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All U.S. states will run into substantial budget shortfalls. They need bailing out. States must be empowered now to keep their cost up. Cutting down on their budgets puts a rocket behind the economic downturn and accelerates a vicious cycle. On top of that, they need Federal assistance in order to get the stimulus programs running.

My series of articles has so far shown that a $1000/month income/cost gap of the average American is the root cause of the economic problem, and it needs bold government action to address it. Market mechanisms fail, and the economy looses at least 27% of activity and more from rising unemployment. Major risk factors in the derivative market need to be contained. My last article proposed to sweep up the unemployed through government infrastructure, education, and military programs. The "supply" side of the labour market needs to be kept below 7%.

California's, New Jersey's and New York's budget shortfalls are few examples of what's to come in probably all states and with certainty on the federal level. The Federal budget alone will see a gaping hole of at least $1 trillion in 2009. Instead of an "income" of $2.5 trillion, they will probably rake in less than $1.8 trillion (25% less each in individual income tax and Social Security/Insurance, 50% less in corporate income tax, and 20% less in the rest).

Unlike the Fed, states don't have the capacity to "expand" money supply. They face a threefold problem:

1) shortfalls in budgets from drops in income and/or sales taxes lead to massive funding gaps

2) financing those state deficits is going to be nearly impossible through the market or from banks. Thus, higher borrowing cost and even higher deficits will follow.

3) the cost for sweeping up the unemployed and keeping the cost up as in my proposal is entirely unfunded.

We all want small and cost effective governments but America missed the opportunity 8 years ago to slash cost. We had the right promises (small government, energy independence), the right economic climate, and supposedly the right President to do just that. However, it turned out differently and government is bigger than ever and the debt load is scary.

I am not suggesting that states and the Federal Government keep the existing, inefficient cost structure. What I do suggest, is that cost is quickly shifted to stimulus measures while the traditional structures are restructured or closed down. Restructuring costs a lot of money and that is exactly what the economy is in need of right now. What matters most is that government keeps its share of the economy or expands it. This approach prepares governments to come out of the crisis successful and much smaller. I will address this question in my article "prepare for budget cuts".

For now, states need the Federal Government to provide them with cheap federal funds to finance their deficits, to refinance their debt load and to pay for the newly hired workforce for infrastructure and education programs.

What is causing the troubles and how to get out of it?

Due to the consumers' deadlock stemming from an income/spending gap, a painful downsizing process is in the making. The root cause is not the commonly cited housing crisis. It is caused by falling wages while cost of living and home "values" went up. The increasing gap was financed with debt and the housing and credit crisis hit home as soon as the Fed increased interest rates. We are at the beginning of a fundamental shift in the bank/consumer relationship. Whether the government likes it or not, lenders say "no more" to spending sprees over and above to what you can safely afford for many years to come (think in a generation).

Probably the most important pillar of stability in this economic situation is government spending. States cutting their budgets will cause more havoc if the cuts are not replaced with stimulus measures that are equal or greater than the cuts, at the expense of more deficits and debt.

The Federal Government needs to provide deficit funding and refinancing for all states in order for them to keep their programs running and shift their priorities. Stimulus funding needs to be focused for states to sweep up the unemployed in infrastructure and education programs. You will see the number of unemployed rising sharply within the next couple of months. States and communities need to create or accelerate investment programs to temporarily provide employment (not jobless benefits), whatever the cost.

There is a problem looming in governments, municipalities and school districts that you do not want to know about:

Nytimes, Nov 1, 2008, Duhigg: "... Without realizing it, the schools were imitating hedge funds. ... Officials were told that just as home buyers had embraced adjustable-rate loans, New York could save money by borrowing at lower interest rates that changed every day. ... During the go-go investing years, school districts, transit agencies and other government entities were quick to jump into the global economy, hoping for fast gains to cover growing pension costs and budgets without raising taxes. ... But now, hundreds of cities and government agencies are facing economic turmoil. Far from being isolated examples, the Wisconsin schools and New York's transportation system are among the many players in a financial fiasco that has ricocheted globally. ... The Wisconsin schools are on the brink of losing their money, confronting educators with possible budget cuts. Interest rates for New York's subways are skyrocketing and contributing to budget woes that have transportation officials considering higher fares and delaying long-planned track repairs."

Unfortunately, school districts, communities, cities, and possibly states are all also engaged in financial bets, C.D.O.s or Collateralized Debt Obligations, made in the unregulated, casino style derivative market. As governments, there is no way out of these obligations, and the taxpayer will have to foot the mounting bills. Without knowing the scope of the problem, I would call that incredibly irresponsible. However, what states must do is launch immediate audits into all levels of government in order to find out what the magnitude of of these deals is. It could be disastrous.

The Fed needs to keep interest at its lowest. The move down to 1% is excellent. However, even lower is better and 0% will probably be the number that we'll see rather sooner than later. It provides for a brief window of opportunity for cheap state refinancing. For now, inflation is NOT a problem. Deflation is already here for a short while still (it means that you earn less but you owe more). Companies will have to get rid of their overstock while adjusting output, there won't be any bonuses, management salaries are falling rapidly. After a battle for market share, fewer competitors will be able to start raising their prices. That will be good news as it will hopefully signal the turning point.

As I have always maintained: somebody will at some point, somehow, have to pay the bill. In the current economic crisis, I don't even need to think about it too hard. It does not matter if the government runs up a debt load of $20 or even $50 trillion within the next 5 years. Inflation will take care of much of that. What matters is that economic life does not come to a screeching halt. That alternative is much, much more expensive and it will come at a cost of human dignity and life.

This article is part of a series of articles focussing on what local, state and federal governments need to do now in order to address the upcoming economic Depression.

economic stimulus (1): the disabled consumer

at http://www.ireport.com/docs/DOC-132064

economic stimulus (2): focus on income and equity

at http://www.ireport.com/docs/DOC-132067

economic stimulus (3): quarantine risk

at http://www.ireport.com/docs/DOC-132200

economic stimulus (4): sweep up the unemployed

at http://www.ireport.com/docs/DOC-132202

economic stimulus (5): bailout state governments

at http://www.ireport.com/docs/DOC-132205

economic stimulus (6): protect food and energy supply

at http://www.ireport.com/docs/DOC-132795

economic stimulus (7): invest into the future

at http://www.ireport.com/docs/DOC-132856

economic stimulus (8): be globally the most competitive

at http://www.ireport.com/docs/DOC-133022 

economic stimulus (9): change politics

at http://www.ireport.com/docs/DOC-133026

economic stimulus (10): prepare for budget cuts

at http://www.ireport.com/docs/DOC-133113

Please comment. I will try to address questions, if I can.

H.R. Tschudi, economist and entrepreneur, Vancouver