All Systems in Distress

Even if the Wall Street bailout works, state and local governments will have fiscal problems for a long time.
November 1, 2008 AT 3:00 AM
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

What does the Troubled Asset Relief Program -- more popularly known as the financial bailout -- mean for state and local governments? While all the focus has been on stabilizing Wall Street, states and localities also have a lot at stake in the revolutionary changes coming to the financial markets.

For the time being, the financial system will no longer be shaped by private market forces. It will be the United States Treasury, supported by various other federal bodies, that will be allocating credit. But this fall, as the traditional credit markets seized up and froze, it was clear that the municipal bond market, largely an innocent bystander in the dramatic unwinding of the credit markets, was heading for trouble. Interest rates spiraled and long-term bond issues were postponed or cancelled.

There are other impacts as well, and what happens to the states during these stressful times is important to the overall economy. States and localities represent 15 percent of the economy and employ 20 million people -- 14 percent of the nation's workforce. Millions more depend on transfer payments (such as welfare assistance, Medicaid payments, and retirement benefits) from these governments. In addition, state and local governments do the meat-and-potatoes work, providing the daily services that are consumed by citizens and businesses. Over time, the sector has been a steadying influence on the economy, experiencing some ups and downs but typically growing along a sustained path.

Now, the balance between state and local current revenues and expenditures is taking a rapid turn toward deficits. At the end of the third quarter, budget deficits were running $200 billion per year for the entire sector. This is roughly twice the scale of the deficits experienced in 2002 and 2003 when the state-and-local sector was hit pretty hard by a mild recession. A major concern is that the economy is only beginning to show the impact of a rapidly deepening recession. Most forecasts, which are being rewritten in red ink on a daily basis, are that the state-and-local sector is in for a sharp stumble.

And that's not all. There is one area where the current financial distress is lighting the fuse of a long-term bomb -- public employee pension funds. Decades ago, the public-pension systems were not very important in the overall financial mix and often funded on a pay-as-you-go basis. That was easy when there were few retirees and benefits were small. But over the past 40 years, the systems saw huge growth in their liabilities and got serious about acquiring assets to pay future claims.

At the close of the 20th century, things were looking pretty good. The sustained run-up in the value of stocks (which constituted 75 percent of pension assets) and the slow pace of inflation indicated that most systems would have plenty of money to pay pension benefits. But the stock market peaked in early 2000 and took a two-year slide. While there was some recovery in the next few years, the annualized returns remained pretty flat -- until the dive of the past few months.

The investment losses that pension funds are suffering are bad news. But even worse news lies ahead. In the calculation of the funding status of pensions, many actuaries have faithfully assumed over the past decade that stock values would grow at rates of 8 percent per year. These anticipated rates of return have made the systems look sounder than they were and, as a result, helped keep employer and employee contribution levels down. But, assuming that the returns for the next 30 years will be like those of the past 30 years is more an act of faith than reason. Actuaries -- at least those who want to stay out of court -- will have to change their assumptions. The unfunded liabilities of the systems will leap, requiring greater contributions from smaller public purses.

The difficulties of the public-pension systems are but one of the implications of the present travails. The entire credit system is undergoing massive change, which is sending policy analysts back into the history books to see how widespread and deep-seated financial crises were handled in earlier eras. Make no mistake about it, the TARP, and the disaster in the financial markets, is only Act One. The distress of governments -- at all levels -- will inevitably have a major role in the following acts.