VoxEU Column International Finance Monetary Policy

Spillover effects in a fiscal union: Evidence from US states and Treasury bond markets

What are the spillover effects within a fiscal union? This column looks at evidence within bond markets for individual US states and the market for US Treasury securities. Results are twofold. First, there are negative spillovers between most markets for individual US state bonds. Second, there is no substantial spillover effect between shocks originating from state securities and from federal markets, except for a few large issuers.

The market for US municipal bonds, a $2.9 trillion tax-exempt bond market amounting to about one third of the US treasury market, has often been viewed as a safe haven by individual investors.1  The most recent US state to default was Arkansas in 1933, during the Great Depression. Throughout history there have been but a handful of state defaults – ten in the aftermath of the US Civil War and eight, plus the then-territory of Florida, during the 1830s and 1840s.

But in the aftermath of the financial crisis, the safety of the so-called 'muni market' has been questioned. On 11 July 2012 the city of San Bernardino declared bankruptcy, becoming the third Californian city to do so in the past month after Stockton (the most populous US city to file) and the small town of Mammoth Lakes. In November 2011, Jefferson County, Alabama, filed the largest-ever US municipal bankruptcy.

Given the many comparisons between the Eurozone today and an emerging United States in centuries past and the different performance of the two monetary unions since the global crisis, a relevant question is whether and how shocks to individual state bond markets spread to other state bond markets (see for example Henning and Kessler 2012 on this site). Another relevant question is whether shocks to individual state bond market spread to US treasury securities and vice versa. In a recent paper, we study the potential spillover effects both within the bond markets for individual US states and between the latter and the market for US Treasury securities over the period 2005 to 2011 (Arezki et al. 2011).

Figure 1. Evolution of Treasury and municipal bond yields

Note: Data are from Bloomberg and Haver Analytics.

The housing bust, the financial crisis, and the recession have devastated state and local tax revenues. As a result, the US municipal bond market has experienced worrisome signs of instability. The average rate on municipal bonds at times surpassed the rates on US Treasury securities. In normal times, rates on municipal securities are lower than on US government offerings because of the tax benefits municipals (munis) receive. The now higher borrowing costs for individual US states reflect concerns about their future revenues and pension obligations, among other things. In addition, there is no bankruptcy mechanism governing state defaults, unlike Chapter 9 for municipalities. In other words, US states can repudiate their debt. Under the 11th Amendment to the US Constitution, individual states have the same sovereign immunity as countries, and states can be sued only with their consent.

For more than three years, states have responded to investor concerns with a series of measures to address both short- and long-run fiscal issues – including cutting spending, raising taxes, borrowing, and turning to the federal government for help in keeping their budgets balanced. However, there is increasing concern that if a state defaults – and many face severe budget issues – the effects would spill over to other municipal securities and even affect the market for US government securities. Also, with few places left to find savings, states are rolling back funds for cities, counties, and school districts. The resulting layoffs could become a drag on the national economy at a time when the recovery from the financial crisis still appears to be fragile. The recent Standard & Poor’s downgrade of the US credit rating from AAA to AA+ is a further concern. Although so far it has had little, if any, effect on US Treasury securities, the one-notch downgrade has increased investor worries that US state bond markets might face consequences were there financial disruptions in federal markets. Moreover, the prospect of more federal budget tightening could further erode already precarious state finances.

The literature on spillover effects in financial markets is abundant, but has so far focused mainly on spillover effects between countries. The contribution of this column and our paper is to explore the spillover effects within the same country namely the United States. The benefits of such a study are twofold.

  • First, it allows us to study spillover between different entities within the same institutional arrangement and culture unlike in cross-country studies. Indeed, the lack of uniformity in institutional arrangements and culture as well as other unobservable or simply difficult to measure country-specific features may lead to biases in the analysis of spillover between countries.
  • Second, analysing spillover effects within the same country allows us to study 'bottom-up' spillover effects-- from bond markets for individual US states to the market for US Treasury securities – and 'top-down' spillover effects – from the market for US Treasury securities to bond markets for individual US states.

From a policy standpoint, this is quite important as many existing or would-be fiscal unions ought to worry not only about the potential risk of spillover from countries outside their union but also from within their own union. In turn understanding the nature of those spillovers can help inform risk management strategies both at the supranational and subnational levels. The raging debate in Europe over whether there should be a stronger fiscal union and whether the issuance of a common euro bond would aid ailing Eurozone economies certainly illustrate the importance of studying spillover not only between countries but also within fiscal unions.

To study spillover effects in the markets for bonds of US states and federal (that is, US Treasury) securities, we empirically tested whether a shock specific to one market is transmitted to other markets. Our tests correct for the higher volatility observed during the financial crisis, starting in 2008. There are obvious linkages between US states, as well as between states and the federal government (transfer payments being a good example). Those linkages could be invoked to explain spillover effects between various bond securities. In contrast, other factors such as investor psychology make spillover effects more difficult to explain. As a result, we focused on describing the nature of the spillover effects rather than trying to find a specific explanation for them.

The results presented in this column and our paper are twofold.

  • First, we find that between most markets for individual US state bonds there are negative spillovers. In other words, an increase in borrowing costs in one US state results in better borrowing conditions for other states.
  • Second, we find no substantial spillover effect between shocks originating from state securities and from federal markets, except for a few large issuers. Using causality tests in the frequency domain, we find that the Treasury bond market directly causes changes in the markets for municipal bonds in both the short and long run. There is also some evidence of causality from the municipal to the Treasury bond market, but only of a long-run nature.

Ang, Andrew, and Francis Longstaff (2011), “Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe”, NBER Working Paper No. 16982.

Arezki, Rabah, Bertrand Candelon, and Amadou Sy (2011), “Spillover Effects from the Munis”, IMF Working Paper, 11/290, Washington.

Calvo, Sara, and Carmen Reinhart (1996), "Capital flows to Latin America: Is there evidence of contagion effects?", Policy Research Working Paper Series 1619, World Bank.

Forbes, Kristin J and Roberto Rigobon (2002), "No Contagion, Only Interdependence: Measuring Stock Market Comovements", Journal of Finance, American Finance Association, 57(5):2223-2261, October.

Henning, C Randall and Martin Kessler (2012), “Lessons for Europe’s fiscal union from US federalism”, VoxEU.org, 25 January.

Moody’s (2010), “U.S. Municipal Bond Default and Recoveries, 1970-2009,” February.

1 The 45,000 bond issuers include state and local governments, school districts, and water authorities that sell their debt securities in the so-called 'muni market'.