The Great Recession's Lessons on Rainy Day Funds

At least one state is using the experience to find a new way to prepare for the next recession.
April 2016
By Justin Marlowe  |  Columnist
A research professor at the University of Chicago’s Harris School of Public Policy

So far, 2016 has been a year of tenuous economics. Record losses in the stock market. Slow job growth. Financial turmoil in China and Europe. For the first time since 2007, state budget planners are talking about the next recession.

That conversation naturally turns toward rainy day funds. These funds -- sometimes called “budget stabilization funds” or “counter-cyclical stabilization policies” -- are one of the few tools states can deploy to protect their budgets when recessions cause revenues to drop. The challenge, of course, is that putting money in a rainy day fund means limiting the state’s spending on highways, education, Medicaid and other needs. As such, one of the biggest challenges of state government finance is finding a rainy day fund amount that’s not too small, but not too large.

States will continue to work through this “Goldilocks” problem. But as they ramp up for the next recession, a few are bringing some new thinking to bear on right-sizing their rainy day funds.

The Great Recession drove home some crucial lessons about rainy day funds. Prior to that, decades of academic research argued that there’s no one-size-fits-all fund amount. This became crystal clear during the past recession. We saw how some states’ revenues were hypersensitive to movements in the broader economy. Others responded to energy prices, commodities, exports to foreign countries or other idiosyncrasies. North Dakota’s revenues actually grew. We learned that each state has its own optimal rainy day fund amount, and that amount varies a lot across the states. Traditional platitudes like the familiar “5 to 8 percent of annual spending” rule really don’t work.

We also learned that states don’t save nearly enough. Most burned through their rainy day funds in the first few months of the recession. This was no surprise. Bo Zhao, a senior economist at the Federal Reserve of Boston, found that most states cap their rainy day fund balances well below the amount needed to cover their typical recession-led drop in revenues.

All this analysis starts from a simple piece of conventional wisdom: The correct rainy day fund amount is the revenue a state will likely lose in a recession. This assumes, of course, that spending doesn’t change. The Great Recession blew up that thinking. From 2008 to 2010 states saw record growth in unemployment claims, Medicaid caseloads, public university enrollments and other new spending needs. As such, one of states’ big conceptual and technical challenges today is how to work the spending side into their rainy day fund policies.

To that end, consider Utah’s recent experience. Last year its state budget staff subjected the state’s finances to a fiscal stress test. Instead of forecasting revenues and spending under normal economic conditions, they forecasted under conditions of severe economic stress. If this sounds familiar, it’s because the Federal Reserve requires big banks to go through this same exercise. For banks, the goal is to see how much capital they need to set aside. In Utah’s case, the goal is using its findings to set its rainy day fund amount for next year’s budget.

The test has showed Utah that its rainy day fund is probably large enough to see it through the next recession. But more important, it has forced several key legislators to consider how certain spending items could quickly outstrip those savings. As a result, “proactive budget adjustment” is now part of the Utah rainy day fund lexicon.

It’s also worth noting this relationship works in both directions. Gary Wagner, a regional economic advisor at the Federal Reserve of Philadelphia, has shown that states with formal rainy day funds have more predictable spending trends than states without such funds. It seems that states with strong rainy day fund policies take steps to mitigate unpredictable spending that can render those policies less effective.

As a tool to stabilize spending, rainy day funds are far from perfect. But as we’ve seen in Utah and elsewhere, they can help to stabilize the often volatile politics of state budgeting. That’s why they’re more important than ever.