NCPA - National Center for Policy Analysis

The Municipal Debt Bubble

January 4, 2011

When state and local governments want to spend more than they collect in revenues, they issue bonds.  Since 2000 the total outstanding state and municipal bond debt, adjusted for inflation, has soared from $1.5 trillion to $2.8 trillion, says Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University.

Municipal bonds are perceived as safe investments because, like U.S. Treasury bonds, they are backed by the full faith, credit and taxing powers of the issuing governments.  Investors know that states and localities can always raid taxpayer wallets to pay off their debts.

But in the last two years tax and fee hikes have faced greater public opposition.  

  • Last year, for example, Jefferson County, Ala., was unable to raise sewer fees to meet its sewer bond obligation.
  • Since governments are generally unwilling to cut spending either, the result of resistance to new revenue raising has been substantial increases in states' and cities' debt levels.
  • Detroit and Los Angeles have announced that they may have to declare bankruptcy, as have a number of smaller cities.

Usually, as a borrower becomes a riskier prospect, lenders start pulling away.  But municipal bonds have not yet lost their low-risk reputation, says de Rugy.

Like homeowners, states and cities splurged on debt and found inventive ways to get around borrowing limits to finance projects they couldn't pay for otherwise.  Now some investors have started betting against the borrowers.

The state and municipal debt crisis could culminate in a request for the third near-trillion-dollar bailout of the last two years.  That much federal borrowing on top of the current debt could very quickly have an impact on interest rates and on the dollar, says de Rugy.

Source: Veronique de Rugy, "The Municipal Debt Bubble," Reason Magazine, January 2011.

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