The Market Won't Fix States' Woes

Bond-market brinkmanship and bankruptcy threats can't save the states from themselves.

As budget season opens, many states - including Massachusetts - face their toughest choices yet on education, social services, and public-worker costs, plus the taxes needed to pay for them. Federal stimulus money is running out, and Washington doesn't want to offer more cash. But Washington can help in another way: by dropping the increasingly fashionable notion that the workings of the bond market can solve states' problems for them.

This notion is rapidly gaining traction in conservative circles. The thinking is that, in many state capitals, special interests from unions to hospital lobbies have taken over the political process. The only thing that can force states to change course, in this account, is fear among the states' lenders. If bondholders worry that states won't repay their debt, then they'll jack up interest rates or just stop lending money.

And the way to scare the bondholders is for Congress to change federal law so that states can legally declare bankruptcy. That's what GOP leaders and advisers, including Newt Gingrich, have suggested.

Congressional leaders are making their intentions clear to bondholders. "We are not interested in a bailout," GOP Representative Paul Ryan, the new House budget chief, said recently. "Should taxpayers in frugal states be bailing out taxpayers in profligate states?'' His answer: No.

Some governors, too, have welcomed such talk, figuring that fear helps them with their legislatures and unions. New Jersey Governor Chris Christie has warned that public-worker costs "will bankrupt" his state. If Christie wanted to scare the bond market, it worked: a state agency had to alter its plans to borrow after interest rates rose.

But enthusiasts of a "market" solution to state woes should be careful what they wish for. What if bondholders listen to the hawks - as they've been doing in recent weeks?

If officials want investors to worry that a state can go bankrupt, the same officials must run the risk that banks, too, will suffer big losses. Banks, after all, own more than $229 billion in state and municipal debt. Banks worried that these holdings are no good would conserve money by lending less to businesses, stalling the recovery.

That's an optimistic scenario. Another $332 billion of municipal debt sits on the books of money-market funds. Many ordinary people believe such investments are as safe as bank accounts. A municipal-bond crisis could spur investor fear here. Similar panic in 2008 spurred a blanket bailout of these investments, but most members of Congress oppose more "Wall Street" bailouts.

A muni-bond crisis, then, would create new dilemmas for Washington. Lawmakers would have to consider: does the public want to see losses in "safe" investments, especially when Congress, in 2008, protected investors in supposedly riskier ventures, from Goldman Sachs debt to AIG stock? With the economy in such a fragile state, is Washington ready to test out its new fix for financial panics, the Dodd-Frank law - and risk blame for job losses if Dodd-Frank doesn't work?

Neither will "markets" solve political problems within state houses.

Case in point: Many voters, in Massachusetts and elsewhere, don't want their representatives to hike taxes. But if you're a bondholder, you often prefer tax hikes to spending cuts. Indeed, Illinois just increased its taxes to comfort bondholders. In the here and now, higher taxes give the state more money to pay its debt. Sure, over several years, tax hikes may drive business away. But many bondholders don't think that far ahead. Spending cuts take time and depend on bondholders' willingness to wait.

A bondholder revolt won't force smarter spending choices, either. The Bay State's public-sector pension funds, although in better shape than many around the nation, will require billions in taxpayer money over the coming decades, more if the state doesn't raise future workers' retirement ages. As it happens, Governor Patrick and legislative leaders have proposed such a reform. But suppose it stalls. They could maintain the status quo for a few more years or longer, and starve infrastructure investment instead.

These are political decisions, not "market'' decisions that bondholders can make. In fact, just as on taxes, a crisis likely would lead to the answer that taxpayers don't expect. Terrified pols would slash infrastructure investment to shore up those pension funds and quell bondholders' fear.

Politicians and voters dreaming of a muni-bond disaster as the cure for state-budget nightmares should realize this: Markets are markets. They aren't fairy godmothers.