Fed Stimulus Can Yield a High Return to Taxpayers
Business + Economy

Fed Stimulus Can Yield a High Return to Taxpayers

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Many people believe that there has been a wasteful surge in government spending as a result of the $767 billion fiscal stimulus package Congress authorized to fight the recession. But when cutbacks at the state and local level are set against the increase in spending at the federal level, the net effect of the stimulus has been fairly small, and may even turn negative in coming years. It’s like swimming against the current. You expend a lot of energy, but you don’t make any progress because the current keeps pulling you back. Thus, it’s no wonder that fiscal policy hasn’t had a larger effect on output and employment.

The collective budget shortfall for state and local governments from the start of the recession in December 2007 through the 2011 fiscal year is estimated to be $425 billion. Much of this shortfall has already been closed through budget cuts and tax increases mandated by state and local balanced budget requirements, and this is a direct offset of the federal stimulus package. There is likely to be another $140 billion shortfall in 2012 that must be closed, bringing the total to $565 billion, and there are additional shortfalls projected for subsequent years that could, in total, more than fully offset the federal stimulus package. (Since a large fraction of the $288 billion in tax cuts in the $767 billion stimulus package went to saving rather than consumption, the net stimulus was probably around $625 billion.)

The large budget shortfalls that state and local governments face in coming years will place a considerable drag on the recovery if they are not addressed, and it's important to realize that there are still ways to help.

One way that addresses both present and future needs would be for the federal government to help each state now in return for a commitment to establish a rainy day fund. The fund, which would smooth state budgets during both good and bad times, could be set at some percentage of the state’s normal output level. To prevent states from raiding the fund, the money would only be released if some regional or national measure of economic conditions such as the unemployment rate crosses a predetermined threshold. As an additional inducement, the federal government could provide help with no strings attached to states with rainy day funds if the size of the state budget shortfall exceeds the size of fund, as it might in severe recessions like the one we just had.

Even if the terms are very attractive, some states may have difficulty doing this voluntarily. States will not want to set revenue aside during booms since, with all the unmet needs each state has, there’s always a way to spend the extra revenue that comes with boom times. To avoid this, it may be necessary to force states to run surpluses during the times when revenues are robust. Tying a rainy day fund to, say, federal transportation funds is one way to force the desired behavior.

Even though this would cost the federal government more now, there would be considerable savings in the future since states would be able to cover their losses during recessions rather than turning to the federal government for help, but politics may squelch that plan. Perhaps there is a way to creatively combine monetary and fiscal policy that would be attractive to lawmakers (this proposal comes from a colleague here at the University of Oregon, George Evans).

State and local governments are required to balance their budgets, but there is an exception in most states for capital projects, and there is plenty of need for such projects. The American Society of Civil Engineers estimates we need to spend $2.2 trillion over five years to bring infrastructure up to speed, an investment that will raise potential output and increase economic growth in addition to helping with the recovery.

How would this infrastructure spending be financed? The budget problems that state and local governments face make it difficult for them to issue bonds to finance these projects at reasonable interest rates. That leaves the Federal Reserve and the Treasury to purchase state and local bonds issued to fund these projects. The Treasury would provide financing at relatively low interest rates up to a preset amount for qualifying projects, perhaps augmented with a federal subsidy or matching funds to encourage states to undertake these investments (“Build America Bonds” in the American Recovery and Reinvestment Act do something similar on a small scale, and these have been very popular).

The additional quantitative easing that the Federal Reserve is considering can also help by buying long-term U.S. Treasuries in an attempt to reduce long-term interest rates. In effect, the Fed would end up purchasing the bonds the Treasury issues to provide financing to state and local governments. When all is said and done, the new infrastructure projects would be financed by the Fed’s quantitative easing without the need for the Fed to set fiscal policy — that remains under the Treasury’s control.

It is likely to be quite some time before the budget problems that state and local governments face are resolved. Thus, there’s plenty of time for the federal government to provide more help, and there is a clear need for it. The only question is whether there is enough political support for further action. Support for unconditional aid to the states is clearly not there, but perhaps a proposal tied to the establishment of a rainy day fund, or a creative byproduct of quantitative easing that enhances our infrastructure, would find a more receptive audience. Let’s hope so. It’s essential that we do something about the budget problems state and local governments face if we want to return to a robust economy sooner rather than later, and our neglected, crumbling infrastructure needs all the help it can get.