State and local governments account for the bulk of fiscal spending
Federal spending is important – TARP will hopefully bring stabilization to the financial markets – but state and local spending is an even bigger fiscal tool. In the second quarter of 2008, real state and local spending was 62% larger than federal spending. When state and local governments are forced to cut expenditures, the economic impact is felt since most public institutions are funded by the state: education, health, insurance programs, roads, etc.
The chart illustrates state and local net saving (tax receipts minus spending) as a percentage of GDP on a quarterly basis spanning 2005:Q1 to 2008:Q2. The chart shows that State budget deficits rose during the last recession (March 2001 through November 2001). As close to an axiom as one can get is how transfer payments rise during an economic downturn, which helps stabilize the economy (automatic stabilizers). A great example is unemployment claims; as job losses pile up, unemployment claims rise, and government spending increases to finance domestic consumption and investment. However, since tax receipts are likewise falling, municipal governments usually issue debt to cover the difference between rising expenditures and falling tax receipts.
However, in a banking and credit crisis this might be impossible. According to BusinessWeek: “Like other credit markets, municipal bonds are nearly frozen. During the week of Sept. 22, three significant bond deals were done. Normally the tally would be about 100. Those that are getting done—like New York City's Sept. 29 deal—are high-priced.”
Point: Municipal credit is too expensive – state and local governments must rely solely on tax receipts and existing lines of credit.
With credit markets flowing as fast as an ice glacier, there is a risk that automatic fiscal expansionary policy will not kick in as it does during a normal recession (one without a banking crisis). Real state and local expenditures are rising – they have risen $12.4 billion since the beginning of 2001 – but how long can state and local governments continue to spend if (1) tax receipts are declining, and (2) they can’t finance spending by selling municipal bonds?
According to BusinessWeek, the ten States with the worst budget gaps:
1) California; Budget gap (as a % of the total budget): 22%; Gap: $22.2 billion
2) Arizona; Budget gap (as a % of the total budget): 19.9%; Gap: $2 billion
3) Florida;Budget gap (as a % of the total budget): 19.9%; Gap: $5.1 billion
4) Nevada; Budget gap (as a % of the total budget): 16%; Gap: $1.2 billion
5) Rhode Island; Budget gap (as a % of the total budget): 13.1%; Gap: $430 million
6) New York; Budget gap (as a % of the total budget): 9.8%; Gap: $5.5 billion
7) Alabama; Budget gap (as a % of the total budget): 9.5%; Gap: $784 million
8) Georgia; Budget gap (as a % of the total budget): 8.7%; Gap: $1.8 billion
9) New Jersey; Budget gap (as a % of the total budget): 7.7%; Gap: $2.5 billion
10) Maryland; Budget gap (as a % of the total budget): 7.2%; Gap: $1.1 billion
Spending has already been cut in these states on public shools, state hospitals, nursing homes, health insurance, new hires, and more. As long as the credit crunch exists, these States will not be able to raise funds through standard municipal issues. Some States, like California, will tap the Treasury, but other States will not.
If you asked me, this is the next shoe to drop in the credit crisis. Those states that need the most stabilization spending – especially in their labor and housing sectors – cannot, or will not be able to, afford it. This will have real macroeconomic effects resulting in loss of consumption, investment, and income.