Why We Are Only Fanning the Flames of the Crisis

A Reuters article Monday announced that a recent National Association for Business Economics (NABE) survey of 47 economists found that “excessive federal indebtedness” and state and local government debt constitute panelists’ first and second greatest concerns for the economy.  Without access to the full report, it’s difficult to say whether the article accurately reflects the results of the survey, but the public summary and previous NABE reports are at least suggestive. 

The tax cut extension ultimately effected in last December’s Obama-GOP deal, for instance, was ostensibly prioritized over deficit reduction by NABE economists last August.  The deal’s contribution to this year’s growth is expected to be sizeable, according to the February survey.  Given that the deal’s budgetary effects amount to nearly $900B in the red, it’s difficult not to see the majority position of the NABE panelists as implicitly predicated on certain distributional policies: government deficits and debt are only a problem once favorable tax policy for the wealthy is a done deal.

In any case, the article presents an opportune moment to discuss the fallacious argument that budget deficits imperil the solvency of the federal government (see also here and here for more thorough, and adept, discussions).  This line of reasoning is dangerous so far as it promotes, or justifies, a neglectful macroeconomic policy at the federal level, but it’s made all the more dangerous in its consequences for the very real fiscal crises in which our state and local governments currently find themselves.

The relationship of the federal government to state and local governments is similar to the former’s relationship to households in that the federal government is the issuer of the currency of which states, counties, cities, and households are users.  As users of the currency, state and local governments, just like households, cannot run budget deficits without risking credit downgrades and insolvency.  Recessions typically diminish revenues for these users of the currency at the very time that their expenditures are most needed.

Readers of this blog will be familiar with the potential, and the need, for the federal government, by virtue of its position as issuer of the currency, to promote employment, output, income, and private expenditure through public expenditure.  Households are reliant on this counter-cyclical fiscal policy to mitigate the destructive effects of economic downturns—particularly unemployment and the suffering it causes.

Households, however, are also affected by the policies of state and local governments.  We rely on state and local governments for many of the services that facilitate not only a decent life but also the future prosperity of the nation: health, security, education, employment, and a social safety net to ameliorate the vagaries of the market economy.  We also surrender the revenues by which these services are funded. 

The problem lies in the dynamic relationships between non-issuer households, non-issuer governments, and the issuer government.  In short, because state and local governments are financially constrained, their budgets tend to be pro-cyclical—expanding services and lowering taxes in booms, cutting services and raising taxes in recessions—, precisely the opposite of what households need from government.

As Prof. Wray has explained on this blog, as users of a currency they don’t issue, state and local governments, like households, must finance their spending.  Revenues can come from bond sales, intergovernmental transfers, charges on services (e.g. hospitals, universities), or taxes, but ultimately the money for the government services we rely on must come from somewhere. 

During a recession, however, these revenues typically decline and the budget crises we’re seeing today result.  Let’s consider a few options state and local governments have in this situation, and their social and economic desirability: tax increases, where possible, are not only politically unpalatable, but socially undesirable as well.  Averaged across the country, middle and low-income households pay roughly twice the state and local taxes of upper-income households.  Revenues through regressive taxation are thus likely to disproportionately burden the lower and middle classes.  It may be added that it is simply bad economics to further tax spending in a time of high unemployment and depressed spending. 

Perhaps, then, the problem can be solved in terms of the services these governments provide.  Increases, for instance, in tuition at state colleges are a plausible means of lightening the load on state coffers, and states and their university systems have generally had no problem going to this well in recent years.  But, it is doubtful that making higher education more expensive is a good long-run plan for any state; and it’s certainly not in line with January’s State of the Union address.  The same, of course, can and has been said of widespread layoffs of teachers. 

An NABE survey last August found that their economists turned to the reduction of public-sector employee benefits and pensions as well as programmatic cuts as favored solutions for state and local budget crises.  But this only advocates for the realization of the very problem we’re dealing with: the pro-cyclical nature of state and local budgets when households, and firms alike, need counter-cyclical action from government. 

Contributors to this blog have made more appropriate recommendations.  Wray argued some time ago for immediate relief of the fiscal crises of state and local governments.  Profs. Black and Carbone (here and here) have similarly argued for a revenue sharing program to offset the pro-cyclical nature of state and local budgets.  Wray continued by proposing the elimination of regressive taxation through federal incentives to states and public investment in infrastructure. 

It is worth noting that all of these are made possible by the federal government’s position as issuer of the currency; and all are made necessary by the positions of households and state and local governments as users of the currency.  It is in fact because the state and local governments on which we rely for many essential services are users of a currency they don’t issue that their budget constraints can actually exacerbate recessions.  Taking account of these facts, each of the recommendations from NEP bloggers avoids the myriad real, long-run harms of, e.g., making higher education unaffordable, laying off teachers and discouraging students from pursuing a career in teaching, cutting back vital government services, neglected much-needed infrastructure investment, and so on.

To the extent that it leads policy-makers at the federal level to cut spending, the fabricated budget crisis of the federal government can only fan the flames of the real fiscal crises of state and local governments and the long-run social and economic problems they create.  The well-known effects of sustained recessions, in terms of lost output and the myriad socials ills stemming from unemployment, are thus compounded by the efforts of state and local governments trying desperately to keep afloat: increased (regressive) taxes suppress spending and increase income inequality, social programs are cut just when they’re needed most, continued neglect of our declining public infrastructure jeopardizes our future prosperity, lay-offs and furloughs of public workers diminish essential services, employment, and spending