Municipal Market and Policy Monthly: Special Focus . Without a Return to Fiscal Federalism, State and Local Governments are in deep trouble.

By George D. Friedlander, Executive Director, George Friedlander and Associates.

[email protected]

 Executive Summary.

State and local governments are going to be in deep budgetary trouble without massive financial help from the Federal government. The Center for Budget and Policy Priorities estimates that state budgetary shortfalls over the next three years will be approximately $650 billion. We are expecting local shortfalls of roughly half that amount, putting the total and roughly $1 trillion, not including the need to help support families and individuals that experience severe financial crises related to the Pandemic, either from job losses or from the illness itself. Of course, beyond the three year period, the structural damage to budgets resulting from the ongoing damage will not magically disappear, and will lead to further damage in terms of reduced services, ongoing layoffs and reduced capacity to respond to ongoing major issues such as climate change. The implications of these troubles are relatively easy to identify:

• ·       Deep cuts in public employee payrolls that are already beginning to appear, and will likely expand rapidly within a matter of weeks and months.
• Corresponding deep cuts in needed services both in terms of first responders such as police fire and healthcare, and in terms of essential longer term activities such as pre-k-12 education and higher learning.
• ·       Massive, corresponding deep cuts in credit ratings for state and local governments that are already beginning—Moody’s cut the outlook for the ratings for ALL states from “neutral” to “negative” on April 30. More piecemeal, but also much deeper cuts in ratings seem inevitable, with both revenue generating entities and local governments facing deep cuts in ratings, and in market access for any new financings.
• ·       Erosion in the economic well-being of the entire nation, that will be extremely difficult to reverse if state and local governments are forced to make deep budget cuts that eat into essential services, employment, and sources of future economic growth.

The “good news,” such as it is, is also relatively straightforward:

• The Federal government is fully capable of filling a large chunk of the impending holes in state and local budgets, given the extremely low borrowing costs and broad debt capacity, as Paul Krugman notes and we discuss below.
• Using basic concepts of fiscal federalism, the case for filling these gaps is strong and straightforward, having little to nothing to do with the political ideas contained in Mitch McConnell’s description of “Blue State Bailouts.” Indeed, in more normal times, the net providers of surplus revenues to the Federal government have been largely the states current most in need of budgetary support. And, the states that have faced the largest need for support related to major weather disasters have NOT been these “Blue States,” but rather more Republican-dominated states in many cases.
• Be that as it may, the case for reliance upon concepts of fiscal federalism as a way to avoid the deepest components of the crisis described herein is strong, and can be effectuated without at all getting into issues related to any issues of claimed historical “wasteful spending: The roughly $1 trillion the Speaker Pelosi has proposed as support for state and local governments can easily be divided up based upon calculations of increased spending needs and reduced revenues that are very -Pandemic-specific, leaving issues related to so-called “wasteful spending” for another time and place.

We end by noting two factors. The first is that the size of the projected state and local fiscal “hole” could easily become deeper and more difficult to repair if the nation experience a second peak in the Pandemic, as many epidemiologists anticipate. In that sense application of precepts of fiscal federalism are simply ways for the nation to reduce the riskiness for economic growth that could accompany such a second round. The second is that, beyond the end of the Pandemic—whether in 12, 18 or 24 months, there is another key partnership “lurking” just beyond: the need to better fund infrastructure and a vast set of financings related to aspects of climate change, including population resettlement, resilience, sustainability and related factors. If state and local governments are permitted to “fall down the rabbit hole” without support from Federal sources, the damage to fundkng for subsequent needs will bevast and extremely damaging to our outlook.

When all is said and done, it is essential that the Federal government return to precepts of fiscal federalism that were once vastly more well-identified and popular, but that are becoming essential once again as the nation fights the ongoing Pandemic.

Final note: In our view, it is extremely important to maintain distinctions between payments to states under fiscal federalism, as discussed below, and dramatically increased access to liquidity facilities and new financing mechanisms for municipal securities as included in the CARES ACT and as supported for expansion by a number of key state and local organizations, including the GFOA, the National Governors’ Organization, and related entities. While the latter are going to be extremely important as sources of financing for key projects, they CANNOT work effectively, in many cases, in the absence of Federal fiscal support that prevents the budgetary and governmental employment crises we describe above and detail below. Ultimately, state and local governments are going to need the “belt and suspenders” support that can only be generated by A COMBINATION OF the two types of support. Realistically, three-year type liquidity facilities will be extremely important for many issuers, as budgetary shortfalls emerge. However, these can only work if combined with the fiscal support that comes from direct Federal payments to state and local governments that relate directly to pandemic-induced budgetary gaps.

Final note: as of Monday, May 4, House Appropriations under the aegis of Chairwoman Nita Lowey was working on separate financial packages for States, Cities and Counties. The National League of Cities, specifically, was asking for $500 billion for cities alone. Clearly as projections of potential illnesses and deaths move higher, projections of budgetary deficits at all levels of government will continue to move higher as well. How these will fare on the Senate side remains to be seen. 

I.                  Introduction: Remember Fiscal Federalism? 

The crisis facing state and local governments--and their employees--is pretty straightforward:

1)State and local governments are going to be in deep budgetary trouble from damage to revenues and increased needs for expenditures that will extend well beyond the peak of the COVID-19 crisis, unless the Federal government intervenes. The Center for Budgetary Priorities recently raised its estimate of state shortfalls over the next three years, directly attributable to the Pandemic, at $650 billion. Shortfalls for local governments and special purpose entities are likely to be close to half that amount, putting the aggregate “hole” directly attributable to the Pandemic at close to $1 trillion, not including any anticipated moneys needed to be spent by state and local governments to deal with financial crises being experienced by families and individuals, either from job losses or from the illness itself. 

https://www.cbpp.org/blog/new-cbo-projections-suggest-even-bigger-state-shortfalls

As the CBPP reprt notes, “underestimating its effects would have grave consequences for state budgets and thus for families, businesses, and communities. If federal aid ends too soon, states will have to depend much more heavily on spending cuts and tax increases to balance their budgets. Accordingly, the next relief package should include a large new round of fiscal relief, using “triggers” based on job market conditions to determine when assistance phases up or phases out.

2) Of course, the cumulative gap doesn’t magically end after two years; reductions in tax and revenue-producing activities will continue beyond that period, given the damage that has been done to revenue producing activities, and the expanded costs state and local governments will face from healthcare-related activities and needed support for families and individuals facing personal financial crises.

3) As described in the Washington Post article below, derived from League of Cities research, the impact of this pattern would be deep cuts in the essential employees needed to maintain the services provided by state and local governments in a "normal" economy.

4) As described by Paul Krugman, also below, the Federal government has the fiscal capacity to prevent a very large portion of this crisis.

5) Capital markets solutions will help, but not solve the problem. Activities so far have largely been aimed at expanding market liquidity, such as through Fed purchases of paper maturing in three years or less. However, for many states, the Fed’s municipal lending facility will likely be of limited use due to borrowing restrictions; nevertheless, this won’t stop Republicans from suggesting that it obviates the need for broader financial relief. Also, it may be worth noting that state balanced budget requirements are often in state constitutions or otherwise difficult to get around or overturn. 

6) Consequently, state and local governments need to be made whole in a budgetary sense, in a way that only Federal government resources can provide. Only by applying Fiscally Federalist principals can this be accomplished, starting with the proposals from Senator Menendez aimed at adding $500 billion in grants, revenues and subsidies, and the more comprehensive $1 trillion proposal articulated by Speaker Pelosi.

7) Subsequently, governments will need to prepare for the "next round" of capital markets borrowings/expenditures, such as for climate change/resiliency/protection against weather-related events. However, state and local governments can only begin to accomplish this if their budgets are in reasonable shape, with the support of the Federal government.

8) It is essential to stress that none of what we are referring to related to “blue-state bailouts” as defined, with apparent sarcasm, by Majority Leader McConnell. The shortfalls in revenues we refer to relate to a) deep reductions in a wide range of economic activities related to a) stay-at-home orders; b) badly damaged economic activities such as meat production that will only get worse as the pandemic broadens into additional geographic locations. but also to c) fears of non-socially- distanced economic activities such as mass transportation and airline travel. Given these patterns, in our view it is, frankly, disingenuous to attempt to relate the massive budgetary shortfalls to prior policy decisions that led to “excess spending” in some states. Policy wars can be waged later. What is going on now relates to broad based increases in needed spending and revenue shortfalls that are a direct result of responses to the pandemic.

9) The policy decisions needed to keep the current budgetary and policy crisis from getting broader and deeper relate directly to two key components of Fiscal Federalism: a) That the budgetary damages the kind of broad and deep disaster-related crises that the Federal government has historically stepped in to fill the breach, not at all dissimilar to major weather events, but with a broader geographic sweep; and that b) as noted by Dr. Krugman below, the Federal government has both the deep capacity and the access to very-low-cost borrowings needs to bring in needed moneys, that it can then disburse as needed to prevent worst-case scenarios that would include massive layoffs, further economic erosion, and further dimunition of needed governmental services including education, police, fire, healthcare and other types of “first responders.”

10) We also note that just as we were going to press, Moody’s lowered the outlook for the entire state sector to “negative” from “stable,” indicating that the agency anticipates severe budgetary disruptions across a broad swath of states as a consequence of the financial pressures generated by the COVID-19 pandemic, and The Center on Budget and Policy Priorities (CBPP) increased their forecast of U.S. state budget shortfalls from $500 billion to $650 billion over the next three years. We note, crucially, that given nearly universal state balanced budget requirements, these massive shortfalls will translate into massive layoffs and cuts in essential services, as discussed below in Section II.

II The deep cuts in jobs are beginning to reach public employees.

In an article dated April 30, The Washington Post takes a week-by-week look at the sectors of the economy that are losing the most jobs—in an environment where identified unemployment has reached 30 million, but with many other parts of the workforce either not yet identified or making less-than normal income

" After that first chaotic week of lockdowns mid-March, as officials scrambled to slow the spread of the deadliest pandemic in more than a century, restaurants and theaters saw job losses slow while losses in other sectors, such as construction and supply-chain work, accelerated. Now, it appears the economic upheaval is hitting professional and public-sector jobs that some once regarded as safe. 3.8 million Americans sought jobless benefits last week, extending pandemic’s grip on the national workforce

“The Labor Department doesn’t release jobless claims by industry. So, building on the work of economist Ben Zipperer and his colleagues at the Economic Policy Institute, we analyzed industry-specific new unemployment-benefit claims from 14 states that publish them. “

https://www.washingtonpost.com/business/2020/04/30/jobless-claims-industry/?utm_campaign=wp_post_most&utm_medium=email&utm_source=newsletter&wpisrc=nl_most

Is noted by The Post that in the last week covered--April 12-18--the gutting of jobs was now beginning to reach the Public Sector:

"Week 5, April 12 to 18: The public sector administration)

"In the week ending April 18, the most recent for which we have data, we can no longer avoid one of the most ominous trends in the entire analysis: a rise in public-sector layoffs. Utilities, public administration and education services — all of which have close implicit or explicit ties to state and local government, were among the worst-faring sectors on a weekly basis. To stem the tide of what could be millions of job losses and furloughs, the National League of Cities is pushing for a $250 billion bailout of cities throughout the country, colleague Tony Romm reports.. State and local governments are typically required to balance their budgets. And now that they’re staring down the barrel of a huge tax-revenue shortfall, “these revenue losses are going to cause government budgets to fall and they’re going to lay people off,” Zipperer said.

“You’re seeing the beginnings of a big contraction in the public sector,” he said. “That’s going to be the next huge thing.

The public sector used to be the bulwark that kept the economy going while the private sector pulled back during a recession, Zipperer said. “Over the last couple of recessions, the public sector hasn’t played that traditional role,” Zipperer said. “As a result, we’ve seen steeper recessions and slower recoveries.” “The impact of the COVID-19 coronavirus is more significant than any of us could have ever expected for our well-being, as well as our municipal financial stability,” Rios reports that officials wrote in a letter to furloughed employees.

State and local governments are typically required to balance their budgets. And now that they’re staring down the barrel of a huge tax-revenue shortfall, “these revenue losses are going to cause government budgets to fall and they’re going to lay people off,” Zipperer said. “You’re seeing the beginnings of a big contraction in the public sector,” he said. “That’s going to be the next huge thing." The public sector used to be the bulwark that kept the economy going while the private sector pulled back during a recession, Zipperer said. “Over the last couple of recessions, the public sector hasn’t played that traditional role,” Zipperer said. “As a result, we’ve seen steeper recessions and slower recoveries.” This outcome seems inevitable for the current, ongoing recession, in the absence of extremely substantial Federal support. And, of course, severe cuts in service will entail, that will hinder the entire US economic outlook and rebound well beyond the end of the Pandemic itself.

Clearly, this outcome is by no means inevitable. As noted in The Hill, on April 30, House Speaker Nancy Pelosi indicated that Democrats will push for including almost $1 trillion in the next coronavirus relief package to help states and local governments hit hard by the pandemic. That figure would likely be the single largest line-item of the Democrats' next emergency package, known as CARES 2, which is also expected to include hundreds of billions of dollars more to help workers, businesses and families weather the crisis. However, this major support for state and local governments is by no means a "done deal." As was also noted in "The Hill," the contents of this new proposal foreshadow a fierce fight with Republicans in the Senate, where GOP leaders had rejected any new funding for state and local governments in the last "interim" coronavirus bill, enacted last week, and are wary that any new help for states going forward would “simply bail out governors for fiscal mismanagement preceding the health crisis,” in our view a factually incorrect way of describing what is now going on.

III.             The case for major support of state and local governments is extremely strong, in our view.

First of all, the idea, as stated by Senator McConnell, that any such major aid to state and local governments simply represents a "Blue States bailout" is simply incorrect in our view. As has been noted by Governor Andrew Cuomo and others, during NON-CRISIS periods, nearly all of the states that take in more moneys from the Federal government than they disburse are co-called "Red States," as shown in this article from USA Today:

https://www.usatoday.com/story/money/economy/2019/03/20/how-much-federal-funding-each-state-receives-government/39202299/

Going a bit deeper, the following is the Rockefeller Institute report on net payments to and from the Federal governments, which further shows that the idea of a “Blue State Bailout” is simply wrong.

https://rockinst.org/issue-area/balance-of-payments-2020/

As this detailed and comprehensive report shows,

“ The New York State per capita balance of payments, -$1,125, continues to rankas one of the least favorable in the nation. New York’s negative per capita

balance of payments is less than all but three other states. The Federal per capita balance of payments in 2018 is $2,063. New Yorkers

pay $3,188 more than this average. Since 2015, the average annual excess burden for New York residents per

capita has been $3,235. The aggregate balance of payments for New Yorkers during this time period was over $116 billion.

The initial impact of the Federal Tax Cuts and Jobs Acts of 2017 (TCJA) can be seen in the preliminary estimates for 2018. The TCJA has shifted revenue collection

from corporate income tax to individual income taxes. The share of Federal revenue generated from individual income taxes grew from 50.3 percent in 2017 to 53.0 percent

in 2018. This shift places a larger portion of the Federal tax burden on states with a greater number of high-income earners, such as New York.”

As the report shows, the three states with the largest negative balance of payments for FY 2018—greater payments to the Federal governments than receipts in the form of Federal expenditures—were New York (-$21.9 billion), New Jersey (-$11.5 billion, Massachusetts (-$9.1 billion) and Connecticut (-$8.0 billion). It is clearly worth noting that all of these states fall into the category of having much greater than average fiscal damage from COVID-19, because illnesses, deaths and reductions in economic activity that generates revenues and taxes have clustered in this part of the Northeast. As the report also shows, at the other extreme, the three states that have the highest net positive balance of payments—receiving sharply more in Federal expenditures than they pay in taxes—are Virginia (+$96.9 billion), Maryland (+$47.9 billion) and Kentucky (+$45.2 billion.) Going from best to worst, the states with the most extreme difference in balance of payments was from Virginia to New York, with an annual net difference for FY 2018 of $118.8 billion.

IV. The magnitude of likely public sector job cuts, lacking substantial Federal support, will be vast and deeply damaging.

In an article on April 29, the Washington Post discussed the magnitude of the threat of public sector job cuts, based upon research provided by the National League of Cities.

https://www.washingtonpost.com/business/2020/04/29/cities-states-layoffs-furloughs-coronavirus/

“Mass layoffs begin in cities and states amid coronavirus fallout, threatening education, sanitation, health and safety. Millions of municipal workers could find themselves out of a job or without pay, according to local leaders, who say programs would fall into disarray unless Washington intervenes.”

As the article notes, “Facing an urgent financial crisis, these and other cities and states nationwide are eyeing dramatic reductions to their workforces, threatening critical public-sector employees and first responders at a time when many Americans may need their local governments’ help the most. Even as President Trump and top Republicans contend that only big-spending, liberal-leaning states are to blame for mounting budget woes, a Washington Post review found the economic havoc wrought by the novel coronavirus is far more widespread — saddling Democratic and Republican mayors and governors alike with souring finances and major revenue gaps. Some local governments have already started laying off or furloughing thousands of their workers, and the numbers are likely to grow markedly in the absence of federal aid. Among municipalities, the new budget cuts could be profound: Between 300,000 and 1 million public-sector workers could soon be out of a job or sent home without pay, according to an estimate from the National League of Cities. The steep reductions in staffing levels could affect education, sanitation, safety and health, local leaders warn, potentially leaving critical public services in disarray.

We further note that the damage to the functioning of state and local governments is highly likely to extend BEYOND the pandemic, even assuming that by fall 2021 or so, a vaccine becomes available and begins to be widely distributed, a hope, not a given. The following article discusses some of this:

https://gen.medium.com/the-harsh-future-of-american-cities-7263da52fd1f

As the article discusses, many major US cities face a “harsh future that is likely to be deeply exacerbated by the Pandemic.”

“for years after, American cities and towns seem likely to see untold scars of both the pandemic and the depression-like recession. On the nation’s current trajectory, one of the most probable post-Covid future scenarios in our cities is stark austerity, with empty coffers for the very services and qualities that make for an appealing urban life — well-paying jobs, robust public transportation, concerts, museums, good schools, varied restaurants, boutiques, well-swept streets, and modern office space. There will be hopping pockets of the old days with adjustments for pandemic safety, but for years, many businesses could be shuttered and even boarded up, unable to weather Covid-19 and the economic downturn. Joblessness will be high, and many of the arts may go dark. What kind of calendar are we looking at? The U.S. is a can-do nation, but don’t be surprised if we are still having this conversation late next year and even in 2022 and are observing a very different urban look and tone then and beyond.”

The risk of this goes back to our main point: ONLY IF the Federal Government spends deeply in order to prevent the austerity, desolation, and sharp reduction in quality of life in our main cities, can we express the hope for a return to the viability needed for cities and other local governments to play their needed role in the growth and revitalization of the country, post-Covid. In our view, this is indeed an ironic concern, given the pre-pandemic patterns of growing urbanization occurring in the US and most other major nations. It really gets this simple: if the Federal government doesn’t take on the greatly heightened fiscal federalism we believe it must, the economic engine provided by growing urbanization will erode and rust for a substantial number of years.

V.             Brookings enter the fray

https://www.brookings.edu/blog/the-avenue/2020/04/28/the-next-covid-19-relief-bill-must-include-massive-aid-to-states-especially-the-hardest-hit-areas/?utm_campaign=brookings-comm&utm_source=hs_email&utm_medium=email&utm_content=87294198

In an article dated April 28, Mark Muro, Senior Policy Director at Brookings, noted that:

“Amid rising layoffs and rampant uncertainty during the COVID-19 pandemic, it’s a good thing that Democrats in the House of Representatives say they plan to move quickly to advance the next big coronavirus relief package. Especially important is the fact that Speaker Nancy Pelosi (D-Calif.) seems determined to build the next package around a generous infusion of aid to hard-hit state and local governments.

Five weeks ago, my colleagues Timothy J. Bartik, Brad Hershbein, Bryan A. Stuart, and I made the case for early and substantial aid to these governments, and in recent weeks, so have Brookings’s Matthew Fiedler and Amy Liu, the Economic Policy Institute, the Center on Budget and Policy Priorities, Vox’s Dylan Matthews, and many others.

All of us argue that while the most heart-rending costs of the recession are the human ones, some of the most insidious pain will emanate from a coming crisis within state and local governments: collapsing revenues, increased demand for safety net programs like Medicaid, and the direct costs of leading the COVID-19 response. In that vein, all of us estimate that states and localities will face revenue shortfalls in the hundreds of billions of dollars by the end of 2021, which will force them to make deep cuts in public services.”

These article note that for state and local leaders, the economic troubles stem from the precipitous drops in revenue that have come as a result of closed businesses and sharp decreases in shopping and travel. However, we expect that the pressures on budgets will go well beyond these revenue patterns, including a need for spending to maintain and/or restore the economic viability of quite literally millions of families and individuals, including a restoration of economic activities that have become a fundamental component of the American way of life. We harken back to the governmental shutdown of early 2019, when many hundreds of thousands of individuals and families were reaching a personal budgetary crisis after only a handful of weeks without pay. In this cycle, for many Americans, the income losses are likely to be vastly longer, and in many cases, include more members of a single family. How, we wonder, will these individuals and families be made whole, without considerable, lengthy assistance from states and local governments? We just do not see an answer to that. And where, then, do the states and local governments acquire the needed cash,if not from the Federal government?

And yet, the quest for support from the Federal coffers has been met with staunch political resistance from Republicans, including Senate Majority Leader Mitch McConnell (R-Ky.), who at one point suggested states should have the option of falling into bankruptcy. Top Trump administration officials have echoed that skepticism and signaled that any aid would come with conditions: On Tuesday, for example, the president said he would approve money only if states cracked down on immigration policies in “sanctuary cities.” When posited this way, frankly, the limitations from the right are highly cynical and clearly political, not economic. We would argue, strongly, that during this extreme economic crisis,  political considerations need to be pushed aside, in order to permit the US economy to become viable once again as soon as possible after the worst of the Pandemic has past.

VI. Loss of capacity to earn revenues at a wide number of types of project facilities, with parallel crisis level cuts in many services.

We note that the loss in revenue and erosion of services in far from being contained within state and local general fund budgets. The rather spectacular decline in use of many revenue-generating facilities has be magnified by the need for social distancing, but will not end, we expect, with instructions from governors in a number of states to move beyond stringent social distancing mechanisms—as a consequence of fears about COVID-19 contagion in crowds, continued work-at-home activities and tendencies, and extreme declines in demand for many goods and services that preclude large increases in employment. In the latter case, we cite restaurants as a single example: in many states, rules for opening restaurants limit use to 25% or so of seating, or require use of outdoor seatings. In any event, state and local facilities that will continue to experience enormous cuts in use include mass transit, airports/ports, tolled highway facilities, charter schools, and very importantly, higher education facilities, many of which will risk being in fiscal insolvency if they are unable to open to a sufficient degree for the 2020 fall semester. Indeed, it will be an important function of now-functionally insolvent state and local governments to retain and maintain the use of these important facilities and activities, in order to prepare for a theoretical economic rebirth once the pandemic is fully controlled, hopefully by broad introduction of an effective vaccination. And, of course, any inability to retain and maintain will accompany with it a severe, parallel drop in labor force participation and compensation—and severe cuts in ratings, discussed in section __ below.

VI. This is all about Fiscal Federalism

While federalism as defined throughout US history has many components, what we are dealing with here is mostly related to two key aspects of Fiscal Federalism, as noted above. Namely, it relates to a) the capacity of the Federal government to borrow funds at the lowest possible costs, and b) the capacity of the Federal government, during severe “fore majeur-level” crisis, to disburse those funds to state and local governments that needs additional funds in order to perform needed activities support economic growth, reduce recessionary effects and retain needed staff, while maintaining a balanced budget. As noted in Wikipedia, Fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government. In other words, it is the study of how competencies (expenditure side) and fiscal instruments (revenue side) are allocated across different (vertical) layers of the administration. An important part of its subject matter is the system of transfer payments or grants by which a central government shares its revenues with lower levels of government." In this case, of course, it relates to the ongoing collapse in revenues at the state level (and below), ongoing increases in expenditure requirements.” This, indeed, is what the current fiscal environment is all about: state and local governments cannot possibly maintain their budgets at needed levels without support from the Federal government that can be, and ought to be, made available.

VII.               Sources of budgetary shortfalls.

Clearly, the budgetary shortfalls resulting from the Pandemic are going to come from a number of sources, which are worth noting in this discussion.

·        On the revenue side, massive cuts in economic activity are gutting all kinds of tax receipts--income taxes, sales taxes as retail activity diminishes, and ultimately, property taxes for both commercial and residential properties.

·        On the expenditure side, a very substantial need for governments to make individuals and families whole as their employment activities provide severe and log-lived diminishing returns.

·        Further, there is a serious risk of one or more additional rounds of the Pandemic which will add to tax shortfalls and increase expenditure needs. While medications are beginning to show up that MAY reduce the severity of COVID-19 in its acute stages (e.g., Retrovir), we have yet to see any evidence that there is not likely to be at least one more peak round of the pandemic before a viable vaccine is discovered, tested, and introduced to a broad swath of the public. This is an essential point: we cannot wait, on a hoe and a prayer, that we will not see additional peaks in the Pandemic before a successful vaccine can be discovered, approved and broadly distributed, which many epidemiologists believe could take an additional 12 months at the short, “lucky” end, and 18 months or more at the “riskier” end. Of course, anywhere withing the 12-18 month range, there are going to be state and local fiscal insufficiencies that lead to downgrades, payroll cuts and termination of essential service activities and projects.

VIII.             As Paul Krugman notes, the Federal government CAN accomplish this.

The capacity of the Federal government to cure a large chunk of this if it choses to do so, as described by Krugman

  https://www.nytimes.com/2020/04/27/opinion/republicans-deficits-coronavirus.html?searchResultPosition=1

As Krugman notes emphatically, Almost a decade has passed since he published a column, “Myths of Austerity,” warning that deficit alarmism would delay recovery from the Great Recession — which it did. Unfortunately, as he further notes, that kind of alarmism seems to be making a comeback.

 “You can see that comeback in the gradually increasing number of news analyses emphasizing how much debt we’ll run up dealing with the Covid-19 crisis. You can also see it in the rhetoric of politicians like Mitch McConnell, the Senate majority leader, who is blocking aid to beleaguered state and local governments because, he says, it would cost too much.” So this seems like a good time to emphasize two key facts. One is economic: While we will run very big budget deficits over the next couple of years, they will do little if any harm. The other is that whatever they may say, very few prominent figures in politics or the media are genuine deficit hawks, who are actually worried about the consequences of rising government debt. “

Still, hypocrisy aside, Krugman asks, “should we be worried about the effects of Covid-19 on debt? No.”

It’s true that we’re headed for some eye-popping numbers. Last week the Congressional Budget Office released preliminary economic and budget projections for the next two years, which were both shocking and unsurprising.

That is, the numbers were grim but more or less in line with what many independent economists have been predicting. In particular, the budget office expects the Covid-19 crisis to drive the unemployment rate to 16 percent in a few months, which might even be on the low side. As Krugman notes, soaring unemployment will cause federal revenues to plunge, and also lead to a surge in spending on safety-net programs like unemployment insurance, Medicaid and food stamps. Add in the large relief packages Congress has passed, and the budget office projects a deficit that will temporarily rise to levels we haven’t seen since World War II, and it expects federal debt to rise to 108 percent from 79 percent of G.D.P., which sounds scary.”

 But, as he notes, the government will be able to borrow that money at incredibly low interest rates. In fact, real interest rates — rates on government bonds protected against inflation — are negative. So the burden of the additional debt as measured by the rise in federal interest payments will be negligible. And no, we don’t have to worry about paying off the debt; we never will, and that’s OK.”

 And, perhaps underemphasized in that discussion is the amount of long-term damage to be done to the national economy if a) states are not made close to whole, b) as a consequence, services such as education, police and fire are permitted to collapse, c) state and local debt ratings move sharply lower, with at least some service insolvencies at the local level; and d) also as a consequence, the vast amount for needed capital construction—on infrastructure generally, but especially related to climate change and its “ close cousins” of sustainability and resiliency—are permitted to lie fallow for a disastrously high number of years.

VII.          How to disburse the proceeds of such an endeavor.

This, as they say in Great Britain, is a “sticky wicket” that we shall attempt to analyze more deeply in a subsequent Paper. Suffice it to say that there ought to be ways to measure the decline in revenues and the increase in needed expenditures that relate specifically of the impact of the Pandemic, and disburse Federal moneys first and foremost on those identifiable gaps. We also note that as we were preparing for publication, two authors placed an op-ed in The Washington Post dealing with this very topic: “Here’s a fair approach to calculating covid-19 specific aid to the states,” authored by Robert Inman and David Skeel.

https://www.washingtonpost.com/opinions/2020/05/05/heres-fair-approach-calculating-covid-19-specific-aid-states/

As they suggest: “Congress should act as the insurer of last resort, covering the extraordinary costs of the covid-19 disaster. But it should not bail out past excesses; nor should it replace revenue loss that would have been caused by an ordinary recession, since fiscally responsible state and local governments should have rainy-day funds for that.” The aggregate costs they identify include tax losses and revenue on the revenue side, and expenditure increases related to unemployment claims and healthcare needs on the expenditure side. (We suspect that there are considerable additional expenditure needs, for food, housing, and prevention of personal bankruptcies, but it’s a start.) The main point is clear: there will be ways to calculate aspects of fiscal federalism that relate ONLY to COVID-19 budget holes, and these can be kept separate and distinct from historical budgetary decisions.

To calculate the extraordinary costs related to the pandemic, it is necessary first to identify the revenue state and local governments are losing. This consists of lost income and sales taxes, as well as fees and other revenue that have dried up with the absence of economic activity. Add that to the cost of surging unemployment claims — which have already increased six-fold from 2019 levels — and the unusually high health-care expenditures.

VIII.        Additional Conclusions:

1.    There is a “death spiral” aspect to Federal unwillingness to provide deep budgetary support: if state and local governments are unable to maintain reasonable budgetary levels, they will face severe additional credit rating downgrades, while also becoming unable to meet post-Pandemic funding needs. Some local governments would likely reach a status of “service insolvency,” within which their capacity to provide needed governmental services would become deeply at risk .

2.    This pattern would drive back over into lower credit ratings, loss of borrowing capacity, and an inability to fund key projects.

3.    We finish by noting additional challenges related to future funding needs, as for infrastructure, climate change responses, resiliency and sustainability. 

The ultimate implications of all of this are that in the absence of support for states and local governments through fiscal federalism, the US faces severe damage to long-term economic growth and competitiveness, that will not be easily reversed.

 Final Note.

In our view, it is extremely important to maintain distinctions between payments to states under fiscal federalism, as discussed above, and dramatically increased access to liquidity facilities and new financing mechanisms for municipal securities as supported by a number of key state and local organizations, including the GFOA, the National Governors’ Organization, and related entities. While the latter are going to be extremely important as sources of financing for key projects, they CANNOT work effectively, in many cases, in the absence of Federal fiscal support that prevents the budgetary and governmental employment crises we describe above. Ultimately, state and local governments are going to need the “belt and suspenders” support that can only be generated by A COMBINATION OF the two types of support. Realistically, three-year type liquidity facilities will be extremely important for many issuers, as budgetary shortfalls emerge. However, these can only work if combined with the fiscal support that comes from direct Federal payments to state and local governments that relate directly to pandemic-induced budgetary gaps.

About the Author

Mr. Friedlander is has been a leading Municipal Market Strategist and Policy Analyst for the past 44 years, spending 41 of those years at Citigroup and predecessor firms. He currently writes a monthly piece on trends and issues in the municipal bond sector, including key policy issues affecting state and local governments that have spillover implications for municipal credit and the functioning of the municipal bond market. He is currently an Affiliated Fellow at the Rockefeller Institute’s Future of Labor Research Center, where he researches and writes about issues that link labor patterns to the functioning and creditworthiness of state and local governments, and ultimately how all of that will link to technological change and climate change.