Watch the State of the States

I have long said that the health of the states is a more valid measure of the health of the nation than looking at national statistics.  Why?

  • The states can’t print money, or force ask allow the central bank to buy their debt.
  • In general, the states must run balanced budgets.  (Would that we constrained the Federal government to do the same through amending the Constitution.  Somebody bring that up after the crisis is over, please?)
  • State statistics are more reliable than Federal statistics, because they serve fewer political goals.

So, what is going on with the states?  I invite readers to comment below on the affairs of their states; I am only going to cover a few big states tonight.  I will start with Illinois.

Illinois has gotten to the point where it is no longer paying its bills.  After years of deferring paying into their pension plans, and borrowing to cover shortfalls, there is no flexibility remaining in the Illinois budget.  The games that can be played accrual items have been played out, and the deficits in pension and retiree health plans are huge.

Rather than the legislature or the governor choosing what taxes to raise and what benefits to cut, well-meaning bureaucrats decide who will get paid and who won’t.  It is a haphazard way of setting priorities.

What will it take for Illinois to act? This isn’t so much an economic problem as a cultural problem.  Can the people of Illinois elect and direct their civil servants to do what is reasonable within taxation levels agreed to by the majority?  This crisis will test what it means to be the state of Illinois.

Then consider New York.  Governor David Patterson is vetoing 6,900 bills because the budget is out of balance.  What will the legislature do?  I can’t tell, but Patterson is showing some lame duck spine.  New York can’t manage with such large deficits.

California is notable, given Governor Schwarzenegger’s move to cut all government salaries to the minimum wage.  But can it be done?  Can the computers be reprogrammed to do it?  And is this the right way to balance California’s budget, or is it just a ploy to get the legislature to compromise?  The courts are going along with the move for now.

New Jersey has bitten the bullet in the short run, and has balanced its budget through shared sacrifice.  Here’s to the man who found courage when faced with the crisis, Chris Christie.  He did one of the hardest things in politics — get warring parties to compromise over budget priorities.  That is tough, as opposed to making decisions where the options are limited during a crisis, like 9/11.  There is little true heroism involved at such times, because the few courses of action are obvious.  That said, it makes the Bush Administration’s dealing with Katrina all the worse, because the options were also few.  (Yes, blame the Louisiana Governor as well, but really, what does it take to get real focus in a crisis?)  In a crisis, someone has to be ugly to get response.

All that said, the crisis in the states is likely to get worse over time, and the main reason is that the states have underfunded their employee benefit plans, and offered benefit increases which cost little in the short run, rather than fight unions over wages.  Perhaps the unions were too clever.  They are pushing the states toward a non-existent bankruptcy.  What if a state stops paying pensions and retiree healthcare?  What then?  The federal government orders them to do so.  But what if they ignore that?  The Feds have no right to order a state to do anything, outside of what the Constitution allows.

In a stylized way, this is what happened.  When states created pension plans, there was a path of expected benefit payments associated with them.  The path of funding the payments was more level than the rising curve of the payments, but states paid in less than the funding path, partly because the markets had done so well.  That led them to assume that the markets would continue to do so well, so their path of funding was reduced in the present, but higher in the future.  It also led them to bias negotiations in favor of offering higher future benefits, and less in current wages.

This worked well so long as the markets were doing really well, up through 2000.  But once that ceased to be true, the path of expected benefit payments was much higher then before, and steeper going into the future.

That is why it will be difficult for the states to get ahead of their funding path shortfalls.  In an era of low interest rates and low market returns, taxes must be raised to now pay real money into the plans, and an increasing amount each year.  It is not as if they are to the point where they have no assets in the plans and must make benefit payments out of cash flow, but the plans are distinctly underfunded on any basis that assumes fair investment returns over the next 30 years, which would be 5% per year, and not 7-9% per year.

So even for states that are presently virtuous like New Jersey, it will be hard to get out of their crises.  It will be even worse for states that are bargaining with the future and betting on a quick return to the false prosperity that was the product of an increasingly leveraged society, 1984-2007.

So watch the states.  The true picture of the nation is there; they don’t have a lot of wiggle room, and will have a difficult next two decades as the demographics catch up with the underfunding of employee benefit plans.