Revisiting and Replenishing Rainy Day Funds

Rainy day funds were nearly washed away by the recession. What should states be doing about them now?
February 28, 2013 AT 5:00 PM

Rainy day funds are back in the news. After their near depletion during the Great Recession, many states have begun replenishing them. It seems like a no-brainer; yet some economists are questioning whether this is the right time in the economic cycle to be squirreling money away.

Meanwhile, Texas, which didn't tap into its rainy day fund during the downturn, is considering using some of its more than $8 billion in savings for a different kind of crisis: the drought. They could be joined by Michigan, which wants to use a part of the $500 million in its rainy day fund to dredge Great Lakes harbors that are grappling with record low water levels.

To gain some insight into the state of state rainy day funds, I talked to Scott Pattison, executive director of the National Association of State Budget Officers (NASBO) and a former Virginia budget officer. His edited responses appear below.

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What was the state of the funds going into the 2008 recession?

In the late '90s, the economy was good and states built up their funds. In the mild post-9/11 recession, state revenues crashed and states significantly used or used up all of their funds. By the mid-2000s, they had built up a very healthy amount of reserves -- over 10 percent of state general funds. The rule of thumb had been 5 percent, but analysts say that's too small today given the volatility of the economy. The fact that the percent doubled was an indication that state reserve balances were strong.

What happened during the Great Recession?

Well, several states utilized most of their rainy day funds. What's interesting is the split or dichotomy we saw. Twenty states came down to having nothing -- Michigan and Illinois, for instance, utilized all of their rainy day funds. Some were like South Dakota, where throughout the recession they maintained a balance in their rainy day fund. Those states that were doing relatively better than others, such as smaller energy and agriculture states like Iowa and Nebraska, ended up not necessarily utilizing the funds at all. They didn't have the same severity of crisis.

What's the state of the funds now?

Right now we're seeing a fairly healthy situation. If you take Alaska and Texas out -- both built up strong reserves because of petroleum -- you still have a fairly good balance of 5 percent of the general fund for the rest of the states, as compared to 2.5 percent in FY 2009 and 2010. So states have doubled their rainy day funds since the depth of the recession. My sense is that the recession was pretty significant and budget cuts were pretty severe, so that's had an effect on senior state officials in that they do not want this to occur again. They feel it's a good idea to make sure they have a cushion.

Is this a good time to replenish the funds?

There could be a legitimate discussion about whether it's too early because the recovery is lackluster or whether it is really good financial management. It depends on the state, and frankly, that's why we're seeing it handled differently in different states. Illinois says, "We don't have anything." Michigan says, "You know what, we need reserves." Reserves provide a cash flow cushion for states, which is always good. But most important, they assist with the basic financial balances and statements that get you better bond ratings. They're a sign of being prepared and of good financial management. A lot of the decisions, though, are not necessarily discretionary. In a lot of cases, you have to put a certain amount away based on constitutional or statutory provisions. Virginia has a specific constitutional provision outlining how much goes in based on formulas of what the financial situation is at end of fiscal year. If Virginia legislators want to spend it on something else, they would have to change the constitution.

From a best practice perspective, what should states be doing now to shore up their funds? For example, is this a good time for states to revisit the rules for taking money out of the funds?

In some states, it's easy and based on formulas. Some have restrictions that you can't use the money all at one time. I haven't heard discussions about changing the rules. I'm sensing that for a lot of folks, they are still managing themselves out of recession. Revenues are coming back but they are below average levels of growth. As we get further along, there might be more revisiting. But depending on the state situation, it is good to have some rules -- whatever they are -- so that it is a meaningful fund. In other words, one that you can't tap into at anytime. There should be a downturn or a crisis at the state level to use the fund.

Is there a "new normal" that applies to rainy day funds?

In the last dozen years or so, we have seen a fairly significant degree of volatility in state revenues, a lot of it on the income tax side. The way people are compensated has changed. Before, you just taxed salary. Now, if times are good, there are bonuses and stock options at the upper income levels. States should be asking themselves, what has the volatility been in our state and how should we look at rainy day funds as one of the ways we smooth out that volatility. There has been good work done in the last few years by Rick Mattoon at the Federal Reserve in Chicago. He's done a lot of work to demonstrate that volatility is much worse than it was. It makes rainy day funds a more important vehicle for states going forward so they can deal with rather significant changes in revenue when the economy switches.