Friday, June 28, 2013

“Those concerned with the cost of government should welcome the finding that Illinois does not face a solvency crisis” – Modeling State Credit Risks in Illinois and Indiana (from Mercatus Center, George Mason University) by Marc Joffe

Is Illinois in serious jeopardy of insolvency? The state has the lowest credit ratings in the nation, and its long-term general-obligation bonds yield 1 percent more than those issued by the most highly-rated states, reflecting a market perception of significant credit risk. As a result, Illinois taxpayers pay tens of millions of dollars in additional interest charges—costs that could be avoided if the state were perceived to be a safe investment…

The model results suggest that Illinois state bonds carry very little credit risk and that Indiana’s obligations are even less risky. While Illinois’s fiscal policies are likely to have negative effects on future state residents and implications for other public policies, they are not sufficiently dangerous to worry bondholders…

I use an open source budget simulation model to evaluate Illinois’ credit risk and to compare it to that of Indiana, a neighboring state generally believed to have better fiscal management. Based on a review of the history and theory of state credit performance, I assume that a state will default if the aggregate of its interest and pension costs reaches 30 percent of total revenues. In Illinois, this ratio is currently 10 percent, compared to 4 percent in Indiana.

My analysis finds that neither state will reach the critical threshold in the next few years under any reasonable economic scenario, suggesting no material default risk. Over the longer term, Illinois has some chance of reaching the default threshold, but it would likely be able to take policy actions to lower the ratio before then. If market participants accept my finding that Illinois does not have material default risk, Illinois’ bond yields will fall, yielding cost savings for taxpayers as the state rolls over its debt…

Illinois bonds are evidently much riskier than Indiana debt, but neither appears to have substantial risk—at least not in the near or intermediate term. The idea that one thing can be proportionately much more risky than another, yet not very risky in absolute terms, may seem like a paradox, but it is not.

A simple analogy from outside the world of finance can drive this point home. According to statistics compiled by Stephens (2011), the odds of dying in a car trip are one in a million, while the odds of dying in a commercial airplane trip are one in 72 million. Although commercial aviation is much safer than driving, almost no one chooses to take a plane rather than a car due to safety concerns. While most people don’t know the exact odds, both risks are so remote that the proportional difference need not be reckoned into anyone’s plans.

Much the same is the case when choosing among state bonds. Thus, Illinois has made much worse fiscal-policy decisions than Indiana, and its bonds are riskier as a result—but they are still not very risky at all in absolute terms. Despite its poor fiscal policies, Illinois has not yet accumulated a dangerous level of debt relative to the size of its economy. Nor has it taken on pension burdens that exceed the state’s ability to raise revenue. Because the state workforce represents a relatively small proportion of the population, the Illinois tax base is more than equal to the task of shouldering the burden of state-retiree pensions.

In general, U.S. states are much safer than corporations and should enjoy higher credit ratings than most private debt issuers. Illinois last defaulted in 1842, and it cured its insolvency in 1857. It has been either debt free or a timely payer for 155 years. Few corporations can claim such a long record of good credit. Even the best-managed companies face the risk that their offerings will lose popularity or become obsolete. If this happens, their revenue and debt servicing capacity can quickly decline.

A government presiding over a large, diversified economy does not face such a problem. Through taxation, it extracts economic rents from citizens and businesses that choose to remain within its borders. Criticism of its tax and regulatory policies aside, the fact is that Illinois is and will likely remain a desirable place by world standards. Situated in the middle of North America, it offers peace, economic stability, infrastructure, and leisure options not equaled in most of the world. It is reasonable to expect that Illinois will continue to be home to a large number of high-income taxpayers and profitable companies. The state will thus continue to generate substantial and growing tax revenues more than sufficient to service its moderate debt burden. Those concerned with the cost of government should welcome the finding that Illinois does not face a solvency crisis.

If this conclusion is embraced by investors, Illinois’s interest rates will be bid down, allowing the state to roll over its debt at lower coupon levels. The result would be reduced debt-service expenditures and thus a lower burden for taxpayers over the long term.

Finally, a conclusion that Illinois’s fiscal policies do not represent a material threat to the state’s solvency should not be interpreted as a statement of support for these policies. To do so would confuse a positive finding with a normative predisposition. Fiscal policies that shift costs onto future generations are morally dubious in any case, but especially so in the current context.

Today, policy is being set primarily by the large and very fortunate baby-boom generation. The baby boomers—of which I am one—have enjoyed some of the highest living standards in world history and witnessed remarkable progress during their lifetimes. Indications are that the smaller cohorts that are following us will be less fortunate. It is these future taxpayers and service recipients who will be the victims of today’s fiscal policies.

Yes, they can shoulder the burden, but forcing this yoke upon them is a great act of unfairness. The view that all government services and transfer payments should be borne by today’s taxpayers is a normative principle. As Indiana found for 74 years after the 1921 implementation of its pay-as-you-go teacher-retirement plan, long-term underfunding did not cause the sky to fall. While it is true that shifting too many costs onto future generations is a recipe for default, Illinois has yet to engage in a level of intergenerational burden shifting that would pose a serious threat to bondholders.

For the complete report by the Mercatus Center: Modeling State Credit Risks in Illinois and Indiana


  1. Glen, thank you for the diligence in seeking very credible supporting reports that prove Illinois politicians are crying wolf only to hide their ineptness in carry out their constitutional responsibilities. Ty Fahner the Civic Committee's henchman along with the Chicago Tribune are also the biggest wolf criers and now need to eat crow for stirring up vicious lies about Illinois's future economic condition. Its also shameful how our governor with all the consultation he has can't see the sham that is taking place.
    Thanks again for all that you are doing!!

    Keith B.

  2. I hate to sound suspicious, but the Mercatus Center is the think tank of the Koch Brothers, as is George Mason their most indoctrinated university in Ayn Rand me-first thinking. I'd love to know what's behind this glowing report of Illinois (which I'm happy to accept). it sounds wonderful but anything associated with the Koch Brothers makes me suspicious. Charles Koch had an incredibly fair-sounding editorial in the Trib last week with things such as mass incarceration of minorities for misdemeanors is wrong (which it is), but these are the same Koch Brothers who advocate for resegregation in the South. Not sure what's going on.. Is it because they want State's rights over federal control?