The U.S. economy in in the sixth year of the current business cycle, longer than all but four expansions since World War II. The stock-market correction at the start of the year spooked businesses and consumers, and even the Federal Reserve has lowered its rate-hike expectations for the year. Unsurprisingly, this has state-government policymakers, along with their local-government counterparts, worried as they piece together their spending plans this spring.
They're worried that revenues will come in lower than expected. They're worried that social-benefit programs will cost more than expected. In short, they're worried about whether they'll be ready for that next downturn in the economy. The bad news: That last worry is well founded in many states. The good news is that most economists, including this one, don't see a high likelihood of the country falling into recession this year. However, there is a better than average probability of a downturn in the next two or three years. How well prepared is your government?
To prepare, it's crucial to first understand what happens to state and local government finances during a recession. The most commonly recognized change will be the decline in tax revenues. For example, during the Great Recession that began in late 2007, state government general-fund revenues fell more than 5 percent in two years. That decline would have been even larger if not for the many tax increases that were imposed to buoy revenues over that time.
Another equally important, though often overlooked, recessionary change to state and local government budgets takes place on the spending side of the ledger. As the economy and household balance sheets deteriorate, individuals demand a greater amount of assistance from government. This includes a wide variety of social-safety net programs such as Medicaid, unemployment insurance and food stamps. During the Great Recession, Medicaid spending increased almost 15 percent.
What's also commonly overlooked is that the sharp uptick in spending typically comes much earlier than the decline in revenues, making it a better leading indicator of economic distress than taxes. State and local government spending on social-benefit payments to individuals surged more than 25 percent in fiscal 2008, a full three quarters before the first year-over-year declines in revenue. States will have a more difficult time recognizing this in the next recession because of all the noise being created in Medicaid enrollment data from the Affordable Care Act, especially in states that opted into the federal law's Medicaid expansion late.
To be fully prepared for the next recession, policymakers should know two things. First, they should know their economies, including where they're most vulnerable during another downturn. Periodically studying the underlying economic environment, and how public policies are shaping it, is a best practice for preparing a government for changes in the business cycle. Knowing how your economy will respond and how competitive it will be with neighbors coming out of a recession are key to ensuring stronger performance during the subsequent recovery.
Second, policymakers need to have a thorough understanding of how a recession will affect their specific fiscal situation. Every state and local government is affected differently during a recession. While states in total lost about 5 percent of revenues during the two-year downturn of the Great Recession, some saw declines of more than 25 percent while others saw no decline for several years. Similarly, while the average state saw Medicaid spending rise by 15 percent in two years, some saw more than twice that amount while others actually saw declines.
The exact effects can be estimated only through a comprehensive stress test conducted on a government-by-government basis. This involves using alternative economic scenarios, similar to the methodologies used by many banks, in conjunction with existing revenue and social-benefit forecast models.
Fortunately, some states and local governments have already taken on this kind of work, and are slowly moving their reserves and their revenue structures in a way to limit fiscal volatility and budget pain. Taking these steps not only makes policymakers' jobs easier over the long-run, but it also helps protect the economy during downturns and foster faster long-run growth.
Governments that have not begun to take these steps are already behind the curve. The longer it takes to get a plan in place, the more difficult the eventual solution will become and the more risk policymakers will be inviting into the economic outlook. Recessions are inevitable, but large emergency budget cuts and tax increases don't have to be. It's never too early for prudent policymakers to protect their budgets and their economies.