%1

The U.S. economy struggled to shake off the last recession, with historically slow growth and a labor market that took more than six years to recover its earlier employment levels. A big part of the reason: state and local governments, which cut spending and fired workers amid widespread budget shortfalls, the New York Times reported. The same dynamic poses one of the biggest threats to America’s recovery from the pandemic downturn. State governments are again experiencing extreme budget problems as they pay out increasing sums to cover unemployment and health costs caused by the coronavirus crisis while revenues from sales taxes and corporate and personal income tax payments plummet. States could face a gap of at least $555 billion through the 2022 fiscal year, according to one estimate. Economists warn that the long-term risk coming from struggling states could prove even more damaging this time than the recession of 2007-9 unless Congress steps in. Yet providing more aid to state and local governments has become one of the biggest political battles in the fight over another pandemic rescue package. The Senate formally adjourned on Thursday until early September, all but ending any chance that an agreement could be reached soon. House members had already left Washington, D.C. President Trump and top Republicans, including Senate Majority Leader Mitch McConnell (R-Ky.), warn that providing more money to states could simply bail out fiscally irresponsible governments that did not manage their budgets and their public pension plans prudently in good times. Treasury Secretary Steven Mnuchin said Wednesday in a television interview that most states had not exhausted the $150 billion that was allocated in the relief bill passed in March, though analysts say much of that has already been earmarked for certain projects. Democrats insist that states need more money and have proposed as much as $1 trillion, saying it would support needed services and help the economy recover more quickly. While many governments entered the downturn with solid tax revenues and billions of dollars in their rainy-day funds, those coffers are quickly dwindling. Nearly all states are required to balance their budgets, meaning officials will need to plug shortfalls by tapping rainy-day funds, raising taxes or cutting costs, including jobs. That worries economists and Federal Reserve officials. Jerome H. Powell, the Fed chair, regularly warns that state job cuts could weigh on the economy’s ability to recover, and his colleagues warn of public-sector budget pain as one of the primary vulnerabilities ahead.

Governor Phil Murphy (D) can sell as much as $9.9 billion in debt to plug a revenue hole from the coronavirus, New Jersey’s highest court ruled amid a looming budget deadline and as states across the country grapple with their finances. The decision by the New Jersey Supreme Court allows one of the most financially strapped U.S. states to increase bonded debt — long-term debt with payments made over decades — by 22%, Bloomberg News reported. New Jersey Republicans had challenged the bond sale, saying it violated the state’s constitution by bypassing voters, while Murphy said that the pandemic was a crisis that gave him the power to act. “The pandemic has caused a health emergency, a broad-based economic one that has devastated many individuals and families, and a fiscal crisis for the state,” Chief Justice Stuart Rabner wrote for the seven judges in yesterday’s unanimous decision. “The present ‘emergency caused by disaster’ extends to all three areas.” The court did limit the size of the offering to the budget gap, requiring New Jersey to certify its revenue projections and the size of the shortfall before the sale. Should the hole be $7 billion, the state would be allowed to borrow only that amount. If it goes in the other direction, however, $9.9 billion — the projected revenue shortfall the state treasurer reported in May — is still the limit.

Spending cuts by state and local governments grappling with the coronavirus pandemic pose a headwind to the U.S. economic recovery as lawmakers consider how much federal aid to provide, the Wall Street Journal reported. State and local governments reduced spending at a 5.6 percent annual rate in the second quarter as they laid off workers and pulled back on services to offset plunging tax revenues. More cuts are on the way. Moody’s Analytics estimates that without additional federal aid, state and local budget shortfalls will total roughly $500 billion over the next two fiscal years. That would shave more than 3 percentage points off U.S. gross domestic product and cost more than 4 million jobs, said Dan White, head of fiscal policy research at Moody’s. Talks in Congress on another economic relief package have stalled, with assistance for state and local governments among the sticking points. Democrats are pushing for $950 billion. Republican leaders, who didn’t include aid for cities and states in their initial plan, have offered $150 billion. They cite concerns about growing U.S. deficits and debt, and they say some state budget woes predate the pandemic. Read more. (Subscription required.) 

In related news, the Federal Reserve said Tuesday it would reduce the rates it charges cities and states seeking short-term loans from an emergency lending program that has seen little takeup so far, the Wall Street Journal reported. Changes to the program must be agreed upon by the Treasury Department, which has approved $35 billion to cover losses on up to $500 billion in loans extended by the Fed. Municipal bond strategists and some Democratic lawmakers have expressed disappointment in recent weeks over the degree to which the Fed positioned the program as a backstop, though Fed officials say the mere announcement of the program in April helped reduce borrowing costs significantly for highly rated municipal issuers. With Tuesday’s changes, the Fed will reduce by 0.5 percentage point the interest-rate spread on tax-exempt notes, and it will also reduce the amount by which rates for taxable notes are adjusted relative to tax-exempt notes. Read more. (Subscription required.) 

An appeals court in Illinois has reinstated litigation seeking to block payments on $14.3 billion in municipal debt, saying the attempt to restrain borrowing in the country’s worst-rated state isn’t frivolous or malicious, WSJ Pro Bankruptcy reported. The appellate court said that John Tillman, chief executive of the right-leaning Illinois Policy Institute, had put forth a legitimate claim in support of his theory that past bond sales by the state were impermissible. The court stressed that it wasn’t deciding the merits of Tillman’s claims but said that the litigation could continue in a lower court. The complaint accused Illinois of taking on more debt than its constitution allows and breaking a state rule prohibiting deficit financing with bond deals in 2003 and 2017. Some of those bonds raised money to prop up Illinois pension funds, while others funded back payments to stretched government vendors. Tillman, a prominent foe of public-sector unions, argues Illinois is barred from taking out long-term debt except for “specific purposes” or to refinance longer-term debt, while the state had instead borrowed to bridge deficits and to speculate on financial markets. He has asked for a court order declaring the 2003 and 2014 debt sales invalid and unenforceable and prohibiting state officials from making further payments to bondholders. A state judge dismissed the litigation last year, saying it risked “an unjustified interference with the application of public funds” and it would draw the courts into political questions that should be left to lawmakers.

Public pension funds set a 22-year performance record in the second quarter, recovering some but not all of their losses from the first quarter, the Wall Street Journal reported. Double-digit stock gains pushed pension returns to a median 11.1 percent for the second quarter, according to Wilshire Trust Universe Comparison Service. Even with the rebound, median annual returns for the public pensions whose fiscal years ended June 30 were 3.2 percent, far short of the funds’ long-term investment-return target of around 7 percent. “That’s the funny thing with math, if you go down 20 percent, a 20 percent return does not make it up.” said Robert J. Waid, managing director at Wilshire Associates. Before the pandemic, public pensions were already trying to plug large funding holes by pursuing aggressive returns to make up for insufficient government funding in past years and decades. State and local pension funds in the U.S. held $4.05 trillion in aggregate as of March 31 — $4.93 trillion less than the cost of promised future obligations, according to Federal Reserve data. Investment shortfalls drive up the amount state and local governments have to pay in. Funds are also bracing for coronavirus-related government-revenue losses.

It’s become abundantly clear that the responsibility for responding to the pandemic cannot lie only with local and state governments. Congress must act decisively — and it must act in ways that don’t repeat mistakes of the recent past, during the Great Recession, according to a commentary by former Federal Reserve Chairman Ben Bernanke today in the New York Times. Our state governments serve a dual role as providers of critical services — health care, public safety, education and mass transit — as well as large employers. Many states, including New Jersey, are responsible for tens of thousands of jobs and the paychecks that go with them. Since a raging outbreak in March, New Jersey has successfully flattened the curve of new COVID-19 cases and hospitalizations. But since the state had to virtually shut down in order to control the spread, that success has come with a staggering price tag: The state faces a revenue shortfall in the billions of dollars. Many other states face ominous budgetary outlooks, too, implying the need for draconian reductions in essential services to state residents and large potential job cuts, according to Bernanke. States and localities are in desperate need of additional federal intervention before the bulk of the CARES Act funding expires this summer. Budget gaps like the one in New Jersey cannot be closed by austerity alone. Multiply New Jersey’s problems to reflect the experiences of 50 state governments and thousands of local governments and the result, without more help from Congress, could be a significantly worse and protracted recession. The CARES Act allocated $150 billion to state and local governments. This new aid package must be significantly larger and provide not only assistance for state and local governments but also continued support for the unemployed, investments in public health and aid as needed to stabilize aggregate demand and restore full employment.