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Letting States Default is Very Dangerous Thinking

Summary:
There’s a growing narrative that states should be allowed to default if they can’t fund their spending needs during the pandemic. Let me be very clear about this: THIS IS AN INSANELY DANGEROUS PROPOSAL Get the message? Let me explain. During the Euro crisis I explained the important difference between the European Monetary Union (EMU) and the USA. The Euro had a series of rolling crises coming out of the financial crisis and they experienced depression-like growth in many countries. Overall, their recovery was much weaker than the recovery in the USA. The primary reason for this is that the member countries in the EMU do not have access to a federal treasury that helps them remain solvent. This is crucial to understand why the US monetary system works and Europe remains somewhat

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There’s a growing narrative that states should be allowed to default if they can’t fund their spending needs during the pandemic. Let me be very clear about this:

THIS IS AN INSANELY DANGEROUS PROPOSAL

Get the message? Let me explain.

During the Euro crisis I explained the important difference between the European Monetary Union (EMU) and the USA. The Euro had a series of rolling crises coming out of the financial crisis and they experienced depression-like growth in many countries. Overall, their recovery was much weaker than the recovery in the USA. The primary reason for this is that the member countries in the EMU do not have access to a federal treasury that helps them remain solvent.

This is crucial to understand why the US monetary system works and Europe remains somewhat dysfunctional. In the USA the states operate balanced budget mandates over time. But state governments are not businesses, that is, they don’t engage in necessarily positive net present value operations. It’s hard to make money putting out fires and keeping the peace. So they end up being cash flow negative across long periods of time. They fill the void by getting federal aid. Every state in the USA balances their budget in the long-term because the federal government’s budget is unbalanced. And the federal government can run an unbalanced budget because they leverage the enormous productive capacity of the world’s largest economy.

Europe doesn’t have this arrangement in place. So the countries in the EMU, which are the equivalent of states in the USA’s system, have occasionally encountered solvency issues. Eventually the European Central Bank imposed implicit backstops so the EMU didn’t experience any solvencies. But it took the Central Bank’s intervention to stop things from really spiraling out of control in Europe.

So, just to reiterate, the states need federal funding across time because the balanced budget amendment rules make it virtually impossible for them to remain solvent entirely on their own. This is a good thing! It helps the state remain somewhat disciplined when budgeting, but it also helps them avoid the risk of insolvency and the mass economic hysteria that would inevitably result.

But let’s also be clear about the unusual nature of this event. Some people keep demanding their pound of flesh from “irresponsible” individuals, corporate America, colleges and now states. I get it in the case of a large public for profit entity like an airline. But why would we voluntarily decide to stop funding public services during the pandemic? Why would we even consider making it more difficult for New York to fight the pandemic and service basic public needs? Is this the entity that deserves to be sacrificed in the name of your “free market” narrative?

Also, can we stop referring to this as a “rainy day”? This isn’t a rainy day. It’s a category 5 hurricane hitting the entire globe. And no, no one plans for a complete sudden stop in the economy so stop blaming individuals, firms and states for not having prepared for a 100 year storm.

Further, to people concerned about the free market and the economy – why would we risk a huge state like New York defaulting? If you think Lehman Bros defaulting was a problem then wait until one of the largest states in the country defaults. And for what? All because some politicians misunderstood the inherent nature of state budgeting while they extract their pound of flesh?

This is crazy talk. Just stop it. This isn’t the time for the blame game and political partisanship. If there was ever a time for the UNITED states to act united then this is it.

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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