Sunday, July 3, 2011

America's Deficit Hysteria is Taking a Toll on State Governments

To follow economic news these days is painful.  It seems that each thing you read is worst than the last.  So in an effort to keep my sanity I have watched quietly as the eurozone dismantles itself.  Perhaps a combination of fatigue and an insular Atlantic has me pacified.  But as whatever mental disease that compels the leadership of Europe these days spreads across the pond, I'm once again obliged to pen a few words in protest.

The State of Minnesota shut its doors last Thursday as a result of an impasse over its $5 billion budget gap.  Minnesota is not alone as most states in the union, in varying degrees, currently face budget crises.  According to  the Center on Budget and Policy Priorities 42 states project budget shortfalls for FY 2012.  These gaps range from 2.4% to 37.40% of their respective general fund budgets, with most states hovering around a median of 11.5%.  States with budget deficits are projected to total over $100 billion in FY2012.  While that sum is better than the current fiscal year deficit of $131 billion, states expect to be in the red for the foreseeable future.

To deal with this issue states are faced with the choice of raising taxes, cutting spending, or a combination of both.  Unlike the federal government, states cannot generally run deficits in perpetuity.  They must balance their budgets or run surpluses.  Usually tax increases are ruled out immediately and for good reason.  We are in the midst of a recession and raising taxes drains spending power from the economy, which only serves to prolong the misery.  Of course, there are other ways to raise taxes that don't have that effect - like increasing marginal tax rates on income and capital gains - but those are often immediately discarded from debate as "socialist" and "unamerican."  They are not, but that is a subject for another post.  So any kind of tax increase is off the table, leaving only spending cuts.

While it seems to be the weapon of choice for governments, spending cuts are often worse than tax increases, especially at the state level.  Typically there is not much fat to trim from state budgets before you cut into the meat.  Take for instance Nevada who ranks the highest in terms of deficit as a proportion of its overall budget.  Below is a snapshot of how Nevada divides its spending pie.  Notice the two largest pieces of the pie are expenditures on education and human services (health care, elderly assistance, employment services, mental health services and programs for families and children).  Now since Nevada has a large budget gap to close - more than 37% of its budget - it has no choice but to look for opportunities to cut spending on education and human services, as they account for 60% of the state's total spending.  You won't find those savings by streamlining the finance / administration sector.

Source:  Nevada Open Government
Cuts to education and health services not only have an immediate, negative impact on the economy, as layoffs and furloughs translate into less demand, but they also limit the ability of the state to meet its long-term social and economic goals: mainting a healthy and well-educated workforce.  What is most appalling is the fact that states are being forced to hollow themselves out to deal with temporary, cyclical budget shortfalls.  These deficits, in large part, are a consequence of the Great Recession.  They have nothing to do with the normal function of each states' budgets and priorities, but rather the reduction in tax revenues and increase in unemployment benefits as jobs disappear from a contracting economy.  As unemployment remains high and federal support to states runs dry, these states are resorting to drastic measures to remain solvent in the short-term.

The massive layoffs, government shutdowns and liquidation of entire "right-sizing" of school districts around the country is completely avoidable.  That is the great tragedy.  The farce is that Washington believes it needs to behave like individual states, member countries to the EU (read:  Greece), or even individual households.  The rhetoric these days is all about balancing the budget or running surpluses, rather than providing liquidity to states to keep them in the black during the recession.  Absolute madness!  Worse, the POTUS is so committed to convincing us that he's just as austere as the next guy that he keeps playing the same old "fallacy of composition" record, hoping that this time it will sell:

"Government has to start living within its means, just like families do.  We have to cut the spending we can’t afford so we can put the economy on sounder footing, and give our businesses the confidence they need to grow and create jobs." ~ Barack Obama, July 2nd 2011 Radio Address (h/t Krugman)

The president is wrong.  The federal government does not face the sort of funding constraints that individual states, businesses or households do.  Nope, they are the issuers of the currency in use by those entities, and as such can never run out of dollars.*  Federal spending is only limited by political will and the sort of inflation an economy experiences as it nears full employment.  With this in mind, the president should instead spend his political capital reminding the polity that incumbent upon the federal government is a responsibility to the states, that during periods of cyclical budget crises they will be extended the liquidity necessary to keep the doors open and resume their long term development strategies.  

* For those unacquainted with the operational facts of modern US finance this claim may come as a shock.  If so, please see this primer on Modern Monetary Theory (MMT)