State and local governments face budget crunch, hurting hopes for a quick economic recovery

Key Points
  • States and local governments have already implemented layoffs and budget cuts as the economic slowdown grows.
  • "State and local government spending is bigger than federal spending, so it's very important to the economy," Comerica chief economist Robert Dye said.
  • On Thursday, that Federal Reserve announced a $500 billion liquidity facility for municipal debt to help cash-strapped local governments.
Pedestrians walk past closed shops along Lexington Avenue amid the coronavirus pandemic on April 7, 2020 in New York City.
John Lamparski | Getty Images

Spiking unemployment around the country and dire predictions for second quarter economic growth have created a budget crunch for many state and local governments, and it could be a long-term drag on the United States economy.

Robert Dye, chief economist at Comerica, said that sharp declines in employment and consumer sales will hurt tax revenues for state and local budgets, which often have legal restrictions that keep them from filling shortfalls with debt, and weaken a key source of jobs in the country.

"That certainly is a big load of challenge for state and local governments ... they can't run deficit financing. And the other thing is that state and local government spending is bigger than federal spending, so it's very important to the economy," Dye said.

The economic impact from the coronavirus pandemic has resulted in more than 16 million new unemployment claims in just the past three weeks. The economic hit has already resulted in layoffs and furloughs for local government employees from Cincinnati to Santa Barbara, and governors slashing spending from budgets. 

In Washington state, site of the first coronavirus outbreak in the U.S., Gov. Jay Inslee cut more than $400 million from the state budget over the next three years. 

The federal government has started to step in to help its smaller cousins. The $2.2 trillion CARES Act included money for state and local governments, though some, including New York Gov. Andrew Cuomo, have said the assistance was not enough as health expenses rise. On Thursday, that Federal Reserve announced a $500 billion liquidity facility for municipal debt to help cash-strapped local governments.

However, funding issues for the public sector are unlikely to disappear when the health crisis passes, Dye said, and weak government spending could be one of the areas that prevents a sharp, V-shaped recovery for the U.S. economy.

"The second quarter hole is so deep that it's going to take several quarters to get back, and that's going to have an impact on state and local government budgets because that has a direct correlation to tax receipts. The economy is not going to get back to that level for two years or three years, and tax receipts are going to be weak for quite some time," Dye said.

Muni market troubles

Concerns about local government finances have already shown up in the in debt market.

Even as the Federal Reserve slashed interest rates, demand for municipal bonds fell sharply in March. The iShares ETF that tracks municipal debt fell about 15% between March 9 and March 19, reflecting lower prices for the underlying bonds.

Primary issuances of new municipal debt also dried up in March. Requests for identifiers of new public sector debt plunged by 21% in March even as corporate debt requests surged, according to CUSIP Global Services.

"When the financial outlook for state and local municipalities quickly turned sour, investors began to move capital out of the muni bond market, causing very strong price dislocations that had not been seen in at least four decades," Luis Alvarado of Wells Fargo Investment Institute said in a note to clients.

The Fed said its new facility, part of a $2.3 trillion group of programs to bolster the U.S. economy, will purchase short-term debt from states, counties with at least 2 million people and cities with a population of at least 1 million.

"We are deploying these lending powers to an unprecedented extent, enabled in large part by the financial backing from Congress and the Treasury," Fed Chair Jerome Powell said on a webinar for the Brookings Institution on Thursday morning. "We will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery."

Raises, tax cuts paused

Even for states that may be able to avoid budget cuts, hopes for future raises for state employees and tax cuts for residents have dimmed.

In Georgia, the state House passed a budget for next fiscal year that included a $1,000 pay raise for teachers and an income tax cut. With the coronavirus pandemic already forcing the state to dip into its rainy day fund, the chances of those surviving into the final budget are slim, said Joe Fleming, a lobbyist for the Georgia Association of Educators. 

"It's pretty much conceded that the tax cut ... and the teacher pay raise for this coming year are doubtful," Fleming said. 

With the future pay raise seemingly on ice, Charlotte Booker, the president of the GAE, said working from home has forced some teachers to cough up their own money to upgrade their technology.

"Many of our teachers already have computers, they already have things set up and put into place, but there are also many of our teachers that do not," Booker said. "And what they're doing, some of what I've heard is they've borrowed things from other people, they've gotten [money] out of their pocket to make sure that they have access."

Fleming and Booker said they hoped they could get the pay raise back on the government agenda for the budget process in 2021, but they are unsure it will be fiscally possible.  

"Only time will tell how quickly we recover from this and how quickly our economy in Georgia recovers for this," Fleming said.