Bailout Sequel May Be as Scary as Original, Analysts Warn

Published December 1, 2008

Despite committing more than $2 trillion to buyouts, bailouts, loans, takeovers, and giveaways, federal government officials continue to struggle to manage credit markets, stock markets, and the entire American economic system. Meanwhile, state governments have begun to demand federal rescue money as well.

“The government has gone wild, much wilder than anybody thought it would,” said Bud Conrad, chief economist at Casey Research, which provides economic research to individual and corporate investors. “The traditional money and banking book that tells how things are supposed to work—throw it out. The Federal Reserve—it’s supposed to have reserves—has loaned out so much money the net effect is its reserves are negative. It’s totally out of control.”

Fed May Buy Into Banks

Confirming Conrad’s point, the Treasury Department announced it would spend an unspecified amount to buy ownership stakes in U.S. banks. That announcement came one day after the government announced plans to spend an unspecified amount to buy short-term corporate debt, all in an effort to keep credit flowing.

Though the amount of money that could be spent was not specified, Treasury and Federal Reserve officials said about $1.3 trillion of short-term debt could qualify.

In addition to using unprecedented powers to prop up financial institutions and other private corporations, federal officials must mull a request for billions of dollars in bailout money from California, the largest state in the nation and by itself the world’s eighth-largest economy, and from Massachusetts.

Economists and public policy experts say approval of the requests could lead to a flood of bailouts for states across the nation.

California Wants $7 Billion

Gov. Arnold Schwarzenegger (R) announced his state’s request for the federal government to buy at least $7 billion of California state government debt on October 3, the same day lawmakers approved and President George W. Bush (R) signed a bill allowing the federal government to spend $700 billion to buy bad debt from banks in a program critics call “cash for trash.”

More than $100 billion in unrelated tax breaks, subsidies, and other spending were attached to the bill.

Schwarzenegger said California needs the federal government to buy the state’s debt because the private market is not buying it. The short-term debt would be used to fund schools, state health care programs, and other services.

Massachusetts quickly followed with a similar request after dropping a proposed $750 million debt issue because of bad market conditions.

Revenue Declines Expected

The Nelson A. Rockefeller Institute of Government confirmed the problems in its quarterly state tax revenue report released in October. It predicts “the damage is just beginning” in state budgets, because tax revenues can be expected to decline as the economy weakens. Adjusted for inflation, state revenues rose about 1.5 percent over the prior year, according to the report.

Arizona, California, Florida, Michigan, and Rhode Island have the worst fiscal situations, according to the report, and the study predicts Connecticut, New Jersey, and New York will soon be in similar financial straits because they rely heavily on the faltering financial services industries. Those industries generate significant amounts of corporate taxes and personal income taxes from employees in those states.

While the Rockefeller Institute blames declining tax revenues for the problems states are having, others blame overspending.

Spending Surges Blamed

One such critic is Sheila Weinberg, founder and chief executive of the Institute for Truth in Accounting, in Northbrook, Illinois. Truth in Accounting advocates more transparent and accurate government financial reporting.

Weinberg notes California has raised spending about 40 percent in four years and cites a huge school construction program in Massachusetts in 2005 as causes for those states’ financial problems.

“Massachusetts really took a hit in 2005 for a massive outlay for construction of schools, and they have not been able to recover,” Weinberg said. “Even though they said they balanced the budget in 2005, their GAAP [generally accepted accounting principles] number was $5 billion in the red.

“Our research into California shows that they have used a lot of accounting maneuvers to pretend they have balanced the budget. They’ve moved tax receipts from one year to the next, that kind of thing,” Weinberg said.

She said this year’s California budget includes a plan to borrow $5 billion from future lottery earnings, but the plan must be approved by voters before it can be implemented, she noted.

“If voters don’t approve it, the state will have to do midyear cuts,” Weinberg said.

“What’s happened in California and other states is that during good economic times they don’t save,” Weinberg explained. “They expand the government, and when revenues start to be a problem, they have to cut services, and it’s hard to cut after you promise them. States should be running rainy day funds” to provide a financial cushion for lean years, she said.

Started Year with Deficits

Economist Jonathan Williams, director of the Tax and Fiscal Policy Task Force of the American Legislative Exchange Council, said about 30 states reported budget deficits for fiscal 2009, which began July 1, and other states are reporting new deficits as the budget year advances.

Williams said he worries especially about the impact of government pension funds on state finances. Some states, notably Illinois, already are woefully underfunded, and falling stock and bond markets will further erode assets as liabilities climb, hurting the funding of all state government pension plans.

“If they don’t get good returns on pensions, I think we could have massive lobbying efforts by states begging for federal assistance,” Williams said.

“This could be really bad,” Williams continued. “It is dangerous for states to be pursuing this kind of bailout. I was just talking with Amity Shlaes [author, economics historian, and syndicated columnist for Bloomberg News] about how states lose in times of crisis. No money goes [out] from Washington without strings attached. Whether it is a week or month or year or 10 years down the road, states will pay dearly for that money.

“And that means citizens will pay.”

Steve Stanek ([email protected]) is a research fellow at The Heartland Institute and managing editor of Budget & Tax News.