Mark McMullen is a senior economist with Moody's Economy.com who specializes in state and local governments. In February, he told FIRE CHIEF that dark days lay ahead for local governments. But few knew just how dark they would be. The economic freefall has hit fire departments hard. Many are faced with layoffs and spending freezes. Ten months since his last interview, McMullen said as that bad as things seem, we may not have seen the worst of it yet.

In January you predicted dark days for municipalities. Now that they are here, how bad will it be and how long will it last?

We knew it was going to be a bad cycle for municipalities and local governments, but I didn't realize that it was going to be this bad. It will be something we haven't seen in quite some time, since the early 1980s. It is not just the severity of the downturn, but the nature of it. It is really a consumer-driven downturn this time. The imbalances started in the housing market and that really is still the main issue. Being consumer-driven, this has put pressure on property taxes and sales taxes, the real backbone of the local government financing. This is opposed to some of the other recent downturns when the imbalances would be in investment, the tech market, or savings and loans and not necessarily hitting households and household spending as hard as this downturn has done. That much we knew; we knew it was going to be bad. What we didn't completely foresee is the extent of this financial crisis and what it has done to borrowing costs and the ability of municipalities to cash in their assets or to use bond financing to spend. Ever since the failure of these bond insurers, we've seen municipal debt rapidly go out of favor with investors to the point now where the interest rates don't reflect the tax incentives. Now, municipalities have to pay a premium to borrow. That's typically the way they keep programs going when revenues fall off, and the revenues have certainly fallen off.

How much will unemployment play into this?

That certainly is a big thing. We've already seen over 1 million job losses since the beginning of the year. The last recession was 2.7 million all tolled; this one will probably be quite a bit worse. In terms of the cycle, you get this shock to spending, which will trickle down and we're seeing it in terms of job losses. Well, job losses mean consumers' income is less so spending gets hurt even further, and even more job losses and you get this negative-reinforcing cycle. What we need to do is break that and that will be the path to recovery.

What will it take to get meaningful short-term relief?

There's little hope, unfortunately, in the short term for municipalities. The revenue across the board are going to be bad. We know the hit on sales tax is real bad and we know the hit on property tax is real bad, and that is lagged by quite a ways because the taxed assessed value of these homes don't really keep up with the market values. We know that those are going to be lack-luster for some time. What municipalities really have to bank on in the near term is either getting aid from the state or federal government, or their valuable assets. Governments hold a lot of valuable assets and they can cash these in when times are tough. Last time around, a lot of states went into their tobacco-settlement funds. This time, we're seeing a lot more securitization of toll roads, or they are tapping into the public-employee retirement systems or into highway trusts or public credit unions. They are going to have to lean on some of this for near-term funding.

What will it take to see meaningful long-term relief?

It is all about getting this self-sustaining economic recovery that we see a year or two down the line. Once we start seeing the spending improve and the house prices improve, these underlying economic drivers of local revenues, then things start to get better. At the same time, when job and income growth resume, then there's less need for these means-tested programs like Medicaid, unemployment insurance and these sorts of things. It is about the economic recovery taking hold, which we don't see happening until the end of next year.

Is the end of 2009 optimistic?

This is our baseline outlook. The economic expansion will begin at this point at the baseline, which is a little bit earlier than the consensus. But we don't expect a rapid expansion at that point either. While things will start to improve toward the end of next year, we're not going to get a real rebound of any sort. We'll have recession-like conditions for quite some time. A lot of these things, like the jobless rate, are lagging indicators. It takes a while before these things reflect a healthy economy. But in terms of the unemployment bottoming out and the house prices bottoming out, that should happen sometime in the second half of next year.

If enacted, what effect will President-elect Obama's tax plan have on the economy?

Not a whole lot. In terms of the overall size of the deficit, the Republicans and the Democrats weren't running that much of a different platform. There are differences in terms of redistribution as the McCain camp pointed out lots of times. In terms of volume, there is only slight differences. We are talking about a trillion-dollar deficit regardless of who was in office. So the tax plan was just a drop in the bucket. That said, we are seeing some impact already. A lot of this month's stock sell off that happened since the election is a reflection of investors expecting higher capital gains taxes, and so are trying to get ahead of these tax increases. For income-tax states, they are expecting a huge drop off in their non-wage forms of income tax collections. That might mean that this tax year won't be as bad as expected, but the drop off will be even more severe following that.

What should the next economic stimulus package look like?

We're looking for aid to states. During the last recession, the federal government came through with $20 billion in aid for states, half of which was tied to the Medicaid program by increasing the federal share of Medicaid payments. The other half was open block grants. This time around, we expect a much larger package. Right now, we're calling for a $70 billion package, with roughly the same split.

Will that be enough?

Not quite. Right now states and localities, according to the Bureau of Economic Analysis numbers, are running deficits of $100 million on an annualized basis in the third quarter. A $70 billion aid package takes care of about two-thirds of the whole for a year. That leaves 30% for states or municipalities to come up with on their own through painful tax increases or program cuts. That stimulus money should come fast as the next administration takes office. That's part of the reason they use this block grant and the pre-existing Medicaid program as a way to funnel money to states. It is an easy way to do it because they have pre-existing channels. When you subsidize unemployment insurance and Medicaid in these state programs, you are also giving money to these distressed populations who will be most likely to go out and spend it.

What early signs should chiefs look for?

Our worst-case scenario is a lock up in credit. We need to see these credit markets starting to operate again. Without any lending, there are not going to be a lot of firms being able to expand operations. We're looking for indicators that credit is starting to flow. We are looking at business loans. Also, the interest-rate spreads are a very good indicator. We look at spreads between rates that banks lend money to each other and these safe, government Treasury bills. These interest rate differences really spiked when the sub-prime financial meltdown first kicked in. They rose to historic highs with this gap five times as wide as it ever was before. When these interest rate spreads come down, that will be the first indicator that the credit markets are working and the financial institutions are willing to do business with each other again. That's the necessary conditions for firms to start hiring.

What's the long-term outlook?

For fire departments the issue is two-fold. Over the long term, many municipalities and states are looking at structural deficits or budget problems, and most of them are related to the demographics. We have this baby-boom generation retiring in mass now. And this has put a lot of pressure on state spending requirements in terms of medical care, public-employee retirement programs and whatnot. The typical state is looking at long-term budget problems ignoring this business cycle. Fortunately for firehouses, it is not as bad as it is for other municipal services, because of the nature of this population shift. The population cohort of school-age kids is shrinking. In terms of the competing demands for local government services, fire departments are in a better standing than K-12. Fire departments are going to be able to demand more because of the nature of the population as it ages, but it will be a smaller pie (to fight over). Overall the long-term outlook is dark because of this.

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