Getting Ready for the Next Recession

States should maintain ample rainy-day funds or risk losing federal money.
July 19, 2010
By Robert D. Atkinson  |  Contributor
Founder and president of the Information Technology and Innovation Foundation

It has become clear that the moves by state and local governments to balance their budgets have canceled out a significant portion of the benefits of the $787 billion American Recovery and Reinvestment Act (ARRA) — the stimulus bill. While Washington aggressively pumped money into the economy to keep people spending and working, state and local governments were taking money out — laying off workers, suspending capital improvements and raising taxes. In short, while the federal government was "leaning into the wind," states and local governments set up wind machines that made the recessionary wind blow even harder.

Workers have the right to expect that the federal and state governments act as partners in managing fiscal policy, especially since state budgets make up a larger share of GDP today than they did 25 years ago. Looking ahead to the next inevitable recession, we need to put policies in place to ensure that state and federal budget policies are more harmonized. One way to do this is to tie the states' receipt of federal funds to their willingness to maintain much larger rainy day funds.

Currently, the states are pulling tens of billions of dollars out of the economy at a critical moment in the fragile recovery. According to the National Association of State Budget Officers' Fiscal Survey of the States, 44 states will reduce their spending in fiscal 2010 compared to 2009 and 2008. With revenues down — even after many governors hiked some taxes and fees — 40 states made mid-year budget cuts to their fiscal 2010 budgets totaling $22 billion.

The news isn't getting any better for the states as the new fiscal year starts for many of them on July 1. The National Conference of States Legislatures predicts all 50 states will have budget shortfalls in FY2011. Since state revenue collections generally lag behind a national recovery, state budget directors are looking at declining revenues well into 2012 — meaning even more budget cuts and tax increases. The Center on Budget and Policy Priorities (CBPP) estimates the combined shortfall will be a record $140 billion for fiscal 2011. This spate of belt-tightening by the state has been called the "anti-stimulus."

The CBPP showed that state and local governments have cut 100,000 education jobs and 231,000 other jobs since mid-2008. The shrinking state and local government sector reduced GDP by one-half of one percentage point. Looking into fiscal year 2011, CBPP calculates that the necessary spending cuts to balance state budgets could cost the economy 900,000 private- and public-sector jobs. These losses could cut in half the 2.2 million jobs saved or created the Obama administration has attributed to the ARRA.

To add to the states' woes, the flow from the federal spigot is about the reduced as ARRA runs out. Thanks to ARRA, over $135 billion in emergency funds used for Medicaid and education eased the budget crises this year. But the ARRA money will pretty much have been spent by 2012, and the economy is not likely to be generating the kind of tax revenue most states will need by then. The CBPP estimates the total of states' budget gap that will have to be closed in fiscal 2012 could be almost $120 billion. That will mean even more spending cuts — more money being taken out of the economy just as the federal government is trying to pour money into the economy — and possible new job losses in the hundreds of thousands. More anti-stimulus.

Don't the states have other options? Forty nine states (all but Vermont) have some form of balanced-budget statute. This means that, unlike the federal government, which can use deficit spending and tax cuts to counteract reductions in private-sector demand, states cannot. But what they can do is save for an economic "rainy day."

The problem is that few states saved enough going into this recession. As a result, the budget cuts and tax increases were much larger than they needed to be, exacerbating the slow rate of national economic recovery. In the recession of 2001, state budget shortfalls were six times greater than rainy-day fund reserves. And the situation has only gotten worse. In 2006, state rainy-day reserves were half what they were going into the previous recession. Moreover, as explained in a 2006 survey from the Tax Policy Center, there was a wide variation in the balances states maintained. This led in part to the severe budget problems many states faced then — and are facing now. Many states cap how much revenue can be captured for rainy-day funds. The 11.5 percent level achieved in 2006, as noted in the NASBO survey, does not reflect the fact that over 30 states had rainy-day accounts of less than 5 percent. Nine states had no rainy-day funds in 2006.

The 2010 balance levels are estimated at 6.2 percent. At first glance, that would not seem that bad. However, if one excludes Texas and Alaska, state rainy-day reserves are down to just 2.2 percent of expenditures, and over half the states in FY09 had rainy day funds of less than 3 percent of state budget. A flood disaster could easily take that down to zero.

Why do U.S. states collectively save so little in rainy-day funds? Certainly, one reason is that there is little political advantage for elected officials, especially governors, to expand government savings, especially if these savings run the risk of being drawn down in the next governor's term. In short, states have little incentive to budget for the future. However, what may be rational for a sitting governor and legislature is irrational for the nation as a whole. If the states had reasonable rainy day funds going into this recession unemployment rates would not have reached the levels they did and recovery would be much stronger.

It is too late to get states to boost rainy-day funds to fight this recession. In fact, doing so would be counterproductive. But we can and should encourage states to put in place better systems for the future.

The federal government is not in a position to alter state budget laws. But going forward, federal policy makers should adopt tough measures to ensure that when the next recession hits that state are not forced to cut tens of billions in public spending and raise taxes at the very time the federal government is ramping up public spending and cutting taxes.

To do this, Congress should pass legislation to tie the receipt of federal funds to maintaining adequate rainy-day funds of at least 10 percent of expenditures. That is, each state would have to maintain these at least this level of reserves.

One key question is timing of such a rule. It would be counterproductive to ask states to begin socking away money until the economy is fully recovered and the U.S. unemployment rate is at or below around 5 percent. But once such a recovery has occurred, states would be required to gradually work their way up to the 10 percent level over five years — or risk losing an array of federal funds. Congress could task the Treasury Department with determining when states could draw down funds, just as they currently task the Department of Labor with determining when extended unemployment benefits kick in.

Of course, the major objection to such as scheme is that it impinges on states' rights. But do states have the right through their fiscal shortsightedness to contribute to job loss, business bankruptcies and fiscal challenges in the rest of the nation? States are all too happy to come to Washington, hat in hand, for bail-out money when the economy goes south and they run out of money. But they are loathe to have Washington tell them how to structure their finances in the national interest. Yet Congress has done just this with regard to the nation's private financial institutions, forcing banks to maintain higher capital reserves. Incenting states to have "higher capital reserves" is no different. In short, there is a reason we are the "United" States and not the Confederation of States.

Getting to this result by attaching strings to federal monies has ample precedent. States had to increase their drinking age to qualify for federal highway money. Community development block grants, agriculture subsidies and other programs tie receipt of funds to certain standards and policies.

Requiring states to act as responsible fiscal bodies would better guarantee that all governments are leaning into the wind policy makers are battling the next economic downturn. This result would be hundreds of thousands of jobs saved and sparing tens of thousands of business and millions of families prolonged economic distress.