Wednesday, October 29, 2008

STATE AND LOCAL FINANCE | Critical Federal Reforms Needed

Whether Obama or McCain gets elected on Tuesday, an early issue for the new president is the fiscal crisis facing state and local governments. Beleaguered officials have watched July-September revenues come in lower than expected while financial markets have become more risk-averse. They have been trooping to the Congress already - expect them to start pressing the President-elect after the election.

The fact is, the Federal Government is the only one of America's 87,500 governmental units that can print money. A Federal response could be to provide short-term fiscal assistance in exchange for commitment for structural changes that will bring state and local revenues and expenses into balance and will bring debt service below a reasonable ratio to a multi-year average of tax revenues.

It's not just that states and localities have seen revenues decline. Many pension funds that have invested heavily in equities and appeared to have adequate funds to pay pension obligations now look grossly underfunded. The loss in value of pension-fund assets invites further questions about pension-fund accounting. In many cases the answers to these questions will distress pensioners, taxayers and investors in municipal debt. When sorrows come, they come not single spies, but in battalions.

In New York State, Gov. David Paterson has a clear understanding of New York State's fiscal outlook. He has just raised his forecast of the budget gap facing the state this fiscal year to $1.5 billion from the $1.2 billion the state projected weeks ago. States and localities are not permitted to run deficits, so Gov. Paterson has asked the state legislature to meet Nov. 18 to close the budget with decisions that will raise more revenue and cut spending. He says nothing will be off the table and he sounds as though he means it.

New York State's problem is huge and gets worse next year and the year after. Borrowing to fund current deficits faces (appropriate) legal obstacles and would be a hard sell. Muni markets are opening up again, but with the loss of credibility of the mni bond insurers, rates are higher.

The only options seem to be to cut budgeted expenses or raise taxes. California is in a similar bind and, despite budget cuts made earlier this year, more than 20 states have identified budget gaps that combine to exceed $11 billion.

The U.S. Treasury is an attractive option for budget-closing loans. States and localities cannot run deficits but Washington can. State and local officials and their Congressional allies can argue that their problems stem from failures of Federal regulation of financial markets and that if banks can be bailed out, why shouldn't Washington provide short-term help to state and local governments?

I imagine the National Governors Association and the U.S. Conference of Mayors are working hard on this question right now.

Washington's challenge - Obama's or McCain's challenge - will be to respond in such a way that the short-term pain of state and local fiscal adjustments is reduced while changes in long-term fiscal practices are made. Federal crisis assistance to state and local governments should come with conditions that are as thought-through and as tough as new regulations being prepared for the financial sector.