How local governments can prepare for a possible recession

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Like a prudent family or business, governments ought to plan for downturns. In fact, former Gov. Jerry Brown always warned the state that downturns always are around the corner – as a way to dampen the Legislature’s interest in creating new, permanent programs. Even if this one is skipped or is mild, future recessions are inevitable.

A recession is beginning now, according to the June 22 Chapman Economic Forecast Update, the most accurate in the country for GDP prediction. Said President Emeritus Jim Doti at the event, “We’re pointing to a negative change in the third quarter and the fourth quarter and that’s the stuff of a recession, perhaps a moderate one … certainly a slowdown of some sort.” He blamed the Federal Reserve Board boosting interest rates from 0.0% in early 2022 to 5.25% today, with more rate hikes ahead.

The California budget just approved by Gov. Gavin Newsom and the Legislature also had to make cuts to eliminate a $31.5 billion deficit for fiscal year 2023-24, which began July 1. That flipped the previous year’s $100 billion surplus. So there will be no local budget rescues from the state.

How can local governments prepare for a recession? Someone who went through three recessions at the local level is John Moorlach, a California state senator from 2015-20, with whom I served as press secretary. Prior to that, after the recession of the early 1990s, as a candidate in 1994 to be Orange County’s treasurer-tax collector, he predicted rising interest rates put the county’s investment portfolio at risk of bankruptcy – which happened in December that year. He was appointed to that position the next year, where he weathered the 2000-01 dot-com recession; then in 2006 he was elected to be a county supervisor until 2015, including during the 2007-09 Great Recession, during which the board had to cut 1,000 county jobs.

Five ways to prepare

He said there are five ways local governments should prepare for an economic slump:

  1. Build reserves. “Start putting your acorns aside,” he urged. That includes postponing expensive projects.
  1. Pay down high-interest debt, beginning with defined-benefit pension plans. The California Public Employees’ Retirement System (CalPERS) currently expects 7% annual returns on investments. But if it doesn’t make that goal for several years – a likely result in a recession – local governments are liable for making up the difference. A key strategy: Prefund pensions according to Section 115 of the Internal Revenue Code, which states, “Gross income does not include … income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof.”
  1. Prioritize programs. “Ask what’s core? What’s non-core? Then prioritize. Obviously, police and fire. Then look at your whole portfolio of services and staffing.” An example would be laying off the economic-development director, who’s not needed during a recession because business activity is down – and not really needed during days of prosperity as the market takes care of itself.
  1. Prepare the bargaining units. A good idea is getting union agreement on early retirement plans, which removes the salaries of employees with the most seniority. Part of this is working around the system of LIFO – last in, first out, which lays off competent new employees before less competent senior employees. Moorlach said, “Move these good recent hires to another division that’s core, instead of non-core. Save some of the stars.”
  1. Don’t frustrate your stakeholders – the citizens and businesses who pay the taxes for government services. Of course, high taxes and regulations driving people and businesses to other states is an old problem in California, with the state’s population dropping by 500,000 during the recent years of prosperity. Higher taxes during a recession would drive away even more. Moorlach said alternatives would include limited layoffs, or getting unions to agree to short-term pay cuts to avoid layoffs. “You have to have good rapport with the unions. Get ready.”

When all else fails

If things get bad enough, local governments can declare Chapter 9 bankruptcy, which U.S. Courts described as providing “a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.” This is, of course, a last resort, but it became necessary for some poorly managed cities in the past.

Moorlach pointed to Stockton’s 2012 Chapter 9 bankruptcy filing, when it sank into $2 billion in unpayable debts. As this case showed, a federal judge is not bound by state laws and court cases, such as the so-called California Rule, which says all contract obligations for pensions and retiree medical care must be met. But for Stockton, the federal court completely wiped out their retiree medical care plan (they still had federal Medicare), removing $500 million from their balance sheet.

Also vanished were Stockton’s pension obligation bonds – POBs. Right on the top of the Government Financial Advisers Association, it warns, “State and local governments should not issue POBs.” It then explains, “The use of POBs rests on the assumption that the bond proceeds, when invested with pension assets in higher-yielding asset classes, will be able to achieve a rate of return that is greater than the interest rate owed over the term of the bonds.  However, POBs involve considerable investment risk, making this goal very speculative.” But if a city like Stockton has a major problem, well then, too bad for the bond holders.

The bankruptcies in California a decade ago in Stockton and San Bernardino did not include pension haircuts. But that solution also could be something distressed cities could plan for heading into a recession. Detroit’s 2013 bankruptcy led to a federal judge cutting pension payments 4.5% and ending cost-of-living adjustments.

Moorlach urged local governments facing such a situation to begin preparing to make major changes in front of a bankruptcy judge, such as jettisoning retiree medical, POBs and accrued vacation and sick leave payments. Although difficult, Stockton’s Chapter 9 filing moved it from among the least financially sound of California’s 482 cities to the upper half.

We don’t know if a severe recession will hit. Maybe President Joe Biden will be right and what he’s calling Bidenomics will keep the prosperity bus rolling. Or it could be worse than the Chapman economists predict. But like a prudent family or business, governments ought to plan for downturns. In fact, former Gov. Jerry Brown always warned the state that downturns always are around the corner – as a way to dampen the Legislature’s interest in creating new, permanent programs. Even if this one is skipped or is mild, future recessions are inevitable. There’s no way, in the end, to repeal the business cycle.

John Seiler is on the Board of the Southern California News Group. Write to him at [email protected]

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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