Paul Krugman asked a good question yesterday: “…if states and localities can borrow freely, how do you explain the drastic fall in their spending I have been documenting?”
This is maybe too literal an answer to address his macroeconomic concerns, but I view state and local government spending as falling because voters wanted it to, either directly or indirectly. Inflation-adjusted net worth per capita is still below the level of the late 1990s, and not returning any time quickly (an important point), and so voters/spenders wanted to cut back somewhere. Local government is the target they chose, and not just in the Red states. My point is not that the median voter is all-wise, but rather the Austerians are the guy next door. Voters apparently don’t see marginal local government activity as having the same value as cash in their pockets. There still may be a role for a federal fiscal bridge to ease the transition, but in democratic systems some expenditure declines are in the cards, just as the rollicking revenues of earlier years led to big boosts in state and local spending. We are not as wealthy as we thought we were, and greater federal borrowing can blunt this reality only to some extent. The notion of a voter ideal point ought to somewhere enter the analysis.
A few months ago I saw a tweet — I forget from whom — noting that the economy would be (would have been) booming if only not for the state and local cutbacks. I differ from that perspective, and I would rephrase it as the (not false) claim that the economy would be booming if only we were wealthier.
I’ve yet to see a good analysis of how freely state and local governments can borrow at the margin, especially in response to a decline in tax revenues. Many bloggers have attacked this piece by John Taylor (pdf), as Taylor argued that the stimulus aid led to a corresponding reduction in state and local borrowing. We still don’t know if this is true, but do we know that it is false? The arguments against Taylor consist of little more than saying he cannot be right. Check out the graph on Taylor’s p.5, noting that inverse correlation is not the same as causality. It’s striking nonetheless, as state and local borrowing goes down as receipts from the federal government go up. Constitutional balanced budget requirements may or may not bind, as many state and local governments can “borrow” quite readily by adjusting contributions to their pension funds, among other moves.
A related question is how voters understand the ability of their state and local governments to spend more by “borrowing” against pension funds, or changing accounting, or in other words what they saw as the opportunity cost of continuing previous levels of public spending at the state and local levels.
My view in 2009 was that federal aid to state and local governments was the one part of the stimulus bill which made sense. It is easier to preserve old jobs than to create new ones. Still, when it comes to analyzing the state and local cutbacks, and the effectiveness of federal aid, we don’t have a lot of clear answers.