States won't default on their debt because they're designed not to, and will make the cuts necessary to remain solvent, according to BNP Paribas Jean-Marc Lucas.
Lucas argues that, while debt may be rising, the increase is only 1.2% since Q4 2007 on the state and local level. Compare this to the Federal government, where debt has increased from 35.9% of GDP to 63.2% of GDP in the same time period, and it looks minuscule.
The reasons why states will not default are multiple.
From Jean-Marc Lucas:
In addition to the modest debt burdens presented above, there are several reasons why the risk that states might default is extremely low. First of all, barring any state laws to the contrary, states can easily increase their revenues and decrease their spending. This generally gives them scope to improve their financial situation. Secondly, in many states servicing debt has priority over other types of spending. Thirdly, the potential benefit from defaulting is relatively small in comparison with the disadvantages. Given the often modest level of state debt, there is not that much to gain from default, yet much to lose since it makes it much more difficult to borrow in the future at a reasonable cost. Lastly, since many holders of state debt are individuals (due to the tax benefits of state bonds) and therefore voters, if a state defaulted its elected officials would pay a very dear political price.
And while municipal debt is certainly more worrying than state debt, Lucas doesn't think you should be all that worried about it either.
Default is less exceptional among the other types of local government entities. In the current environment some may therefore very well come under closer scrutiny. However, there are two reasons why this risk should also not be exaggerated. First of all, default risk is incomparably lower for local governments than in the private sector. According to Fitch, the historical default rate for the overall "municipal" sector is well below 1%. Secondly, the vast majority of the defaults observed in the local debt market are on securities issued to finance specific projects (often in the health-care and housing sectors) and do not involve local government entities per se, i.e. cities and counties. According to Moody’s, of the 54 defaults on local government debt observed since 1970, only four directly involved cities or counties.
So history tells us this can't happen. Only some comfort in that.
Note the projected shortfalls state governments will be trying to make up through cuts and tax increases.