Coronavirus shutdowns will decimate state and local governments after a delay

Some of the most delusional people (from an economic perspective) that I have spoken to lately are people who (1) work for government agencies, or (2) are retired government employees who rely on pension income to pay their bills.

As someone who spent over a decade working as a government economist and structuring public bond deals, I can tell you this is going to be a financial event for state and local governments unlike anything anyone alive has ever seen. It will be about ten times worse than the Great Financial Crisis of 2008 (and even more if you live in places like California, Washington state, Illinois, New York, New Jersey, Connecticut, or Kentucky), which prompted thousands of layoffs in the public sector. But many in the public sector don’t know that yet.

The Federal Reserve has included state and local governments in their commercial paper program, which allows them to borrow short-term to fund operations. But that’s not a grant program – it’s a lending facility. It’s not even intended to protect state and local governments. It’s intended to protect the large financial institutions that buy their short-term debt so they do not book those losses in the middle of this event and create a financial contagion.

The federal government has never had and likely never will have any desire to fully backstop the finances of 50 states, some of which represent economies larger than most countries. The financial burden would be unthinkable. We’d truly become a Venezuela or Argentina.

One of the biggest differences between the federal government and state governments is that state and local governments actually have to balance their budgets. They don’t have a blank check to fund their bureaucracies forever, and bureaucrats definitely do not have safe jobs after a financial crisis.

The federal government can borrow in the bond market to finance a deficit (within practical limits, as we are seeing now) and it can even outright print money (within practical limits, at some point your currency has to mean something).

State governments do not have that luxury. The only things they borrow money for are long-term capital projects like infrastructure and short-term borrowing to smooth cash flows only until they receive tax revenues from residents and businesses. Their constitutions require them to balance their budget every year. Local governments rely on property taxes, and I think it is safe to say the real estate bubble is over.

Some states have historically done things that are tantamount to deficit financing if you think about them philosophically. One big example that comes to mind is giving their pension beneficiaries IOUs on required contributions to the pension fund. But they are limited in their ability to do that, since many pensions now are already dramatically underfunded thanks to decades of diverting money from pension contributions to pork spending. This is on top of major losses in the financial markets that pensions will report in June. Stuff like this has already left a number of states with considerable structural budget gaps, even before coronavirus.

Some states are a month into forgoing tax revenues indirectly, by shutting down the means that businesses use to generate taxable profits and that residents contribute via taxes on their personal spending. There will be a paperwork-driven delay in when that hits the books, but it will hit at some point this year. And it will be the ugliest financial reality states have encountered since WW2.

They’ll probably see 30% or more declines in the revenues they collect within a year by my reckoning. Since public education, Medicaid, and public pension funding are the largest expenditures in state budgets, there will be mandatory cuts to all of those things. States can totally and utterly wipe out spending from categories other than those three and they still will not balance their budgets after this. This event is going to take out classroom spending and health care benefits.

State and local government workers will be laid off for this, but it will probably come after the private sector has gone back to work and states get around to tallying up the carnage.

Even a strong recovery after the shutdowns end will not mitigate the effect. This shutdown is destroying firms. You can say that “people will just go back to doing what they were doing” after a couple months, but that is not how economics works. It takes capital to start and operate a business, and the government has arbitrarily nuked that capital. Employees can’t go back to work at companies that went bust. That should be an obvious point, but it somehow isn’t to policymakers.

The other component of this is that alongside a spectacular decline in government revenues there will also be a spectacular uptick in demand for government services. Since we are talking about a large part of the workforce being put out of service and applying for unemployment and other benefits, you are looking at billions of dollars in new demand for services. That is going to conflict with core government services (like public education) for funding.

You can think of this as the analog to destroying capital in the private sector. Money spent on new demands for services is money that won’t be available to pay a school teacher or purchase textbooks.

This means that core government services are being hit from both sides. Even states in the best financial position (meaning they have robust rainy day funds) are not going to be exempt from this reality. They are going to blow through that money in no time. The states with little to no reserves are beyond fucked. The cost will go right to budgeted priorities.

This is only now starting to dawn on policymakers. It was always a stupid policy decision, but seem people need to be slapped upside the face with the consequences before they understand what they have done.

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