by Calculated Risk on 12/26/2010 03:29:00 PM

Last weekend I posted some questions for next year: Ten Economic Questions for 2011. I'm working through the questions and trying to add some predictions, or at least some thoughts for each question before the end of year.

7) State and Local Governments: How much of a drag will state and local budget problems have on economic growth and employment? Will there be any significant muni defaults?

The good news is it appears state and local government revenue has stabilized. The bad news is the budget gaps will still be huge in 2011. The National Conference of State Legislatures (NCSL) released a report earlier this month, "State Budget Update: November 2010," forecasting

an increasing majority of state legislative fiscal directors are reporting that the revenue outlook for the remaining seven months of FY 2011 looks promising. At the same time, however, most states also are forecasting significant budget gaps in FY 2012. ... Funds from the American Recovery and Reinvestment Act (ARRA) have helped support state budgets since FY 2009. States will face a $37.9 billion loss in federal funds in FY 2012 compared to FY 2011, according to the Federal Funds Information for States. This is expected to make big holes in state budgets, what many state officials call the "ARRA cliff effect."

Including the loss of the ARRA funds, the state budget gaps are expected to total around $110 billion in 2011, down from $174 billion in 2010. This suggests further budget cuts for states.

In a recent research note, "Amid Stronger Growth, State and Local Drag Persists", Goldman Sachs' Andrew Tilton wrote:

The ability of states to defer adjustment is waning, based on public comments from state officials and budget analyst reports. Most states have tapped rainy day funds, privatized assets, decreased pension fund contributions, delayed wage or contractor payments, and so on. While there are many possible tactics, the hardest-hit jurisdictions have already exhausted the most practical and politically attractive options, and so further budget adjustments are more likely to be made through spending cuts.

And spending cuts means more state and local layoffs. So far in 2010 most of the government job cuts have been at the local level (about 200,000 jobs lost), and the cuts will probably be fewer in 2011 - but still a drag on employment. Goldman's estimate is the state and local government budget problems will be about a 0.5% drag on national GDP in 2011.

The other key issue is possible state and local defaults. Analyst Meredith Whitney has made headlines recently predicting widespread defaults. On 60 Minutes she said: "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

Several analysts have disputed Whitney's statement. Bloomberg columnist Joe Mysak wrote: Meredith Whitney Overreaches With Muni Meltdown Call

If pressed, I would say that we might see between 100 and 200 municipal defaults next year, maybe totaling in the $5 billion or $10 billion range.
...
Most defaults in the modern era aren’t governmental or what we might call municipal at all. The majority are corporate or nonprofit borrowings in the guise of some municipal conduit -- nursing homes, housing developments, biofuel refineries -- so they could qualify for tax-free financing.

And that is an important point that Bond Girl recently made at Self-evident.org: Default and bankruptcy in the municipal bond market (part one)

I am just writing this post to demystify a process that evidently needs demystifying. ...

One of the more frustrating aspects of muni market coverage in the news and blogosphere is the tendency to talk about municipal debt as if only one type of bond is issued and traded. There is actually considerable diversity among borrowers in the muni market (e.g., they are not all government entities), and by extension, the types of commitments that are made for the repayment of the debt. Although the relative health of the muni market has macroeconomic consequences, this is in many ways a market that defies generalization. ...

Bond Girl has followed up with another post about the Chapter 9 bankruptcy process: Default and bankruptcy in the municipal bond market (part two)

Clearly Bond Girl disagrees with Whitney (I'll side with Bond Girl). There will be defaults, but they probably will not lead to anything on the scale that Whitney is predicting with "hundreds of billions of dollars' worth of defaults".

Ten Questions:
• Question #1 for 2011: House Prices
• Question #2 for 2011: Residential Investment
• Question #3 for 2011: Delinquencies and Distressed house sales
• Question #4 for 2011: U.S. Economic Growth
• Question #5 for 2011: Employment
• Question #6 for 2011: Unemployment Rate
• Question #7 for 2011: State and Local Governments
• Question #8 for 2011: Europe and the Euro
• Question #9 for 2011: Inflation
• Question #10 for 2011: Monetary Policy