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The States' Dire Straits

By Michael Wallace While Wall Street grows increasingly optimistic that fiscal and monetary stimulus will work their magic on the national economy, market players may be overlooking one potential drag on the recovery: the dire condition of state finances. Legislatures nationwide have scrambled to close budget gaps as revenue receipts come up short.

Indeed, the ongoing fiscal drag from the state sector could offset a large chunk of the $350 billion stimulus from the Bush Administration's recently enacted tax-relief package -- unless a solid economic recovery unfolds in the latter half of this year. This places monetary policy back in the swing position and suggests the Federal Reserve could extend its accommodative stance well into next year. However, we at MMS International don't expect the Fed to make any change to interest rates for the remainder of the year, though we anticipate rate hikes of 25 basis points in each of the first two quarters of 2004.

RAINY DAY FUNDS. The dire condition of state finances was brought home in a recent report from the National Governors Assn. (NGA) -- a bipartisan group of the 50 state governors -- in league with the National Association of State Budget Officers (NASBO). The report detailed the sizable shortfall faced by state governments. According to the NGA, through the 2003 fiscal yearend on June 30, 37 states slashed spending by a total of $14.5 billion. On top of these cuts, 29 states proposed tax-and-fee hikes totaling some $17.5 billion.

If all goes according to plan, the total subtraction from the national stimulus will be $32 billion -- the largest such bite in more than 20 years. True, $20 billion from the Bush tax plan has been earmarked to help relieve states' fiscal woes. But the states remain financially vulnerable due to increased spending on homeland security and a rapidly rising bill from Medicaid. Moreover, the states have seen a net decline of $42.5 billion in their "rainy day" funds, which had been set aside during the flush times of economic growth.

Unlike the more flexible federal government, states are required to balance their budgets each year and have been forced to make broad, Draconian program cuts. Countermeasures have included across-the-board budget cuts, use of rainy day funds, state employee layoffs and early retirement, and reorganization of programs and agencies. Some hard-pressed states have taken to debt refinancing, hiring freezes, and selling debt backed by future tobacco-settlement revenues.

NOT-SO-GOLDEN STATE. The bottom line: The states' forced belt-tightening will take a substantial bite out of the Federal government's front-loaded fiscal stimulus -- estimated at $50 billion to $60 billion per year for the next five years -- before it's up for extension.

Lags in state fiscal policy also suggest that the effects from local-level financial crises will rattle on for at least another year before any recovery in revenues kicks in. The true wild card is California. It hasn't resolved its $38 billion budget crisis, which has degenerated into a quagmire of partisan squabbling and a costly effort to recall Governor Gray Davis.

Ratings agency Standard & Poor's recently placed the Golden State on "credit watch negative" due to the deadlock on budget negotiations (like BusinessWeek and BusinessWeek Online, Standard & Poor's is a division of The McGraw-Hill Companies). Any subsequent ratings downgrade could further imperil the state's finances by raising borrowing costs significantly. California lost nearly a third of its capital-gains revenues from stock options during the three-year slump in technology shares. Any benefit from the 35% recovery in the tech-laden Nasdaq won't be felt until next year. Revenues from personal income tax declined by nearly 27% in 2002.

"REFLATIONARY" REBOUND. Admittedly, California is the most extreme example of a state in fiscal distress. But its sheer size makes its problems impossible to ignore. And it's likely that the Fed is keeping a keen eye on the situation. Even though Federal Reserve Chairman Alan Greenspan marveled at the timeliness of the last two rounds of the Bush Administration's fiscal stimulus, with state-budget deterioration in the back of his mind, he's unlikely to deviate far from his accommodative policy position in his July 15 testimony before the House Financial Services Committee.

Greenspan will likely keep his focus on fostering the rebound in equities while keeping rates near rock-bottom levels to spur business investment. His goal: keeping the economy on track for a solid second-half rebound -- despite any discomfort with a "reflationary" policy among more hawkish Fed board members. The shaky status of state budgets nationwide -- and its potential to cripple a nascent economic recovery -- will only strengthen the Fed chief's vigilance in that regard. Wallace is a senior market strategist for MMS International

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