States, the Federal Deficit and the ‘T’ Word

Most of the focus during the credit crisis has been on the $700 billion liquidity package and the other federal funds that have been necessary to stabilize the United States and world financial markets. Soon the focus will shift to the $150 billion to $300 billion economic recovery package, which is being prepared in the U.S. House of Representatives and could be considered during either a lame duck session or at the beginning of the 111 ^th Congress.

While these are huge expenditures, they are one-time as opposed to recurring expenditures, and a substantial portion would likely be paid back over time. Of greater concern for states is the federal budget baseline deficit and a looming threat: the “T” word-“trillion.” The closer the baseline federal deficit gets to the trillion-dollar mark, the harsher and deeper the repercussions will be for states.

The Congressional Budget Office (CBO) has projected the fiscal year baseline (FY) 2010 deficit-the difference between what the federal government takes in from taxes and other sources and what it spends each year-to be about $438 billion. (The baseline does not include any funds for the credit crisis.) Now that the “patch” for the alternative minimum tax plus other tax credits have been enacted, this figure will increase to about $560 billion. It is important to note that this total estimate is based on the assumption that the economy will slow but not go into recession.

However, if one assumes that there will be a recession and that real GDP will decline during at least the last calendar quarter of 2008 and the first two quarters of 2009, federal revenue growth will slow dramatically. While this economic weakness might not push our 2010 federal deficit into the “T” zone, it will clearly increase the deficit to more than $700 billion. And if the economy continues to weaken and the government makes large supplemental appropriations for the Iraq and Afghanistan wars, then the deficit for 2010 could approach a trillion dollars.

Furthermore, this operating deficit combined with the various appropriations for the liquidity bailouts could push the total federal debt outstanding-the amount the government owes to all creditors, which is now about $10.3 trillion-to about $12 trillion by the end of FY 2010.

Another factor that will drag on the U.S. economy-and increase financial pressure on states-is the restructuring of risk in the financial markets as a result of the credit crisis. (It is likely that the spread between the interest rate on federal debt and the interest rate on corporate and municipal debt will increase.) Combined with the huge increase in federal debt, this restructuring will likely increase all long-term interest rates and crowd out some corporate debt and state and local municipal debt.

The higher interest cost for private-sector capital investment will be reflected in lower levels of investment and productivity, resulting in lower levels of U.S. economic growth. Moreover, given the lack of U.S. savings, foreigners and foreign governments will be the only ones who can afford to purchase and hold this new federal debt. This puts our economy in an even more precarious position: For example, if large foreign investors such as China decided to dump their U.S. debt holdings, it could lead to depreciation of the dollar in global markets and encourage other foreign investors to sell off their U.S. holdings.

To retain these investors and attract new ones, U.S. interest rates would have to increase, further stifling economic growth.

In addition, the fact that the baseline federal deficit will be between $700 billion and $1 trillion for FY 2010 will pose a huge challenge for President-elect Obama and the 111 ^th Congress. In the face of this massive budget deficit, the federal government will need to reduce growth in the major entitlement programs such as Medicare, Medicaid and Social Security. However, Obama has promised tax cuts and increased expenditures for energy and health care. Balancing these two opposing goals will be very difficult, and his approach to this challenge ultimately will affect states.

In short, the sum of all these parts equals several negative effects for states:

• Interest rates for both short-term and long-term municipal bonds will increase over time as more and more they must compete with federal bonds, which carry lower risk;
• The domestic discretionary part of the federal budget, which includes education, welfare, non-Medicaid health care, and employment and training state grants, will be squeezed in the future because it is very difficult to cut entitlements;
• New presidential initiatives for health care, which could provide some fiscal relief for states, likely will have to be postponed or scaled back;
• The federal government will have limited revenues and, therefore, will be more inclined both to mandate state funds and enact more maintenance of effort provisions so that states are not able to cut funding;
• Even after the short-run recession, it is likely that the long-run growth of the U.S. economy over the next decade will be lower than has been witnessed over the last several decades. This means that the growth in state revenues will also lag over the next decade.

The federal deficit has been growing because of the lack of restraint on entitlements, the cost of the wars in Iraq and Afghanistan and because of significant tax cuts. The impact of these factors is now being exacerbated by the recent liquidity crisis and economic downturn. Taken together, all these things could push the federal deficit in 2010 toward a trillion dollars-and this will have serious negative consequences for states over both the near- and long-term.

Raymond C. Scheppach, Ph.D. is the executive director of the National Governors Association. The views expressed here are those of the author and do not necessarily represent those of the National Governors Association.