While essentially ignoring the ballooning federal deficit and the ballooning Fed balance sheet, Bernanke says states should build bigger buffers.

Federal Reserve Chairman Ben Bernanke on Monday called for states to build up larger rainy-day funds as he said consumer spending is set to sustain the economic recovery.

Bernanke said states should have taken more steps — and should do so in the future — to prepare for economic downturns. At the end of 2006, he noted, state governments had set aside 12% of their general expenditures in reserve funds.

“Given the depth of the recent recession, even these historically high reserve-fund balances proved insufficient to buffer fully the budgets of most states. Thus, state governments may wish to revisit their criteria for accumulating fiscal reserves. Building a rainy-day fund during good times may not be politically popular, but it can pay off during the bad times,” the Fed chief and South Carolina native said.

He also said states may want to “consider revenue stability along with other critical features of the tax code such as fairness, support for economic growth, and administrative costs” in what seems like coded language for broadening and deepening state food and spending taxes.

He also asked states to refrain from across-the-board spending cuts and instead look to deliver necessary services — particularly health care — at lower costs.

Text of Bernanke’s Speech

Inquiring minds are reading Challenges for the Economy and State Governments, Bernanke’s Address at the Annual Meeting of the Southern Legislative Conference of the Council of State Governments, Charleston, South Carolina. Here are a few key snips:

The Economic Outlook

After a precipitous decline in late 2008 and early 2009, the U.S. economy stabilized in the middle of last year and is now expanding at a moderate pace. While the support to economic activity from stimulative fiscal policies and firms’ restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth. In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.

To be sure, notable restraints on the recovery persist. The housing market has remained weak, with the overhang of vacant or foreclosed houses weighing on home prices and new construction. Similarly, poor economic fundamentals and tight credit are holding back investment in nonresidential structures, such as office buildings, hotels, and shopping malls.

Importantly, the slow recovery in the labor market and the attendant uncertainty about job prospects are weighing on household confidence and spending. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, an improvement but still a pace insufficient to reduce the unemployment rate materially. In all likelihood, significant time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers’ employment and earnings prospects.

Fiscal Challenges for State Governments

Cuts in state and local programs and employment are also weighing on economic activity. These cuts principally reflect the historically large decreases in state tax revenues during the recession. Sales tax revenues have declined with household and business spending, and income tax revenues have been hit by drops in wages and salaries, capital gains, and corporate profits. In contrast, property tax revenues collected by local governments generally held up well through the beginning of this year, although reappraisals of the values of homes and commercial properties may affect those collections in the future.

Medicaid spending is another source of pressure on state budgets. The recession and the weak job market have swelled the rolls of Medicaid participants. In 2009, caseloads were 11 percent above their 2007 level in the region represented by the SLC, again similar to the average in all states.

A question for the longer run is whether the vulnerability of state budgets to business-cycle downturns can be ameliorated. The pressures that states face during and after a recession are the result, in part, of balanced-budget rules in state constitutions that prohibit the use of long-term borrowing to cover operating budget shortfalls, a constraint not faced by the federal government, as you know. I do not advocate changing the balanced-budget rules followed by 49 of the 50 states; they provide important discipline and are a key reason that states have not built up long-term debt burdens comparable to those of many national governments. However, as is the case today, these rules may force significant state cutbacks in bad economic times when services are most needed. Moreover, many government programs–in areas such as education or health care, for example–are likely to be most effective when funding sources are stable and predictable, allowing for longer-term planning.

Tools exist to help mitigate the effects of the business cycle on state budgets. Many states deal with revenue fluctuations by building up reserve–or “rainy day”–funds during good economic times. Measured as a percent of general fund expenditures, the aggregate reserve fund balances for all state governments stood at a record of about 12 percent at the end of 2006; the states represented by the SLC had accumulated above-average reserves of around 16 percent. These high reserve-fund balances were helpful in lessening the severity of spending cuts or tax increases in many states. Nevertheless, given the depth of the recent recession, even these historically high reserve-fund balances proved insufficient to buffer fully the budgets of most states. Thus, state governments may wish to revisit their criteria for accumulating fiscal reserves. Building a rainy-day fund during good times may not be politically popular, but it can pay off during the bad times.

As state legislatures review their tax systems, they may wish to consider revenue stability along with other critical features of the tax code such as fairness, support for economic growth, and administrative costs.

As you know, with the retirement of state employees that are part of the baby-boom generation and the continued rise in health-care costs, states’ retiree pension and health-care obligations will become even more difficult to meet in coming years. Estimates of states’ unfunded pension liabilities span a wide range, but some researchers put the figure as high as $2 trillion at the end of last year. States’ unfunded liabilities are significantly higher than before the recession and financial crisis because many pension fund investments have declined in value, and because many states have found it difficult to maintain pension contributions while their budgets are under stress. Indeed, some estimates suggest that, on average, states would need to more than double their typical annual pension contributions over the next decade to avoid collectively exhausting their pension funds during the next couple of decades. This daunting problem has no easy solution; in particular, proposals that include modifications of benefits schedules must take into account that accrued pension benefits of state and local workers in many jurisdictions are accorded strong legal protection, including, in some states, constitutional protection.

In addition to pensions, states will have to address the burgeoning cost of retiree health benefits. Estimates of these liabilities are subject to significant uncertainty, largely because we have little basis on which to project health-care costs decades into the future. However, one recent estimate suggests that state governments have a collective liability of almost $600 billion for retiree health benefits. These benefits have traditionally been funded on a pay-as-you-go basis and therefore could entail a substantial fiscal burden in coming years as large numbers of state workers retire.

Of course, the demographic and health-care trends faced by state governments present severe challenges for federal fiscal policymakers as well. Long-term projections of the federal government’s budget under current policies and plausible economic assumptions show a structural budget gap that is both large relative to the size of the economy and increasing over time. To steer clear of sudden, sharp, and disruptive shifts in spending programs and tax policies, and to retain the confidence of the public and financial markets, federal policymakers need to develop a credible plan to restore fiscal sustainability.

The states have the opportunity to serve as role models for effective long-term fiscal planning. Given the size of long-term obligations and the importance of meeting commitments to employees and the public, I don’t think these problems can be solved simply through across-the-board cuts in existing state programs. Instead, states should intensively review the effectiveness of all of their programs and be willing to make significant changes to deliver necessary services at lower cost. This willingness to look for new solutions seems especially important in the case of health programs, where costs are growing the most quickly.

Bernanke’s “Timely” Warning

Bernanke’s warning regarding what states should have done a decade ago sure is “timely”. It is also disingenuous. He now wants states to save more, but not make spending cuts. When does this start? Now? Of course not. It might wreck the nascent recovery, always a Keynesian concern.

If balanced budgets are good for states, why aren’t they equally good for the federal government, now running a deficit of $1.4 trillion? Where is the federal “rainy day” fund proposal?

Somehow Bernanke thinks that states can magically reduce medical expenses without cutting services. Is he hinting that unions should pick up more of their costs?

Ironically, Greenspan is starting to speak sentences that are understandable, while Bernanke is now speaking in riddles. MarketWatch decoded Bernanke-Speak that states should “consider revenue stability along with other critical features of the tax code such as fairness, support for economic growth, and administrative costs” as a call for broadening food stamp programs and raising taxes.

Is that what he is saying? Who knows?

Finally, in spite of souring consumer spending plans, housing headed back in the gutter, high unemployment rates, and consumer balance sheets in disarray, somehow Bernanke thinks consumer spending is “set to sustain the economic recovery”.

I don’t and neither does the treasury market. 10-year treasuries are sitting at 2.95 percent in spite of today’s better than expected manufacturing ISM numbers.

Mike “Mish” Shedlock
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