From the November 2009 issue of Research Magazine • Subscribe!

The Next Economic Debacle

Manhattan Institute scholar Nicole Gelinas warns the response to the economic crisis sets the stage for a more severe crisis down the road.

When reservation at this well-known midtown Mexican place, I had no idea it doubled as a back entrance to the Ed Sullivan Theater, the home of the Late Show with David Letterman. Nor could I have foreseen that it would be the night Barack Obama chose to go on the program. So it was a bit of a surprise to arrive at our lunch rendezvous only to see the entire block cordoned off by sand-filled sanitation trucks and guarded by hundreds of New York City police officers.


As we settled down to our meal, a hand-picked audience kept filing through the restaurant and disappearing in the back, like members of some secret society. My only regret was that the president, taping that night's show only a few feet away, couldn't listen in on our conversation and hear what Nicole Gelinas had to say about the current economic recovery and the way it is setting the stage for the next financial debacle that is likely to be worse.

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Who: Nicole Gelinas, Searle Freedom Trust Fellow, the Manhattan Institute


Where: Cafe Iguana, 240 West 54th Street, New York, September 21, 2009


On the Menu: Avocado fries, goat cheese wrap and a recipe for future financial disaster.

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Misguided Expectations

Even though the focus of our discussion is municipal finance, the main subject of Gelinas' research, she begins with the two troubled Detroit automakers, GM and Chrysler.

"In both cases, the government didn't allow the normal course of bankruptcy to take effect but instead protected the interests of the trade unions, even though they were not senior debt holders," she says.

Earlier this year, GM went in and out of bankruptcy under the tutelage of the government, as a result of which bondholders owed some $27 billion by GM were taken to the cleaners, potentially losing as much as 80 percent of their investment. Bondholders at Chrysler, following a Washington-brokered sugar-daddy marriage with Italy's Fiat, got around 33 cents on the dollar.


"The government stepped in to protect its constituents," explains Gelinas. "This sends a clear warning to holders of municipal debt. It is very likely that if issuers, especially city and local governments, don't have enough money for debt service and for politically expedient spending, political considerations will come first."


But she also identifies this as a problem for municipal unions. They shouldn't demand too many concessions in their contracts because in the end they may not get all they bargain for.

The constitutional protection for local government pensions has not been established, and medical benefits are even more likely not to be paid in full if the municipality can't afford them.

Gelinas divides local governments into two categories. One is cities and municipalities, which can go bankrupt and, as courts recently ruled, can claim protection from creditors under Chapter 9 of the bankruptcy code. States, on the other hand, are sovereign entities and can't declare bankruptcy.


"This area has not yet been explored. Lawyers and investors are wondering what will be the status of California's recently issued IOU, which the state used in lieu of money to pay its creditors."


According to Gelinas, playing politics over sound business considerations is what got local government finances in trouble in the first place. Governments have been spending heavily on social services, notably on Medicaid and education, while neglecting such common sense areas as infrastructure, where much more investment is needed. This creates a vicious cycle.

Investing into politically expedient black holes requires higher taxes and does nothing to attract new businesses and new jobs, which is required to expand the tax base. Neglected infrastructure boosts operating budgets, just as businesses flee to other parts of the country where infrastructure is better and where taxes are lower (and some even opt for going abroad). As governments go deeper and deeper into debt, debt service begins to loom large on their budgets.


New York City is a good example, says Gelinas. The city has been presented as an example for others to follow in the way it came back from the dead after the 1970s fiscal crisis. Gelinas disagrees: "We are not doing anything differently now compared to what we did back then. It's just that our main industry, financial services, took off after 1982 and there was no limit to what the city government could spend." In fact, it did spend without any restraint and when the financial services industry faltered last year, the city immediately found itself with a huge hole in its budget.


With taxes in places such as New York and California going up, and the tax base shrinking as a result of persistent unemployment, a vicious cycle is developing. "Who would ever want to set up a business in New York or California if you can avoid getting taxed by starting it in Houston, Texas?" asks Gelinas.

Besides, she points to low property values in Florida, Nevada and other places hard hit by the real estate crisis. Those states have their own problems, and their severity may one day match those of the bigger states, but for now she expects job growth to occur mainly in those parts of the United States.

A Few Years Down the Road

The worst may be over for the current financial crisis thanks to government guarantees to failing financial institutions. But Gelinas warns that the way it was resolved means that the next crisis will inevitably come at some point in the future -- maybe as much as 10 to 15 years down the road -- and that it is likely to be much worse than the crash of 2008.


That's because government intervention increasingly distorts market forces and gets away from the free market model which the United States championed in the earlier post-World War II era and which served it so well. By not allowing those who took on excessive risk in order to earn higher profits to face the appropriate consequences, she says the government has given a carte blanche to others to take even more risk.


"The 'too big to fail' issue has not been addressed," she assets. A handful of giant banks which have been saved by a de facto guarantee from Washington are certain to take even more risks in the future, and they will be able to borrow cheaply because lenders will assume that the government in Washington will not allow them to lose a single penny of their money. That's a recipe for a future disaster of an even bigger proportion.


At the same time, the Fed is now distorting the real estate market by buying asset-backed securities and thus supporting house prices. Gelinas believes that even though there will be a near-term benefit, the distortion of the market will ultimately harm all market players, homeowners, builders and lenders alike. It is not even possible to calculate the exact damage, because market signals are getting so distorted. Gelinas has written a book about the shortcomings of financial regulation on Wall Street, which is coming out this month.

Old-Fashioned Values

In general, Gelinas seems to believe in the virtues of prudence and hard work, which become a reward in themselves. And that there is no free lunch.


For instance, she believes that the more states demand from the federal government, the deeper hole they dig for themselves in the future. Washington has been borrowing heavily, with the budget deficit approaching $1.6 trillion in fiscal 2008-2009 and totaling $9 trillion over the next decade. This kind of borrowing can't go on forever. When eventually the flow of funds stops and Treasury yields spike, states will see their own borrowing costs escalate even more.


She also doesn't believe that municipalities should take a hard look at their financial advisor fees both on the fund management side and bond issuance side. She feels that risk management products are expensive and provide limited benefits, whereas pension funds have no business investing in private equity deals and putting their money into complex products. "They should get back to stocks and bonds," she says. "If your 14-year-old son can't understand those products, municipal entities shouldn't be investing in them."


Being a fellow at the Manhattan Institute you would expect Gelinas to be quite conservative. She is, but she is a market conservative. From this point of view, she gives low marks to Obama's economic team, but she is unsparing about the Bush administration as well:

"Obama's people are not doing anything differently from the Bush Administration," she asserts.


Even Ronald Reagan comes in for a bit of sharp criticism. It was on his watch that the "too big to fail" policy was inaugurated, when the Fed and the FDIC took over the failing Continental Illinois bank and didn't allow reckless investors to take well-deserved losses. Since then, crises have been getting progressively more severe, and the way the government is approaching every new crisis, Gelinas feels, the process is likely to continue.

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