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US States Need Federal Funding to Combat the Pandemic

With US state governments facing massive budget shortfalls as a result of the COVID-19 crisis, most will have no choice but to raise taxes or slash spending, further compounding the recession. If Congress and the White House do not step in with additional funding, they will have effectively manufactured another crisis.

BERKELEY – The COVID-19 pandemic has catapulted federalism to the top of the political agenda in America. Confronted with the glaring lack of leadership from the Trump administration, state governments on the front lines have taken charge of the response. But with budget deadlines for the new fiscal year rapidly approaching, many states face unanticipated shortfalls as a result of the crisis. In a recent letter to congressional leaders, the National Governors Association requested an additional $500 billion or more in flexible federal funding, in addition to the $150 billion that was granted for restricted uses under the recent $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act.

In weighing this request, Congress and the White House must determine whether there is a valid macroeconomic rationale for a significant additional tranche of flexible state funding and whether the federal government can afford it. The answer to both questions is a resounding yes.

But US Senate Majority Leader Mitch McConnell, a Republican, has suggested that additional federal funding would amount to a bailout for predominantly “blue” (Democratic-controlled) states, and has argued that states in fiscal crisis should instead consider declaring bankruptcy. McConnell’s insinuation that state budget shortfalls are the result of profligacy is misleading and politically divisive. Both red and blue states confront huge budget shortfalls that stem from declining revenues, not excess spending.

State revenues are plummeting as a result of necessary COVID-19 lockdown measures, which have triggered a recession deeper than any experienced since World War II. State governments are also bearing most of the direct costs of combating the virus, and sharing the costs of administering federal safety-net programs such as unemployment insurance and Medicaid, for which expenditures have risen dramatically as a result of the crisis.

Unlike the federal government, state governments are constrained by balanced-budget laws. Without federal funds to cover their looming fiscal gaps, they will have to raise taxes or implement deep spending cuts. The macroeconomic rationale for additional state aid is thus simple and compelling. If state governments are forced to slam on their fiscal brakes, much of the benefit from the federal government’s own countercyclical stimulus measures will be offset, resulting in an unnecessarily deeper recession, higher unemployment, and a slower recovery.

The lessons of the global recession a decade ago confirm these alarming predictions. Between 2008 and 2014, state governments suffered a budget hit of about $600 billion, but received only $150 billion in federal aid. State governments therefore had to draw down their accumulated reserves (rainy-day funds), increase taxes, and cut “discretionary” spending.

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These austerity measures were a significant drag on growth. State governments were forced to reduce employment in essential services such as education, public health, and hospitals, with an estimated negative multiplier effect of 1.7 or more (meaning that each $1 of cuts led to a $1.70 loss of economic activity). Worse, austerity had long-lasting effects. Real (inflation-adjusted) state spending did not exceed its pre-recession peak until 2019, and state and local payrolls did not return to their pre-recession highs until the end of the year, just as COVID-19 was emerging.

Scarred by this trauma, most states have gradually built up their rainy-day funds to protect themselves against another unexpected budgetary downdraft. In the 2019 fiscal year, these reserves reached all-time highs in many states, and amounted to an average of 8% of state general fund expenditures.

The problem, of course, is that not even massive rainy-day funds are sufficient to fill the huge budgetary holes created by the COVID-19 pandemic. Nor is bankruptcy even an option for states. McConnell seems to have forgotten that the US Constitution prohibits state governments from “impairing the obligation of contracts,” including their own. By contrast, municipalities do have a legal right to declare bankruptcy, and there is good reason to worry that many may be forced to exercise it as a result of COVID-19, further destabilizing US and global financial markets.

Fearing precisely that outcome, the US Federal Reserve has introduced an unprecedented $500 billion lending facility to backstop the $4 trillion municipal-bond market. State and local governments depend on this market to fund capital projects like roads and schools and to bridge short-term gaps between receipts and outlays. Municipal bonds have historically been a relatively safe, tax-advantaged investment class, because the rates of default by municipal issuers have been low. But now that many of these issuers’ budgetary outlooks have deteriorated, investor concerns have risen, driving up municipal-bond yields.

Through the creation of its new Municipal Liquidity Facility (eligibility for which has now been expanded), the Fed has committed to purchasing billions of dollars of municipal bonds at favorable interest rates, thereby restoring stability to this market. Moreover, the MLF is just one of many bold measures implemented by the Fed to stabilize financial markets and provide monetary-policy stimulus to battle the recession induced by the necessary COVID-19 shutdowns. The Fed has also slashed policy lending rates to near zero, launched an unlimited asset-purchase program for US Treasuries and mortgage-backed securities, strengthened the commercial securities markets used by companies to raise short-term cash, and established a new Main Street Lending Program, leveraging CARES funds to lend directly to small and medium-size businesses. Owing to these programs, the Fed’s balance sheet could reach an historic high of 40% of GDP by the end of the year.

Investors around the world are willing to lend to the US federal government at negative real interest rates, and the Fed is committed to unlimited purchases of US Treasuries, even as the federal budget deficit heads toward $3.7 trillion (20% of GDP) by the end of the year. Under current and foreseeable global conditions, the US government has no budget constraint: it can and should run huge budget deficits to finance the war against COVID-19 and the deep recession it has triggered.

Another major stimulus package, including at least $650 billion in flexible funding for state and local governments on the front lines of that war, is both affordable and essential. Federalism in responsibilities requires federalism in funding.