August 6, 2011

S&P Downgrade Serves as Wake-up Call for States

Eileen Norcross

Senior Research Fellow

S&P’s decision to downgrade the federal government’s debt will produce a reaction in other debt markets. State and local governments that are otherwise doing well, but are carrying the risk of a lot of federal projects on their balance sheets may find it more expensive to borrow.

In July, Moody’s put five states with economies tied to the federal government on a downgrade watch list: Tennessee, Maryland, Virginia, South Carolina and New Mexico. But they haven't been downgraded. This week, Moody's confirmed their AAa rating. It's likely, however, these states will find their finances under greater scrutiny going forward.

In the case of Virginia and Maryland, their large military spending crowds out other types of investment. This results in a lack of diversification in the state economy.

With this wake up call, states like these can take this opportunity to pursue the right policies with its tax and fiscal choices so it can still attract business activity rather than just industries that are federally subsidized.

The federal downgrade also affects private companies that contract with those governments and local governments financing projects with debt. The decision to downgrade the federal government injects uncertainty into these decisions. But this doesn’t mean that these governments won’t be able to repay their debts. It may make it more expensive for them to issue it. By how much, is unclear