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Monday, February 22, 2010

States in Fiscal Crisis: How Did We Get Here?

Ok, state budgets suck right now.  We know this.  For instance, the New York Times reports (again) this week on the vicious cycle of state budgets and the economy.  As fiscally-strapped states cut jobs and other spending, their economies weaken, pushing their own revenues and those of their neighbors lower yet.  And then the states call for federal assistance.  This is a familiar story, although one that the size of the current recession makes more dramatic.  Why don't states ever learn?  Are we doomed to replay this gloomy story over and over, like a recording of Gotterdamerung stuck on repeat?  Will the plus-sized lady ever, finally, sing?   

Although there is no magic ring or other neat solution to crises as big as the one we have now, there are solid policies the federal government and states could pursue together that would help a good bit.  That's the argument of a new paper by me and my erstwhile FSU colleague Jon Klick.  And, thanks to Jon, we've got the data to support our noodling.   You're at least mildly intrigued, no?  Read more...

So, the basic problem is that state revenures are "pro-cyclical": when the economy is good, revenues go up, spending goes up, the economy improves (although there's a danger of inflation).  When it stinks, then eh, not so much.  Rational actors should want to insure themselves against the risk of being out of work during one of these economic slowdowns, but because of imperfections in the insurance market, they often can't.  So we have alternatives, like social insurance.  But these are exactly the kinds of things that states cut during downturns. 

Zoinks!  Why do they do that?  Well, what they ought to do is borrow.  That's what an individual would do: she would move money from when she's richer (the future) to when she really, really needs the cash (now).   (Aside to people who remember their econ 101: Keynesian economists would also say that there are macroeconomic reasons for borrowing during downturns, but since there is debate about that, we rest our argument purely on the microeconomic income-smoothing rationale.)  But states can't really borrow effectively.  Since public officials have limited times in office, there's a significant danger that unlimited borrowing authority could lead to excess indebtedness, as officials discount the costs to the public of future debt obligations.  So states tie their own hands through legal rules that make it hard for their officials to borrow, as with so-called "balanced budget" requirements.  (These turn out to be not especially effective at limiting borrowing, but pretty good at raising the cost of borrowing.) 

On the flip side, states could also get out of this mess by saving.  But none of them have ever done that to nearly the degree they'd need to mitigate later recessions.  Really, ever.  And that's not so surprising, because again the benefits of savings are later, while the officials have to win elections and collect other goodies of being in office now.   

All of this is bad news for people who live in a state hit by a fiscal crisis.  But, worse, it's also bad news for that state's neighbors and trading partners.  When the crisis state cuts its spending and lays off workers, that reduces spending in other states, too.  So another, predictable reason that states under-protect themselves against downturns is because a large part of the social harm that results is an externality.  

So, yes, there's a case for federal intervention.  But we don't think it should necessarily be just a jobs bill. Tune in next time for the solution and the data on whether it would work.     

Posted by BDG on February 22, 2010 at 11:23 AM in Tax | Permalink


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