Perhaps the most persistent refrain from the muni optimists is that governments won’t default because they cannot afford to have the credit market closed to them.
Because municipalities serve a public function, they must find ways to successfully satisfy their debt services and continue as viable entities. They rely on access to the capital markets for both operating and capital expenditures. As a consequence, municipalities cannot generally afford to alienate investors by defaulting since this will result in future attempts of issuance being shunned by the capital markets.
Although this is stated as a fact, it is actually a forecast. It is an opinion about the future state of things. Worse, it’s a forecast of a forecast of a forecast: It is a triple-derivative forecast.
The first forecast is that credit markets will shun municipalities and states that default. This is not implausible on its face—although there are reasons to be skeptical—but it is a guess, rather than a fact. We simply don’t have enough experience with muni defaults to know with any certainty how the credit markets will react.
One reason to be skeptical of the shunning theory is that it seems to assume that investors will react to munis much as they might to corporate borrowers. But munis have a distinct advantage over corporates: a captive market. Munis can be tax-exempt for in-state investors. This means that they have a built-in market that is not subject to the same level of competition for capital that corporations are.
Another reason to be skeptical is that the shunning theory only remains plausible if defaults are limited to a few cities or states.
If defaults become widespread, investors will be unable to choose only the non-defaulting issuers. If they did so, yields would become miniscule. The shunning theory depends on same muni issuers looking worse than most—if all issuers look risky, the shunning effect evaporates.
The second forecast builds on the first. It says that political decisions will be made to rationally avoid the shunning effect.
This assumes states always act in their self-interest, rather than as directed by self-interested sub-groups—such as politicians, public employee unions, or taxpayer groups. This assumption is just wrong. It is based on naïve political science—or, perhaps, it is another instance of fund managers playing finance while their borrowers play politics. Wrong game, fellas.
What’s more, it assumes that state political decisions are based on accurate perceptions of reality and that those perceptions match those of bond managers. This is also a mistake. Political decisions are often the result of error, such as the impression that Saddam Hussein was harboring weapons of mass destruction in Iraq. And political decisions can be based on forecasts that differ from those of bond managers, such as the likelihood of being shunned by the market or the harm that would come from being shunned.
The final forecast embedded in the statement is that states or cities will be harmed if they are shunned by credit markets; that they will no longer be able to carry out important public functions or no longer be “viable.”
This assumption might not be unreasonable. But it is unproven. Orange County continues on. It is not a hellhole.
What’s more, the case of Russia’s 1998 default on its debt is a strong counter-example. Russia’s default was followed by a decade in which the country grew 7 percent a year. These years of prosperity are pushing the Russian government into budget surplus. Until very recently, Russia hasn’t attempted to access the international credit markets since the default—with little harm to show for it.
Is it really reasonable to suspect that governments will agree with all these questionable forecasts? Because that is what many muni optimists are implicitly doing.
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