Somewhat buried in all of the talk about fiscal stimulus, bank bailouts, auto company bankruptcies and the generally awful state of the world has been the predicament that the various states of the Republic are experiencing. The fiscal stimulus plan sticks a wad of gum in this rather large breach in the dike but it won’t stop the flood from coming.

The Center on Budget and Policy Priorities (hat tip Calculated Risk) has quite a good post which defines the scope of the problem in a series of well put together graphs and tables and discusses the potential policy responses. The opening paragraph of their report neatly summarizes the scope of the crisis:

States are facing a great fiscal crisis.  At least 46 states faced or are facing shortfalls in their budgets for this and/or next year, and severe fiscal problems are highly likely to continue into the following year as well.  Combined budget gaps for the remainder of this fiscal year and state fiscal years 2010 and 2011 are estimated to total more than $350 billion.

The table below shows the likely development of the budget shortfalls.

It has been an article of faith among economists and the media that states cannot at this time raise taxes or significantly cut back services for fear of making the recession worse. To that end, the fiscal stimulus bill contained a number of provisions that transfer federal funds to the states. Semi-discretionary funds for infrastructure projects will presumably allow the states to maintain budgeted expenditures and targeted transfers for social welfare programs like medicaid are designed to fill developing gaps in the funding capacity of the states.

All of that is well and good but it fails to do anything more than maintain existing levels of spending and alleviate the immediate need for the states to access very inhospitable credit markets. The longer term is no brighter and it’s doubtful that a continuing flow of funds from the federal government can or should be the solution.

The simple fact is that the states over spent during the boom and have no reasonable means of closing the gap they currently face. To compound the problem, those that relied heavily on property taxes as a source of revenue will likely see a significant decline in their taxable base as properties are reassessed. To add insult to injury most if not all are laboring under fictitious accounting for pension liabilities, a tsunami that it just years away from swamping them. It is not putting too fine a point on the problem to suggest that the states have little choice but to both increase taxes and restrict services over the longer term in order to bring their fiscal house in order. To say that this will obviously act as a drag on the recovery is stating the obvious.

Since the outcome of the current economic crisis is anything but certain, the plight of the states may be worse than it currently appears. Credit markets are likely to be inhospitable to any borrower that cannot demonstrate a sound financial base. Additionally, if the recovery results in decreased consumption, a greater propensity to save and a relatively moderate housing recovery then the fiscal situation is likely to be more attenuated.

It’s probably not a stretch to suggest that we may well be at a rather important juncture in the role of the states in the federal system. So far, Washington seems loathe to scale back programs and appears to be intent on using the fiscal might of the country to maintain the status quo. Since many of those social programs require the participation of the states and since those spending responsibilities appear to have outstripped their capacities, the rather large question looms as to who exactly is going to fill the gap. It’s a question that goes far beyond economics and to the basic relationship between the states and the federal government. The manner in which it is solved will have profound implications for governance and power in the years ahead.

In the final analysis, the states have been reduced to financial basket cases. The recovery of their economies is based on a return to a economy that many believe not to be in the best long-term interests of the country. They cannot be allowed for the moment to take the steps necessary to put their houses in order and therefore have to rely on the federal government for survival. Beyond the immediate situation, it is difficult to see a scenario in which significant cuts in services and higher taxes represent at least for the medium term the only solution. That may not be politically acceptable, so the federal government may indeed agglomerate more power to itself as the expense of federalism.

Not a very inviting set of circumstances and here’s hoping I have this all wrong.