Originally published on WNYC News Blog.

States and local governments should build up larger "rainy day" funds, Federal Reserve Board Chairman Ben Bernanke said Wednesday evening.

[caption id="attachment_220" align="alignleft" width="331" caption="Fed Chairman Ben Bernanke speaking before the Citizens Budget Commission"][/caption]

"Building an adequate reserve fund during good times may not be politically popular," he said in a speech before the Citizens Budget Commission, "but doing so can pay off during bad times as well as lessen the tendency to overspend when times are good."

Bernanke’s comments at the annual dinner for the New York City fiscal group focused on the budget issues facing state and local governments.

The Fed chairman acknowledged that many municipalities had rainy day funds, but he said they proved insufficient to cover the massive shortfalls in revenues in combination with increases in demand for services such as Medicaid.

He did say, however, that his suggestion would do little to help the many states and municipalities today coping with multi-billion dollar budget deficits.

Bernanke sounded a note of optimism, pointing to recent developments that state revenues are rising nationwide and that fewer states are facing midyear budget gaps this fiscal year.

"If the economy continues to strengthen at about the pace projected by the Federal Reserve and many private forecasters, states and localities may start to get a little breathing space," he said.  "However, because the pace of near-term economic growth expected by most forecasters is relatively modest given the depth of the downturn, some time will likely be required before state and local fiscal conditions return to something approximating normal."

Nonetheless, he told the audience that he foresees more austerity for state and local governments as lawmakers "confront more tough decisions as they develop their budgets for fiscal year 2012."

And he cautioned that current budget cuts, while necessary to balance local budgets, are slowing the economic recovery.

Bernanke said that strains on state budgets have left some investors concerned about the health of municipal bonds.

"Continued evidence that states and localities are addressing fiscal shortfalls should help calm the municipal bond market," he said. "Fortunately, although these measures of risk in the municipal bond market remain elevated, they have been looking somewhat better recently, presumably reflecting expectations of continuing improvement in the finances of states and localities."

He promised the Fed will keep a close eye on the municipal bond market

And while he steered clear of expressly opposing proposed cuts to education in New York State, the Fed chairman ended his speech by emphasizing the importance of investments in K-12 schooling, community colleges, and vocational schools that retrain workers.