Navigating the New Normal Economy

Even without a double-dip recession, it's a lost decade for state and local governments and their employees.
by | August 11, 2011

Last week's swoon in the stock markets reflected a global glum among investors who see economic growth stalling out. It's hard to see an engine for expansion anywhere, from sovereign debt crises in Europe to the recent U.S. deficit deal forcing cutbacks to emerging economies raising rates to curb inflation. Fears have now returned that the Western economies could double dip into a secondary recession similar to the Depression-era problems of 1937 (see chart below). With interest rates already skimming at record lows, there is little room for effective Federal Reserve monetary stimulus, leaving the U.S. in a malaise similar to Japan's "lost decade" that has now extended to a 20-year period of economic stagnation. We are now hovering below "stall speed" -- the 2 percent real GDP growth rate threshold that portended another recession in six of the last seven occurrences.

State and local governments were just beginning to see rays of hope in their budgets, as income tax and sales tax receipts had begun to bounce back from the lows of the Great Recession. That was expected to help offset the drain of federal funds as the ARRA stimulus program winds down. Now, it looks much less likely that states and localities will see the top-line revenue growth that budget officers had anticipated last spring. Income tax revenues from capital gains vaporized in the past two weeks except for the IPO market in a handful of high-tech states. In some states, this now bodes for yet more cutbacks in operating budgets and aid to local governments. Ohio's Gov. John Kasich is already preparing for worse to come, and others will likely follow. California just announced a 10 percent revenue shortfall and analysts there expect more cutbacks.

U.S.+GDP+change+recessions

(Sources: Charles Schwab/Sonders; Bureau of Economic Analysis; FactSet)

Meanwhile, the rising costs of employee benefits including health insurance and retirement programs are putting the squeeze on these fragile budgets. With the stock market down for the calendar year, pension plans cannot look to Wall Street to fix their unfunded liabilities, which requires them to send bigger bills to public employers this year and next. National health care legislation has done nothing as yet to curb the rising tide of health insurance costs hitting public employers.

As I explained in a recent column, many public employers will be forced to continue a multiyear program of pay freezes and in some cases outright salary reductions in order to make ends meet. "Pension attrition" will force many employers to impose extended hiring freezes to reduce headcount -- cutting service levels -- in order to pay for escalating retirement plan contributions.

The gloomier scenario feared by some economists and investors is a double-dip recession. Such an event could result from faltering global demand as governments and consumers retrench to restore their underwater balance sheets and the demise of real estate prices and investment income. Everybody could be thrust back in the ditch with fewer policy tools to return to economic growth. Many economists put the odds of this dismal outlook as 50-50. Nobody credible is predicting a rip-roaring recovery. Even the optimists now expect the best possible case going forward will be a multiyear slog of slow growth known as the "new normal." Sluggish economic growth will fail to create jobs as stronger companies hold tight on cash and look for opportunities to buy out their competitors if stock prices continue dropping. This creates a vicious cycle of standstill economies where aggregate demand is insufficient to justify expansion and rehiring in the private sector. Even with record-low interest rates, there is no incentive to borrow money to expand businesses, and the public won't support new bond issues to build infrastructure because they see the pile of debt outstanding as already problematic.

Compensation Correction. Public employees will bear much of the brunt of this stagnation scenario in what I'm calling the "Lost Decade" for state and local government workers. Nationally, wages and salaries are still more than 4 percent below 2008 levels (see the red right graph in the charts below), and there is a widening gap between public- and private-sector health-care contribution ratios. So, from the standpoint of market-competitiveness, public-sector cash compensation will probably need to stand still for several more years before private-sector compensation rises to levels that would make public salaries and benefits uncompetitive in regional labor markets. When coupled with revenue constraints and other budget pressures -- plus the need to freeze the base of future pension benefits for retiring baby boomers -- this tends to reinforce the likelihood that most public-sector salaries will stay in the deep freezer well into this decade.

Great+Recession%27s+impact+on+wages%2C+income%2C+pensions

(Source: Wall Street Journal, Aug. 3, 2011, pg. A4)

Fiscal discipline. Elected officials will continue to face mounting demands from stakeholders in all corners asking for the restoration of this and that service, program, benefit or whatever else was cut since the onset of the Great Recession. The challenge now is to rebuild reserves in case a double dip does occur and to maintain vital services while also resuming deferred maintenance and capital expenditures for aging facilities and equipment. Multiyear financial forecasts must now take into account the expected effect of new governmental accounting standards for pensions and, ultimately, other retirement benefits, which will hit the books in fiscal 2013-2014. That may require new policies to devote a specified percentage of new revenues or leftover budget surpluses for delayed equipment replacement, restoring financial reserves, and to begin funding retiree medical benefits using actuarial principles instead of the unsustainable pay-as-you-go approach. "Sustainable spending" must become part of the mantra at every budget session and whenever a constituent proposes new expenditures without a funding source.

Time for the taxable bond option. One area where state and local governments can still contribute to economic growth is through infrastructure spending, if Congress would only give us the tools. As I have suggested before, it's now time to revisit the 2009 Build America Bonds program with a more sensible formula that would cost the U.S Treasury and federal taxpayers nothing more, while giving a stronger incentive to states, localities and transportation authorities to build roads, bridges, terminals and other long-term facilities that support economic development and create jobs for the millions now out of work in the construction trades. In light of fiscal restraint in Washington, D.C., this strategy offers one of the few policies that Congress can approve quickly to spur some growth.  Hopefully, the Obama administration will figure this one out sooner rather than later. Washington has run out of easy solutions and this is one of the few tricks left in their bag of pump-primers.

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