State Budget Crisis

[csizemore@hsdent.com]

State and local budgets have been hammered by a "perfect storm" of falling property and real estate transfer taxes, falling corporate and personal income taxes, and falling sales taxes...all while having to deal with surging needs for government services and unemployment benefits. And as California realized with horror last month, getting financing to plug the holes in the midst of an international credit crisis can be impossible. With no other options, states are "sharpening their knives."

"Facing Deficits, States Get Out Sharper Knives"
New York Times, November 17, 2008
By JENNIFER STEINHAUER

Two short months ago lawmakers in California struggled to close a $15 billion hole in the state budget. It was among the biggest deficits in state history. Now the state faces an additional $11 billion shortfall and may be unable to pay its bills this spring.

The astonishing decline in revenues is without modern precedent here, but California is hardly alone. A majority of states — many with budgets already full of deep cuts and dependent on raiding rainy-day funds or tax increases — are scrambling to find ways to get through the rest of the year without hacking apart vital services or raising taxes...

The plunging revenues — the result of an unusual assemblage of personal, sales, capital gains and corporate taxes falling significantly — have poked holes in budgets that are just weeks and months old and that came about only after difficult legislative sessions.

The root of this crisis is, of course, the housing bust. As the Times continues:

In keeping with recent economic trends, the states with the worst problems are those where housing booms morphed into a large-scale mortgage crisis over the last two years.

The current-year budget gap in Rhode Island represents over 11 percent of the state’s entire general fund, in large part because of the high number of subprime loans. The story is similar in Arizona, California, Florida and Nevada.

In addition, the crisis in the financial markets had immediate and widespread impact on state budgets. States have lost revenues from capital gains taxes and bonuses that have evaporated, and growing job losses have reduced state income taxes while draining unemployment funds.

In addition to the "here and now" effects of the crisis, there are other, more long-term effects as well. Without access to credit, business cannot expand and take on new workers. Furthermore, the businesses of tomorrow that are still nothing more than business plans in their would-be founders heads, are also effectively locked out. As the Times continues:

Further, the national credit crunch makes it harder for businesses to get loans, which trickles back into losses to states. When California was temporarily unable to gain access to the credit markets in the days leading up to the federal bailout package, state budget directors across the country noted the moment with horror.

Link: http://www.nytimes.com/2008/11/17/us/17fiscal.html?partner=permalink&exprod=permalink

Here is an excellent graphic from the article, courtesy of Barry Ritholtz's site: http://www.ritholtz.com/blog/wp-content/uploads/2008/11/state-strain.png

[csizemore@hsdent.com]

Continuing this theme, let's see what the Economist wrote this week:

"Local zeroes"
Nov 13th 2008

It is not the first time local governments have faced financial difficulties. States that relied heavily on income taxes suffered huge deficits following the stockmarket crash of 2001-02. Yet cities and counties, which mostly rely on property and sales taxes, often saw little or no drop in revenues. This time few are escaping. In many places all significant sources of public revenue—income taxes, business taxes, sales taxes and property taxes—are falling.

New York’s Rockefeller Institute calculates that real tax revenues in the third quarter fell below 2007 levels in 31 out of 42 states that released figures. Worse is almost certainly to come. In the land of the $700 billion bail-out, expected shortfalls of a few billion dollars in the biggest states and cities might not seem catastrophic. Unlike the federal government, though, states are generally required to balance their books every year. And, unlike the bank rescue plan, there is no chance that the lost money will eventually come back.

The causes of the crisis are no mystery. The Economist recites the now well-known causes:

The first places to run into trouble were those hit by the downturn in the housing market. Arizona, Florida and Nevada built too many unaffordable houses in the middle years of this decade. When mortgage rates reset, they suffered an epidemic of foreclosures. As prices plunged and buyers disappeared, revenues from sources as diverse as development fees and sales taxes on bathroom taps dropped.

Of all states, California is truly the most desperate at the moment. California was hit hard in the "dot com" recession and in the early 1990s defense downsizing recession. But this "housing recession" is by far the worst to ravage the state's finances in living memory:

One state has the great misfortune to belong to both troubled groups. California has suffered about a quarter of all foreclosures in America. Yet the state’s fortunes are tied even more closely to the financial markets. More than half of all revenues to the general fund come from income taxes, and half of those taxes are paid by just 144,000 wealthy taxpayers. As stock options and capital gains disappear, California finds itself deeper in the red than any other state.

Of course, as the Economist points out, much of this crisis was completely avoidable:

Long before local governments had revenue problems, they had spending problems. They have guaranteed their employees lavish pensions and toughened criminal codes in such a way that prison populations have risen fast. Public spending in New York state has increased by more than 40% in the past five years; in California, general-fund expenditure has more than doubled since the mid-1990s.

Link: http://www.economist.com/world/unitedstates/PrinterFriendly.cfm?story_id=12608223

[csizemore@hsdent.com]

The Wall Street Journal also had some choice words for our "spendthrift" states:

"Our Spendthrift States Don't Need a Bailout"
"Governors need to learn to use fat years to prepare for lean ones."

By STEVE MALANGA
Wall Street Journal, NOVEMBER 18, 2008

Last year at this time, many governors and state legislators were imploring Congress to let them spend more money by expanding the State Children's Health Insurance Program. Since the states share the cost of the program with Washington, the expansion would have allowed them to cover families with incomes up to 300% of the poverty level (more in some cases). It also would have meant hundreds of millions in additional state spending, and an estimated $24 billion in additional federal spending. President Bush vetoed the bill.

Today, governors and state legislators are singing a different tune. Unable to pay their bills as tax revenues shrink, they're imploring Washington to bail them out.

Oops. One of the problems with Keynesian economics is that it is never actually practiced. Governments follow Lord Keynes advice during the hard times, using deficit spending as an attempt to stimulate demand...but they conveniently ignore the second half of his plan: during boom times, use surpluses to pay down debts and build up emergency funds for the future. We are seeing this again, on a larger scale, but this time we do not expect a new economic boom to come along and bail us out again. Japan spent money recklessly all throughout the 1990s in an attempt to stimulate the economy. The results were mixed at best, but the debts remain: Japan's government debt is approximately 130% of its annual GDP, a number that past generations would have considered shameful. And thus far no economic boom has come along to allow Japan to grow out of that debt. Given Japan's demographics, it may never come at all.

Later in the article, Mr. Malanga attacks an issue near and dear to HS Dent: state pension and OPEB (health care) funding. This is a topic we covered in detail in The Death of Pensions special report, and it's one that we will return to several times in the coming years. This may be the single biggest sub-crisis facing the states and the nation as a whole. As Mr. Malanga continues:

Another, deadlier issue is their failure to deal with huge and growing employee pension and benefits liabilities.

For years, state and local politicians have bought support from public sector unions by promising big benefits.... States have collectively racked up some $731 billion in unfunded liabilities for pensions and other retirement benefits, according to a study published last December by the Pew Charitable Trusts' Center on the States. In particular, the states have been promising their employees rich nonpension benefits -- such as retirement health and dental care -- and paying for virtually none of it. According to Pew estimates, states have put aside a mere $11 billion to fund $381 billion in future nonpension benefits.

Get ready for more "emergency" meetings of state congresses and for more state governors to make the trip to Washington, hat in hand. You can also expect taxes to go up, as well as fees. Expect everything from speeding tickets to late library books to get a lot more expensive.

http://online.wsj.com/article/SB122697315476635963.html#printMode

[csizemore@hsdent.com]

New Jersey is in a mess. It's pension plans are underfunded by an amount that virtually guarantees state bankruptcy. And now, Governor Corzine is advocating reducing contributions to the fund?

Deeper in Debt
New York Times, December 12, 2008

It was only last year that Gov. Jon Corzine of New Jersey was calling for a major, and hugely unpopular, increase in turnpike tolls. The goal was to cut in half the state’s $30 billion budget shortfall, caused in large part by the underfunding of public-employee pension funds.

Now Mr. Corzine is pushing a proposal that in the short term would make the pension problem worse. Unfortunately, given plunging revenues, he has no choice.

Under his proposal, cash-strapped municipalities would reduce their payments to the pension funds by half for 2009, and by lesser amounts in 2010 and 2011. (Payments would return to 100 percent in 2012, including an additional sum to make up for the underpayments.)

Even then, the chronic pension fund debt would remain, and more must be done to pay it down.... Without tough, and politically difficult policies, New Jersey will never dig out of its debt.

Watch the Governor make his proposal on YouTube:

http://www.youtube.com/watch?v=_5jzvD4tWyo

[csizemore@hsdent.com]

The budget crisis in California just keeps getting more and more desperate. Consider Governor Schwarzenegger's most recent emergency moves:

"State Offices to Close Twice a Month Amid Budget Crisis"
Wall Street Journal, January 12, 2009

Short of cash and facing a $42 billion budget deficit over the next 18 months, California will close state offices on the first and third Fridays of the month starting in February....

The furloughs, ordered by Gov. Arnold Schwarzenegger last month. amount to about a 10% pay cut for state workers.

Could we possibly be looking at the bankruptcy of the largest state in the union by population and economic clout? We're not sure how this is going to end, but be warned: given California economic size and economic power, a prolonged crisis in the Golden State will have a ripple effect throughout the U.S. economy. It won't be pretty.