The Hidden Problem: State Budget Collapse

The news that California has now run so low of cash that it is resorting to using IOU’s to pay its creditors should have made you sit up and take notice: for all the rumbling about the parlous condition of the federal treasury the states are relatively worse off.

Should we care?

Absolutely.

First let me point you to an excellent summary of the situation by the Center on Budget and Policy Priorities. The gist of this report is that the worst is yet to come, and that the worst is very bad indeed. Only a couple of states have so far managed to stay in the black and some, California being the most obvious, are on the brink of total disaster.

The expected budget shortfall for all the states combined looks as if it will be in the region of $111 billion this year, $166 billion in 2010, and $180 billion in 2011. In other words there is no turn around in sight. Since most states have constitutional restrictions on their ability to run deficits they will be forced to adjust somehow. This inevitably means they will cut services and reduce spending or they will raise taxes.

Nothing could be worse for the national economy.

Not only do states provide the bulk of essential services like Medicaid, but they are the providers of education and local social services. The impact over the next few years of cuts in budgets for those services will produce a massive human cost and lasting damage on the economy: education expenditure will be significantly reduced and may take decades to recover.

The slump in home prices has slashed property values and reduced property tax income, and the rapid rise in unemployment has eaten into local income tax revenues. This double assault on local funding has produced a crisis of unparalleled proportion: state deficits are now running at an aggregate level of about 24% of total budgets. That is a crippling and daunting problem. Some states are even worse: California’s shortfall is over 50% of its budget.

There has been nothing like this since the Great Depression.

The bigger problem is, of course, that the budget balancing efforts by the states offset the fiscal stimulus being pumped out at the federal level. It is as if we had fifty-one economic policies with fifty trying to restrict and one trying to expand the economy. As a matter of fact that’s exactly what we are faced with.

The depth and length of the state level crisis is a significant drag on the federal effort. By now you are all aware of my opinion that the federal stimulus package was far too small, it was about half that I would have liked to have seen. Now the states are cutting into even the smaller amount: if the states are successful in reducing their spending sufficiently to return to balance in 2011 they are, in effect, counteracting against, or reducing, the federal stimulus by about $180 billion. Since the entire federal package was only around $800 billion, that’s a huge drag on the economy.

This problem is largely hidden from view and so receives little media attention, but it is a major component of the overall economic picture. The impact of the various local attempts to balance state budgets is severe enough that I would like to see a coordinated approach as part of the next round of stimulus. Perhaps state budgets can be underwritten temporarily at the federal level and so services can be maintained and jobs preserved. That would have immediate impact on the level of unemployment since it would prevent state employees being fired, and it would remove the fiscal drag that state budget balancing is having on our overall growth.

This, naturally, assumes that we will have another round of stimulus at the federal level. But that seems inevitable. And the state level crisis is a good reason to add to the list to support such another round.