Saturday, July 31, 2010

Nevermind...

This week I had written an op-ed I was going to submit to the Washington post, emphasizing the point I made earlier that we really haven't done much of any fiscal stimulus and that the only reason why everyone thinks we have is because nobody thinks about states and localities when it comes to issues of national significance (like macroeconomic performance). I was waiting for the Friday GDP numbers to come out to make my case based on the last three quarters - when they did, though, total government spending was actually positive for the second quarter of 2010. So nevermind on that op-ed. The previous two quarters were still negative, although they had change slightly. This was the original text of my submission:

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"The American economy faces a major threat to economic recovery that most of the public probably isn’t aware of: government has been slashing spending for the last nine months. This Friday it became official when the Commerce Department released its quarterly economic statistics. In the second quarter of 2010, total government spending fell by [X] percent. In the first quarter of 2010, it had been reduced by 1.9 percent while in the fourth quarter of 2009 it dropped by 1.3 percent.

Recently, economists have been debating the merits of precisely this kind of “austerity.” Some have argued that reducing public spending can spur economic growth. Others are convinced that it is a sure way to kill the recovery. This discussion has generally revolved around Europe, which is increasingly pursuing austerity measures, and whether Europe offers a model or a cautionary tale for the United States. What this debate often leaves out is that belt-tightening by the government has already come to our shores, and it has been with us for the better part of a year now.

This seems to contradict what everyone knows: that the Obama administration has been running record-breaking deficits. Politicians and cable news commentators bombard us with concerns about our profligacy over the radio during our commute to work every morning and on television every night. How can it possibly be true that government has been slashing spending for the past nine months?

What the public often forgets is that the United States is a federal system with state and local governments as well as a federal government. We don’t “forget” about federalism in the sense that we don’t realize these other levels of government exist; they are an important part of our lives. But we do forget their relevance to problems of national significance, such as the current recession. This is a serious oversight, because together state and local government budgets are about one and a half times the size of the federal budget. That means that amidst all the discussion of the role of government in the economy during a downturn, many of us are completely forgetting about a significant portion of the government spending that goes on. Unfortunately, the economy and the job market don’t have the luxury of forgetting this. The economy can’t tell the difference between a dollar appropriated by the federal government and one appropriated by a state or local government.

Government spending has been shrinking for the last nine months because the federal government has been almost entirely preoccupied with filling in the hole that state and local governments have been digging, and the states have been digging that hole faster than the federal government has been filling it since the third quarter of last year. This results in a net reduction of government spending in the United States. If you think that government spending during a recession is harmful, you may be comforted by this news. However, those inclined to celebrate this reduction in government spending should consider the fact that the economic outlook began to darken again precisely when total government spending (federal spending, plus state and local spending) started to shrink.

Austerity is pursued in state and local governments for many reasons. Municipal bond markets aren’t always as accommodating as the market for federal debt. Some of these entities are constrained by balanced budget requirements in their constitutions, or statutory limitations on running deficits. Local governments that rely on property taxes have been hit hard by the housing crash. In addition to all these real constraints, though, a lot of state and local leaders simply believe that tight-fistedness is a virtue during a recession. Many governors, mayors, and county boards don’t seem to have received the memo from much of standard economic theory that responsible governments are supposed to lean against the economic winds. They should take a step back when the economy is heating up and government spending risks crowding out private activities and jump in to buy and use idle resources when the private sector is too fearful of what the future holds.

While some states, such as California, have a legitimately difficult time convincing creditors to lend to them, others, like my home state of Virginia, have no such excuse. Virginia has an excellent credit rating, but our governor and our state legislature apparently feel an abiding need to run a budget surplus during the worst downturn since the Great Depression. This decision in Richmond has the same impact on the economy as the recent decision of many big businesses to sit on profits instead of using that income to hire and invest. The Virginia state government is essentially telling us that it makes more sense to sit on our tax dollars right now than it does to use them to put unemployed Virginians and unused equipment to productive work. Yet for this, Governor McDonnell gets celebrated by voters and the press.

The growth of the federal government in the decades since the last downturn of this magnitude in the 1930s leads many Americans to forget about the significance of our federal system of local, state, and national governments. The public debate over economic policy is distorted by the fact that we’re not even talking about the majority of government spending that occurs outside of the federal government. Those of us who acknowledge the importance of stimulus get complacent because we aren’t aware that government spending is actually being reduced right now, not increased. Those who argue against stimulus are galvanized by false claims that total government spending is soaring.

State governments have always played a fundamental role in the history of our republic, and they are just as essential today as they have been in the past. We can no longer afford to write them out of the story of the government response to the recession."

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The argument itself still stands, of course. The logic is still good, and we still overestimate how much fiscal stimulus we're doing because we forget about the states. The positive numbers for quarter-to-quarter change this quarter are also probably related to several previous quarters of negative growth in government spending (i.e. we're still down from where we should be but they can't fall forever so you're going to get periods of positive growth). But it's harder to make that case convincingly when one of the three quarters you're looking at runs against your thesis.

So how do we interpret these recent GDP numbers?

1. It's good news public spending is not shrinking again. Private spending probably would have looked better if we didn't have six months of austerity at the end of 2009 and the beginning of 2010.

2. Fiscal policy has a lag, just like monetary policy. Shortly after spending initially stalled out we saw a weakening (also due to the fiscal crisis). Then public spending picked up dramatically with the stimulus package, after a quarter or two GDP did too. Then after an early spring of weak stimulus, we're seeing a continued weakening in GDP. In three to six months we may see another upward trend (hold me to it - we can check the data) as a result of this increase in fiscal stimulus, but a lot of that depends on whether it is sustained through the third quarter and what else happens.

3. This all is just going to contribute to confusion over what is exactly going on, which is unfortunate. We're still doing tepid, on again-off again stimulus which isn't good for the economy or for clear analysis. Informally eye-balling it, we're seeing a something like a delayed wave pattern (I demonstrate it here) with output lagging a quarter or two behind public spending. We shall see, though.

4 comments:

  1. Daniel, that would have made a good article. I am glad you shared it here, at least. A few thoughts:

    1) You write that "the federal government has been almost entirely preoccupied with filling in the hole that state and local governments have been digging." While this is true of public spending in the aggregate, the federal government hasn't been filling the hole with the same dirt. The federal spending has been directed toward alternative ends, and so is consistent with a different composition of relative prices. To the extent that present unemployment is structural, I am concerned that federal spending may be frustrating a necessary reallocation of resources--or "recalculation."

    2) Given the above, even when local governments begin filling the spending hole, will the federal government have the political will to stop? One danger of fiscal stimuli like these is the "ratchet effect," i.e. "there is nothing more permanent than a temporary government program."

    3) I still think this is all academic, because I think monetary policy is the only tool that we should ever need in this situation. I mean, sure, we could slice cheese with a spoon, in theory, but why does it matter when we have a knife?

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  2. Jonathan M. F. CatalánJuly 31, 2010 at 10:19 PM

    Why didn't you modify it and send it in?

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  3. I wasn't sure how I would rework it at first, since I framed it as an explanation of a recent turn in policy.

    I suppose at any point I could always rewrite certain parts of it to talk about how the total stimulus, over the course of the downturn, was actually a lot smaller than the federal stimulus would imply. I don't think I'll do that any time soon - got a lot of other projects moving - but thanks for the encouragement.

    I'm working through your article, btw - hope to have a post up on it soon.

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  4. Lee Kelly -
    I definitely agree on the compositional point. As you might have guessed, though, from my perspective that takes a back seat when we're so far below full employment. Compositional arguments and capital structure points are more cogent for me when we're closer to full employment - when I would actually worry that real crowding out would occur. Right now, I'm of the opinion that crowding in is more likely.

    As for the spending subsiding - I think it ultimately depends on what spending. Most of the stimulus itself I think would. Some that might stay, such as the TANF employment benefits, might actually be more effective than the current welfare benefits offered by that program. Other spending - like anything related to health care - is probably likely to stay too, and I'm more hesitant about that. But I would suspect the unemployment benefits, the education and medicaid funds to the states, most of the infrastructure, etc. would all subside. Aside from some catchy Reagan-era slogans, I'm not sure why we would expect that they wouldn't.

    As for the spoon and cheese, I would agree with the analogy but probably apply it differently :)

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