For some U.S. states, budget woes are on the horizon

April 23, 2014, 9:14 PM UTC
The United States of budgets

FORTUNE — The economist John Maynard Keynes once said, “The boom, not the slump, is the time for austerity.”

Though it’s hard to imagine using the word “boom” for America’s slow, often painful economic recovery, Keynes’ insight has particular relevance for state fiscal policymakers.

Thanks to five years of economic expansion, many U.S. states are approaching the start of fiscal 2015 in a better budgetary position than at any other point since the start of the Great Recession. But many, due in part to what I call “austerity fatigue,” face intensifying pressures from various stakeholders to relax their focus on fiscal repair. It’s understandable — after five or six years of budgetary restraint — that policy advocates see a need for funding restoration. But it might not be realistic given the anemic nature of the economic recovery.

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To be sure, a survey Standard and Poor’s released Wednesday of the 50 U.S. states found relatively good news in terms of credit standing. A majority of states have leveraged the expansion that began in June 2009 relatively well, with 36 able to balance their budget for fiscal 2014. That means their ending balances were equal to or greater than what was anticipated at the time they enacted the budgets.

But the survey also found that less than half of states are back to pre-recession budget strength. According to our analysis, just 24 anticipate reserves and ending balances in fiscal 2014 equal to or greater than 2008, meaning 26 anticipate less fiscal cushion.

Meanwhile, pension concerns still weigh on over half of the country. We found that 23 states, including California, Kansas, and New Mexico, have not regularly funded their actuarially recommended pension contributions — an indicator of future obligations that will need to be addressed whether or not the economy continues to grow.

The overall picture is mixed. Massachusetts, New York, and Ohio have all moved in a positive rating direction due to more fully repaired budgetary structures. Others such as Pennsylvania, Illinois, and New Jersey have seen downward rating action due in part to plugging short-term budget gaps in return for long-term obligations.

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We put Pennsylvania, which is rated AA, on a negative watch in the summer of 2012; Illinois was downgraded from A to A- last year, but its outlook remains developing, meaning we could still lower the rating further if its pension reforms don’t stick. Also, New Jersey was downgraded earlier this month from AA- to A+ in part due to structural budgetary imbalances.

Just three states, Pennsylvania, New Hampshire, and Kentucky, are on negative outlook, meaning we think there is a one-third chance that they could be downgraded within two years.

This could mean difficult headwinds for some states heading into fiscal 2015, and reasons for fiscal policymakers to resist feelings of austerity fatigue by either cutting taxes or counting on continually strengthening revenue. The prudent approach, as difficult as it may be, is to consider our current economic expansion to be at a mature stage and to be prepared for the next decline.

Sound pessimistic? Perhaps, but here is the reasoning behind that sentiment.

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Our economic forecast calls for somewhat faster real economic growth in 2014 of 2.8% and 3.2% in 2015, up from 1.9% in 2013. That would mean states enter the final months of fiscal 2014 from a position of strength relative to recent years. But their better fiscal standing primarily reflects events that have already occurred. And it’s possible that even if economic growth accelerates in 2014, state revenue trends could level off as a result of less bullish equity markets.

It’s also possible that states may face upward pressure on required spending, such as for Medicaid. If the surge in enrollments in federal and state health insurance exchanges is any indication, there could be stronger-than-forecast enrollments in Medicaid from the previously eligible but not enrolled population. Given that the states will only receive lower pre-health reform subsidy rates for these enrollees, providing coverage to this group could pressure state budgets if more enroll than had been forecast.

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Finally, tax cuts or new spending proposals could involve assuming a riskier fiscal profile. While voters might approve of such measures, they could undermine a state’s ability to weather the next downturn. For those states that have yet to fully repair their finances, doing so could also represent a missed opportunity. As a result, such states might be forced once again to pursue austerity measures during the next slump, rather than the boom.

All of these factors combined could put states back in the same position as they were just after the crisis, with a pressing need to balance budgets but fewer levers. Those that took advantage of the current upturn are better positioned to weather any pending difficulties.

As fiscal policymakers finish developing their budgets, they should set aside the bullish headlines we’ve seen in the past year about rising revenue streams, and put Keynes’ comment about austerity front-of-mind, because while this may not be the boom times, it may be the best we get.

Gabe Petek is a managing director at Standard & Poor’s Ratings Service’ U.S. public finance division.

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