Should states and localities be worried about the U.S. downgrade?

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Welcome back to Route Fifty’s Public Finance Update! I’m Liz Farmer, and lately I’ve been wondering why Fitch Ratings’ downgrade of the federal government last month didn’t generate much hand-wringing among state and local officials. It’s a big contrast to 2011, when S&P Global Ratings knocked Uncle Sam down from AAA to AA+ following the Great Recession. That decision, the first-ever downgrade of the U.S. government, caused all sorts of questions about the downstream effect on states and localities.

“With the federal debt downgraded, it’s hard to imagine that state and local bonds won’t be far behind,” an op-ed in The Fiscal Times reasoned at the time.

Fitch’s downgrade in August to AA+ was partly due to how the federal government had handled the debt crisis, mirroring S&P’s 2011 downgrade, which also followed a debt ceiling standoff in Congress. But the recent ratings cut didn’t generate as much of a splash at the state and local level because it’s now well-established that subnational credit quality is measured somewhat separately from the U.S. government’s.

“Essentially, yes, we do think that the 17 states that we rate as AAA are less likely to default on their obligations than the United States government,” said Fitch analyst Eric Kim. “A big piece of that is that state governments have a tremendous amount of sovereignty over their own ability to manage their revenue and spending profiles.”

More broadly, however, the factors driving the U.S. downgrade—financial concerns, deteriorating governance and polarization—do impact state and local governments by creating uncertainty around the ability of Congress and the president to provide a backstop in times of crisis. States and localities came out of the COVID-19 recession on a strong financial footing largely because of the federal relief funding that flowed almost immediately in response. That was followed by historic federal investments in infrastructure and climate change readiness, much of which will support state and local projects.

So while the U.S. downgrade doesn’t immediately change the picture for state and local credit quality, it could be viewed as a canary in the coalmine. Here are two big takeaways state and local officials should keep in mind amid yet another budget showdown in Congress that increasingly looks like a possible government shutdown.

The Consequences of Congress’ Short-Term Thinking

Some credit watchers say that the muted reaction to the national downgrade signals that federal lawmakers are too focused on the short term.

“The government is lurching from crisis to crisis, it's not able to sustainably balance its budget and it doesn't think strategically about long-term finance,” said Matt Fabian, a partner at Municipal Market Analytics, or MMA. “We had this budget crisis and the only discussion was about how to cut spending. And the only consensus was that we shouldn’t cut spending. That’s a problem.”

Observers describe the downgrade as a “symptom” that the federal government isn’t operating in a normal environment. The 2011 demotion showed that to be the case: The stalemates over federal spending only continued and ultimately led to sequestration in 2013. Those across-the-board spending cuts reduced federal grants to states by $5.8 billion and took the biggest toll on Wyoming, Utah, North Dakota, Montana and South Dakota, according to the Economic Policy Institute.

All told, sequestration prolonged the national recovery from the Great Recession, shrunk economic output by $287 billion, and forced more budget cuts and layoffs for state and local governments.

In a commentary, Fitch noted that future “actions by the U.S. government to rein in the nation's very high debt burden by curtailing spending could directly affect [U.S. public finance] credits that rely on federal funding for certain programs, particularly Medicaid, housing subsidies and grants, higher education grants and student loans, and the Highway Trust Fund.”

MMA’s Lisa Washburn also called into question the reliability of federal emergency funds for natural disasters, noting that the increase in extreme weather events will make states and localities increasingly dependent on more frequent emergency transfers from FEMA and Congress.

“Consider what [Florida’s] fiscal position, which is rated AAA by all rating agencies, may be without the billions of federal dollars infused to rebuild and support its economy following disaster declarations,” she wrote last month.

Partisan Bickering Has Long-term Consequences

It’s impossible to keep politics out of budgeting. But the U.S. downgrade is a reminder that our increasing political polarization has financial consequences that can outlast the budget cycle. 

Credit ratings incorporate a range of factors that include the revenue and expenditure frameworks, the long-term liability burden, and management (also referred to as governance). Ratings agencies place a lot of importance on the latter by looking at how a government prepares for a downturn, manages its finances in boom years and how it operates within its fiscal constraints. When things aren’t running smoothly, ratings agencies notice.

“When it comes to management, we assume a fundamental level of quality,” said Fitch analyst Michael Rinaldi. “The way our criteria works, it becomes potentially a more important factor to the extent that there's evidence of really weak management. Because that would signal … it is incapable of dealing with the types of stresses that state and local governments tend to face.”

Illinois took that to the extreme in 2015 when it went more than two years without passing a budget. The state had been skating on financial thin ice for a while thanks to decades of mismanagement, but it was only under the partisan-fueled budget impasse between then Republican Gov. Bruce Rauner and the Democrat-led legislature that Illinois’ declining credit rating began to snowball. Illinois’ rating had been inching downward every few years, but in less than 24 months, the state’s credit rating fell three notches to one step above junk status. 

That slide, along with the devastation that the impasse brought to nonprofit service providers, pushed a handful of Republicans to join with Democrats to pass a budget over Rauner’s veto to end the impasse in 2017.

Governance continues to be a top factor in credit rating agency actions, a consideration that is likely to grow in importance. A 2019 report by S&P notes that one-third of its U.S. public finance ratings actions were driven by environmental, social and governance, or ESG, factors, and that governance was the most dominant factor affecting credit quality. 

“We expect ESG factors to become more explicit factors of rating actions as awareness by market participants grows and transparency and disclosure improve,” the report said.