Last week, New York Federal Reserve President Dudley discussed the importance of state and local governments to economic output, debt management and the delivery of core public services. Local and state governments generate roughly $2 trillion in economic output, about 11% of total U.S. GDP, 50% higher than the federal government’s contribution. In terms of jobs, they account for almost one in seven American workers. Municipal governments also provide core public services such as public safety, education, health services and clean water. Dudley emphasized that without stable core public services it would be difficult for the Fed to achieve its principal mandate. Finally, prudent municipal debt management and the use of debt proceeds are vitally important. Good municipal debt generates a “fiscal surplus” where the value of the services minus the tax price paid is positive. Dudley warned that when municipal borrowing is used to fill operating deficits it negates this benefit, and that the recent bankruptcies of the Cities of Detroit and Stockton foreshadow a widespread problem that is not reflected in current bond ratings. If Detroit and Stockton foreshadow more municipal bankruptcies, bond ratings inadequately capture that risk. Currently, only a few states have the legal groundwork for local municipal bankruptcy filings in place, limiting available options (see chart below). That being said, debt that cannot be repaid will be repudiated, legal framework on not. Fed President Dudley just fired a warning shot, and the municipal market should take notice.