Short and long-term squeeze on state and local governments

27 Nov 2011 by Jim Fickett.

State and local governments face a short-term shock from the loss of federal stimulus funds, and long-term difficulties from rising Medicare costs and over-committed retirement systems. Nevertheless, municipal bonds remain a relatively safe investment for now.

Last week the US Bureau of Economic Analysis reported state and local government income and expenditure data through Q3.

On the income side, tax revenue has been growing at a normal rate since a low at the beginning of 2009, but help from the federal government has, as expected, dropped sharply in the last few quarters (note all figures are adjusted for inflation):

Overall there is currently a big short-term shock on the income side, though income growth will normalize in the longer term.

On the expenditure side, the first long-term problem is that all the growth for the last few years has been in transfer payments – mainly Medicare – leaving consumption – mainly wages – and investment flat or declining.

The second long-term problem is, of course, under-funded and over-promised retirement systems. Contributions to retirements systems are counted under consumption, and as those contributions go up, to compensate for lack of realistic planning in earlier years, payments to current employees must go down. Hence both state and local employment has been declining significantly:

This in turn means that state and local government has made a negative contribution to GDP growth for the last five quarters.

Since the recent overhaul of health care did very little to contain costs, and since the retirement plan funding problem is just going to get worse for quite a few years, state and local government budgets, and employment, will remain under strain for the long term.

While the long-term outlook for state and local governments is difficult, this should not hinder investment in municipal bonds. Among those informed about the muni market, there is, in fact, something close to consensus that short-term dangers are low. Here is a recent article from Bloomberg:

“We believe the past year’s focus on default risk and bankruptcies is a bit off the mark,” [Peter] DeGroot [head of municipal research at JPMorgan Chase] and [Josh] Rudolph said in [a report to investors], sent today. “General-obligation credit has two key exposures to the economic cycle: tax revenues and pension funding. Neither of the two are expected to deteriorate enough to broadly threaten ability to pay.”