Deciding to default

By Dave Anderson:

I have long argued that municipal bond default will become an attractive option in the near future for many political stakeholders because once the first few large municipalities default, the rest of the marginal municipalities won't be able to access credit at non-credit card rates anyways.  

Municipal financial managers do not want to default as they fear losing access to credit.

However there is a collective action problem.  A few defaults among the thousands of California borrowing entities will cut off credit for everyone else. Once a few entities default, everyone is screwed. 

If financial managers expect other managers to default, the smart thing to do is default first. Defecting and defaulting quickly reduces the pain of being forced to choose between repairing a creaky bridge or paying interest on that variable rate debt that Goldman Sachs told your city council was such a great deal a few years ago but is now eating up a massive proportion of your discretionary budget. At that point, correlated and rolling defaults become far more likely as communities say fuck-it and tell the bond insurers to go after them...as no one has any money anyways.

Default is a political decision more than an economic decision in this framework as the municipalities may be able to tax more, but the political costs of increased taxation (and probable impacts from increased out-migration) greatly outweigh the political benefits of maintaining a half-decent credit rating and sending all the local money out of the region.  Default is attractive when the options are firing half the police force, closing all the pools and not paving any streets for the next three years to pay off a large debt, or keeping most public services and public employment working while screwing those SOBs on Wall Street.

This basic analysis is the reason why so many analysts fear the results of a Greek default or debt repudiation.  Peter Boone and Simon Johnson at Economix illustrate the pain and benefit distribution of the potential decision by Greece to default:

>This new program calls for �fiscal adjustments� � cuts to the fiscal deficit, mostly through spending cuts � totaling 11 percent of gross domestic product in 2010, 4.3 percent in 2011, and 2 percent in 2012 and 2013. The total debt-to-G.D.P. ratio peaks at 149 percent in 2012-13 before starting a gentle glide path back down to sanity.

This new program is honest enough to show why it is unlikely to succeed.

Daniel Gros, an eminent economist on euro zone issues who is based in Brussels, has argued that for each 1 percent of G.D.P. decline in Greek government spending, total demand in the country falls by 2.5 percent of G.D.P.  If the government reduces spending by 15 percent of G.D.P. � the initial shock to demand could be well over 30 percent of G.D.P....

The politics of these implied budget surpluses remains brutal.  Since most Greek debt is held abroad, roughly 80 percent of the budget savings the Greek government makes go straight to Germans, the French and other foreign debt holders (mostly banks).  If growth turns out poorly, will the Greeks be prepared for ever-tougher austerity to pay the Germans? Even if everything goes well, Greek citizens seem unlikely to welcome this version of their �new normal.�

Which politician wants to tell their constituents that they need to take a 30% to 50% reduction in their standard of living to pay-off a bunch of damn foreigners at near par and maintain allegiance to a monetary system that increases their pain?  The current set may be willing to make that argument, but the next election will promote politicians who promise to take away some of the pain and screw the foreigners instead of their own people.