Welcome to Thoughts on the market. I'm Michael Zezes, head of Public Policy Research and Municipal Strategy for Morgan Stanley.

Along with my colleagues bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public

policy and financial markets.

It's Wednesday, July 22nd and 11 a.m. in New York.

As Washington, D.C. comes to life this week with Congress back in session, State capitals around the country are

eagerly watching what their federal government counterparts will negotiate

in terms of another round of fiscal stimulus for the economy.

That's because State governments are hoping DC helps them fix some pretty substantial budget holes that

opened as a result of the COVID-19 recession leading to precipitous drops and tax revenues.

And investors should care too, because if these holes aren't plugged, we can expect headwinds for markets and the economy.

Let's start with the size of the problem.

By our estimate, we think the 50 states combined are looking at a budget shortfall of

180 to 375 billion dollars through the end of fiscal 2021.

States could mitigate this problem by draining reserves,

but that would still leave deficits of 100 to 300 billion dollars.

Closing the rest of these deficits would require tax increases, borrowing, and or spending cuts.

If you're a muni investor, this would drive concerns of ratings down grades and wider spreads.

For all kinds of investors, the concern would be that this level of austerity could drag on the economic recovery, with states reducing employment, spending less on infrastructure, and potentially taking disposable income out of consumers' pockets through higher taxes.

Fortunately, we think DC is going to deliver and largely mitigate these concerns.

While Senate Republicans initially balked at the idea of providing more aid to state and local governments

on the idea that they didn't want

to incentivize poor budget choices, their tone is since moderated.

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