Back when society's balance sheet was reasonably solid, the occasional bear
market was no big deal. A 20% drop in the average S&P 500 stock would
scare investors and lead to slight declines in consumer spending and government
capital gains tax revenue, but the overall economy would barely notice such
a minor speed bump.
But that was then. Like a person with an impaired immune system, today's developed
world is so highly leveraged that a shock of any kind risks catastrophic
complications. Which is why governments and central banks now meet every
incipient crisis with quick infusions of newly-created cash and lower interest
rates. We can't risk letting markets be markets any more.
Among the many things that might go wrong if equities fluctuate normally,
state and local budgets that depend on capital gains revenues and sales taxes
(both of which tend to fall in bear markets) would take a potentially serious
hit. From today's Bloomberg:
Recovering
U.S. State Budgets Run Headlong Into Stock Declines
The gradual recovery of U.S. state budgets, which collectively anticipated
3.1 percent more revenue this year, may be reversed by stock market declines
that imperil income taxes, their largest source of money.
Since 2011, states have been restoring education, health care and other
programs slashed during the recession, and the trend was forecast to
continue this year, according to the National Association of State Budget
Officers in Washington.
Monday's 3.9 percent decrease in the Standard & Poor's 500 Index,
continuing the index's worst downturn since the financial crisis in 2009,
spells trouble for states like California whose reliance on capital-gains
taxes makes them vulnerable to swings in equity markets. The market correction
comes after a rout in oil prices that has stung states including Alaska
and Texas that rely on revenue from petroleum production.
"Before the last week-and-a-half or so, states have been in the best relative
fiscal health since the end of the Great Recession," said Arturo Perez,
fiscal program director for the National Conference of State Legislatures
in Denver. "This is a big game of wait-and-see."
In surveys of fiscal officers from all 50 states conducted between February
and April, the budget officers group found that states were expecting
to spend 3.1 percent more in the year that began July 1, a slower rate
of growth than the 4.6 percent in the year that ended June 30.
U.S. stocks fell the most in almost four years after China unexpectedly
devalued the yuan Aug. 11, which raised concerns about the depth of the
the slowdown in the world's second-largest economy. The slump in Chinese
equities hammered emerging-market assets and sank commodities from oil
to metals.
The state with the most at stake may be California, where slumping income
tax collections during the recession in 2009 led to credit downgrades
by Standard & Poor's, Moody's Investors Service and Fitch Ratings,
pushing the most-populous state to the ratings basement. California is
uniquely vulnerable because more than 11 percent of revenue last year
came from taxes on capital gains, the highest proportion in the country,
according to its Finance Department.
"The market correction that we're seeing is a harsh reminder California's
revenue base is susceptible to that," Petek said. "Until they can somehow
reduce their reliance on capital gains related tax revenues, they will
be better off looking at that from a cautious standpoint."
A dip in revenue on Wall Street could weigh on New York's budget, which
in fiscal 2014 raised about $13.2 billion, or about 19 percent of total
collections, from corporate and personal income levies on Wall Street
firms and their workers.
The budget for the fiscal year that ends March 31 anticipates a 5.8 percent
increase in personal income-tax revenue after it increased 3.2 percent
in fiscal 2015. Corporate tax growth, which includes bank taxes, was
projected to be almost flat.
California is a big state so it spends a lot of money, probably about $113
billion in the current fiscal year. Still, a capital gains swing from 2014
to 2009 levels would blow a fairly painful $8 billion hole in its budget.
And the current correction, if it turns into something more extreme, would
send already-high unfunded pension liabilities into the stratosphere. This
would, in a world of honest governance, require either massive cuts in benefits
or equally massive infusions of taxpayer cash, with all the attendant turmoil
that that implies. Some representative state pension liabilities:
So today, a bear market related fall-off in capital gains would cause a double
crisis, cutting pension fund investment returns (and thus raising the level
of underfunding) and cutting tax revenues, diminishing states' ability to
even keep up with their current pension funding schedule.
In the scenario that keeps governors up at night, the spike in unfunded liabilities
raises interest rates on the municipal bonds states and cities issue to cover
day-to-day spending, throwing budgets even further out of balance and sending
the worst offenders into a death spiral that ends in default. See Illinois for
a glimpse of other states' future in the next bear market.
That market perturbations are no longer tolerable explains Europe's reaction
to Greece's crisis -- years of negotiations and debt acrobatics when a strong,
confident currency union would have just kicked the miscreant out. And it
explains China's serial yuan devaluations, multi-hundred-billion-dollar equity
buying program, and sudden cuts in interest rates and bank reserve requirements.
Managing markets has become a full-time job for elected officials whose predecessors
barely used to pay attention.
And it will only get worse. Every intervention either involves more debt up
front or encourages more borrowing in the future. Leverage and fragility
go up, making the next crisis that much more dangerous and intervention that
much more necessary.
