The debt ceiling fight in Congress doesn’t pose an immediate fiscal threat to states, according to public finance experts, but a prolonged standoff could create problems for state treasurers and failing to raise it would wallop state budgets — along with the economy.
A U.S. default could trigger a financial crisis and recession, said Eric Kim, head of U.S. state ratings and senior director at credit rating agency Fitch Ratings.
“While most states are being conservative and anticipating at least a slowdown in economic activity, if not an outright recession [this year], as we are — something that is deeper than that and sharper than that has the risk of throwing budgets out of whack,” he said.
Congress must periodically increase the amount of debt the federal government can hold so the government can borrow enough money to pay its bills. House Republicans say they’ll refuse to raise the current $31 trillion-plus limit this year unless Congress also slashes federal spending. Congressional Democrats and President Biden say the debt ceiling must be raised without any preconditions.
Analysts at Fitch Ratings and the other major credit rating agencies expect Congress to eventually make a deal to raise or suspend the limit, rather than risk economic chaos. But the debt ceiling standoff could be the most protracted and painful in years.
Treasury Secretary Janet Yellen last week began taking “extraordinary measures” to prevent the government from hitting the debt limit until June.
As part of that effort, the Treasury may stop issuing State and Local Government Securities, which localities can use to save money when they refinance or refund bonds, said Bill Glasgall, senior director of public finance at the Volcker Alliance, a New York-based nonprofit. Such a pause “ticks off state and local treasurers” because it would reduce their flexibility, he said.
If Congress fails to raise the debt ceiling in June and the U.S. government starts to miss debt payments, Fitch Ratings and other credit rating agencies would likely downgrade their estimate of the U.S. government’s creditworthiness. That would make it more expensive for the U.S. to borrow money.
A U.S. downgrade could affect state credit ratings as well. Two of the three major credit rating agencies, S&P Global and Fitch Ratings, don’t directly link state ratings to the U.S. rating. But Moody’s Investors Services has said that a U.S. downgrade would drag state and local ratings down with it.
During the 2011 debt limit impasse, Moody’s said it could lower ratings for Maryland, New Mexico, South Carolina, Tennessee and Virginia along with its U.S. rating, CNN Money reported at the time. Moody’s singled out those states because of the prevalence of federal contracts and federal employment there, among other factors, CNN Money said.
More alarmingly, a U.S. default would likely cause turmoil in financial markets and the broader economy. “State budgets are tied to economic conditions, so that would clearly put pressure on state budgets,” Kim said.
State budgets could also suffer if Republicans in Congress successfully negotiate a debt ceiling deal that involves spending cuts.
About 37% of general state revenue comes from federal transfers, according to the latest U.S. Census survey of state and local government finances. For some states, such as Mississippi, the share is closer to 50%.
Federal grants help states pay for everything from housing assistance to highways. Crucially, federal dollars help states fund Medicaid programs, which provide health insurance coverage to low income people and people with disabilities.
“If there’s some commitment that the federal government undertakes as part of a debt ceiling deal that results in a long-term reduction of Medicaid spending, such as moving it to a block grants program, for example … that could put some long-term pressure on states,” Kim said.
Republicans in Congress have for years pushed to reduce federal spending on Medicaid and the Children’s Health Insurance Program, which provides health insurance coverage to children.
Splitting the two programs into five block grants and tying their cost growth to population growth, among other changes, could save the federal government $3.6 trillion over 10 years, according to a budget plan for fiscal 2023 proposed by the Republican Study Committee, a conservative caucus of House Republicans.
Congressional Democrats would fight such spending cuts, however. And even if they were enacted, they might not last.
Kim noted that the budget-cutting law that emerged out of the 2011 debt ceiling fight didn’t endure. Over the following decade, Congress continually voted to increase spending limits.