U.S. States Aren't Prepared for the Next Fiscal Shock

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A man sits on stairs on the street in front of an abandoned home in Camden, New Jersey. The state has missed Governor Chris Christie’s revenue forecasts for three straight years as its recovery trailed the nation’s and costs rose for pensions, health benefits and debt service. Photographer: Emile Wamsteker/Bloomberg

U.S. states, still grappling with the lingering effects of the longest recession since the 1930s, are even more vulnerable to another fiscal shock.

The governments have a little more than half the reserves they’d stashed away before the 18-month recession that ended in June 2009, according to a report last month by Pew Charitable Trusts. New Jersey, Pennsylvania, Illinois and Arkansas have saved the least.

Skimpier rainy-day funds have implications for the national economy, which is in its sixth year of expansion. States would have to cut spending or raise revenue by a combined $21 billion in the event of a recession, exacerbating economic weakness, Moody’s Analytics found in a stress test of state finances. Reserves take on added importance for governments balancing obligatory pension and health-care costs with swings in tax collections, said Daniel White, a senior economist at the arm of Moody’s Corp.

“What the Great Recession has shown is that things have fundamentally changed in terms of the way that state fiscal conditions are determined,” White said from West Chester, Pennsylvania. “They need to be much more prepared for very volatile fiscal conditions than they had been in the past.”

Investor Focus

Investors are monitoring states’ fiscal balances after seeing how reserves helped some governments weather the recession, said John Donaldson, who helps manage $800 million of munis as director of fixed income at Haverford Trust Co. in Radnor, Pennsylvania.

California won credit upgrades and saw borrowing costs shrink after voters in November agreed to bolster rainy-day funds. With Fitch Ratings lifting California to A+ in February, its fifth-highest level, the state has its highest marks from the three biggest rating companies since at least 2009.

Bond buyers demand about 0.3 percentage point of extra yield to own 10-year California munis instead of benchmark debt, close to the lowest spread since 2007, data compiled by Bloomberg show.

“We’re looking for stability and credit quality,” said Richard Ciccarone, Chicago-based chief executive officer of Merritt Research Services LLC, which analyzes municipal finance. “A rainy-day fund is a symbol of conservative financial management.”

Preparation Failure

States were unprepared for the last recession. In 2009, budget gaps totaled $117 billion, about twice the level of reserves, according to Pew, a research group. With more of a cushion, they would’ve cut fewer jobs, White said.

The governments employ about 5.1 million nonfarm workers, about 140,000 fewer than the 2008 peak, Bureau of Labor Statistics data show.

States such as New York and Illinois, more reliant on income levies, should budget more like energy producers Alaska and North Dakota, which are accustomed to revenue swings, White said. Tax collections have become more prone to swings partly because of variability among high earners, he said.

In the next recession, the federal government may not assist states as it did in 2009, with grants for Medicaid and education, White said.

Stress Test

In Moody’s test, based on fiscal 2015 data, a recession would open up a combined deficit of $64 billion, or 8.5 percent of general-fund expenses, eclipsing states’ $43 billion of reserves. The company recommends states hold at least 8.5 percent of budgeted costs.

The median number of days states could run on reserves dropped to an estimated 22 this year, from 41 before the recession began in 2007, according to Pew. At least 32 states expect lower reserves this year than in 2014, the report said.

Analysts don’t expect a recession soon. The economy will probably expand through at least mid-2016, according to analysts surveyed by Bloomberg.

Yet the current expansion is 70 months old, according to the National Bureau of Economic Research. That compares with 73 months for the previous expansion, from November 2001 to December 2007. The average from 1945 to 2009 is 58.4 months.

‘Thinking Ahead’

Now’s the time to sock away cash, said White at Moody’s.

California took a page from Massachusetts in learning from the last recession. Massachusetts in 2010 implemented a policy of diverting some capital-gains taxes to rainy-day reserves, said Brenna Erford, manager at Pew.

“Those are two examples of states taking that experience and really thinking ahead to how they can best mitigate their budget crises over the future that are related to recession,” Erford said.

Yet other states have found it harder to change their practices.

New Jersey ranks 47th in Pew’s ranking of states, with 3.3 days of cash on hand, or 0.9 percent of spending as of 2014. Since 1996, the state’s surplus as a percentage of expenditures has trailed the U.S. average, according to an analysis by David Rosen, New Jersey’s nonpartisan legislative budget officer.

The state has missed Governor Chris Christie’s revenue forecasts for three straight years as its recovery trailed the nation’s and costs rose for pensions, health benefits and debt service. It will begin fiscal 2016 with a projected surplus of $388 million, up $87 million from a year earlier, said Christopher Santarelli, a spokesman for the treasury.

“This projected surplus takes into account the many competing interests in this budget against the backdrop of the state’s tax structure,” he said.

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