January 16, 2018 03:52 pm CST
Beware the risks
By Geoffrey Pike, Wealth Daily

The city of Stockton, California filed for Chapter 9 bankruptcy in 2012 — the largest city in U.S. history to do so at that time. Soon after, the city of Detroit became the largest city to file for bankruptcy protection.

The president of the New York Federal Reserve, William Dudley, recently gave the opening remarks at a conference discussing Chapter 9 bankruptcy and other alternatives for distressed municipalities.

It should be noted that the Federal Reserve Bank of New York is the most powerful member bank of the Federal Reserve. The president of the New York Fed is always granted a seat at the Federal Open Market Committee (unlike the other regional banks that rotate) and serves as the alternate chair of the FOMC.

Dudley’s opening speech warned of the dangers of other municipalities following in Stockton and Detroit's footsteps. He pointed out the risks of using debt to finance operating deficits, as opposed to using debt for infrastructure and productive assets.

He pointed in particular to underfunded pensions. He doesn’t quite say it like this, but politicians are making promises to today’s voters to buy votes, and they will let somebody in the future worry about the problem. It is easy for a politician to promise a big pension to government employees 20 years down the road. The problem is that 20 years pass before you know it, and you end up with something like Detroit.

While Dudley didn’t specifically mention any other cities, Chicago has major fiscal problems, and it would not be surprising for it to take over Detroit as the largest bankruptcy in U.S. history. It is hard to say if Dudley is giving a warning of what to expect or if he is trying to prevent this from happening.

Either way, it is rather ironic coming from a major Fed official. Overall, his remarks are quite accurate, and his warnings should be taken seriously. But talk about needing to look in the mirror...

Dudley stated, “The municipal bond market is very large, with outstanding issues totaling over $3.5 trillion.”

Has he considered the U.S. national debt that is currently over $18 trillion? Has he considered the federal unfunded liabilities, mostly made up of Medicare and Social Security, that some estimate to be over $200 trillion?

While many city and state governments have certainly overpromised many government employees on what to expect in retirement, the U.S. government has overpromised an entire generation of Americans... or more.

The Federal Government Lives By Different Rules

Most states and cities in the U.S. have provisions that mandate something close to a balanced budget. But really, regardless of balanced budget requirements, state and local governments are limited by economics.

They can issue debt, but it is something similar to a family going into debt. At some point, if the debt gets too high relative to the income, then the lenders are going to demand higher interest rates or else stop lending completely.

At some point, the local government will not be able to borrow any more and will be forced to cut back, whether through debt reduction or outright bankruptcy.

This is what is happening to Greece. Without bailouts from other European countries, the Greek government would have already completely defaulted. It would have been forced to dramatically cut back on government spending.

The U.S. federal government lives by different rules, especially over the last 100 years. It does not have to worry nearly as much about finding lenders. It has a central bank in the form of the Fed, which can simply create money out of thin air and buy up U.S. government debt, helping to fund the deficits.

This is what enables the government to accumulate so much debt. It can finance its debt through monetary inflation, which state and local governments cannot do.

There are really only two possible limits placed against the federal government and the Fed in racking up more debt. One limit is hyperinflation. If prices start rising quickly, then the Fed will be forced to cut back on its purchases of debt or else risk sending the dollar into hyperinflation, which even Fed members do not want.

The other limit is public opinion. And while there are many more vocal opponents of the Fed than probably ever before, it is still a relatively small minority at this point.

Unfortunately, many Americans don’t oppose massive deficits. They will say they do, but they would rather have deficits than have to pay higher taxes or see their favorite government programs cut.

This is why, despite any minor criticisms they may have, most politicians love the Fed: It enables them to spend more money. It enables them to extract more money out of the people without officially raising taxes.

It also allows them to delay any day of reckoning in terms of the debt. Local municipalities face bankruptcy with a lot less debt, even on a per-capita basis. But the federal government just keeps going, and the Fed feeds the fire.

Unfortunately, it just means the problems can grow to a much greater magnitude. It will eventually mean more pain down the road in dealing with the debt and all of the big promises that were made by previous politicians.

More Bankruptcies

There is little chance that some of the big cities already deep in debt are going to listen to Dudley’s warnings. The goal of the current politicians will always be to attempt to delay it for the next group. At some point, the city just runs out of money.

Many people view bankruptcy as a bad thing, which it certainly is. But we have to be clear that the bankruptcy itself is not the problem. At that point, it is really the solution.

The problem came a long time ago. In most cases, it has been ongoing for decades, and it has finally caught up. Keynes said that in the long run, we are all dead. That is true for Keynes right now, but we are all living in the present. Living in the present includes having to deal with past mistakes.

Think about a family that has to file for bankruptcy because it simply can no longer pay the bills. It didn’t all of a sudden get bad — there was a build-up of debt. Assuming there wasn’t a job loss in the family or a one-time major expense, it means there was a spending problem all along. Before filing for bankruptcy, the family was likely struggling to pay its bills for many months or even years.

I am in the minority in that I actually view municipal bankruptcies favorably. I know many will say issuing debt is a contract and the government should make good on its supposed obligations.

But the problem here is that it is not the obligations of the politicians who made the promises. They made the promises on behalf of the taxpayers. The only way to meet the promises is to extract more money from the taxpayer — who never signed the contract.

Heed the Warning

While Dudley’s warning was likely directed at state and local governments to get their fiscal house in order, I view it as a warning to investors...

Don’t lend your money to an entity that can easily default on its promises. This would include any state or local government. Stay away from municipal bonds, particularly in big cities, unless you are quite willing to face the risks of a default.

Many state and city workers should also view this as a warning that their promised pensions may not be as safe as once thought. The younger you are, the more you should take this seriously. But if you are younger, at least you have time to adjust if anything does happen.

Meanwhile, for investors in U.S. bonds, you are not likely to see a default anytime soon because of the Fed’s ability to pay you off in freshly created dollars.

With that said, if you are investing in U.S. bonds, you might have to worry about another type of default. It won’t be an outright default — you will get your money that was promised. The problem is that your money is going to buy you a lot less in the future than it does today.

The Fed’s ability to ensure there isn’t a default in U.S. debt is also the very thing that will ensure you will lose purchasing power.

Until next time,

Geoffrey Pike for Wealth Daily

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