by Calculated Risk on 3/02/2011 08:11:00 PM

From Fed Chairman Ben Bernanke: Challenges for State and Local Governments

As the recession took hold, revenues dropped precipitously, especially at the state level. Driven partly by balanced-budget requirements under their constitutions, many governments have responded by cutting numerous programs and reducing workforces. As necessary as these cuts may have been, they have left some jurisdictions struggling to maintain essential services. The fiscal problems of state and local governments have also had national implications, as their spending cuts and tax increases have been a headwind on the economic recovery. Moreover, concerns about both the current fiscal condition of these governments and their longer-term commitments to provide pensions and health benefits have recently led to strains in municipal bond markets.

This is one of the key downside risks this year along with oil prices, the European financial crisis and housing.

And on the muni bond market:

Around the turn of the year ... investor concerns about the fiscal situations of many governments, including those of some populous states, resulted in increased yields on municipal bonds relative to Treasury bonds as well as a widening of credit default swap spreads for a number of states. Fortunately, although these measures of risk in the municipal bond market remain elevated, they have been looking somewhat better recently, presumably reflecting expectations of continuing improvement in the finances of states and localities. The Federal Reserve will continue to monitor the municipal bond market closely.

And on the long run challenges:

[S]tate and local governments are also confronting some difficult fiscal challenges in the longer term. Indeed, with the retirement of public employees who are part of the baby-boom generation and the continued rise in health-care costs, meeting obligations for pension and retiree health-care expenses will become increasingly difficult for many states and localities. Estimates of state and local governments' unfunded pension liabilities for the nation as a whole span a wide range, with some researchers putting the figure in the neighborhood of $2 trillion to $3 trillion.