Economy in U.S. Slows as States Lose Federal Stimulus Funds

Sunday, June 13, 2010

Spending cuts by state and local governments from New York to California may act as a drag on the economy into 2011, only the second time in more than a half century that such reductions have restricted growth for three consecutive years.
States face a cumulative budget gap of $127.4 billion as 46 prepare for the start of their fiscal year on July 1, according to a report this month by the National Governors Association and the National Association of State Budget Officers. They will have to fill that hole largely on their own, as aid from the federal government under programs including President Barack Obama’s $787 billion stimulus package starts to wind down.
State and local cutbacks may trim growth by about a quarter percentage point in 2010 and 2011 after shaving it by 0.02 point in 2010, said Mark Zandi, chief economist at Moody’s Analytics Inc. He also sees the governments lopping payrolls by 200,000 during the next year after reducing them by 190,000 in the 12 months through May.
“The budget cutting that is dead ahead will be a significant impediment to economic growth later this year into 2011,” he said in an interview.
That impact will help convince Federal Reserve Chairman Ben S. Bernanke and his colleagues to keep the federal funds rate banks charge each other for overnight loans at zero to 0.25 percent through the end of this year, said John Lonski, chief economist at Moody’s Capital Markets Group in New York.
‘Fiscal Drag’
“This type of fiscal drag on economic activity makes it all the more likely that the fed funds rate will remain extraordinarily low for an extended period,” he said in an interview. “I don’t think that it’s lightening up anytime soon.” The rate has been near zero since December 2008.
Bernanke singled out “pressures on state and local budgets” as one impediment to expansion during his testimony to the House Budget Committee on June 9. Municipal governments account for about 13 percent of U.S. gross domestic product.
Warren Buffett, whose Berkshire Hathaway Inc. has been paring its municipal-bond portfolio, predicted a “terrible problem” for state and local government debt in June 2 testimony to the U.S. Financial Crisis Inquiry Commission in New York. The Omaha, Nebraska-based company cut its municipal holdings to less than $3.9 billion as of March 31 from more than $4.7 billion at the end of 2008, according to the company’s first-quarter report.
‘Extreme Financial Difficulty’
Buffett, Berkshire’s chief executive officer, predicted in May the U.S. probably will feel compelled to rescue a state facing “extreme financial difficulty” after it committed $700 billion to bail out financial firms and automakers.
Credit default swaps of five states -- California, Illinois, Michigan, New Jersey and New York -- have risen an average of 91.5 basis points since May 3, according to data compiled by Bloomberg, as bondholders seek protection. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Pennsylvania Governor Ed Rendell said he doesn’t think the federal government will have to bail out any state.
“I don’t see that,” he said in a June 3 interview on Bloomberg Television’s “InBusiness With Margaret Brennan.” “And it’s not at that point in Pennsylvania.” The state “just sold on Wall Street the biggest bond offering since the recession, over $1 billion,” he said. “We had our lowest interest rate ever: 3.1 percent.”
‘Too Low’
Such yields are “just too low” for many investors, Matt Fabian, managing director of Municipal Market Advisors in Westport, Connecticut, said in a June 9 interview on Bloomberg Television’s “In the Loop with Betty Liu.”
“On the presumption that income-tax rates are going to be rising over the next year or two years, then these may in the end be attractive levels, but it’s hard to say right now,” he added.
Rendell joined fellow Democratic governors of Washington, Kansas and Wisconsin on June 9 to press Congress to pass a six- month extension for increased federal spending on the Medicaid health program for the poor.
“If we don’t do this, I think this will put us back in a recession,” Rendell said in a conference call with reporters. Without the extension, the extra payments will end Dec. 31.
The aid is part of a broader jobs bill the Senate began considering last week. The House passed a different employment bill last month that didn’t include the Medicaid provision because of lawmaker concern about the $1.6 trillion federal budget deficit.
Declining Payrolls
State and local governments will have to dismiss 162,000 workers if Congress fails to extend about $24 billion of Medicaid payments, Lawrence Mishel, president of the Economic Policy Institute in Washington, said during the governors’ call. Payrolls have already registered 11 straight months of year- over-year declines, the longest stretch of continuous drops since 1983, based on Labor Department data.
Spending cuts by state and local governments chopped 0.49 percentage point off GDP in the first quarter, the most since 1981, as the economy expanded 3 percent. The impact of the budget squeeze probably was larger than that, as the GDP data don’t break out the effects of tax increases on growth, Zandi said.
States raised taxes and fees by almost $23.9 billion in fiscal 2010, according to the report by the Washington-based associations for state governors and state budget officers. Forty states, including Florida, California and New York, made mid-year budget cuts totaling $22 billion, the report said.
Balanced-Budget Laws
Policy makers in a number of states are having trouble agreeing on further steps to resolve their financial problems. Action is necessary because every state except Vermont has some sort of balanced-budget law.
California, with a $1.8 trillion economy that’s bigger than Russia’s, faces a $19 billion deficit. Republican Governor Arnold Schwarzenegger wants deeper spending cuts, including elimination of the main welfare program for the poor, while Democratic lawmakers have backed tax increases.
New York, the third-most populous U.S. state, has been operating under weekly spending bills because lawmakers haven’t agreed on a comprehensive budget to close a projected $8.5 billion gap for the fiscal year that began April 1.
Illinois Rate Cut
Illinois, with a deficit equal to half its $25.9 billion budget, saw its debt rating cut after it failed to “enact significant recurring measures” to reduce the shortfall, Moody’s Investors Service said in a June 4 press release. The New York-based agency reduced the rating on $29 billion of general-obligation debt by one level to A1, putting Illinois on par with California as the lowest-rated U.S. state.
States “expect 2011 to be as bad as 2010,” said Raymond Scheppach, executive director of the governors’ association. They “will not begin the path to recovery until 2012.”