Rainy days ahead: States boost reserves anticipating slowdown

An expanding economy led to expanded budgets. Now, with slowdown looming, rainy-day funds get more attention

Massachusetts Governor Charlie Baker signing the state's fiscal 2020 budget in his ceremonial office in the State House. (Pat Greenhouse/The Boston Globe via Getty Images)
Massachusetts Governor Charlie Baker signing the state's fiscal 2020 budget in his ceremonial office in the State House. (Pat Greenhouse/The Boston Globe via Getty Images)
Posted January 27, 2020 at 7:00am

As the longest economic expansion in American history continued last year, state governments increased salaries for teachers and other public employees, authorized new construction projects and — recognizing good times won’t last forever — added to reserve funds.

Cash reserves could become more important this year, as experts project the economy to slow down in 2020. Though a full-scale recession seems less likely than it did at points last year, a slower rate of growth still appears likely. Fitch Ratings, a credit ratings agency, projects a 1.7 percent expansion in 2020, which would be the lowest level since 2011.

Understanding that growth — which has lasted since the Great Recession officially ended in June 2009 — can’t last forever, most states have tried to budget conservatively and set money aside, according to Eric Kim, senior director of public finance at Fitch.

The median state rainy day fund grew to 7.6 percent of general fund expenses in fiscal 2020, a record and a significant increase from 1.6 percent in fiscal 2011, according to a study by the National Association of State Budget Officers.

Still, a significant slowdown would mean changes to state budgets.

“The decade-long nationwide economic growth has been really beneficial for states,” Kim said. “When that starts to turn a bit … that’s going to mean some adjustments.”

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A slowdown will also lead states to cut spending and possibly boost revenue, said Brian Sigritz, director of state fiscal studies as NASBO. 

“I think states have probably done as good a job as could be expected as far as building up rainy day funds and reserves and trying to prepare themselves,” Sigritz said. “But whenever the next recession comes, rainy day funds and reserves are just going to be one of the tools states will use.”

Straight tax hikes are generally a last resort for state officials, Sigritz said. But states could look to raise revenues through legalizing recreational marijuana or sports betting, according to Lucy Dadayan, a senior research associate with the Urban-Brookings Tax Policy Center, a nonpartisan think tank backed by the center-left Brookings Institution and the Urban Institute.

Slower spending

The possibility of a downturn in fiscal 2021, which in most states runs from July 2020 to June 2021, may be greater than in fiscal 2020. But even this fiscal year, growth in spending is already down slightly. 

From fiscal 2018 to 2019, state general fund spending grew 5.8 percent, the largest gain since the Great Recession. NASBO forecasts an increase of 4.8 percent for fiscal 2020. 

A downturn could require budget adjustments in the middle of the fiscal year, which states have largely avoided over the last two strong years, according to the NASBO report.

An economic slowdown wouldn’t necessarily need to be on the scale of the Great Recession for states to trim budgets, Sigritz said.

“Any kind of drop in revenue for a state is a challenge,” he said. “You will start to see some different cutbacks.”

In recent good times, lawmakers have added funding to a variety of programs, which Sigritz said is a good strategy to deal with potential future shortfalls because it gives states something to cut during downturns.

“When the national economy does well, most state economies do well,” Kim said. “And then states are able to restore fiscal flexibility.”

Some of the issues states have prioritized in recent budgets, though, like education, workforce development and opioid treatment, are likely to remain priorities, Sigritz said. Governors and other state leaders have invested their political capital in attention to those issues.

Ready? 

Fitch rates the credit of 47 states as AA or better, meaning investments are “not significantly vulnerable to foreseeable events,” which includes economic downturns. In other words, the credit rating agency thinks most states will be able to weather a recession. 

Several governors in state of the state addresses this year boasted about the money they’d put into rainy day funds, asked the legislature to put in more, or both. 

“Instead of going on a sugar high and spending through our surplus, we brought our Rainy Day Fund to a record-breaking $1 billion,” Florida Gov. Ron DeSantis, a Republican, said. 

Some states, led by Utah, have also begun “stress testing” their fiscal health, a tool banks have used to project how they would react under different economic conditions. Such modeling can be helpful because recessions don’t necessarily affect all industries, or the states to which they’re important, equally. 

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A recession that hits the oil and gas industry, for example, would impact extraction states like Alaska or North Dakota more than others.

In addition to when it comes, there’s also the question of how strong the next recession will be. 

“More states probably are better prepared this time around than they were during the Great Recession in the sense that they have more surpluses available,” Dadayan said. “At the same time it always comes down to the reliance on different sectors of the economy and also the structure of the taxes.

“It’s hard to predict if they’re well-prepared or not because it’s hard to predict how severe the next recession will be,” she added. “But they’re better prepared than last time around, for sure.”