Being Clear About the Cards with Government Bonds

So much turmoil has 38 Studios thrust upon the state of Rhode Island that I find it necessary to tie together a post on the Current-Anchor with one on RIFuture as the most efficient means of disagreeing with both.

Let me set the stage.  Here’s Patrick on this site, yesterday:

If that is the case, that over the long-term it will cost the state more money to default on the bonds than to pay them back, what is the prudent choice?

And here’s Sam Howard on RI Future:

The best we can do is bow to circumstance, lick our wounds, and ensure that this can never, ever, happen again.

I like this juxtaposition because the answer to both of them amounts to saying the same thing with different words.  Will it “cost the state more money to default”?  It seems to me that Patrick’s answer takes an unjustifiably narrow view of “cost.”

Turning to Sam, the question becomes: How can we go about “ensuring that this can never, ever, happen again”?  The current incentives for both government and the bond market are such that repeat performances are virtually ensured.  To pit Patrick and Sam against each other: What if the cost of repaying the bonds is that we miss a rare opportunity actually to ensure that this can never, ever happen again?

As I’ve already suggested, moral obligation bonds are little more than a mechanism for governments and investors to defraud voters of their rights in situations when they’re supposed to be required to approve debt.  Some skepticism is in order when — once again — it seems as if the people and their representatives in government have no cards to play in the game.  If the ratings agencies can warn, with straight faces, that they’ll lower our general obligation bond rating, well, we have to respond to the threats or else!  We have no choice!  There’s nothing you can do but hand over your money!

The rhetoric suggests to me that the people who run governments don’t want to have any cards.  They like a situation in which they can commit taxpayers to debt without voter approval.  And investors like the deal because they get better returns on their investments for the same amount of risk.  And government agents like it (again) because they can become the focus of the affections of investors and brokers.

It simply can’t be the case that the people who make the whole transaction possible — the people who ultimately spend their money paying back the debt rather than feeding their families, advancing their careers, or improving their houses — have no leverage.  Asserting leverage and changing incentives can be expensive and painful, but it’s possible and, I’d say, necessary.

First of all, the investors and ratings agencies can’t afford to have “moral obligation bonds” become too well known as a sly way to hook taxpayers for more-expensive debt.  It was one thing when the defaults and downgrades were a city here and a fire district there.  What happens when a state insists that moral obligation bonds and general obligation bonds must actually be different things and the ratings agencies say that they are not?  What happens when Rhode Island points out that the language that makes something legal, as opposed to unconstitutional, cannot be “boilerplate”?

It’s big news… big enough that it will create a political opportunity for people who oppose moral obligation bonds across the country.  Maybe it’ll be big enough news to put these decidedly immoral bonds on the much-deserved path of decline, to the point that selling them in the future will be seen as evidence that a government is reckless and corrupt.

Second of all, the wrangle and leverage doesn’t end with the ratings agencies.  They’re middlemen.  I’m sure this is more complicated to accomplish than it sounds, but imagine it:  What if the state of Rhode Island went out to sell general obligation bonds and set its own terms for the debt?  Maybe Moody’s and S&P would call the bonds junk, but that would simply be a lie.  Backed by the full faith and credit of the state, with the express approval of the voters, the bonds would be as good and as safe a bet as if 38 Studios had never happened.

Are we to believe that the state couldn’t find enough investors who are sufficiently savvy to identify how badly rated the bonds are and to ignore the agencies?

In the absence of this little bit of courage, what’s the option to make sure that “this can never, ever, happen again”?  We’ve seen this movie before.  Some minor push will emerge to pass laws or constitutional amendments banning moral obligation bonds, but somebody will come up with an excuse why they’re necessary that peels off enough votes to ensure that the legislation goes away.  Then it’s just a matter of whether it’s your guy or my guy proposing the reckless investment in the future.  Probably more quickly than we think, enough people will have forgotten the details of 38 Studios that they’ll believe again that feel-good projects can be funded with other people’s money and without risk to the taxpayer.

This will be so because the laws and the assurances are only written in the sand of people’s memories and their pitifully informed impressions.

That’s the result when we let the words on the page mean something other than what they say.  Everything about the 38 Studios bonds stated that the risk was on the company and on the investors.  Now it turns out that the risk is really on taxpayers who never had the opportunity to consent to the debt.

It’d be impossible to put a number on it, but it’s difficult to believe that allowing this inversion to stand will be less costly in the long run than setting the language right.

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