Prime Numbers: State Woes Threaten National Economy

Prime Numbers: State Woes Threaten National Economy

• Economic growth slowed to 2.4 percent last quarter.

• State budget cuts could reduce GDP growth by 1 percent.

• Nearly 2/3 of economists say state and local finances threaten recovery.

The crisis in state and local budgets is fast becoming a new wild card in the economic outlook. Governments are slashing programs, destroying both public and private-sector jobs, while raising taxes that eat into already weak household incomes. Nearly two-thirds of 42 economists surveyed by the Associated Press viewed the intense pressure on state and local finances as either a “significant” or “severe” threat to the national economy.

In the wake of the deepest recession since the 1930s, a dearth of revenues has already forced an unprecedented two-year decline in state spending, in the 2009 and 2010 fiscal years. The strength of the economy and the amount of federal support will determine budgets in the coming fiscal year, which began on July 1 for most states. Neither is a sure thing. Economists generally have turned more downbeat about prospects for growth and jobs, and Congress is showing increased aversion to more stimulus spending.

Instead of picking up steam in the first half of the year, as many forecasters had projected, the economy lost momentum. The economy grew at a 2.4 percent annual rate in the second quarter, according to Friday’s report on real gross domestic product, down from the first quarter’s revised 3.7 percent pace and the fourth quarter’s 5 percent clip. Consumer spending, which accounts for some 70 percent of all goods and services purchased, was particularly disappointing, growing only 1.6 percent last quarter, with significant downward revisions for all four quarters of 2009. Economists attribute the GDP slowdown to the European debt crisis, expiration of the homebuyer tax credit, stock market volatility, and deteriorating state and local finances.


The poor fiscal condition of the states has not gone unnoticed in the financial markets. The cost of insuring state bonds using credit default swaps has risen over the past year. By this metric, economists at J.P. Morgan Chase note that bonds issued by both Illinois and California are now deemed riskier than bonds issued by the fiscally challenged governments of Portugal, Ireland and Spain.

Unlike the federal government, most states are required to balance their budgets each year, so state governments addressed shortfalls for fiscal 2010 and 2011 with a mix of spending cuts, revenue raisers, federal dollars and rainy day reserves. A joint study by the National Governors Association and the National Association of State Budget Officers shows that in fiscal 2010, revenues were nearly 12 percent below the 2008 level. That forced 40 states to make mid-year spending cuts totaling $22 billion, on top of actions they had already taken.

For fiscal 2011, the fear is that revenues will disappoint once again, forcing even more spending cuts. Forty-six states faced budget shortfalls for fiscal year 2011 before enacting revenue enhancers and cuts in outlays that will create a further drag on the economy. The Center for Budget and Policy Priorities (CBPP) warns that historical experience and current economic projections suggest 2011 will be worse than 2010 by the time the fiscal year ends, due to declining federal assistance.


The increase in federal grants-in-aid under the 2009 Recovery Act accounted for more than half the increase in current receipts of state and local governments since the first quarter of 2009. Most of those funds will be exhausted by December. Any new receipts in the coming year may be insufficient to replace the loss of the extra $140 billion in federal aid. Plus, states may not be getting some federal money they were expecting. Congress is stalled over how to pay for a $24 billion proposal to extend the temporary boost in its share of Medicaid funding through December. That proposal was part of the Recovery Act, and many states built those funds into their fiscal 2011 budgets. Without the extension, 25 states will face new budget gaps, totaling more than $12 billion, according to the National Conference of State Legislatures. If states get no further federal assistance, says the CBPP, steps needed to eliminate the deficits could cost the economy some 900,000 jobs next year and subtract a full percentage point from GDP growth.

The risk is that the downdraft on the economy from state and local cutbacks could intensify in the coming year, just when the boost to economic growth from Washington’s stimulus package is fading. The effects on consumer spending and business activity from the 193,000 jobs lost in state and local governments in the year through June are evident, and more job losses are expected. In education alone, the American Association of School Administrators estimates that job cuts in education could total as many as 275,000 in the 2010-11 school year.

First-quarter 2010 revenues rose 2.5 percent from a year ago, according to the July 13 State Revenue Report from the Rockefeller Institute, the first year-over-year gain since the third quarter of 2008. However, the Rockefeller analysts say that revenue gain was the result of legislated tax hikes in two states — California and New York. Receipts in the other 48 states fell 1.5 percent, with 33 states reporting overall tax declines. Moreover, many states pushed their 2010 budget problems into 2011, with special borrowing programs and fiscal gimmickry, actions that could backfire if revenues fall short again.

The prognosis isn’t good. The drag on the overall economy will remain heavy. Historically, state revenue collections lag well behind upturns in the business cycle. Even if this recovery’s strength matches the past, Rockefeller Institute analysts say it would still take state receipts a few years to regain their pre-recession peak. This time, with only moderate economic growth and little expected improvement in the unemployment rate, the recovery in the fiscal condition of state and local governments will take even longer.