State and Local Governments and Real Estate: The Problems are Still There

“Moody’s Investors Service, the ratings agency, said in a report last week that many states ‘are increasingly pushing down their problems to their local governments.’ The Moody’s report warned that this would be “the toughest year for local governments since the economic downturn began.” (See “States Pass Budget Pain to Cities,” http://www.nytimes.com/2011/03/24/us/24cities.html?hp.)

“The state budget squeeze is fast becoming a city budget squeeze, as struggling states around the nation plan deep cuts in aid to cities and local governments that will almost certainly result in more service cuts, layoffs and local tax increases.”

Homes, over the last fifty years, served as the piggy-bank for the middle classes and the working classes as the rising price of houses during this time served as the major source for these people to increase their wealth. We are learning more and more that the inflated values of land and commercial real estate and the growing wealth of these classes also served as a piggy-bank for other sectors of the economy, such as state and local governments.

And, this piggy-bank was the source for increasing employment, rising wages, and other benefits in the public sectors of the economy.

Now the piggy-bank is broken and state and local governments are feeling the pain as have home owners, small commercial banks and small businesses over the past three years. (See my post http://seekingalpha.com/article/259867-banking-and-real-estate-the-problems-are-still-there.)

People are learning that those that “live” by inflation, “suffer” by deflation.

Ben Bernanke and the Federal Reserve are trying as hard as they can to create inflation once again so as to preserve the banking system, the housing market, and, now, state and local governments.

The economy, however, may not be responding as the Fed might want it to.

In a real sense there are two economies. There are the better off, those that benefitted from the credit inflation of the last fifty years, the people that learned how to use inflation and who have the resources to protect themselves against changes in prices. Then there are the others, those who can’t protect themselves from changing prices.

One result of this is that the income distribution in the United States is skewed more toward the wealthy than ever before in the history of the country.

The history: in the early 1960s, there were many intellectuals and policy makers who believed that inflation was beneficial to the worker because a little inflation was not a bad trade off for higher levels of employment. This trade off was captured in something called the Phillips Curve.
Although the Phillips Curve was intellectually contested by the end of the 1960s, the myth of the Phillips Curve lived on in many official circles and some still believe in it to this day.

Yet, the credit inflation that was supposed to be a ‘boon’ to the blue-collar worker and the middle class resulted in a withering of American manufacturing capability in steel, autos, and then other industries. It resulted in substantial amounts of under-employment for working age people. It decimated the housing industry. It has made many of the smaller commercial banks in the United States insolvent. And, it has now bankrupt the American system of local government.

We have had a bailout of the steel industry. We have had two bailouts of the auto industry. Labor unions in the manufacturing industries are so week that union leaders are now training people to go into other countries and build up labor unions there. We have had a bailout of the banking industry. We are now going through a workout and possible bailout of state and local governments.

Labor unions in the public sector, teachers unions, are now acting in much the same way as did the auto unions and the steel unions before them, as the economic base for their benefits have faded away.

People and organizations can only live beyond their means for so long and credit inflation can create the “good days” for only so long. And, when the good days are over, people must return to a more controlled and disciplined life style. The pain of the ‘return’ is not easy to bear.

The efforts by Mr. Bernanke and the Federal Reserve to create another round of credit inflation is, unfortunately, producing a further bifurcation of American society.

While the middle class and the blue collar workers continue to suffer and continue to restructure their budgets and balance sheets, those who have more are taking advantage of the Federal Reserve’s actions to further strengthen their position.

Large commercial banks are bigger than they were when they were “too big to fail” in 2008. Payrolls and bonuses at financial institutions are exceeding earlier years.

Large corporations are sitting on “tons” of cash and possess immense borrowing power at miniscule interest rates. And, we see one large merger taking place here and another large merger taking place there: AT&T and T-Mobile; Deutsche Bőrse and the NYSE Euronext; Warren Buffet and Lubrizol, and Caterpillar and Bucyrus. The projection is for more of this to take place in America...and in the world.

And, the wealthy? Consumer spending is picking up but the strength is not at the lower end of the value chain. Manufacturing is picking up but for higher end goods. Overall, the pickup is just modest because it is not supported throughout the income spectrum.

I raised the question earlier, in such an environment “Will the Financial Industry Dance Alone?” (http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone) The answer to this question seems to be “No, the financial industry will not dance alone. Big corporations will dance along too as will the wealthy.” There was concern in the 2000s that the benefits of the economic growth at that time were not spread evenly throughout the economy.
My feeling is that you haven’t seen anything yet.

The efforts by the Federal Reserve to inflate the economy are not going to be spread evenly throughout the economy. State and local governments are going to have to re-structure and downsize. The people in these bodies are going to have to lower their expectations as well as the people that have been served by them.

Similar to the situation with the smaller banks, one hopes to get through this adjustment period without major disturbances. That is, government officials and regulators are working overtime to keep a lid on things so that insolvencies and bankruptcies do not overwhelm the system. The efforts to contain these problems seem to be having some success. Ever Meredith Whitney, the financial analyst who predicted massive defaults in the municipal bond area still contends that there will be a large number of defaults although not as many as she first feared.

Still, things are changing and will my guess is that in many areas of the society we will not return to the “plush” years experienced in the last half of the twentieth century.

The Obama Speech: The Day After

The Obama speech to the Congress on Tuesday night was “well given” and, basically, “well received”. It has been criticized for, among other things, not being specific enough. But, this was not the purpose of the speech. The speech was the first effort of the new President to lay out a vision for the near term and the future.

It was about the “vision” thing. A leader is, first and foremost, supposed to give us the “big picture” and not the details. The leader is supposed to provide us with something we can hold onto because we like the worldview it represents…or, provide us with something to disagree with because it does not conform to our worldview. I think that President Obama did that.

In terms of the crises in the economy and the financial markets, the thing that does not seem to come through in the “big picture”, however, is that there are two categories of problems we face. These two sets of problems can be put into boxes that are labeled…the problems of the past…and the problems of the future.

These are different issues and must receive different attention if they are to be resolved. Too often we lump them together for a bastard “Keynesian” solution.

The first set of problems has to do with debt…too much of it…and inappropriately assumed. This is the box of problems from the past…the box labeled “Insolvency Crisis”.

Too much debt, inappropriately assumed is a burden…it can cause finance and commerce to slow down or stop…and this can lead to a cumulative result in which the burden of the debt gets heavier and heavier. This burden is exacerbated as insolvencies grow and deflation becomes the problem (not inflation).

It has been argued that the only thing government can do to counter this problem is to reflate (Irving Fisher) or inflate (Keynes). That is, the only way government can lessen the burden of this excessive load of debt is to reduce the “real” value of the debt by causing prices to rise rapidly. But, this only recreates the environment in which the excessive debt was created! And, the consequence of this is just more and more leverage…which, in the longer run only makes the situation that much worse.

The excessive debt was created within the asset bubble world of the last decade or so. This world of asset price inflation resulted in a greater assumption of riskier assets and an overly aggressive assumption of leverage.

Financial and economic positions were taken than could only be justified within the rarefied world of the bubble!

The valuations from that time cannot stand up…outside the bubble!

In the case of the “Insolvency Crisis”, I believe that the only three choices are:
1. let the economy adjust to more realistic valuations by itself and just accept that we have to bear the burden of this adjustment;
2. help to smooth out the adjustment to more realistic valuations;
3. inflate our way out of the crisis…which, of course, would mean that we were just postponing the resolution of the foundation of the crisis.

The third of these choices is often attributed to Keynes and it is, I believe, an inappropriate application of Keynesian thinking…because it does not really resolve the situation.

President Obama is opting for choice number two…a choice I think most of us agree with. He is saying that choice number one is just too painful for the country and it’s people to go through. Hence, government must play a role in helping people and institutions work through the “debt problem” and that is going to cost…how much, we just don’t know.

That is the vision…the devil is in the details. And, that, I believe, is the problem right now. Most of us can agree with the vision…we just haven’t received sufficient information on how this is going to be done and how much it might cost. And, without greater certainty…markets will drop!

The second set of problems has to do with the future…and the box containing this set of problems is labeled “What We Want To Be.” President Obama stated in his speech Tuesday evening that in his vision of the future, he sees America as energy independent…he sees Americans protected with some form of universal healthcare…he sees Americans as among the best educated in the world. President Obama sees an America that is energetic and innovative…a continuation of what America has been in the past.

This, to me, is the stimulative part of the President’s program…the part of the program that is not focused on the consolidation of past ills, as is the part of the program discussed above. This part of the program is an effort to provide incentives to create the next era and not “bailout” the old.

That is the vision…the devil is in the details. A first look at some of the specifics came in the stimulus package recently passed. More will be coming in the near future. Again, more details will help us get over the grey areas of uncertainty that constrain our willingness to commit.

We need to keep these two sets of problems separate as we go forward. The first set of problems is going to take time…and not everything that is done to resolve these issues is going to be “fair”. As I have said before, once one has created this set of problems, one finds that all the choices available for solving the problems are not happy ones. But, “inflating” our way out of these problems is not the solution…it can only, ultimately, make more pain for the future.

The second set of problems must be looked upon in terms of the opportunities that are available to us. In my view, no serious economic crisis has ever been resolved without the creation of new innovations and new technological platforms. In the Great Depression, the innovations and the new technologies did really come about until the end of the 1930s and into the 1940s and were related to war. Earlier stimulus efforts in the 1930s tended to support what existed in the past.

We don’t want government providing stimulus to the economy that will just result in the old world being “re-created”…we do not want the “old” products or the “old” managements renewed and rewarded! We must move on to the future.

By providing his “vision” of this future, President Obama has changed the field of engagement. President Obama is not just talking “stimulus”…he is talking about the world we want to live in. We may not agree with him on everything. We may not agree with him on most things. But, we must accept the challenge, and…while we are attempting to resolve the debt problems from the past…we must enter the dialogue and debate about what the shape of the future will be.

In this sense, what President Obama has put forth is a stimulus plan…but with more than just one meaning of the word stimulus.