Illinois Is the New California

by Kristina Rasmussen The Manhattan Institute’s Josh Barro has an excellent column on RealClearMarkets today in which he explains how Illinois overtook California as America’s least creditworthy state and why our Pension Funding & Fairness Act is a good way back to fiscal sanity: If you go to Sacramento this week, don’t be surprised to hear champagne corks popping and...

by Kristina Rasmussen

The Manhattan Institute’s Josh Barro has an excellent column on RealClearMarkets today in which he explains how Illinois overtook California as America’s least creditworthy state and why our Pension Funding & Fairness Act is a good way back to fiscal sanity:

If you go to Sacramento this week, don’t be surprised to hear champagne corks popping and chants of “We’re #2! We’re #2!” The cause for celebration? Illinois has overtaken California as the worst credit risk among American states…

As of Monday, the credit default swap spread for Illinois general obligation bonds climbed to 313 basis points for a five-year contract — meaning a bondholder must pay over 3% of the bond’s face value per year to be insured against default.

That’s a higher price than for all but seven sovereign entities tracked by CMA, and slightly higher than California, whose five-year CDS spread sits at 293. Investors rate Illinois’s debt as slightly riskier than Iceland’s or Latvia’s, but not quite as big a gamble as Iraq’s.

What are we doing so wrong?

What is Illinois doing that has the markets so nervous? A few months back, I explored the issue, noting that Illinois doesn’t face many of the challenges that typify “states in peril.” Unlike California, Illinois cannot blame its budget woes on a particularly volatile revenue system or on outsize exposure to the housing bubble. Illinois’s crisis is unique in that it is purely a creature of mismanagement by elected officials.

Like California, Illinois hasn’t balanced a budget in nearly a decade, and instead uses gimmicks and borrowing to close gaps. Like California, Illinois regularly issues bonds to pay for current government operations. But unlike California, Illinois has some of the country’s least-funded public employee pension plans.

Public employee pensions plans create fiscal challenges for all states, but it’s hard to find one that is coping more poorly than Illinois. Legislators have routinely closed budget gaps by deferring pension payments. (Or sometimes they make the payments by issuing Pension Obligation Bonds, over $13 billion in the last 10 years). In a recent study that I co-authored looking at the funding status of teacher pension plans in the states, Illinois was the second-worst performer; only West Virginia’s pension fund has a lower funding ratio.

The solution?

The bond markets are screaming that Illinois needs real fiscal reform, and they didn’t find the pension reform to be satisfactory. To calm the bond markets, Illinois must stop using its pension funds as a venue for backdoor borrowing, stop borrowing to pay for current operations, and stop spending more money than it takes in.

The Illinois Policy Institute has been advancing a creative solution to the state’s budget woes. They have proposed a constitutional spending cap, similar to one enacted in Colorado in 1992, that would limit state spending growth to population plus inflation growth.

But unlike Colorado’s cap, which was designed to finance tax rebates, the Illinois proposal would direct that the state to fully fund its pension contributions each year. It would also require the state to pay off the billions in deferred payments to providers, and to maintain a rainy day fund equal to 8% of state spending. Only once the state had achieved these measures to put its fiscal house in order would taxpayers start seeing rebates.

Illinois legislators should seriously consider the cap or other measures to ensure that Illinois sees real budget balance. They would also do well to take a page from New Jersey Governor Chris Christie, who has been focusing on reining in the cost of local government, which can then reduce the need for budget-busting rises in local aid.

The end game?

If Illinois doesn’t take steps to get its fiscal house in order, it will face a vicious cycle — rising borrowing costs that eat up more of the state’s budget, which will grow the state’s budget deficit and make it an even worse credit risk. And we will all have evidence that, yes, you can do worse than California.