Stateline Story

Budget Insiders See Worse Ahead in Calif., Mich.

Two of the states hit hardest by the Great Recession-California and Michigan-are bracing for an even tougher time making ends meet next year, putting big spending cuts or outright elimination of some services on the table, top budget officials from both states said Friday (Nov. 13).

Michael Genest, the budget director for California Gov. Arnold Schwarzenegger (R), said his state faces a budget gap next year of at least $7 billion-and likely more-after eliminating $60 billion in red ink this year. The "nightmare scenario" for his state is that continuing revenue drops will spell severe impacts on government services or taxpayers in California, Genest said at an event sponsored by the Pew Center on the States.

Mitchell Bean, director of the nonpartisan Michigan House Fiscal Agency, said Gov. Jennifer Granholm (D) already has warned state agencies to prepare for 20 percent cuts next year.

"I have a feeling that it's going to look pretty gruesome," he said. Michigan already is running on a budget shrunken to 1969 levels, in inflation-adjusted terms, Bean said.

Across-the-board cuts won't save enough, Bean said, so lawmakers must choose programs to eliminate.

Both California and Michigan were prominently featured in a new report issued this week by the Pew Center on the States, "Beyond California: States in Fiscal Peril." The report examined nine states that share some of the same economic and fiscal pressures that pushed California to the brink of insolvency this year, when it ran out of cash and had to issue IOUs for a time. The other states are: Arizona, Florida, Illinois, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin.

Michigan's budget troubles started with the decline of its auto industry. It was the only state never to emerge from the 2001 recession and now has the country's highest unemployment rate at 15.3 percent. The drumbeat of bad business news has taken its toll in Lansing. Twice in the last three years, state government shut down-albeit only for a few hours each time-because legislators could not reach a budget deal on time.

Likewise, California lawmakers in the last two years faced an unrelenting series of budget challenges. In 2008, the Legislature was a record 85 days late in passing its budget. A frozen credit market earlier this year prompted officials to seek a $7 billion loan guarantee from the federal government, although that request was denied. This summer, the state paid its contractors for several months with IOUs because it ran out of cash.

Genest said the situation earlier this year was so desperate that he researched whether California could declare bankruptcy, but he could not find a way. He even considered whether California could return to territorial status, essentially putting Congress in charge, but that proved to be too "impractical."

After several false starts, Schwarzenegger and the Legislature found a way to close a $60 billion shortfall that opened up for fiscal years 2009 and 2010.

"To my amazement, the political process did solve the problem. Admittedly, they did it in a temporary way," Genest said. "They solved the problem on paper, proving the axiom I started with: The arithmetic will win the argument. I think that's how we get out of this-out of desperation."

California's bondholders will be the most protected group because the state constitution guarantees they will be paid, he said. (The state charter also specifies that schools be first in line to be funded, though lawmakers can change how much they spend on education, he explained.)

Genest, who is retiring at the end of the year, warned that California's budget problems will persist even after the state works its way through this recession. He singled out Medi-Cal, the state's Medicaid health-care program for the poor, as unaffordable for the state. If the program's costs continue to climb 8 percent a year, the state will have little money left for anything other than schools and debt service by 2040, he said.

The health-care reform proposals now before Congress could further strain state budgets because they would expand Medicaid, Genest said.

Genest said Congress should overhaul Medicaid, now funded jointly by state and federal governments but run by the states. The federal government should cover more of the costs, give states more flexibility or even make a drastic switch and let federal officials take over Medicaid completely, he said.

"If you want to imagine a crisis, as a thought experiment, imagine all 50 states writing a letter to the federal government saying, 'We're no longer providing Medicaid.' That would get Congress' attention. And that's about the only real leverage we have," Genest said.

Besides Medicaid, the cost of providing pensions and health care to retired California public employees continues to grow, and both are very difficult to bring under control, Genest said.

"The sooner politicians and the public recognize that (there) needs to be a profound change, the more likely (that change) will happen," he said.

In Michigan, Medicaid and prisons continue to devour an ever-larger portion of the budget, Bean said. In 1969, those two categories accounted for just 10 percent of Michigan's general fund spending; now they make up nearly half, Bean said. (Michigan's school aid isn't included in its general fund.)

Making matters worse, Michigan's strict term limits give lawmakers little incentive to come up with long-term solutions, Bean added. Lawmakers can serve no more than six years in the House and eight years in the Senate.

Bean said Michigan may see more local governments becoming insolvent. In Michigan, that means state-appointed officials essentially take over the municipality's finances."Unless something changes, it (the state's budget situation) will get worse every year. There is no end in sight, even in a recovery. It is a structural problem," he said.