Monday, March 22, 2010

State Budgets and Recessions

Living in Minnesota and being from Illinois, it is impossible for me to ignore the awful effect that "The Great Recession" has had on state budget balance. Minnesota is looking at deficit of over a billion dollars, and Illinois' budget is in the worst shape of any state not governed by an Austrian movie star. Why did state budgets take such a hard hit, and why is this a problem? Here's the background:

  • State and local governments cannot run budget deficits. Many states have balanced budget language in their constitutions, and even those that don't are unable to borrow or print money like the federal government.
  • Most states have income taxes, but they, along with county and municipal governments, also get a large portion of their revenue from sales and property taxes. In a recession, people lose their jobs (driving down income tax reciepts), buy less (driving down sales tax receipts) and especially in this recession, property values plummet (driving down property tax receipts). 
  • State-run programs like Medicaid, unemployment insurance and assistance, and other state-run health care programs for the poor are most in need during recessions, right when available funds plummet.

These factors are structural. They are also quite predictable. So when the Great Recession hit, how did the country deal with the problem? An ad-hoc combination of federal stimulus dollars and state-level tax hikes and spending cuts.

Why are the tax hikes and especially spending cuts so bad? They actually exacerbate the effect of the recession. When states start laying off employees and cutting back on assistance to the unemployed and working poor, those people stop spending money, worsening the economy and further lowering state tax revenue. It's a vicious cycle. That's the economic argument. The more moralistic argument is that cutting health care for the poor, laying off teachers, and letting our already crumbling infrastructure deteriorate further is just wrong.

The best weapon against this is federal deficit spending. I know it's hard to talk about deficit spending when so many are screaming that the sky is falling due to the national debt. But in a recession, basic economics says that the federal government must step in to replace the falling demand from consumers. Ideally, the government would have built up cash reserves during the good times, instead of racking up big deficits, allowing the spending to be less painful. Unfortunately, eight years of a fiscally irresponsible Bush administration put the kibosh on that. However, that's still no excuse to hang states out to dry. Accordingly, the American Recovery and Reinvestment Act included a large infusion of cash to state and local governments. It hasn't been enough, and it had to go through the political gauntlet of passing a polarized and politicized congress.

Therefore, it would make sense for there to be automatic stabilizers that kick in when a recession hits. The ad-hoc way we currently deal with recessions is not working. Are there any? I asked Nick Johnson, who heads up the State Fiscal Project for the Center on Budget and Policy Priorities:

The simple answer is no, there are no automatic stabilizers for state revenue that kick in during a recession.  The more complicated answer is there are some potential such mechanisms, but they don’t work well

Well, that's disappointing. The potential mechanisms he refers to are the "rainy-day funds" that some states have but are too small to deal even with small recessions, and the automatically increasing federal Medicaid funds as more members enroll that must be matched by increasing state funds. So clearly, there's room for growth. As it turns out, Mr. Johnson already wrote an article for the American Prospect on the same topic, to which he pointed me.

When I was thinking about and researching this post, I realized that I had basically no idea what an automatic stabilizer would look like. I had only a vague idea of emergency funds being sent to states when the economy hits some benchmark that marks a recession. Thankfully, Mr. Johnson's article lays out some more specific ideas. For example, pegging the federal funds for Medicaid to the unemployment rate and working in recession boosts to the formulas that dictate the grants states get for education and human services. He also puts the onus on the states to do a better job of building up better rainy-day funds, and not falling into the trap of pro-cyclical policies.

That last piece of advice applies to the federal government. We need to do a better job of getting our fiscal house in order when the economy is flying high, so that we can better respond when it comes crashing down.

But overall, it's important that Washington take some steps to ensure that in future recessions there is a way to support state budgets without having to go through the time-consuming and policy-wrecking gauntlet that is the US Congress. Our current policy falls way too hard on the people who least deserve it.

(Published at MinnPost)


  1. Though I'm no expert on history, it seems that an important consideration in the legacy of an administration is the state of the union for the period immediately following that administration's office term(s). With respect to Bush 43, it's evident that a big part of his administration's delinquencies lay in the condition Obama received the country in. At the approaching midterm (and beyond - to 2012, even), do you think constituents will make this connection when making their selections for Congress (broadly speaking)? Or do you think the Democratic party will receive the brunt of the blame for current conditions (without appropriate consideration for lag between a change in trajectory and vector of public effect)?

  2. Basically, the public will give a president or governing party slack for a while, but eventually they own it. Obama is certainly into the period where he now owns the destroyed economy and ballooning deficits. Congress was pretty unpopular in the first place, and their display of bickering and fighting over the past year has not improved their stake. There's a long-standing correlation between the economy and popularity of the party in power. As a result, the Dems are looking at pretty hefty losses in 2010. One can argue whether or not this is fair, but in an environment of 10% unemployment, incumbents are at a severe disadvantage. Indeed, Obama's job approval on the economy has steadily declined.

    There are a couple caveats to the above. First, the Dems were going to lose seats in 2010 regardless. The president's party nearly always loses seats in the midterms. Plus, majorities as large as the Dems have are just not sustainable. So the question for Dems in 2010 is not "how do we stay where we are or pick up seats?", it's actually "how do we minimize our losses?". An economy in a jobless recovery will not help their efforts. I can't find the poll offhand, but I believe the last polls have had a majority of the public saying the stimulus didn't work. That's factually incorrect, but it will contribute to Dem losses. The other is that in a period of 10% unemployment, the fact that President Obama has stayed right around a 50% approval rating is remarkable, considering a very solid correlation between unemployment and approval ratings.

    So Obama is still getting something of a pass, but Congress isn't. On the plus side, one of the only groups with worse approval ratings than the Dem congress is the GOP congress.