Summary: Let’s examine a favorite story of doomsters – the burden of public pension plans. Will this crash, or help crash, America? History gives an answer.
The essence of doomsterism – seen in the confident predictions of certain doom that flood our media – is the doomsters’ overweening confidence that only they see the unique danger that lies ahead. Their forecasts are always wrong (with a microscopic number of exceptions) because western societies have mechanisms to deal with shocks of almost every kind.
This post looks at one of the current favorites of doomsters: government pension plans. This looming problem has hit the headlines yet again, with another amazing story. This time from Oregon.
By Mary Williams Walsh in the NYT, 14 April.
“Governments are struggling as mounting pension obligations crowd out the rest of their budgets. Oregon faces a severe, self-inflicted crisis.”
I wrote a series about this problem in 2010, when we could have fixed it (perhaps): About the coming crisis in public pensions, about State and local bankruptcies, and about the States on the brink of financial catastrophe. That was then. We have passed the “prevention” exit. Now we have to deal with the consequences of our past imprudence. “Our” imprudence, since we ignored thirty years of warnings about the mad pension plans of many (not all, or even most) States and municipalities.
What are our options? For the borderline cases, raising taxes and borrowing money will allow muddling through. For the worst off, borrowing and raising taxes will just initiate death spirals. People and businesses will flee, as they have from Detroit.
Some will hope for a bailout, so that prudent States pay for their folly. That’s not going to happen. Their only feasible option is bankruptcy. How main fail depends on the rate of economic growth during the next few decades.
Do governments go broke?
Yes, often. Defaulting on their loans was the only alternative for cash poor governments before the invention of modern financial systems (which allowed inflation and devaluation). The literature about this is fascinating (see some links below). Phillip II defaulted four times, even though 16th century Spain had almost all the money in the world.
Creditors had (and have) few options when governments defaulted.
- Their could seize assets of the debtor that were beyond its control (usually outside that State’s territory).
- They could attempt to obtain relief using the State’s internal processes (e.g., suing a State under its own Constitution or laws).
- They could get another State to intervene, as powerful creditors have had the US government help to collect payments from small nations (sometimes using the Marines).
- They could renegotiate the loan.
In most cases, number four was the best (and often the only) option. Governments seldom do hard defaults – telling creditors to get lost – because they will need to borrow money again, eventually. So both sides negotiate and change the terms of the loan: its maturity or interest rate, or reduce the amount due.
America has twice done soft defaults. The first was on 3 June 1933, with the wonderfully titled congressional resolution “To assure uniform value to the coins and currencies of the United States” (text here) – ending convertibility of dollars to gold, except for other nations. Our second soft default was in 1971, when President Nixon ended convertibility of the US dollar into gold by governments (see Wikipedia).
Now about those State and local governments …
States of the United States have a form of sovereignty. The 11th Amendment prevents US citizens from using the Federal Courts to compel States (and their municipalities) to honor their loans. Only State constitutions and laws can do so. If they don’t do so, too bad for the creditor.
Journalists often write grossly incorrect stories about bankruptcy of State and local governments (here is a recent example by CBS). America has had many rough patches, and States have defaulted at least 17 times.
- Eight States defaulted during the 1840’s. Four were outright repudiations: Arkansas, Florida, Michigan, and Mississippi. Adjustments to the loans were made in Pennsylvania, Maryland, Illinois, Indiana, and Louisiana.
- Eight States defaulted to varying degrees after the Civil War (during the 1870’s and 1880’s): Alabama, Arkansas, Florida, Georgia, Louisiana, North Carolina, South Carolina, Tennessee, and West Virginia.
- Arkansas defaulted on its bonds in 1933; but eventually paid all creditors in full.
Most of these disputes were settled only after long battles in the State legislatures and courts (State and Federal), usually with partial payments to the creditors – often after long delays. This left a large body of case law about State defaults. This will be dusted off and used again in the next few decades because there will be more State defaults on their obligations — debts and pensions — before the last Baby Boomer goes to her reward.
We survived those defaults, and will survive the coming ones.
What about unpayable pensions of local governments?
Local governments are entities of the States, regulated by State laws. Their handling of local bankruptcies vary widely. Plus there is the near certainty of large actions by State legislatures and courts.
Since 1937, defaults of municipalities are sometimes governed by Chapter 9 of the Federal Bankruptcy Code. It is far more limited and restricted in nature than the bankruptcy process for private entities. Also, State law must authorize bankruptcy (see this map showing municipal bankruptcy authority by State).
The bottom line: some State and local governments will decide not to pay. Their creditors and pensioners will take haircuts of some kind. There are many ways to do this. For example, the Pension Benefit Guarantee Corporation covers pensions of businesses that default on their pensions. It pays a maximum of $64,432 per year to workers who retire at age 65 (under their program for single-employer plans).
The coming defaults can be handled well with a modicum of courage and wisdom by our leaders and the public. Mitigation – sharing the pain, protecting the most vulnerable – should be the goal. The legal machinery and the precedents to guide us already exist.
Afterward the defaults
Defaults are symptoms of deeper problems. Will Americans learn and reform, or will we just repeat the cycle – as serial defaulters, like Costa Rica, do?
For more information
For more about the history of government defaults.
- See the history of municipal bankruptcy filings: graphs showing filings 1938-2015 by years, by State, by type of entity.
- To understand how this works, see the US Courts page about Chapter 9. For more detail see the “Primer on Municipal Debt Adjustment” by Chapman and Cutler LLP.
- I recommend this brief review of sovereign defaults: “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises“ by the brilliant economists Carmen M. Reinhart and Kenneth S. Rogoff.
- Even superpowers default, as described in “The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position, 1560-1598″ by Mauricio Drelichman and Hans-Joachim Voth.
- Life goes on after sovereign defaults, as explained by “Default settings“ in The Economist, 31 March 2010 — “Sovereign defaults do not typically lead to economic catastrophe.”
- Why the U.S. cannot inflate its way out of debt.
- Another way to look at the national debt. More comforting, less scary.
- Cacophony about Social Security shows our real political dysfunctionality.
- Fact & myth about the debt supercycle, a story of modern America.
- Harsh truths about the Federal debt, showing how Left & Right lie to us.