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U.S. States May Be Tested In Unprecedented Ways


- Budget reserves are a first-line defense against revenue shortfalls and in a majority of states remain insufficient to absorb the first-year fiscal effects of a moderately severe recession;

- Most states nevertheless retain an adequate capacity to make fiscal adjustments in response to a downturn;

- Economic growth has accelerated in 2018, reducing the likelihood of a recession within the next 12 months; and

- Evaluating state fiscal strength now, amid an expansion, is relevant because larger federal deficits and a still-low federal funds rate imply there could be less countercyclical support in the next downturn.

Sep. 17 2018 — It has now been 10 years since the start of what former Federal Reserve Chairman Ben Bernanke called the "worst financial crisis in global history." What ensued in its wake was also the most severe economic downturn since the Great Depression. In retrospect, U.S. states weathered the historic turmoil remarkably well from a credit perspective. No state saw its credit rating fall to below the 'A' category. Curiously, however, the distribution of state credit ratings now—more than nine years into an economic recovery—is somewhat lower and extends further down the rating scale than before.

In a recent study, S&P Global Ratings evaluated the states' level of fiscal preparedness for another downturn and found that, overall, the picture is mixed. On the one hand, most states are in an adequate position to manage through a hypothetical recession that causes moderate budget stress. On the other, doing so would require making fiscal adjustments that go beyond drawing from accumulated budget reserves alone, because in most states, budget reserves remain insufficient to absorb even the first-year fiscal effects of a downturn.

While credit quality across the state sector remains strong, it has become more uneven, reflecting that states face a range of long-term structural headwinds. Reaching lower on the ratings' scale, the current spectrum of state ratings also implicitly acknowledges that in contrast to prior cycles, the capacity to assemble a counteractive response, both on the monetary and (federal) fiscal policy fronts—even after the extended expansion—has diminished. Widening federal budget deficits and a still-low federal funds rate imply that the economic and fiscal brunt of the next recession is likely to fall more squarely on the states. And given that states are structurally predisposed to the countervailing effects of pro-cyclical revenue trends and countercyclical expenditure pressures, they could be challenged as never before by the next recession. 

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