WASHINGTON — State lawmakers should consider both stabilizing their revenue streams against cyclical volatility and building up more rainy day funds to get through tough economic times, Federal Reserve Board chairman Ben Bernanke said Wednesday night.
In prepared remarks to be given at the Citizens Budget Commission’s annual awards dinner in New York City, Bernanke said while rainy day funds have largely been exhausted and it may be politically unpopular to build up greater reserves, they may make voters and policymakers less reluctant to approve new bond issues and take on additional costs for debt payments in periods of fiscal and economic stress.
A Feb. 3 report from the Center on Budget and Policy Priorities found that state rainy day fund policies vary widely from state to state. Some states fail to fortify their rainy day funds when economic conditions are good, while other states are too stingy in releasing the money when the economic climate calls for emergency spending. Nine states have fully exhausted their reserve funds since fiscal 2006, the report said.
Bernanke said the muni bond market generally “is functioning reasonably well” and that steps states and localities are taking to address their budget gaps “should help calm the... market.”
“The Federal Reserve will continue to monitor the municipal bond market closely,” he said.
The Fed chairman noted that early in the year investor concerns about state fiscal conditions caused muni bond yields to rise relative to Treasury bond yields and said “these measures of risk ... remain elevated.”
He added however, that “they have been looking somewhat better recently, presumably reflecting expectations of continuing improvement in the finances of states and localities.”
Much will depend on whether the economy continues to strengthen and the labor market improves, Bernanke said.
“However, because the pace of near-term economic growth expected by most forecasters is relatively modest given the depth of the downturn, some time will likely be required before state and local fiscal conditions return to something approximating normal,” he said.
Municipal governments “will confront more tough decisions” as they prepare fiscal 2012 budgets, he said, adding that while revenues are rebounding for many state governments, federal stimulus funds are winding down this year and demands on Medicaid and other social services “will likely remain elevated.”
Compounding the difficulties faced by many state governments “is that their revenues — always sensitive to economic conditions — appear to have become even more tied to the economy over time.”
Bernanke noted for example that states are relying more on personal income taxes, which have helped to “compound” their revenue problems. Capital income “tends to vary substantially more than wage and salary income,” he said.
Also, sales taxes, “may have become more cyclical because of an increasing tendency to exempt certain necessities, for which demand is relatively more stable,” Bernanke said.
Earlier on Wednesday at a House Financial Services Committee hearing, Bernanke told Rep. Brad Sherman, D-Calif., that the idea of crafting legislation that would allow states to file for bankruptcy protection “is a very complex one.”
Such legislation would raise legal questions about states rights, such as whether a bankruptcy judge could tell a state to raise taxes, Bernanke said.
Sherman had asked Bernanke how such legislation would impact states’ ability to continue to borrow in the muni market. “That’s really hard to judge,” the Fed chairman said, adding that investors currently try to assess the risk of bond defaults and states’ financial conditions.
