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Monday, July 15, 2013

The New War Between the States

Fate of the States: The New Geography of American Prosperity

Meredith Whitney. Fate of the States: The New Geography of American Prosperity. New York: Portfolio, 2013. 272 pages.

Prices in a capitalist system provide signals to the marketplace. For instance, the price to rent a UHaul truck in Los Angeles to drop off in Dallas is double the price of renting in Dallas and dropping off in L.A. The signal here is pretty clear: People are lining up to get out of California and Texans are happy right where they are.   

This U-Haul price-shopping exercise echoes the prognostications of bank analyst Meredith Whitney in her new book Fate of the States: The New Geography of American Prosperity. For those who don’t obsessively watch financial TV, Whitney came to fame in 2007 when, while working at Oppenheimer & Co., she downgraded Citigroup and said the mega-bank would have to raise capital, cut its dividend, and sell assets. Days later it all happened as Whitney called it.

Three years later, Whitney appeared on “60 Minutes” claiming there would be a rash of municipal bond defaults. There have been a handful of government bankruptcy filings, but it is far from what Whitney predicted—so far. 

The author’s overarching theme in Fate of the States is that America’s economic power is shifting from its coasts to its middle. Whitney describes how power has shifted before, but the current trends are different: External factors aren’t driving economic fortunes anymore, but instead, “communities [are] being gutted by government ineptitude,” writes Whitney. 

At the top of this list are New Jersey, California, and Illinois, where high debt and economic dysfunction have persisted. These basket cases insist on trying to tax their way out of problems. The Golden State is pushing its high earners to other states by raising its top income-tax rate to over 10.5 percent. Illinois hiked its rate by two-thirds in 2011.

Comparing New Jersey with neighboring Pennsylvania is instructive. Jersey has the highest property taxes in the nation and a top state income-tax rate of nearly 9 percent. Pennsylvania’s income-tax rate is 3.07 percent and its property taxes are half those of the Garden State. You could move right next door and escape New Jersey’s predations. 

Today wealthy taxpayers are voting with their feet and taking their wallets with them—leaving local and state governments high and dry. When the rich leave, so do many jobs; working stiffs then hit the road to find employment. Business relocations away from California, for example, increased fivefold between 2008 and 2011.

Whitney reminds us that economic power has shifted from one location to another several times in the recent past. The Industrial Revolution led to a migration from the United Kingdom to New England and to the mid-Atlantic states. What she calls the Power Revolution followed, which drove population to the southeast and southwest. Next was the Manufacturing Revolution, which drew workers to Detroit and Cleveland. 

The Leverage/Housing Revolution sent people to the coasts, but it—along with the bust it set up—was a different type of animal. In the West, Arizona, Nevada, and California boomed. In the East, it was Florida, Georgia, and North Carolina. But they boomed because of ceaseless and, it turns out, misguided government intervention. 

Whitney’s story features the housing crisis prominently. She makes a point that was lost at the time: Why were homebuyers increasingly using adjustable-rate loan products in 2004, when rates were increasing? They should have been doing the opposite. And what were lenders thinking when they were underwriting loans that borrowers could only temporarily afford?

The short answer to both questions comes down to government’s role in pushing homeownership. Bill Clinton believed homeownership was “the realization of the American dream.” Fannie Mae did its part to push these initiatives, lowering down-payment requirements. George W. Bush’s administrations doubled down on housing, particularly in the wake of the dot-com bust and the 9/11 attacks, pushing the “Ownership Society.” 

The housing boom looked like it was a win-win for everyone. Between 2002 and 2005, 1.2 million real-estate-related jobs were created. These jobs couldn’t be sent offshore. The unemployment rate sank to its lowest level on record. This was especially apparent in the warm-weather states where the boom echoed the loudest. 

Home prices rose nearly 500 percent in California and Florida from 1994 to 2006. Homeownership rose by 12 percent in the Sun Belt states at the same time. Thinking the party would never end, consumers piled on debt. In booming states like Nevada and California, debt per capita, the vast majority of which was tied to real estate, more than doubled in a decade.

“Sand state” governments also bet on real-estate prices increasing forever and went on spending sprees of their own. 

The real estate crash has led to a government bust in addition to generating the worst unemployment rates in the nation. States “have cut over a quarter of a trillion dollars out of their budgets” over the past five years, according to the author. They didn’t shrink by choice; tax receipts plunged. This fiscal problem rolls downhill. States receive a third of their funding from the federal government, while more than 40 percent of local government money comes from the respective states. Property taxes (now assessed on properties with lower values) make up the rest of local government spending.

Meanwhile, governments are stuck with pension obligations that seemed reasonable in the boom years, forcing them to cut back elsewhere. For instance, Whitney discusses Contra Costa County, California, where the county is paying 665 retired firefighters pensions of $100,000 per year, while it can only afford 261 active firefighters to put out fires. This story leads off an entire chapter on the government-pension time bomb.

If that story doesn’t make your head spin, the assumptions employed by state pension plans will. Bernanke’s zero interest-rate policy (ZIRP) is well known. However, state pension funds are still assuming 8 percent annual returns. In the simplest terms using Whitney’s example, the gap for a $30 billion pension fund between an 8 percent assumption and a zero-rate one is $2.4 billion. That $2.4 billion is the number taxpayers are on the hook for. “No wonder that inside of just one decade,” writes Whitney, “government pension funds went from being fully funded to being underfunded by nearly $1 trillion.”  

Almost every state is playing accounting games with its pension plans while hoping for a big score in the market. States make the minimum (or no) contribution, “hoping to outrun the debt being accumulated.” As the author explains, this is the equivalent of taking out a margin loan to buy stocks. Outlandish return assumptions lower the amount states must contribute to the funds. As the gap between the return assumptions and real-life conditions widens, state contributions become less sufficient. 

So is there any prosperity to be had in the U.S.A.? Those red states in the middle of the country are America’s emerging market, says the author. People and businesses are fleeing high taxes and shrunken services for right-to-work states like Texas, Oklahoma, and North Dakota. 

Right-to-work states ban compulsory union membership and provide a much friendlier environment for employers. The result, writes Whitney, is that “since 2008 right-to-work states have grown their economies over three times as fast as non-right-to-work states.”     

To illustrate how government ineptitude pushes while these growth rates pull, we should remember that California sits on top of oil just waiting to be extracted. The state’s Monterey shale deposit alone is said to hold 15 billion gallons. Nobody is going to be allowed near it. Despite its fiscal troubles, California politicians have no interest in a resource that could be exploited to help solve the state’s fiscal woes. Governor Jerry Brown told former Royal Dutch Shell president John Hofmeister, “This is not logic, it’s California. This is simply not going to happen here.” Municipal bankruptcy, however, is already happening there: In Whitney’s chapter on the pension time bomb, all but one of the cases she outlines are based in California.

Whitney’s Fate of the States is the playbook of the modern war among the states: an economic war where less government wins. While the federal government and a few states continue to spiral out of control, the nation’s Heartland has found fiscal religion and wants the jobs and economic prosperity that go with it. Young people take note: The Midwest may not be glamorous, but that’s where the jobs will be.