States Will Be Slammed by Default

A federal default could cascade through state governments, forcing tax increases and budget cuts on local taxpayers. Medicaid budgets could be slashed. Federal money for unemployment benefits could halt. State colleges could lose federal grants.

The Pew Center on the States reports that the municipal market would get swept along in the wreckage, severely constricting state budgets.

Different states would experience different kinds of shock.

Take Colorado. A federal default would cause more than 53,000 federal employees to be furloughed. All national parks would be shut down, and thousands of military service members would not be paid until a deal is reached. With Colorado’s large military presence, this could strike at the incomes of many families.

Moody’s has created a watch list warning the states of Maryland, New Mexico, Tennessee, Virginia and South Carolina as being at the highest risk for a downgrade. Should the federal government default and downgrade from its current AAA rating, these states will suffer most, largely due to their high federal employment numbers and Medicaid exposure. Some states are taking preventative action.

New Mexico – which takes in $500 million of federal funds each month for unemployment and forestry programs – has asked agencies to request any federal reimbursements by Friday, to ensure the return of their payments.

California borrowed $5.4 billion from a bank on Tuesday to avoid the interest increases that would accompany a default. This will increase municipal debt, but may save the state in the case of a default-instigated financial disaster.

The direct risk to states is obvious. There is also a less discussed risk that a federal debt downgrade will raise state borrowing costs.

“Maryland had a bond sale scheduled for this week – a $700 million bond sale,” said Pew Research Manager Sarah Emmans. “And the treasurer decided to postpone part of it due to the uncertainty of the August 2 deadline.”

Increases in state borrowing costs will disrupt local economics.

“State and local governments actually issue debt to build things like roads, bridges and highways,” said Emmans. “So if there’s a default, then it’s harder for them to issue debt. They might have to cancel or postpone a lot of those projects that both create jobs and also provide vital services to taxpayers.”

A recent article claims most of us are affected by the "normalcy bias" - a mental state causing us to underestimate the severity of the looming default and generating our inability to cope with it. But some states are taking actions to prepare themselves – and their cash stocks – for financial disaster.

“State and local governments can’t go very long without that federal money,” said Emmans.