Winning the Battle, Losing the War: Part I

The current political dispute between Wisconsin Governor Scott Walker and the state’s public employee unions is the first battle in a struggle that will dominate the public policy arena at all levels of government in the next 10 years -- how to pay for public employee retirement benefits, what role public employee unions will play delivering government services and their role in the future of the Democratic Party.

I seek to explore these ideas in a series of forthcoming posts. My initial post will cover the cost of retirement benefits to state and local governments (SLGs). Future posts will cover what Walter Russell Mead calls the blue model, the problems of federal deficit spending and the how these disputes will change the political environment of America. Although I expect battles between Republican governors and public employee unions to energize the base of the Democratic Party in the 2012 elections, helping Obama secure his second term, the core public policies in dispute threatens to tear apart the Democratic Party – and will force a substantial political realignment.

Pensions & Unfunded Liabilities

Unlike the federal government, every state in the union (except for Vermont) has a legal requirement of a balanced budget. Although this can be offset in deficit years by relying on the bond market to cover shortfalls SLG’s don’t have the luxury of printing the world’s reserve currency to keep interest rates low, much less pay back the loans.

The wretched standing of SLG budgets has been a victim of the Great Recession. California alone saw revenues fall from $103 billion in 2007-08 to $83 billion in 2008-2009, and will only recover to an expected $94 billion in 2010-11. Revenue figures will improve as our nation’s economic recovery continues. Nevertheless, larger budget problems have been exposed during the crisis and loom ominously in the future.

Rather remarkably, the money discussed in the Troubled Asset Relief Program (TARP) is just a mere fraction compared to the amount of money needed to right SLG pension obligations. Originally estimated to cost taxpayers $300 billion, recent Congressional Budget Office (CBO) figures estimated TARP will end up costing taxpayers $25 billion. This does not include bailing out Fannie and Freddie Mac, which has cost $153 billion so far with the potential of an addition $68-$210 billion needed by 2013.

Estimates on the unfunded liabilities of the states vary. The Pew Center recently estimated the total to be $1 trillion at the end of fiscal year 2008, yet this study used the accounting standards of state pension boards. Using standards required by the private sector the total could be as much as $3 trillion – and this doesn’t even include local governments! These unfunded liabilities has been recognized from figures across the political spectrum, from Reason to the Heritage Foundation to Washington Post progressive pundit Ezra Klein.

As the daunting dilemma has revealed itself investors and public officials have taken notice. Moody’s, the rating agency that rated junk housing derivates as AAA, recently announced they would factor in pension obligations into their credit ratings – even though these figures are not listed on their audited financial statements. This will certainly lower state credit ratings, increase interest rates on state issued debt and augment the strain placed on state budgets. An additional long term issue SLGs will have to confront is increasing health care costs for retired employees; not only will the number of retirees increase, so has the inflation rate for health care.

The same New York Times article linked above revealed states already have $2.8 trillion worth of outstanding bonds. This set of financial realities doesn’t paint an appealing picture for the future of state government budgets.

What in the World to Do?

Reserve Chairman Ben Bernanke: "We have no expectation or intention to get involved in state and local finance.” The states "should not expect loans from the Fed."

Felix Rohatyn, the longtime advisor to the Democratic Party and legendary financier who helped save New York City from bankruptcy in the 1970’s, recently told the New York Times “it seems to me that crying wolf is probably a good thing to do at this point.”

Former Los Angeles Mayor Richard Riordan: “throughout the country, 90 percent of cities and states are going to go bankrupt within the next five years, many of them sooner.”

SLGs are looking at financial armageddon in the next 10 years and the Fed won’t bail them out. What we are about to witness is best describe by astrophysicists as an “Impact Event.” The governance and political alliance structure of SLGs will never be the same after the dust settles.