A drop in the bucket: rainy day funds proved no match against recession-era budget gaps.

• Author: Haggerty, Todd
• Position: STATE BUDGETS

Rainy day funds are one of the most common tools states have to soften the blow of economic downturns and budget shortfalls. With the severe fiscal drought of the last decade you might assume the funds had all but dried up. Not so. Although they still remain below their prerecession peak, they have steadily been rising.

When the balances of Alaska and Texas are removed from the tally (because their large reserves skew state averages), state rainy day funds fell from a total of $25.9 billion in FY 2007 to $10.4 billion in FY 2010, and now sit at an estimated $21.6 billion.

The funds played a role in helping lawmakers balance budgets throughout the last two recessions, but the role they played was a secondary one. This was partly due to a sense of uncertainty among policymakers--a feeling that despite how bad things are, they could get worse--that has led states to preserve balances rather than exhaust them during risky fiscal climates.

The main reason rainy day funds did not save the day single handedly, however, is that the majority of them were simply not large enough to fill the deep budget gaps states faced.

In FY 2002, for example, the median rainy day fund balance stood at $95.7 million while the median budget gap was $394.8 million. This difference was even more pronounced in FY 2010, when the median rainy day fund was $105.7 million and the median budget gap was $1.3 billion. These figures each reflect just one year, understating the fact that in both recessions, states faced budget gaps four or more years in a row.

This illustrates that, by design, rainy day funds are intended to solve short-term budget problems, not to address severe or prolonged budget problems.

How Much is Enough?

Legislators, budget experts and observers have debated how much states should allocate for these "budget stabilization funds" since they were first developed. In fact, what size to cap these funds at has been the most controversial aspect of them over the years.

In the early 1980s, rating agencies recommended that states, in general, should set aside 3 percent to 5 percent of their revenues for the reserves. More recently, the Government Finance Officers Association suggested up to 15 percent or two months of general fund revenues might be more helpful.

It may not be politically feasible, however, for a state to maintain the level of reserves that many experts recommend, and appropriate reserve levels vary by state. Specific circumstances, such as the...