Home – Are States Ready For The Next Economic Downturn?

Are States Ready For The Next Economic Downturn?

 The way this year began - with a stock market correction that saw the Dow, NASDAQ and S&P 500 indexes all drop more than 10 percent by mid-February followed by an estimate from the Atlanta Federal Reserve that the U.S. economy grew less than 1 percent in the first quarter - undoubtedly had many state lawmakers reflecting on the Great Recession as they worked on budgets for next fiscal year. The market has rebounded since then and the Atlanta Fed’s forecast for the second quarter was a bit more encouraging, 2.2 percent annualized GDP growth. But the question remains: How prepared are states for the next major economic downturn?


The U.S. economy is in its seventh straight year of expansion, the fourth-longest streak since World War II, according to an August 2014 report from The Economist and data from the National Bureau of Economic Research. That report also indicated that the longest post-war expansion lasted only ten years, from 1991 to 2001, while the average for the three longest post-war expansions is just under 8 years. So the odds are another downturn isn’t far off.


Nearly eight years after the Great Recession, some states are in better fiscal shape than others. A study released this month by the Mercatus Center at George Mason University, ranked Kentucky, Illinois, New Jersey, Massachusetts and Connecticut as the least fiscally healthy states overall. Based on their 2014 annual financial reports, those states had “massive debt obligations” and tens to hundreds of billions of dollars in unfunded pension and health care benefit liabilities, “constituting a significant risk to taxpayers in both the short and the long term.” But even the top-ranked states in the Mercatus study - Alaska, Nebraska, Wyoming, North Dakota, and South Dakota, all of which had plenty of revenue and cash on hand and relatively little short-term debt as of FY 2014 - weren’t completely free of fiscal challenges. The decline in oil prices has been threatening the short-term solvency of Alaska and the other oil-producing states, while all five face long-term fiscal pressures related to their pension and health care systems.


One area of the study that seems particularly relevant to a discussion of states’ recession readiness is a measurement the Mercatus researchers refer to as “service-level solvency,” or “how much fiscal ‘slack’ a state has to increase spending should citizens demand more services.” During the Great Recession, Medicaid spending increased by nearly 15 percent, according to the Kaiser Family Foundation.


Mercatus’ service-level solvency ranking is based on three ratios: taxes, expenses and revenues compared to state personal income, with states having higher levels of the former in relation to the latter potentially encountering “difficulty obtaining increased revenues in a sudden downturn.” The two states at the bottom of that ranking - Alaska and North Dakota, owing largely to their dependence on volatile oil revenues - were among those that ranked highest in fiscal performance overall. New Mexico and Vermont topped the service-level solvency ranking. (For more on the subject see Bird’s eye view.)


If another recession does come soon, states will likely get less help from Washington than they did during the Great Recession. Back then, as New York Magazine’s Annie Lowrey reported in March: “Ben Bernanke’s Federal Reserve slashed short-term interest rates all the way down to zero. Then, it started buying huge amounts of bonds to bring longer-term interest rates down and to boost asset prices,” a policy known as “quantitative easing,” which “increased real GDP by 1.5 percent as of the first quarter of 2015,” based on an estimate from the Center for Budget and Policy Priorities.


But at that time the federal funds rate was at 5.25 percent, so the Fed had plenty of room to lower short-term interest rates. With that rate now standing at almost zero, the Fed would have to venture into negative numbers, a gambit that has produced “less than spectacular” results where it has been tried. There is also some question about how much room there is to cut taxes and boost spending to get the economy moving, given that the federal government has a heavier debt burden than it did when the Great Recession began.


“We know that lower debt is better than higher debt, and we know a slighter trajectory of debt is better than a steeper trajectory of debt,” said Wendy Edelberg of the Congressional Budget Office, as Lowrey reported. “We can make those qualitative statements, but it is hard to know when investors might lose confidence.”


What could matter even more is that, as Lowrey observed, the 111th Congress that passed the American Recovery and Reinvestment Act of 2009 is not the same as the current 114th.


“This is the Congress that wants to gut the social safety net, slashing spending on programs for lower-income families by 42 percent as of 2026,” she said. “This is the Congress that wants to amend the Constitution to require balanced budgets. This is a Congress dominated by a party that insists that stimulus failed, despite all of the evidence to the contrary.”


Consequently, it may be particularly important for states to fully prepare for the next recession. And there are two things policymakers need to know in order to do that, according to an April 19 article in Governing by Dan White, a senior economist at Moody’s Analytics who consults with governments on fiscal policy:


First, they should know their economies, including where they're most vulnerable during another downturn. Periodically studying the underlying economic environment, and how public policies are shaping it, is a best practice for preparing a government for changes in the business cycle. Knowing how your economy will respond and how competitive it will be with neighbors coming out of a recession are key to ensuring stronger performance during the subsequent recovery.”


“Second, policymakers need to have a thorough understanding of how a recession will affect their specific fiscal situation. Every state and local government is affected differently during a recession. While states in total lost about 5 percent of revenues during the two-year downturn of the Great Recession, some saw declines of more than 25 percent while others saw no decline for several years. Similarly, while the average state saw Medicaid spending rise by 15 percent in two years, some saw more than twice that amount while others actually saw declines.”


White said the only way for governments to determine the potential effects of a recession is through comprehensive fiscal stress testing using “alternative economic scenarios, similar to the methodologies used by many banks, in conjunction with existing revenue and social-benefit forecast models.” Moody’s Investors Service recently conducted such a stress-testing analysis on the nation’s four most populous states. The test revealed that Texas was the most prepared for a recession and California the least, with New York and Florida falling between them.


“Historically, California has shown vulnerability as the center of the highly volatile tech industry and is reliant on personal income taxes, while Florida was the epicenter of the most recent housing slump,” said Emily Raimes, a vice president and senior credit officer at Moody’s. “Texas and New York have seen lesser declines amid lower oil prices and Wall Street downturns.”


Moody’s also said Texas’ cash reserves “provide ample coverage for a major single year revenue decline” and “Florida also has adequate reserves to cover a deficit, while California and New York fall short.”


White of Moody’s Analytics said governments that haven’t started taking the steps he recommended to prepare for recession are “already behind the curve.”

“The longer it takes to get a plan in place, the more difficult the eventual solution will become and the more risk policymakers will be inviting into the economic outlook,” he said. “Recessions are inevitable, but large emergency budget cuts and tax increases don't have to be.”