City and state officials across the country are preparing for the next downturn with a variety of smart financial strategies – many put in place in the wake of the last recession.

If there was a silver lining to the Great Recession for cities and states across the country, it’s this: public officials learned lessons about sustainable financing. 

As a result, a playbook of sorts has emerged for weathering the next economic storm better. And many local government leaders are borrowing from its pages as they prepare for the next downturn.

Mike Belsky
Mike Belsky, Executive Director of the Center for Municipal Finance

Among the key tactics are budget “stress tests,” larger reserve funds, and longer-term financial planning, says Mike Belsky AM'83, Executive Director of the Center for Municipal Finance at the University of Chicago Harris School of Public Policy.

Belsky, a former managing director of the public finance group at Fitch Ratings who also served as mayor of Highland Park, Illinois, says he’s encouraged by the way state and local government officials nationwide have gotten smarter in the wake of the recession a decade ago. 

“They’re much better prepared,” Belsky says. “People have their eyes open because that was such a severe downturn.”

Budget Blues

The Great Recession hit many local governments hard, as plunging property values and reduced consumer spending translated into much lower tax receipts. A number of cities filed for Chapter 9 bankruptcy during or in the wake of the downturn. These included Detroit, as well as Vallejo, Stockton and San Bernardino in California and Harrisburg in Pennsylvania. 

The U.S. economy has been expanding for about a decade now. That’s been good news for depleted municipal coffers. At the same time, many experts predict a contraction in the not-so-distant future. A majority of economists think a recession is possible before the next presidential inauguration in early 2020, according to a report by the National Association of Business Economics.

This time, though, cities and states are in better shape for the lean year or years to come. Collectively, government officials have drawn a series of lessons from the last recession. One of the newer strategies in the recession-resistance playbook is “stress testing” budgets, says Michael Nadol, president of PFM Group Consulting, a firm that specializes in public sector financial sustainability and workforce strategies. 

PFM Group Consulting logo
PFM Group Consulting

Stress testing involves analyzing how city finances could handle various recession scenarios, such as a revenue drop of 30 percent. These scenarios can suggest a wide range of recession-preparation strategies, depending on the kind of revenue sources and spending obligations local governments have, Nadol says. California, for example, is quite dependent on retail and income taxes—making it highly sensitive to economic fluctuations. Other local governments like St. Louis and Baltimore rely more on property taxes, which are less volatile.

“The effects of these tests can be very different,” Nadol says.

PFM Group Consulting has published a report on “Recession Readiness in the Public Sector,” with information on budget stress testing and action plans for fiscal sustainability.

Taking The Long View 

Nadol was Deputy Mayor, Director of Labor Negotiations and Director of Finance in Philadelphia in the 1990s, and helped spearhead the city’s financial rebound. A key takeaway from that experience that applies today is expanding the time horizon of financial planning. Nadol and his colleagues in Philadelphia looked out 5 to 10 years, and he says this long-term approach can help municipalities and states avoid unwise, short-time spending and budget decisions.

“That was really helpful for getting your thinking beyond that year-to-year budgeting,” Nadol says.

Related to long-term planning is setting aside bigger reserves to prepare for recessions. Belsky says a good rule of thumb is a “rainy day” fund of 10 to 20 percent of the annual budget. A fifth of the budget may seem like a big number. But the last recession taught officials and observers that government revenue can dry up fast, with few options for replacing it. “You have to react quickly,” Belsky says. “Increasing taxes is really damaging during a downturn, because everyone is hurting.” 

Belsky was Mayor of Highland Park during the Great Recession. The small city outside of Chicago—which now has about 30,000 people—had measures in place to prepare for a recession. These included a policy to keep the reserve balance at 35 percent of the annual budget and a "pay as you go" approach to some capital spending projects—meaning the city could freeze those initiatives when short on cash.

Thanks to preparations like these, Belsky and other Highland Park leaders managed to avoid layoffs. Still, city officials cut back on popular programs including a police foot patrol and public entertainment every Thursday night downtown. “We didn’t suffer as much as other communities, but we did feel an impact,” he recalls.Yet another strategy municipal and state leaders are adopting now to avoid deep cuts during the next downturn is “Outcome Budgeting.” This is an approach to public financing that Baltimore has pioneered. Many cities and states adopt annual budgets by deciding how much to increase or decrease the spending on various departments. The “base” budget for each department is rarely examined. Outcome budgeting takes a fresh look at the entire budget by focusing on desired aims rather than department-by-department asks.

For example, rather than simply increase the police department budget with a vague hope that public safety will increase, outcome budgeting would start with the goal of public safety and consider a wide range of programs and spending that might contribute to decreased crime. 

“What this forces you to do is look at the ‘base’ that hasn’t been touched for years,” Belsky explains. “It’s a real paradigm shift for thinking about budgets.”

Outcome budgeting can ruffle feathers but it typically leads to smarter financial choices, argues Andrew Kleine, Baltimore’s former budget director and author of the 2018 book, City on the Line: How Baltimore Transformed its Budget to Beat the Great Recession and Deliver Outcomes

Outcome budgeting “encourages more competition and collaboration for resources,” Kleine said in an interview last year. “It’s an exciting opportunity for entrepreneurial agency heads, but old school executives have a harder time adjusting.” 

Upgrading the Raters

Even as local governments have been applying the lessons of the last recession, the agencies that rate city and state bonds have changed their ways. Around the time of the Great Recession, rating agencies downgraded municipal and state debt just as local governments were financially vulnerable. But over the past decade, Fitch Ratings has adopted what it calls a “through-the-cycle performance approach,” says Laura Porter, head of U.S. public finance and a managing director at Fitch. 

Fitch Ratings logo
Fitch Ratings

This amounts to a more holistic view of cities and states, and whether their bondholders will be paid. “If you’re using reserves in a downturn, that’s Ok as long as your building reserves in good times,” Porter says. “You should be communicating your plans.” 

Porter says California is an especially compelling story. The state entered the year 2008 with effectively no reserves, and its budget deficit quickly ran into the tens of billions during the Great Recession—prompting some to call it “a wreck” and a “failed state.” But California is on track to generate reserves by next year of more than $19 billion, an unprecedented amount that equates to roughly 9 percent of the state’s $215 billion budget.

“We’ve never taken action to be prepared before,” says state senator Holly Mitchell, D-Los Angeles, chairwoman of the California Senate Budget Committee. “We’ve only managed by expanding and cutting, cutting and expanding. This is the first time we’ve had something considered a safety net reserve.”

Fitch has upgraded California’s bond rating twice since the recession. 

In effect, the Golden State is one of many cities and states that took their lumps from the last downturn and have acted to prevent the same level of pain.

Like Belsky, Porter is impressed by the way local government officials have followed a smart playbook to prepare for the next recession. 

“In the vast majority of cases,” she says, “people have made good decisions.”