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Bernanke on the States’ Budget Crises

Today, Ben Bernanke, the chairman of the Federal Reserve, addressed the annual meeting of the Southern Legislative Conference of the Council of State Governments. The topic was timely: the yawning budget gaps facing states.

All states save for Vermont are barred from running deficits. That means, when tax revenues fall and spending on programs like unemployment insurance rises during recessions, states face large fiscal gaps. Most make these up with rainy-day funds or bond issuance. But the severity of the recession has pushed some states close to insolvency. They are making up the gap by doing everything from turning off street lamps to reducing the frequency of trash pick-ups to raising parking meter rates to firing hundreds of thousands of workers.

Today, the Senate is expected to vote on a package to relieve states: billions of dollars in Medicaid funding and a pool of cash to help local governments keep teachers on the payroll. But the bill is a fraction of what Congress initially hoped to pass, containing half of the Medicaid funding states expected and less than a third of the education-jobs funding originally proposed.

Bernanke did an excellent job of laying out the states’ fiscal problems. But when it came to solutions, he came up mostly empty. “Assistance from the federal government, especially through the fiscal stimulus package, has eased, but certainly not eliminated, the budget difficulties faced by states,” Bernanke said. “Although states and localities will continue to receive significant aid this year, that source of help will be winding down next year.”

Here, he discusses possible solutions — bolstered rainy-day funds and changes to the “capital budget,” the Congressional budget for infrastructure investments.

I do not advocate changing the balanced-budget rules followed by 49 of the 50 states; they provide important discipline and are a key reason that states have not built up long-term debt burdens comparable to those of many national governments. However, as is the case today, these rules may force significant state cutbacks in bad economic times when services are most needed. Moreover, many government programs — in areas such as education or health care, for example — are likely to be most effective when funding sources are stable and predictable, allowing for longer-term planning.

Tools exist to help mitigate the effects of the business cycle on state budgets. Many states deal with revenue fluctuations by building up reserve — or “rainy day” — funds during good economic times. Measured as a percent of general fund expenditures, the aggregate reserve fund balances for all state governments stood at a record of about 12 percent at the end of 2006; the states represented by the SLC had accumulated above-average reserves of around 16 percent. These high reserve-fund balances were helpful in lessening the severity of spending cuts or tax increases in many states. Nevertheless, given the depth of the recent recession, even these historically high reserve-fund balances proved insufficient to buffer fully the budgets of most states. Thus, state governments may wish to revisit their criteria for accumulating fiscal reserves. Building a rainy-day fund during good times may not be politically popular, but it can pay off during the bad times.

In principle, some smoothing of state government expenditures over time could take place through the capital budget. Maintaining or even increasing the pace of infrastructure construction when the economy is weak fosters economic development and provides local jobs, and it may even allow the state to get more bang for the buck because of increased competition among private contractors when demand is slack. However, voters and policymakers may understandably be reluctant to approve new bond issues and take on additional costs for debt payments in a period of fiscal and economic stress.

But states can only save so much, and the stimulus increased capital spending dramatically; it does not seem to me these suffice as a long-term fix. There are other ideas, such as the partial federalization of Medicaid, that seem to make more sense.

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