One Crisis that Did Not Materialize

A little more than a year ago, many investors were worried about the US state and local government finances. There were genuine concerns that what was happening in Greece could very well be the future of numerous US local governments. Yet the much forecast debt crisis of US city and state governments failed to materialize.

While Greece and other peripheral countries in Europe are paying close to record yields, despite ECB bond purchases, US states and municipalities are paying the lowest interest rates in a couple of years. As of the late in Q3, local governments defaulted on a little more than $1 bln this year. This is about a quarter of last year's total. Some analysts were predicting hundreds of billions of dollar in defaults.

State and local government revenues rose almost 7% in Q2 from a year ago. It is the biggest increase since Q2 2006 and is the seventh consecutive quarterly increase.

State and local governments not only have revenues increased, but financing costs have fallen. Long-term interest rates paid by state and local governments appear to be the at about 2 1/2 year lows. California, one of the more debt distressed states, according to reports recently paid about 2/3 less on a $5.4 bln note sale than it did last November. It also sold about $2.4 bln in long-term bonds in Sept at yields about a third less than it did two years ago.

US states and local governments cut their debt by 3.2% in Q2 and 4.2% in Q1. This year looks to be the first year since 1996 that local governments in the US reduced their indebtedness.

Government spending has been a drag on US GDP for 5 of the past seven quarters. The key reason is that the cuts on the state and local level more than offset the increase on the national level. Yesterday's report on August construction spending suggests that there is light at the end of the tunnel, or perhaps that the drag from state and local governments may ease just in time for more austerity at the Federal level. The 1.4% rise in construction spending (market consensus was for a -0.2% print) was led by the biggest jump in public spending in 2 1/2 years. Federal spending on construction actually fell 0.5%, the third consecutive decline. However, state and local government spending rose 3.5%.

This note should not be read as an investment recommendation about municipal bonds. Instead it takes look at the improvement in state and local finances in the US. It is an unexpected positive development, especially relative to fears and projections. To appreciate US growth dynamics, the interplay between the federal government on one hand and state and local governments on the other is important. With the national jobs report due out in a few days, it is noteworthy that the private sector has created 1.7 mln jobs over the past 12 months, while government sector, mostly at the state and local level have shed 450k jobs.

This discussion also sheds light on the European debt crisis. The absence of substantial fiscal transfers is hard wired into the euro zone. This is problem at the very core of the EMU project. It is part of the reason why we are experiencing a European debt crisis but not a crisis of local and state governments in the US.