US states face a fiscal crunch

California, New York and others have no choice but to cut

Across the US, the recession is confronting state and local governments with revenue shortfalls that threaten their solvency. The harder you look at their budgets, the worse their plight seems. Years of relying on accounting gimmicks disguised what was a bad underlying fiscal position even before the recession began. The downturn is a budgetary calamity in any event, but it is uncovering problems of much longer standing.

Undue budget tightening will jeopardise recovery whether applied at federal level or lower down. In principle, just as Washington should combine continued stimulus in the short term with a credible commitment to subsequent fiscal discipline, states and cities should avoid excessive tightening in 2011. But the federal government, for now at least, can borrow on favourable terms. Anxiety over state and local government debt is growing. Spreads on bonds issued by troubled states such as Illinois and California have widened in recent months. For many, a crunch is at hand.

The federal stimulus gave states hundreds of billions of dollars to ease the stress, but support tapers down this year. Ideally, help would be maintained but that is unlikely with Republicans in control of the House of Representatives. Many states are having to retrench abruptly. In California and New York, even staunchly Democratic governors are promising a tough line on spending. They have little choice: state taxes are so high that voters would refuse increases.

If the macroeconomic climate were not so threatening, and if essential services were not in jeopardy, one would applaud this zeal to make cuts. Reform is needed and would be desirable even if fiscal reality did not insist. A big problem is that public sector unions have forced pay and especially benefits out of line with private sector norms. Nationally, unfunded state pension liabilities stand at well over $1,000bn. The arresting details of these arrangements, only now receiving close attention, have become a political issue in their own right.

Year by year, governments complied with balanced budget rules and other supposed constraints by creating quasi-government agencies that could borrow, by selling and leasing back buildings and other assets, by bundling future years’ lottery proceeds, and other manoeuvres. The squeeze is now upon them; the federal stimulus is fading away; and the gimmicks are all used up. For state finances, the year of reckoning has arrived, and the timing could hardly be worse.

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