While I am optimistic about investment prospects for the next year or two, I am keeping a very close eye on the coming crisis. I have described the coming crisis a number of times since the beginning of 2008. Here is a thumbnail sketch. Three negative trends are converging in 2015 (plus or minus 2 years): the US Government will borrow $5 Trillion or more; and, Social Security system will be spending more than it receives; and, State & Municipal pension plans will not contain enough money to pay their promised benefits. I continue to believe we must watch these three trends closely. I ran across an article that discusses what happened the last time States & Municipalities could not pay their bills and defaulted. It is interesting reading:


When States Defaulted: 1841

Land values soared. States splurged on new programs. Then it all went bust, bringing down banks and state governments with them. This wasn’t America in 2011, it was America in 1841, when a now-forgotten depression pushed eight states and a desolate territory called Florida into the unthinkable: They defaulted on debts. Deputy WSJ Money & Investing Editor Dennis Berman explains why history shows higher taxes are highly probable as states cope with defaults on their loans.

This was an incredible step, even then. Fledgling U.S. states like Indiana and Illinois were still building credibility on global debt markets. They rightly feared “a prejudice so deep and wide” that they could never sell bonds in Europe again, said one banker.

Their paranoia would be familiar to the shell-shocked California and Illinois of 2011. Each is beset by budget problems so great that some have begun debating default or bankruptcy. These worriers may draw comfort from the state crises that raged and retreated long ago. Most of the states eventually paid off their debts, and changed their laws to safeguard their finances, helping make U.S. states some of the world’s best credits.

Congress, meanwhile, helped set a precedent that still holds: In 1843, it rejected an elaborate plan for a bailout, with one critic later observing it would “cause recklessness and extravagance” among the states. Surely, someone will dust off those ideas in 2011.

Yet for all their similarities, there was an ominous difference from now: Leaders and citizens of the 1840s were more willing to accept new taxes to pay for the infrastructure and to defend, in the earnest words of the time, their “moral duty” of meeting debts. In Indiana and Ohio, property taxes went up eightfold in the early 1840s. New York, Pennsylvania, Maryland, and Massachusetts all installed state property taxes, the first in 40 years for Pennsylvania.
“People didn’t want to raise taxes but they did,” says John J. Wallis, a University of Maryland economic historian. He traces our current states crises back to those defaults in 1841, after which legislators amended constitutions to clamp down on new borrowing. Over time, these rules have been perverted by politicians, meaning that “constitutional rules have made it harder to raise taxes than to raise expenditures,” he says.

There were differences between today and 19th century. Then, expensive state programs weren’t for government pensions or Medicaid. They were for roads and canals. And in today’s slow-growth economy, raising taxes won’t solve all of the states’ fiscal woes. Any real solution will require wholesale cuts in government programs and spending, too.

When the defaults began in January 1841, investors dumped state bonds, pushing yields above 12% in early 1841, and to nearly 30% by 1842. The consequences of those defaults would last for decades: Among historians, the rule of thumb is that U.S. states would pay interest rates one percentage point higher than Canadian issuers the rest of the 19th century. To this day, Mississippi hasn’t paid back some of those bonds, even after a 100-year English bid to collect.

The defaults weren’t crippling. U.S. states went back into the public markets in the railroad boom of the 1850s, most of them armed with stronger safeguards for creditors and new constitutions.

Could states default today without causing another 1841? Randall Kroszner, a former Fed governor and University of Chicago professor, calls it as a long shot. “Only if there were a clear legal framework, and a clear way in which people would be treated, and not interminable delays through the courts,” he says. “States should be very averse to defaulting.”

For Mr. Wallis, the lessons of the 1840s are bracingly clear. Taxpayers and politicians have lost the connection between borrowing and costs. So taxpayers must be willing to approve tax rises as a direct part of new borrowing plans.

“There is nothing wrong with raising taxes to support government services that voters want and are willing to pay for,” he says. But government needs to be set up “so that both voters and legislatures are forced to make decisions about taxing, spending, and borrowing simultaneously.” (Source: The Wall Street Journal)