The New Normal Economic Environment

With a little luck and some help from our friends overseas, the U.S. economy will begin to pull out of its malaise in 2010. The recovery, however, will be less robust than previous turnarounds, reflecting the hangover from the real estate bubble in 2007 and its associated stock-market bubble. State and local budgets will lag the general economy on the way back up, as tax receipts typically trail the general economy. States that enjoyed a revenue rush from taxes on capital gains won't be seeing anything like that for a long time to come. Investors' portfolios will carry forward their huge 2008 losses.

This is the New Normal economic environment. To survive in it, there are a handful of ground rules that state and local officials in charge of fiscal policies ought to preach and practice.

1. Live within your means. Some elected officials try to promote politically popular pet projects without a viable long-term funding plan. That kind of short-term thinking won't be possible--lurking financial problems will surface before today's incumbents leave office. So, fiscal policies will have to address the limits of the New Normal economy. Setting expectations is a vital part, starting with a budgetary teach-in for policy makers--maybe a special study session that focuses on realistic five-year revenue projections and five- to seven-year increases in retirement-plan expenses. That will be an eye-opener.

2. Look to the future. It's time to set long-term priorities and stick to them--even though governing bodies tend to focus on the issue du jour and react to the current developments without putting all competing priorities in perspective. If basic services such as roads and public safety are all the community can afford, then it may be time to begin a long-term process of downsizing or eliminating activities that were great ideas but are simply unaffordable in light of other costs.

3. Stop deferring expenses. When the economy enters a recession as deep as this one has been, it is natural to cut back on equipment replacement, infrastructure and capital maintenance. But deferred expenses don't go away. They come back and bite you later. Budget officers should prepare a list of all ongoing deferred spending. That way, policy makers can see what needs to be funded before discretionary programs can be restored. Get department heads involved--they won't be bashful about their needs.

4. Fund retirement obligations. Few states and localities are funding their retiree medical benefits on a proper actuarial basis. Many can't even afford the pension and post-employment medical benefits they have already granted. The new reality is that policy makers have to fund full annual contributions to both plans--or else the costs will escalate really fast--fast enough to torpedo those leaders before they leave office. Meanwhile, most public employers need to scale back their benefits for new employees and begin making all employees pay a greater share of the cost of their benefits.

5. Dedicate your surplus. At some point, state and local revenues will once again exceed budget estimates. When they do, it will still be necessary to focus on fiscal catch-up. Depleted reserves will have to be restored. For three to five years, at least 25 percent of budget surpluses should go to retiree medical benefit trusts (known as OPEB in public finance circles) that are presently unfunded. Another 15 to 30 percent should be used to restore deferred equipment purchases and facilities maintenance.

6. Set up a rainy-day fund. This may be the most important fiscal policy decision any governing body can make. The suggestions I've already offered will likely consume every dollar of free revenue that most governments receive between now and 2012. But once the revenue revival comes and stabilizes, it will be important to set money aside from the operating budget for lean periods in the future. The time to enact such a policy is now, when memories are fresh and the pain of recent retrenchments is vivid.