Money Morning

State Budget Crises Threaten U.S. Economic Recovery

Across the country state budget crises are threatening to undermine the U.S. economic recovery.

Monday, July 19, 2010

Some 48 states are emerging from a round of painful budget cuts for their 2010 fiscal budgets, and at least 46 states face shortfalls for the upcoming 2011 fiscal year, which in most states began July 1.

The recession has caused the steepest decline in state tax receipts on record - and states will continue to struggle to find the revenue needed to support critical public services for a number of years as a result.

Since virtually all states are required to balance their operating budgets each year they cannot maintain services during an economic downturn by running a deficit, as the federal government does.

Heading into the recession, states had substantial budget surpluses, generating record reserves. But those have now been depleted. And with federal stimulus funds dwindling, states must address remaining shortfalls with a combination of spending cuts and/or tax increases.

Spending Cuts & Tax Increases Not Enough

States have slashed spending by $74 billion since 2008, according to the National Association of State Budget Officers.

If states continue to cut spending as they have in the current fiscal year without additional federal aid, the national economy stands to lose up to 900,000 public- and private-sector jobs according to the Center on Budget and Policy Priorities (CBPP).

In response, states are taking actions to mitigate the extent of the cuts by raising taxes.

Since the recession began, more than 30 states have attempted to address budget shortfalls by increasing taxes. But like budget cuts, tax increases remove demand from the economy by reducing the amount of money consumers have to spend. As a result, falling revenues fail to adequately fund spending, leading to massive deficits.

States have projected total budget deficits of $127 billion through 2012, according to a report last month by the governors association and the National Association of State Budget Officers. But the CBPP says the numbers could actually be much worse.

Counting year-to-date deficits, 48 states still face such shortfalls in their budgets for fiscal year 2010, totaling $200 billion or 30% of state budgets - the largest gaps on record.

And states' fiscal problems will continue into the next fiscal year and likely beyond. The numbers suggest that when all is said and done, states will have to deal with total budget shortfalls of some $260 billion for 2011 and 2012.

Shortfalls Hit Home

The budget shortfalls have led to draconian cuts in expenditures.

Cuts enacted in at least 45 states plus the District of Columbia since 2008 have occurred in all major areas of state services, including health care, services to the elderly and disabled, K-12 education, higher education, road and bridge maintenance and other areas.

Illinois let $5 billion of bills go unpaid. Washington closed state offices. Minnesota is delaying tax refunds for a second year.

All those budget cuts eventually are felt at the local level, where counties and municipalities provide services to local citizens. Local government activities, such as funding police, school buildings, fire departments, parks and social programs, are in the line of fire.

Los Angeles furloughed workers with unpaid days off to help close its budget gap, and Detroit has shut schools. A survey by the National League of Cities released in May, showed 70% of cities are cutting payrolls, with some 68% reducing capital projects.

"We are where the rubber meets the road," Sam Olivito of the California Contract Cities Association, which represents cities that outsource public services, told the Financial Times. "Local government is the fabric of our nation - it's what keeps everything working properly."

The cuts in state-funded services would have been much greater had President Barack Obama's $787 billion stimulus program not provided roughly $140 billion over two and a half years to help states pay for education, health care, public safety, and other key services.

Many states including New York and California have urged Congress to extend stimulus spending authorized to combat the recession, including extra Medicaid funding and money to pay public school teachers. But the stimulus program is winding down and states can no longer count on the federal government for more budget bailouts.

States expecting Congress to authorize more assistance are "going to be left with a very large hole to fill," Erskine Bowles, co-chairman of the National Commission on Fiscal Responsibility and Reform told Bloomberg.

Former Republican Senator Alan Simpson of Wyoming, the panel's other co-chairman, told governors on Tuesday that the depth of the federal government's spending imbalance is "shocking," leaving no funding available for state fixes.

"The pig is dead," said Simpson, referring to so-called pork-barrel spending that Congress directs to states. "There's no more bacon."

Muni-Bond Investors Protected

No matter how bad it gets, lawmakers are willing to suffer the wrath of angry voters saddled with reduced services and higher taxes to protect their one remaining lifeline-municipal bond investors.

Despite all the pain the cuts inflict on their citizens, the states are desperate to retain the favor of investors, who buy more than $400 billion of state and local debt each year to finance roads and bridges, pay for new schools and maintain parks and libraries.

"They don't want to lose that access," Hayes told Bloomberg.

Municipal bonds default less than company debt, Moody's Corp. (NYSE: MCO) said in a February report. The average failure rate for investment-grade municipal debt from 1970 through 2009 was 0.03%, compared with 0.97% for similar corporate bonds, Moody's said.

Since the Great Depression of the 1930s, only one state - Arkansas - has defaulted. That was after it assumed debts of its municipalities to keep them from financial failure.

To make ends meet, half the states in the country, including Indiana, Massachusetts and Nevada, have fired workers in the past budget year and 22 have put staff on temporary leave, the governors group and budget officers association said.

California Governor Arnold Schwarzenegger's administration last week asked a judge to force state Controller John Chiang to slash the pay of almost 200,000 state workers to the minimum wage until a budget is passed. Schwarzenegger and the Democrat-controlled legislature are at odds over how to bridge a $19.1 billion deficit.

Illinois, which is selling $900 million of bonds for capital projects this week, won't let investors down, Governor Pat Quinn told Bloomberg. Moody's Investors Service lowered the state's credit grade last month by one level to A1, matching California as its lowest-rated state.

"Our bonds have always been repaid," Quinn said in an interview at the National Governors Association meeting in Boston July 10. "We have provisions in our constitution that are very protective."

No End in Sight

State fiscal woes will be "just as tough" next year because the economy is on pace to grow at a "lackluster" rate of about 3% a year, Yolanda Kodrzycki, an economist at the Federal Reserve Bank of Boston, told a meeting of state governors July 10.

The economy needs to grow at an annual average rate of about 4% in order for the unemployment rate to fall back to 5% by 2015, she said.

Cities and towns faced with a drop in property-tax collections will only add to the problem. Property-tax collections fell in the first quarter for the first time since the onset of the real-estate market's crash, to $107.7 billion from $108.4 billion a year earlier, the Census Bureau said on June 29.

"The road to economic recovery is a long one," Kodrzycki said. "It's a sobering picture."