fiscal crisis in the US currency union

A county in the state of Alabama, which participates in both the US monetary union – the US dollar is its only legal currency – and the US fiscal union – residents of Alabama pay federal taxes and receive federal transfers – is unable to pay its three billion dollar debt. It has has managed to avoid default (bankruptcy) even though it has received no aid, no bail-out, from the federal or state government.

The deal to avoid bankruptcy involves, most importantly, willingness of creditors to write off more than a third of the amount they are owed. The county in return promises an austerity package: “Sewer rates will rise 8.2 per cent for the first three years and then no more than 3.25 per cent”. The county intends to issue new bonds to refinance the remaining two billion dollars of debt. The bonds will be sold on financial markets, with no legal backing from higher levels of government. If the bond sale goes poorly – if purchasers demand a high yield  – further write-downs of the debt are a distinct possibility.

Jefferson County in Alabama, home to Birmingham, on Friday agreed to the framework for a settlement with creditors owed $3.14bn of debt, averting an imminent filing of the largest municipal bankruptcy in US history.

Under the terms, creditors will forgive $1.1bn of debt. JPMorgan, the largest creditor and the arranger of the debt deals, will take most of the losses ….

Investors in the US municipal bond market expressed relief that bankruptcy had been avoided, but there was debate as to whether the settlement, which includes one of the largest losses for municipal bonds in recent memory, set a precedent, particularly amid recent concerns of rising local defaults in the wake of the US recession. ….

The settlement hinges on the state of Alabama enacting legislation to create an entity to run the sewer system and sell new bonds to refinance about $2bn in remaining debt. These new bonds, which the will be backed by a moral but not legal guarantee from the state, also still have to be sold.

Nicole Bullock, “Alabama county reaches $3bn debt settlement“, Financial Times, 17 September 2011.

The case of Jefferson County, although it involves small amounts, is typical of the treatment of fiscal crises in the US currency union. Purchasers of state, county and municipal bonds in the United States do not, and cannot, expect higher levels of government to bail out states, counties and municipalities when they are unable to service their debts. Financial institutions, in contrast, are bailed out frequently by the US government and the US central bank (Federal Reserve).

If the eurozone was to treat Greece as federal and state governments treat Jefferson County, members would not bail-out Greece. Following the US model, banks might be helped, when they suffer losses after a Greek default, but not the government of Greece itself. The distinction is important, because not all sovereign debt is held by banks, and not all banks will require financial assistance. Returning to the example of Jefferson County, JPMorgan and other financial institutions should be able to absorb a billion dollar loss without government assistance.

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