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The States’ Fiscal Crisis Might Be the Next Big Risk

Veteran analyst Meredith Whitney is making waves, via Fortune, with a report arguing that local-government budget gaps are the next big foreboding cloud on the horizon, promising massive job losses, bond defaults and other recovery-threatening problems in the next few years. The fiscal woes are worst in California, New Jersey, Illinois and Ohio, the report says. Texas, Virginia and Washington are doing best, budget-wise. Here, Whitney discusses those results from her new 600-page report, “The Tragedy of the Commons,” on CNBC:

Whitney says the “similarities between the states and the [investment banks before the financial crisis] are extreme, to the extent that the states have been spending dramatically, growing leverage dramatically. [Municipal] debt has doubled since 2000, but spending has also grown way faster than revenue.”

From 2000 to 2008, states’ tax revenue increased 45 percent, but spending increased 60 percent. To finance the difference — as all states save for Vermont are required to run balanced budgets — politicians used off-balance-sheet vehicles, reduced transfers into pension funds, and borrowed against future revenue. “You borrow from future dollars to benefit the present. Basically generational robbery,” she says. “The bonus [for the government officials who did it] is to get reelected.” (She notes that the ratings agencies were totally out to lunch on this.)

In fiscal-year 2011, states will be $121 billion in the red, and there won’t be any more federal stimulus dollars to make up the difference. That means they will have to lay off more workers and cut more services. But Whitney does not think the states will default on their debt, as the federal government will step in to help.

Cities and towns are in the same dire straits as states, facing widening budget gaps as stimulus dollars dry up. In some cases, state houses will step in to help local governments — as happened with, for instance, Harrisburg, Pa., which needed state dollars to meet a debt payment. But state houses will not be able to fully backstop cities and towns — as also happened with Harrisburg, facing bankruptcy. Defaults and other debt-payment problems mean investors won’t touch municipal bonds — meaning cities can no longer issue bonds to make up their budget gaps.

That leaves only a few other crummy options for cash-strapped cities and towns: Defaults and bankruptcies, tax and fee increases, the sale of public goods, and austerity budgets, slashing funding for street lights, elementary schools, police, mental-health services, libraries, sidewalks, etc.

The question I have is whether states can tackle this problem now rather than later — assessing local budgets and working with the federal government to figure out how to stave off utter budgetary catastrophe.

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