Democracy, wealth, and local stimulus spending

by on March 6, 2012 at 7:28 am in Economics, Political Science | Permalink

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.

1 The Other Jim March 6, 2012 at 7:42 am

>>…if states and localities can borrow freely, how do you explain the drastic fall in their spending?

In what universe is that a good question?

It assumes that any dollar that Government can spend, it should spend.

You might as well ask, “Why did you stop doing vodka shots when there is still another bottle up in the attic?”

2 Andre March 6, 2012 at 2:19 pm

I don’t think that analogy is apt, and not to Krugman’s point anyway. A financial crisis hits and very suddenly people want larger class sizes? Less police? Shorter weeks / service hours from local goverment agencies? Was there a long term trend of declining demand for services over many years prior to the crisis. There is no way the shorter term cash on hand can replace those services.

I don’t think economics has as much to do with the cut backs as politics. Politicians won’t make cuts, or at least hold the line, when times are good so this is the only time things can go in the other direction. If you can use the cover of federal stimulus money to mask the severity of your cuts so much the better.

3 Salem March 6, 2012 at 6:50 pm

“A financial crisis hits and very suddenly people want larger class sizes? Less police? Shorter weeks / service hours from local goverment agencies? Was there a long term trend of declining demand for services over many years prior to the crisis. There is no way the shorter term cash on hand can replace those services.”

Multiple equilibria holds in politics as well as economics.

And of course the lower tax burden can replace those services – especially if you didn’t consume much of them to begin with.

4 Michael March 7, 2012 at 11:39 am

Well, from what I am aware, the data shows that marginal changes in class size has very little impact on academic achievement, so yeah, the funds grow short and people realize that the cost of that extra teacher or two isn’t really worth it after all. Why does Krugman sidestep the most obvious explanation? Do you really believe that there is absolutely no fat to trim in local government?

Granted, I fully support arguments that government officials always look first to cut the best producers of gov’t services in an attempt to shore up support for revenue increases, but still, the premise of Krugman’s question is fundamentally flawed.

5 Michael March 7, 2012 at 11:31 am

Right, my first thought on reading that question is to notice the implicit assumption that all local government spending is inherently good. Maybe Dr Krugman should start by analyzing that question.

6 Andrew' March 6, 2012 at 7:52 am

I still don’t understand how they did it how they did it, but somehow they by-passed budget limits by setting up a shell corporation to borrow the money. Then I guess they pay the shell corporation out of current accounts or something.

7 FE March 6, 2012 at 8:06 am

Krugman is arguing for a ratchet system in which state and local spending goes up during boom times (thanks to high tax receipts) and stays level during bust times (thanks to federal stimulus). I don’t recall him arguing for cuts during the boom to prevent permanent increases to state and local spending.

8 david March 6, 2012 at 8:10 am

At some point states have to pay back funds borrowed from the federal government. If they do so, they’re not spending those tax receipts.

9 dirck March 6, 2012 at 8:29 am

I agree with The Other Jim . The mindset that creates a question like Krugman’s is exactly what has created the government debt crisis that almost every developed economy is currently facing .Instead of either increasing revenue (taxes) to cover current spending or reducing current spending to match revenue ,most have opted to borrow the difference without making any sincere effort to address the imbalance in either the short or the long term .

10 Brandon Berg March 6, 2012 at 8:33 am

Might the lower progressivity of state taxes play a role here?

11 tedm March 6, 2012 at 8:33 am

RE: Paul Krugman – (a) if state and local governments are credit constrained in a way that limits aggregate demand, and (b) it is the state and local proportion of G that is responsible for the “meager” fiscal response of the US, then (c) how can you (Paul Krugman) maintain that the bond markets have shown no sign of limiting debt-financed fiscal policy? Also – given the potential for more municipal bankruptcies, and the (remote) possibility of state fiscal problems – we should probably distinguish state from local bond markets because states are not subject to the federal bankruptcy code but municipalities are.

12 Chris March 6, 2012 at 8:38 am

Simple answer: Medicaid crowd-out.

13 John Bailey March 6, 2012 at 8:50 am

The economy would be booming, if it weren’t for…

Efforts to maintain rapid growth have stymied it, leaving huge structural problems (U.S. – housing – Europe – Euro, China – construction, Japan – debt).

Mankind’s first attempt at guaranteeing retirement, health care, financial security, housing, and employment has created unsustainable debts, deficits, and entitlements.

Democracies can allocate resources among competing interests fairly effectively as long as economic production is growing so that things are getting better for the overall population. Hard choices produce paralysis.

The Eurozone, U.K. and Japan are all tipping toward recession.

Magic money from the Bank of Japan, European Central Bank, Bank of England, and, possibly, the Fed will likely delay the process of dragging China and the U.S. along, at the cost of extending and deepening it.

The demographic consequence of the `baby boom` means real business (as well as political, social and psychological) shocks, including default/restructuring of entitlement/guarantee programs.

Governing elites won’t solve these problems.

14 Becky Hargrove March 6, 2012 at 8:58 am

It seems that the legal mandate to meet present pension benefits, which can only be done by raiding the benefits from future retirees, will bring down a lot more local governments. At least any new local governments of the future, if and when they arise, might understand that they cannot make open ended promises that do not take all citizens and group sustainabilities into account. But people will develop such a mindset about open ended promises over and over again, if everyone does not learn at an early age how wealth actually spreads through community.

15 louis March 6, 2012 at 9:03 am

“Voters apparently don’t see marginal local government activity as having the same value as cash in their pockets. ”

That’s only an argument once you assume that the local gov’ts are budget constrained! If they borrow to maintain spending, then no cash is taken out of citizens’ pockets.

16 Cliff March 6, 2012 at 9:19 am

Borrowing = future taxes?

17 Mike March 6, 2012 at 9:38 am

Yeah, even if people somehow don’t get this at the federal level, the average voter sees this pretty clearly at the local level.

18 doug March 6, 2012 at 9:58 am

And you know this because, XXXX study demostrates it. Or that is your perspective? I doubt the average voter, who is digging themselves out from under a mountain of debt, recognizes this relationship.

19 Uninformed Observer March 6, 2012 at 10:12 am

Don’t be obtuse. The average voter understands intuitively that “money doesn’t grow on trees.” If the maxim applies to their own finances, why should their local government be any different?

Can we agree, without citing studies, that a) we are in a recession, b) the “average voter” feels personally the constraints that recession places on their personal spending choices, and c) the “average voter” is choosing to borrow less and spend less as a result?

I suppose c) can be supported in a a number of ways, from household debt and consumption stats, but I thought a) and b) were pretty unassailable.

20 Phill March 6, 2012 at 1:23 pm

Not if your bet is that GDP will rise accordingly.

21 Hasdrubal March 6, 2012 at 2:48 pm

Local governments are often constrained by their citizens: They have to send a referendum to voters in order to borrow in the same way they have to send a referendum to the voters to increase taxes or increase spending on most things.

22 chuck martel March 6, 2012 at 9:25 am

” . . . 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.”
__________________________

So it’s more important to “create/preserve” jobs than to create/preserve wealth? Then it must not matter what exactly the individual job-holder does, as long as he gets paid. The clerk down at city hall examining and perhaps approving applications for various permits is just as important to the economy as an auto mechanic or welder or block layer, right? There has been an intermittent derisive comment through the last few years that our economy was becoming one where we “flipped burgers for one another”. But it’s just fine if we have one where the biggest proportion of the work force is employed in bureaucratic nit-picking and paid with imaginary money.

23 Dan Hill March 6, 2012 at 9:40 am

I suspect voters realised that local government spending comes directly out of their own pockets. They are less serious about reducing federal spending because they implicitly assume that it will be paid for by someone else (the rich, corporations)

24 John Thacker March 6, 2012 at 9:40 am

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.

Easier, perhaps, but my view is that in a time of high unemployment, it makes more sense to employ unemployed people than preserve the pensions increases and wages of those that already have jobs, (when private sector counterparts are going without raises as well).

I understand that in many states (unlike Virginia), the various laws would result in state and local governments laying people off, because public employee unions would rather hold the line on pensions and have layoffs than prevent lost jobs, if the money wasn’t there.

25 chuck martel March 6, 2012 at 9:46 am

Mark Thoma says: “…permanent changes in taxes are a poor tool to apply against temporary cyclical problems….”
______________________________

Nobody is going to respond to a permanent change in anything, they’ll be far more likely to respond to a temporary one.

26 derek March 6, 2012 at 10:09 am

Two answers. Pension liabilities and Meredith Whitney.

Is Krugman really suggesting that there is a line up of lenders ready to lend against the current pension fund to a municipality whose revenues have dropped and not recovered to 2007 levels so that they can stimulate AD?

Really?

27 Floccina March 6, 2012 at 10:25 am

Does if have to do with perceived future property tax income declines due to falling home prices?

28 KLO March 6, 2012 at 11:09 am

Probably not. Falling home prices do not mean reductions in property taxes. Instead, the rates simply go up. Assessing the value of property is done for allocation purposes (what fraction of the total desired revenue each person will pay) rather than to determine the gross amount of tax that will be paid.

Over time, there might be some correlation between increases in the value of property and total tax paid, but this will more likely be due to demographic and economic changes that produce substantial increases in housing prices than mere increase in property values.

29 KLO March 6, 2012 at 11:13 am

As a follow-up, this is the conclusion of a Federal Reserve paper from 2010:

We find that property tax revenues do not tend to decrease following house price
declines. We conclude that the resilience of property tax receipts is due to significant lags
between market values and assessed values of housing and the tendency of policy makers to
offset declines in the tax base with higher tax rates.

http://www.federalreserve.gov/pubs/feds/2010/201049/201049pap.pdf

I would place special emphasis on the second point. Since the collapse of housing prices in 2007, we have not seen declines in property tax revenue. Compare that with payroll and income tax revenue.

30 Anthony March 6, 2012 at 1:32 pm

In California in particular, this was not entirely the case. Property is not reassessed until it is sold, so in normal times, most property is assessed at a lower value than its market value (in particular, assessments may only increase 2% per year unless the property is sold, and appreciation is usually more than 2%). So normally, if there was a sudden drop in property values, assessed values wouldn’t decline nearly so much, and thus revenues wouldn’t decline much either. Raising rates requires a 2/3 vote in the affected jurisdiction, and is thus nearly impossible in response to declining property values.

However, during the mid-2000s boom, many, many properties changed hands at inflated values, and thus the assessed values increased rapidly, too. Somehow, spending managed to consume all the increased revenue (and then some, in some jurisdictions), and when the crash came, and many properties lost 30% to 50% of their most recent sale prices, the assessed values went down as much. My house in Oakland, for example, was reassessed at less than 50% of what I paid for it after the crash, and three years later, to barely over 50% of my original purchase price. Oakland has not raised tax rates, and in fact, had a parcel tax removed in that period.

The paper you linked above states that as of 2008, revenues had not declined in California, but even in 2008, revenues in some jurisdictions in California did drop significantly, while revenues in other areas continued to grow because fewer properties had changed hands during the boom, or prices had not declined as far after the crash. I’d also be interested to see what happened to the trend in revenues since 2008.

31 Brian Donohue March 6, 2012 at 2:21 pm

Here’s a single data point that supports your contention: my property taxes have increased 60% in the past four years.

32 Bender Bending Rodriguez March 6, 2012 at 4:28 pm

Not necessarily. Taxes to cover the public schools are assessed as a percentage of property value, with any increases requiring a referendum. The value of my house can go down and I can vote against a tax increase for the local school district.

Sure, the state can change the rates, but again, this usually requires some kind of input from the voters, no?

33 Rahul March 6, 2012 at 11:14 am

The basic question is did spending reduce because local bodies didn’t want to any more; or because they couldn’t borrow.

I see a lot of ideological debates and arguments in the comments as well as by Tyler and Krugman. Isn’t there any data / surveys (I see one on Krugman’s post) that could let us decide in a more factual way?

34 The Anti-Gnostic March 6, 2012 at 11:28 am

“My view in 2009 was that federal aid to state and local governments was the one part of the stimulus bill which made sense.”

There’s a similar experiment across the Atlantic that isn’t panning out too well.

35 Ed March 6, 2012 at 12:03 pm

How much of the financial problems of state and local governments caused by the pensions issue?

I’m genuinely curious, though I realize its a big component. If much of the spending is now on employee pensions, taxpayers working in the private sector may not be sympathetic to the idea of paying higher taxes to pay more to people who are not now working for the private sector and may not even live in the area, because of contracts made long ago that they weren’t consulted on.

A related question is how much cynicism was involved in creating these overgenerous pensions to begin with. Did public sector managers agree to the deals realizing that the governments in the future couldn’t pay, and assuming that the governments would just default? Did the same cynicism enter into some of the private sector pension arrangements? Again I have my suspicions but I’d like to get more solid information.

36 The Anti-Gnostic March 6, 2012 at 12:59 pm

If much of the spending is now on employee pensions, taxpayers working in the private sector may not be sympathetic to the idea of paying higher taxes to pay more to people who are not now working for the private sector and may not even live in the area, because of contracts made long ago that they weren’t consulted on.

Ya think?! Maybe current taxpayers can find other ways to spend money than on bedpans and insulin for old white strangers?!

Oh man, when this bill comes due…

37 Brian Donohue March 6, 2012 at 2:24 pm

In Illinois, it’s simple. Teacher salaries are the responsibility of local school boards, but pensions are financed at the state level. So the whole pump up retirement wheeze has been depressingly predictable for a long time. In fact, it continues unabated (adding 200 sick days to final year’s pay to double pension, etc.)

38 ohwilleke March 6, 2012 at 12:12 pm

Since when can state and local governments borrow freely?

State and local goverment borrowly is widely regulated compared to federal government borrowing or private sector borrowing. There is elaborate federal income tax regulation of it (ironic since state and local income is excluded from federal income – the regulation comes from qualifying for the exclusion), almost all state and local governments are subject to statutory and constitutional limits on borrowing that amount to something close to a balanced budget in the absence of special approval for borrowing (often from voters), it is almost all quasi-secured debt in reality (with pre-approved tax revenues or enterprise income pledged to payment of the bonds) despite being described as unsecured debt since debt collection from municipalities works very differently from debt collection from private parties, and state and local governments can’t print money.

Their interest rates may be low, but their compliance issues are immense.

39 Anthony March 6, 2012 at 12:49 pm

I thought the same thing: “if states and localities can borrow freely” is a counterfactual assumption.

40 Bob Knaus March 6, 2012 at 12:34 pm

In an otherwise excellent paper, John Taylor’s concluding sentence is incorrect:
“Currently, the increased debt caused by ARRA—both directly through its deficit financing and indirectly through its de-emphasis on controlling spending—is likely a drag on economic growth.”

If he is correct that the state & local government response to ARRA was to reduce borrowing rather than increase spending, then by definition the amount of state & local debt must be reduced by an amount equal to the ARRA increase in Federal debt (minus transactions costs of course).

41 Steve Roth March 6, 2012 at 12:58 pm

“state and local government spending as falling because voters wanted it to,”

Makes sense. Classic tragedy of the commons.

42 Andre March 6, 2012 at 2:10 pm

Marginal value of government services worth less than money in your pocket indeed:

http://thinkprogress.org/special/2011/12/06/383580/tennesee-fire-fighters-family-home-burn/?mobile=nc

43 Bender Bending Rodriguez March 6, 2012 at 4:33 pm

Won’t somebody think of the children!

Oh, wait. Sorry, I got caught up in the panic of the moment. Perhaps, and I’m just spitballin’ here, there are some other
functions that local government is performing that don’t have the same marginal value as police and fire protection.

44 Jason March 6, 2012 at 3:20 pm

“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.”

If you measure the deviation from trend in state and local government spending, the reduction in borrowing is exactly the same amount as the reduction in spending.

http://research.stlouisfed.org/fredgraph.png?g=5vz

We should be spending ~$140 billion more today whereas the graph on p.5 shows a drop of $140 billion in borrowing.

It seems more like states cut spending to reduce borrowing as much as possible but only after including the ARRA money. If there had been no such money, borrowing would have still headed towards zero and state spending would have been reduced by another ~ $140 billion.

“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.”

You’re an economist! This is like a physicist saying ‘I haven’t seen a good theory of quantum gravity.’ Don’t just sit there and say other people aren’t up to snuff. Go build one!

45 Jason March 6, 2012 at 3:23 pm

And people have issues with the FRED graph starting in 2000 and rising with the housing bubble, here is 1990:

http://research.stlouisfed.org/fredgraph.png?g=5vB

Same trend.

46 Yancey Ward March 6, 2012 at 8:12 pm

The answer is that the average American is smarter than Paul Krugman.

47 Jon Biggar March 6, 2012 at 8:13 pm

Could the cuts appearing primarily at the state and local government level be because they are more responsive (overall or just quicker) to changes in voter sentiments?

Does anyone care to argue that the Federal government, as it is currently constituted and managed, is as or more responsive that state or local governments to a voter sentiment shift towards less spending?

Does this then appear as a leading indicator that the Federal government will eventually respond similarly and start making real cuts?

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