50 Little Hoovers

Unlike the Federal government, states and municipalities are not allowed to run deficits to finance their ongoing operations (they can, of course, float bond issues for capital projects). In a recession, tax revenues fall. The primary source of tax revenues for the states are sales taxes and property taxes; some states also have income taxes.

Well, with retail sales falling, so are sales taxes with the price of housing going down. So are tax assessments with people out of work, or working far fewer hours. Income taxes are falling. At the same time, many of the automatic stabilizer type programs are at least partially state funded -- for example Medicaid and unemployment benefits. Those costs rise in a recession.

Also, with people under greater stress, the need for things like child protective services and foster care go up. The states are thus caught in a terrible bind. They either have to slash spending where they can, or raise taxes and fees.

Slashing spending adds to unemployment, as people are laid off. It also means that service suffers. If you thought it was bad waiting on line at the Department of Motor Vehicles when there were 10 people working in the office, it gets a lot worse when there are only five people working.

Raising taxes in a downturn is not an attractive option, either. If retail sales are already down, raising the sales tax rate from 6% to 8% sure is not going to help the situation.

For this year, the stimulus bill has helped to cushion the blow for many states, and many had built up “rainy day funds” during the expansion. But next year, the stimulus support will start to fade, and the rainy day funds will be exhausted. In effect, the budget rules force a reduction in total demand in the face of a slowdown. This is exactly what President Hoover did early in the Depression as he tried to balance the budget in the face of falling tax revenues.

One of the things that states are doing is raising various fees, which economically look a lot like taxes. One example of this comes from Arizona (http://www.azcentral.com/news/election/azelections/articles/2009/10/07/20091007azbudget-ON.html).  There, the state plans to raise its license fee for child care centers from $150 for three years to a stunning $13,442 for the largest daycare centers (more than 150 kids).

Now, day care is not exactly the highest margin business in the world, and the workers are almost all near-minimum-wage employees. The increased fees will help pay for inspections of daycare centers. While that is a good thing -- parents don’t want their kids going to unsanitary or dangerous daycare centers -- it is also has a huge and sudden burden on the daycare centers.

Undoubtedly, most of the increased costs will be passed along to parents.  Many of those parents are either single parents or people where both have to work just to make ends meet. Child care is needed if they want to work. If the costs can’t be passed on, then lots of those low-income child care workers will probably lose their jobs.

This is just another example of how the real incomes of working class people are being squeezed. With less income, they will have less to spend. This will hurt retailers. While this might mean less spending by the existing customers of the deep discount stores like Family Dollar (FDO - Analyst Report) and Wal-Mart (WMT - Analyst Report), they will probably be picking up customers that used to shop at higher end stores like Macy’s (M - Analyst Report).

There is an offset, though, for many in retail -- the vacancy rate for strip malls is now at its highest level since 1992 at 10.3% in the third quarter. This is putting pressure on rents, which will lower the costs for the retail firms. That benefit might be slow in coming but long lasting, since many retail stores have very long leases. The graph below (from http://www.calculatedriskblog.com/) shows the vacancy rate in strip malls (including big box power centers) since 2005.

The decline in rents and the higher vacancy rates mean sharply reduced cash flows for the owners of these malls. This will lead to more of them being unable to roll over their mortgages when they come due, and lead to very large numbers of commercial foreclosures.

Generally it is the small to mid-sized banks ($1 billion to about $15 billion in assets) that have the biggest exposure to commercial real estate, including strip malls. While none of those individually are big enough to threaten the financial system, it does mean that the FDIC will continue to have its hands full, and the $45 billion prepayment of assessments to bail out the Deposit Insurance Fund will not be nearly enough.

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