Pick your poison to remedy the economy

By Steven Pearlstein
Friday, July 2, 2010; A16

The liberal Democratic narrative on fiscal policy this week runs something like this:

Because of steep declines in tax revenue caused by the recession, state and local governments are facing severe budget shortfalls -- $90 billion in the case of states alone. Unless the federal government steps in to borrow more money to fill the hole, vital services will be cut, 1 million additional jobs will be lost, and the economy will be dragged back into recession.

You can quibble with the numbers and some of the logic, but as a general proposition, this narrative is largely correct. And the people who are pushing it believe it justifies having the federal government add to its already burgeoning debt and sending another round of emergency aid to the states.

There is, however, a different narrative to describe the current situation that is equally defensible but leads to a very different policy prescription:

Since the last recession a decade ago, spending by state and local governments has grown faster than the economy. The percentage of the workforce employed by state and local governments rose steadily over that period, from 13.6 percent to more than 15 percent today. And during most of that same period, the compensation of government workers rose faster than that of private sector employees, particularly as a result of generous (some would say lavish) health insurance and pension benefits negotiated by their unions.

All of that seemed reasonable when skyrocketing property values, corporate profits and investment gains were swelling government coffers -- so much so that many states wound up cutting taxes. But now that the credit bubble has burst and tax revenue has plummeted, many states have significant structural deficits that will not disappear even when the economy returns to normal levels of growth and employment. Providing additional federal assistance to those states will only serve to postpone the tax increases and spending cuts that will inevitably be needed to bring budgets back into balance.

You see the box we've gotten ourselves into. To fix the economy in the long run, we have to weaken it in the short run -- yet weakening it in the short run makes it just that much harder to fix it in the long run. Any way you look at it, the economics are terrible, and the politics are even worse.

In terms of state and local governments, the reality is that they are spending significantly more than they can afford at current levels of taxation.

One way to close that gap would be to cut state and local government payrolls by about 1 million workers from the current level of 20 million, bringing the share of the total workforce back to where it was in 2005. Despite the headlines, the cuts up to now have numbered only 200,000, according to the Bureau of Labor Statistics.

Another approach would be to reduce the pay and benefits of the existing workforce by 5 percent or more. A number of states have already instituted wage freezes and mandatory furloughs, or negotiated cuts in those generous pension and health benefits, but the resistance from workers has been fierce, and the short-term savings are relatively small.

A third approach would be to raise taxes, which many states and localities have done but only selectively and modestly.

But no matter which policies are chosen, the short-term macroeconomic consequences are pretty much the same: fewer jobs and lower overall after-tax incomes. The only real question is how this pain is distributed, which in the end is what these fights are all about.

So what does all this suggest about another round of federal assistance to the states?

To me, it suggests that the policy goal should be focused less on short-term stimulus than on closing the states' structural budget deficits. States that take credible steps to close the gap over the next few years ought to rewarded with federal money to help laid-off government workers or maintain vital services until the economy rebounds. States that don't should be allowed to fend for themselves. Think of it as the public finance version of the "stress test" used to stabilize the banking sector, or the education department's successful "race to the top."

It is fashionable these days in liberal circles to belittle "Hooverite" voters and politicians for worrying more about deficit spending than unemployment, but the analogy to the 1930s is imperfect. It ignores the fact that the United States entered this crisis not as the world's biggest creditor, but as its biggest debtor. It ignores the extensive social safety net put in place since the Depression. Most of all it ignores the unprecedented steps the government has taken to quickly respond to the financial crisis and the economic downturn.

Voters aren't stupid -- they understand they are being asked to make a false choice between too much debt and too much unemployment. And what they want is some assurance that their money isn't used to re-inflate the old bubbles or return to the free-spending past, but invested in a more secure and sustainable future.

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