Leon Evans is used to doing more with less. But with the state facing an estimated $18 billion budget shortfall, even Evans is dreading the spending cuts to come. Evans runs the Center for Health Care Services, the local mental health authority in San Antonio. The people who operate public mental health clinics in Texas have to be efficient, and Evans has become creative at finding ways to treat as many people as possible.

The state provides the Center for Health Care Services enough money to treat about 4,200 patients each month. The center stretches those funds to serve more than 6,000 clients. Still, it’s not even close to meeting demand. Thousands with severe mental illnesses go without treatment.

The center has also worked with hospitals and law enforcement to create some of the most innovative jail-diversion programs in the country. Those programs combined keep about 1,000 people a month out of the Bexar County jail, placing them in treatment programs instead.

Those innovative programs, which save taxpayer money, are now at risk. “Taxpayers end up paying anyway,” Evans said. “If you can’t deliver services one way, then [people] end up going to emergency rooms and to jails and eventually to prison if they don’t get mental health and substance abuse treatment.”

More on state aid here and here.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change — only four months after the Fed ended its massive bond-buying program — would signal deepening concern about the economic outlook. If the Fed’s forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.

Moving to stop the Fed’s portfolio from shrinking would prevent monetary policy from slightly tightening in the face of a weakening recovery.

Buying new bonds with this stream of cash from maturing bonds — projected at about $200 billion by 2011 — would show the public and markets that the Fed is seeking ways to support economic growth. It could also be a compromise that rival factions at the Fed support, as officials differ about whether and how to address a subpar recovery.

The central bank’s $2.3 trillion portfolio has nearly tripled in size since 2007.

This is not much, but it is something. The Journal reports that the Fed will make its decision after seeing the rest of this week’s economic data. This morning, the Bureau of Economic Analysis reported that spending declined last month, signaling a strong fade in the recovery. All in all, the Fed has shown real conservatism in ringing alarm bells about the economy. Yesterday, for instance, Bernanke addressed the budgeting crisis facing states, which are not allowed to run deficits. He did not say the federal government should supply funds to help avoid layoffs and cutbacks to programs like Medicaid. Instead, he said states should keep bigger rainy day funds in the future.

He elaborates with a number of data points in his Fiscal Times column:

A June 3 report from the National Governors Association and the National Association of State Budget Officers shows that the states have cut aggregate spending by $74.4 billion, or 10.8 percent, since 2008. The expiration of $55 billion in temporary federal aid to the states could lead to further substantial spending cuts beginning on July 1.

Budget expert Stan Collender warned on June 8 that a sharp cutback in state spending mandated by state balanced budget requirements could have a negative effect on the economy as a whole. [...]

A May 26 report from Pew reviewed the responses of 13 cities to the recession. Virtually all were enacting broad based tax increases as well as new fees, job cuts and reductions in pay and benefits for municipal workers. [...]

A March 5 OECD study examined the cyclical behavior of subnational governments throughout the OECD. It found that such governments in the U.S. behaved in a far more cyclical manner — exacerbating the business cycle rather than moderating it — than in any other major country. A February study by economists Joshua Aizenman and Gurnain Kaur Pasricha found that fiscal contraction in the states offset almost 100 percent of the fiscal stimulus at the federal level in 2009.

These data are as strong an argument as any for the passage of the jobs bill and other more aggressive measures to help boost demand and lower unemployment.

I find it interesting that you have a lot of the Republicans running around and pushing back on the stimulus money and saying this doesn’t create any new jobs, and then they go out and they do the photo ops and they are posing with the big check and they say, isn’t this great? … It doesn’t match up. …

I think it’s kind of politics, rather than thinking about only one thing, and this is how do we support the president, how do we support him and do everything that we can in order to go and stimulate the economy, get the economy back, and think about the people rather than politics.

Schwarzenegger’s perspective on the economic turmoil, of course, couldn’t be more different from that of GOP leaders on Capitol Hill. He’s got a state to run, a budget to balance, a jobs crisis to tackle — meaning he’s actually interested in a full economic recovery. Republicans in Congress, on the other hand, have their eyes on just one thing: November’s midterm elections. And the worse off the country is eight months from now, the better the GOP will do at the polls. Though they’d never admit it, they’re actually cheering for the chaos to continue. Look for more and more Schwarzeneggers to start calling them out.

In recognition of that flawed formula, Congress last year provided an increase in the federal portion of Medicaid funding — an $87 billion provision designed to prevent low-income families from losing health coverage amid the recession. Trouble is, that money runs out at the end of this year — exactly halfway through the fiscal year of most states. That looming deadline has left state legislators in a pickle, unsure whether to craft their budgets under the assumption that the extra federal funds will keep coming, or expire.

Today, those officials will be cheering: The Obama administration’s budget blueprint is pushing for an additional six months of enhanced federal Medicaid payments — a move that would allow states to stabilize their Medicaid rolls trough the end of fiscal year 2011. The Wall Street Journal reports:

Obama’s budget plan estimates the U.S. will spend $317.6 billion in grants for state health programs in fiscal 2011, up 7.8% from an estimated $294.6 billion in fiscal 2010 and up 18.4% from spending in fiscal 2009 of $268.3 billion.

Of course, this is different from actually fixing Medicaid’s funding flaw.

Although $10 billion in stimulus funds for education has been granted to the state, those funds come with a caveat, as outlined by the U.S. Department of Education:

As part of the state’s application, each governor must include an assurance that the state will maintain the same level of support for elementary, secondary, and postsecondary education in FY 2009 through FY 2011 as it did in FY 2006.

This is to ensure that states use stimulus dollars to fund innovation and improvement in schools, rather than merely to plug budget holes. If California fails to ensure that its schools will receive the same amount of money from the state general fund as they did in 2006, the state will no longer qualify for stimulus funds for education.

But Schwarzenegger’s proposal leaves education funds unaccounted for until the state borrows money from local governments.  According to the Chronicle:

The flaw in Schwarzenegger’s proposal centers on his plan to borrow $2 billion from local governments, which would then be used to pay for education. That move would free up $2 billion in the state’s general fund, which carries the $26.3 billion shortfall.

As a result, the Chronicle reports, California would not meet the Department of Education’s condition that the state maintains its 2006 level of support for education. The money borrowed from local governments would replenish funds to 2006 levels, but the stimulus provision requires that state funding remain consistent.

Although California has received much of the $10 billion in stimulus funds it was allocated for education, Schwarzenegger’s maneuver could end up jeopardizing the rest of the money, and the initial grants may need to be repaid to the government. Secretary of Education Arne Duncan has warned both Tennessee and Pennsylvania lawmakers against similar proposals, but neither state suffers from as dire a budgetary crisis as California. With an unbalanced budget looking him down the nose nine days after California’s new fiscal year began, Schwarzenegger will need to find a sufficient compromise soon — one that isn’t as potentially crippling as his current proposal.

Many states face fundamental legal barriers to accepting such loans. The constitutions of a number of states explicitly bar the state from borrowing funds to cover operating expenses. Other state constitutions or statutes strictly limit the amount of debt that the state may incur, and in some states, such loans would exceed the limit. In addition, most states have balanced-budget requirements that may bar them from accepting operating-budget loans. As a result, most states likely would not be able to accept federal loans.

Some help that would be.

Combined, these factors force states to cut services to their neediest residents during a time when the need is greatest. The perversity of that equation hasn’t been lost on Paul Krugman, the Nobel Prize-winning economist, who uses his column in The New York Times today to push for a Medicaid program funded solely by the federal government, which can borrow money in a recession to meet the budget challenges when more and more people become Medicaid-eligible. From the column:

[S]hredding the social safety net at a moment when many more Americans need help isn’t just cruel. It adds to the sense of insecurity that is one important factor driving the economy down. [...]

As a nation, we don’t believe that our fellow citizens should go without essential health care. Why, then, does a large share of funding for Medicaid come from state governments, which are forced to cut the program precisely when it’s needed most?

This is hardly a change of heart for Krugman, who has long-advocated for the creation of a nationalized health care system. But reforms of such magnitude don’t happen in times of non-crisis (Just ask the Clintons). Whether the current recession will force Washington policymakers to consider some reworking of Medicaid’s funding mechanism has yet to be seen. But you can bet that roughly 50 state governors would be behind such a change.

Twenty-one states and the District of Columbia now face budget shortfalls totaling $8.9 billion this fiscal year, according to an analysis released this month by the Center on Budget and Policy Priorities, a liberal policy watchdog.

The financial crisis has been particularly tough on states, for at least two reasons.

First, consumers are spending less, and that means sales-tax revenues are falling at the same time that demand for social services like unemployment benefits, food aid and Medicaid is rising.

Second, unlike the federal government, states (generally) are required by law to balance their annual budgets.

And here’s a hint: It’s not the wealthy folks who usually feel the pain of the squeeze.

This fiscal year, 22 states have already made or proposed cuts to programs benefiting some of their most vulnerable residents, CBPP found. Some examples, according to another CBPP report:

• 14 states have cut programs providing health-care services to low-income residents. Rhode Island, for example, eliminated care for an estimated 1,000 low-income parents.

• 11 states have cut medical care for the elderly and disabled. Ohio, for example, has closed two mental health facilities.

• 17 states have cut funding to public colleges and universities. Community and technical college students in Kentucky, for example, have seen average tuition hikes of 5.2 percent as a result of education cuts there.

• 13 states have cut funding to public elementary, middle and high schools. Aid to local school districts in Florida, for example, has been cut by roughly $130 per student.

Unlike some banks, of course, the folks affected by these cuts are not too big to fail.