.” The people agreed, and with two historic ballot measures, voters approved trimming retirement benefits for government workers in both cities so that more dollars could be allocated to productive means rather than for pensions and retiree health-care costs.27
Again, what this all this boils down to is the simple fact that there is not enough money to go around. All sides need to give. If compromises cannot be reached, the only alternative may be bankruptcy, and as alternatives go, bankruptcy has pitfalls for everyone involved. In government bankruptcy proceedings, coupon payments to muni investors and pension payments to former state employees have “senior” status. That is, they take priority over funding of basic social services like education, police protection, and road and bridge maintenance. In other words, municipal bondholders and pensioners have equal and first claim on tax receipts, and all other spending is subordinate to those payments. Something often forgotten is that the deal on the table is often better than the one determined by the courts. Consider Central Falls, Rhode Island. When the unions couldn’t agree on appropriate concessions, the town was forced to declare bankruptcy. The ultimate pensions granted to the unions were far worse than the ones the city of Central Falls had been offering during negotiations, so much so, in fact, that other cities and towns in Rhode Island were scared enough to fall in line on one of the most sweeping pension reforms yet in this country. Rhode Island’s state treasurer, Gina Raimondo, is now the go-to adviser on pension reform to politicians across the country.
Chapter 5
The Negative Feedback Loop from Hell
In 2006 Nevada was the envy of the nation. Today it’s an economic calamity—a victim of runaway spending and borrowing during better times.
Fueled by tourism and roaring demand for real estate, Nevada’s economy in the mid-2000s was truly electric. The state’s gross domestic product was growing at a pace more common to up-and-coming third-world nations than parts of the United States. According to the U.S. Bureau of Economic Analysis, the Nevada economy grew an average of 9 percent a year in 2004 and 2005—three times the growth rate of the U.S. GDP. What was happening in the city of Las Vegas was especially breathtaking: Personal income in the Las Vegas metropolitan area increased 10 percent in 2005.1 The city had morphed into a supercharged jobs magnet, with metro-area population expanding 42 percent during the 2000s—the fastest population growth in the country. “I think we’re at the crossroads, whether we want to be the entertainment capital of the world or a great American city,” Las Vegas mayor Oscar Goodman gushed in 2005. “Things are so wonderful in Las Vegas, and it’s time to move to the next level.”2
Fast-forward six years, and suffice it to say that things in Las Vegas are no longer so wonderful. Mayor Goodman and other government leaders never appreciated just how much of their windfall derived from a housing bubble that was sure to end badly. Home prices in the state had doubled between 2001 and 2006, funneling huge sums of new tax dollars into state and local coffers. State tax revenue had doubled over that period as well, and the legislature seemed intent on spending every last dime.
Then came the real-estate crash. Las Vegas home prices fell 60 percent. Statewide, the decline was 56 percent, and now 57 percent of Nevada mortgages have negative equity—that is, homeowners owe more on their homes than the properties are worth. By 2011 Nevada’s onetime state budget surplus had evaporated into the widest budget deficit in the country—$1.2 billion, equivalent to 54 percent of the total state budget. Schoolchildren and college kids bore the brunt of the inevitable budget cuts. In-state tuition at the University of Nevada at Las Vegas soared from $6,600 to $10,700 a year, and the legislature cut K-12 school funding by $270 per student.3
The timing could not have been much worse for local school systems like Las Vegas’s Clark County School District, which experienced a 33 percent decline in property-tax collections between 2008 and 2012. Pushed to the fiscal brink and its teachers unwilling to accept cuts to pay or benefits, the school district announced in May 2012 that it had to lay off 1,015 teachers and reading specialists in order to close a $64 million budget shortfall.4 Average class size in the school district soared from thirty to thirty-five pupils for grades four and five and from thirty-two to thirty-nine for grades six through twelve. One kindergarten teacher was told to expect thirty-seven students in her class for the 2012–13 school year. “With 37 kids, how are we supposed to teach anything?” Griffith Elementary School teacher Christie Rodriguez complained to the Las Vegas Sun. Rodriguez’s own daughter was set to begin school the following year. “It’s terrifying,” she said, “to think [my daughter] will be in a class with that many kids.”5 So terrifying, in fact, that many Clark County parents have been voting with their feet. Once the fastest-growing school district in the country, Clark County has seen its enrollment drop for four consecutive years.6
This is not an isolated story. In Nevada and all across the United States, cities and states that were once flush with cash are running out of money needed to pay for libraries, safe streets, clean drinking water, and, yes, schools. Even worse, the debts they’ve rung up in order to close budget gaps are threatening governments’ ability to deliver these basic services not just today but also in the future. Meanwhile, new economic epicenters are emerging in some of the unlikeliest places. Booms in American agriculture and energy production have turned states like Iowa and North Dakota into hot job markets while also ushering in a new era of U.S. manufacturing. In these areas, governments are struggling to keep up with the demand for housing and for infrastructure like roads, bridges, and schools. The good news is that these governments have the money to pay for all this, and they are spending and investing like crazy. North Dakota, a state with virtually no debt and some of the fastest-growing oil fields in the world, is working hard to keep pace with all the new population growth and industrial development: Roads are being graded, temporary housing is being erected, and schools are being built. From 2011 to 2012 North Dakota’s spending per pupil shot up over 8 percent to $12,225, versus $8,363 in Nevada, according to the National Kids Count Program.7
The reversal of fortune started off quietly, but each year the cutbacks in public services take more of a toll on communities that not so long ago were swimming in cash. Things so many used to take for granted—new textbooks for classrooms, low student-teacher ratios, open libraries, adequately staffed police stations and fire houses, regular trash collection—have been meaningfully reduced or done away with entirely. Since 2008 nearly seven hundred thousand state and local government jobs have been eliminated.
The crisis would be more manageable if the only problem were declining tax revenues. Cutbacks in state spending have exacerbated the loca
l tax-revenue decline. During the 2012 and 2013 fiscal years alone, states cut payouts to local governments by a total of $1 billion.8 At the same time, municipalities are being hammered by the rising costs associated with mountains of debt and public-employee pension obligations accumulated when times were more flush. It’s certainly possible that elected officials in North Dakota would have wildly overspent in the mid-2000s if the money had been available. But regardless of whether the fiscal prudence of central corridor states was the result of serendipity or good planning, the reality is that these states don’t have the financial burdens now crushing the housing-boom states. They are free to spend money on actual improvements and services, rather than on old debt and excessive retirement benefits. A tale of two Americas is emerging: one weighed down by debt and facing de minimis economic growth and another brimming with opportunity and nimble to invest in the future.
Over just the past decade, state spending has spiked 67 percent while tax receipts have increased a mere 30 percent. States racked up a stunning $2 trillion in additional debt, all while leaning more and more on handouts from the federal government. But not all states. Some took on little debt, while others took on staggering amounts.9
Total Liabilities / GSP, FY2011
Note: Total liabilities include GO debt, unfunded pension liabilities, and unfunded OPEB liabilities.
SOURCES: STATE CAFRS, COMPTROLLERS, PEW CENTER, MOODY’S, AND MWAG
Despite all the public focus on the fiscal cliff and the need to reduce the federal debt, there has been relatively little attention paid to reducing the debt incurred by the states and backed by their taxing authority. From 2009 to 2011 that debt grew by over $400 billion, or by over one-fifth. And that still wasn’t enough for spending-addicted states. Rather than dealing with the root cause of this mess—too much spending on too many of the wrong things—states have papered over their budget gaps by taking more from the feds, by borrowing more from the bond market, and by shirking their responsibility to fully fund the pensions of government employees. The federal government’s outlays to states have risen more than 130 percent. They now stand at their highest levels ever and are expected to reach over $700 billion by 2016.10 State politicians should have treated the post-2008 increase in federal aid as a bridge loan—one designed to help states avoid drastic cutbacks while they worked to close their budget gaps. Instead, they just kept on spending.
% Change in State Expenditures from 2000 to 2010
SOURCES: BEA, U.S. CENSUS, AND MWAG
The mismanagement of states’ finances was until recently a well-kept, dirty little secret, as politicians and budget makers disclosed precious little about their actual debt loads. Rising tax receipts from a booming housing environment and a prolonged low-interest-rate environment, which motivated states to borrow more and investors to demand more municipal bonds, led to a “there are no calories in chocolate cake” style delusion for many cities and states. In San Bernardino, California, which filed for bankruptcy protection in 2012, the city attorney has alleged that the mayor and the city council didn’t know how deep a fiscal hole the city was in until it was too late. “We haven’t had good, solid information over the last 16 years,” one city councilman told the local paper. “Why? That’s up for determination. I don’t believe they’re falsified. I believe there’s maybe some incompetency or ineptness or trying to stretch the truth, trying to make things look better.”11
Until 2009 when regulators started requiring fuller disclosure, investors and taxpayers had no way of knowing that 75 percent of state and local debt was off the balance sheet, in the forms of unfunded pension and health-care benefits. Because this information was not widely available, states and cities maintained easy access to the debt markets without raising questions about the added cost of new borrowings. Most “experts” looking at municipal affairs have focused on debt-service levels and on some caps on that debt. They have stated unequivocally that there’s nothing to worry about. They’re quick to point out that states have never defaulted and that bond defaults by cities and other muni bond issuers have been almost as rare. The reality is that just because something has not happened in the past does not mean it won’t happen in the future. That was one of the more painful lessons from the housing bust. Far too many lenders, home buyers, and real-estate investors refused to believe home prices could decline significantly because there had not been a decline in the average U.S. home price since the Great Depression.
The first cracks in the there’s-nothing-to-worry-about facade are now appearing. In 2012 the California cities of San Bernardino, Stockton, and Mammoth Lakes all filed for bankruptcy protection, and many cities throughout Michigan have been taken over by state-appointed emergency managers. The credit-rating agencies have begun telling bond investors to expect more defaults. In September 2012 Fitch Ratings cautioned investors that it “anticipates an increase in defaults and bankruptcies.”12 Moody’s Investors Service has already warned that the California bankruptcy filings “could signify not only a lack of ability, but a lack of willingness to pay debt service at the expense of other financial obligations.”13 There surely would have been even more defaults by now had interest rates not dropped to historic lows. The average yield on the Bond Buyer Go 20-Bond Municipal Bond Index (WSLB20) has plummeted from 6 percent in October 2008 to 3.7 percent in January 2013, and the near halving of interest rates has allowed states and municipalities teetering on the brink of fiscal crisis to borrow more money without paying more in finance costs.14
Piling on debt at a low interest rate may allow a state to remain below a “debt cap” that limits monthly or yearly debt payments. But it is a short-term fix. Any spike in interest rates—obviously rates cannot stay low forever—would push some state and local budgets over the brink. When borrowing costs do finally rise, the pricey pensions and other generous benefits promised to state and local government workers will go from a theoretical worry for taxpayers to a painfully real one. If those obligations are already starting to crowd out money needed for basic public services in places like Las Vegas, just imagine what happens when more baby boomer–age civil servants start retiring en masse. Taxpayers will learn that by law debt and pension payments actually take priority over all other state spending, including that for education and public safety. For some municipalities, bankruptcy might actually be the only way out.
There’s a reason politicians put off making hard decisions. After all, why alienate key constituencies in order to solve a problem that might not come to a head until after they’ve left office? But with this budget crisis, ignoring and procrastinating may not work. The mayor who turns a blind eye risks his city sliding into Detroit-like despair and disrepair. The governor who does not act risks letting his state become America’s Greece—subjecting her citizens to all the privations associated with austerity budgeting. He risks sinking his state or city into an economic feedback loop from hell—one in which budget deficits beget tax hikes and spending cuts, which drive away jobs, further eroding the tax base and deepening the budget crisis that the hikes and cuts were intended to fix. Look at what’s happened in the actual Greece. The bottom income-tax rate there has increased from 5 percent in 2000 to 18 percent in 2010.15 Greece’s unemployment now exceeds 24 percent, and the GDP has declined 6 percent per year for two consecutive years.16 Alexandros Adamidis, a business-relocation expert in Bulgaria, recently told a Greek newspaper that he receives “10 phone calls a day” from Greek businesses seeking to relocate.17 The Financial Post reported that between April 2011 and April 2012, some seven thousand Greeks left Greece for Germany in search of jobs and lower taxes.18 This is the fate elected officials in housing-bust states are tempting if they fail to fix their finances.
American consumers love their credit cards—sometimes too much. Politicians like to buy on credit too. But while consumers know there’s a downside to revolving credit-card debt, politicians actually have little incentive to do anything but revolve because they’ll be gone before the b
igger bill comes due. Plus the new spending facilitated by increased borrowing is good politics. While some of the increased state spending has gone to fund vital projects and services, a disproportionate amount has gone to state employees—hiring more people (1.4 million) and, more often, increasing existing employees’ pay and benefits. Given the tremendous escalation in pay, pension, and other benefits over the past decade, it is hard to imagine that any mayor, school-board member, or city councilman actually believed these deals would be affordable in the future. But because these increases are contractual, they are difficult to abrogate or trim. The actual amount of “discretionary spending” in most budgets is quite low. The Las Vegas school system tried to close its budget gap by suspending contractually negotiated teacher pay raises, a solution vehemently opposed by the teachers’ union; an arbitrator wound up ruling in favor of the union, forcing districtwide layoffs. Indeed, what ends up being the most discretionary are the expenditures that have the most tangible impact on everyday life—social services, road repairs, new textbooks for classrooms, additional teachers to reduce class sizes, school buses, police and fire-safety vehicles, parks, libraries, and all the other services individuals and families depend upon. Over the past five years, $290 billion has been cut from such core services. But the real pain will be felt over the years to come, as “emergency” money that was meant to cushion the blow eventually runs out. In the past four years, the money saved through spending cuts at the state level accounted for less than half of the dollars used to close budget gaps. Until now, states have been able to bridge budget gaps by tapping rainy-day funds, accessing federal stimulus money, increasing taxes, or borrowing more money via the bond market. But these levers have all already been pulled.
Fate of the States: The New Geography of American Prosperity Page 9