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How to target federal aid to state and local governments
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Federal Reserve Board chairman Ben Bernanke knows lots more about 1930s Depression economics than I do. He wrote his doctoral dissertation on the topic. My studies on this topic ended with my undergraduate thesis — plus a month-long 1977 federal symposium on countercyclical public finance that brought 20 state and local government leaders together to study New Deal economic history from a modern perspective. There aren't many seasoned analysts of state and local government finances who still write professionally about the Great Depression. So I'd like to share some lessons from history as Congress deliberates whether and how to inject fiscal stimulus via the state and local government sector (rather than spend the money directly or simply cut taxes).
When the economy faces the specter of a deep recession becoming an outright depression, there are strong arguments to make that state and local governments need financial aid from Uncle Sam. Because their budgets are cyclical and they are required to balance their budgets by state constitution, they are forced to cut spending when taxes decline, which only deepens the recession. The federal government, on the other hand, can borrow and print money to keep its spending constant. Despite what classic conservatives may think about deficit spending, most post-Keynesian economists now accept that in a widely deflationary situation like the one we face in the U.S. today, a federal deficit is better than the alternative, which is a global depression.
Depression-era differences between federal versus state and local government fiscal practices are enlightening. Everybody knows that the federal government raised its spending through various New Deal agencies such as the Works Progress Administration, the Civilian Conservation Corps and other relief programs. But for all the money the U.S. government spent above its pre-Depression baseline, a significant offsetting percentage of spending relative to GDP was reduced by state and local governments. Without the power to print money, states and especially localities had to cut spending as their revenues shrunk throughout the 1930s. Their constitutionally required actions to balance their shrinking budgets resulted in a huge offset of Uncle Sam's New Deal spending.
In today's economy, the lessons from history are very clear. No matter how much extra spending the Congress reasonably pumps out at the national level, state and local government cutbacks could largely offset the federal stimulus. Without countercyclical federal aid from the feds, most governors and local elected officials will have no choice but to lay off workers, cut back their capital spending and defer maintenance in order to reconcile their plunging sales, income and property tax revenues. Those same local officials are now writing Christmas lists of projects for Santa Obama to deliver to their constituents at no cost to local taxpayers.
So in this context, what kind of federal assistance can Congress approve and still make sense from an economic standpoint? How can federal dollars be spent best if given to states and localities?
First, the stimulus has to get into the general economy as quickly as possible. In the past, much of the money that went to state and local governments as "counter-cyclical assistance" was actually spent after the economy had already recovered from the recession that prompted the spending law. That is why many economists prefer tax rebates to spending programs: It's faster to wire a payment to taxpayers than to start and finish a spending program. Construction projects (although popular with public officials) take a long time to design, engineer, bid out and complete. Likewise, the process of writing regulations and rules for sending money to states and localities to hire additional workers can take months. The 1976-78 Carter-era CETA program (Comprehensive Employment and Training Act) provided a vivid example of hiring people after the economy was already recovering.
Previous federal programs, along with a mandate to inject the spending stimulus as directly and quickly as possible, suggest ways to guide federal policy in 2009. Experience also has shown that state and local officials are very shrewd about substituting federal dollars for their own dollars to keep as much discretion in their budgets as possible. This means that no matter how many strings Congress ties to the money, the recipients will find a way to shuffle the federal aid to their local advantage. Some will even find ways to replenish their reserves with the federal moolah, which flunks the intent of the stimulus package just as badly as when individuals hoard their tax rebates or pay off credit cards.
Even so, there is mounting political support for the lame-duck Congress to spend money on local infrastructure projects. Local officials from several cities have made a direct pitch for as much as $50 billion in federal assistance.
So here are some brief "directional" observations to guide public policy:
Short-stop imminent layoffs. This is job number-one. Every public sector employee who is laid off and runs out of unemployment relief could cause several private workers to lose their jobs. That's the so-called "employment multiplier effect" in reverse. Unemployment snowballs. Also, public-sector unemployment eats up state reserves for private workers. But Congress cannot read minds: Nobody really knows which public workers' jobs would be cut next if it were not for federal assistance. So the governors and state budget directors need to collaborate with federal officials to craft a plan to stabilize payroll spending only where revenues have shrunk enough to force layoffs. One approach would be to reimburse states and localities for recalling workers who are laid off more than 30 days as a direct result of a revenue shortfall, which puts people already laid off back to work until such time as local revenues recover.
Unfortunately this introduces the "moral hazard" of rewarding the politicians that failed to establish rainy day funds to avoid layoffs. But that can be countered with a requirement that recipient governments establish such reserves in the future as a condition for receiving such assistance. I will explain this idea later.
Deferred building maintenance. A potentially worthwhile idea that has now surfaced is for Congress to grant money to public school districts (and this could also include other localities) to immediately fix their deferred maintenance on such items as antiquated wiring, leaky plumbing and other building repairs that have been postponed. This idea has merit on two fronts: the projects can be bid out quickly and they are labor intensive. The problem is that such a policy favors schools that chronically fail to properly budget their capital maintenance, and overlooks those that properly maintain their property. Therefore, at least half of the money awarded under such a program should be repayable in installments to the U.S. Treasury, beginning one year after this recession ends.
Accelerated construction. The countercyclical construction projects of the Carter years taught us how NOT to run such a program: The Feds then set up elaborate state scoring systems and the bureaucratic decision-making process lasted longer than the economic downturn. A few simple rules would enable federal money to get into the economy within 90 days. Here's what Congress can require:
• Show us your plans. Capital projects must have previously appeared on a multi-year capital program like a 5-year capital spending plan. From that blueprint, the projects must have now been deferred or delayed because of 2008-9 revenue insufficiency. This rule rewards good long-term financial planning by state and local governments and avoids reimbursing them for money they were spending already. For example, it makes no sense to use federal stimulus money for a road that was already funded by a 2007 bond issue but just hasn't been built, or a building renovation that was already scheduled to start.
• 90-90. Capital projects must be started in 90 days and 90 percent completed in 270 days. This requires that the plans must have already been drawn or substantially complete. In some cases, a "design-build" approach can be used to get the money flowing into the economy quickly. Long, drawn-out construction projects must flunk the eligibility test because they are not countercyclical.
• Labor intensity. Preference should be given to projects that re-employ construction workers. Employment creates more economic stimulus than equipment purchases — even though the purchases may make a project quicker to complete. So, high labor-content projects should get preference over those that are capital intensive. More hammers, less concrete, no equipment purchases. (Sorry, hospitals.)
• Backstop muni bond insurance to re-open the markets for infrastructure projects. Many public officials tell me they have infrastructure improvement projects "waiting on the shelf" that they could launch quickly with local taxpayers footing the bill — if only they could regain access to the municipal bond market at a reasonable cost. There is a way to accomplish this: federal reinsurance of privately insured infrastructure bonds. A secondary federal guarantee could quickly unfreeze the municipal bond market and get public projects moving along quickly. Every bond so issued and insured would then effectively be AAA rated.
As explained further in my companion column on this topic, this powerful strategy provides a more frugal way to stimulate major infrastructure spending quickly without federal taxpayers picking up the entire tab for local projects, project that primarily benefit local interests and can be paid for by local taxpayers and facilities users. There will be far less wasteful pork barrel if local users of the facilities must repay the debt thus incurred.
Focus on the weakest states. To clear Congress, the stimulus legislation will undoubtedly "spread enough pork around" to win a majority of votes. Instead of per-capita aid, the formulas should tilt toward states with the highest unemployment and the greatest fiscal stress.
Impose a binding "Rainy Day Fund" requirement. To control the moral hazard of rewarding states that followed spendthrift fiscal policies (while punishing those that put money away in a rainy-day fund), the 2009 aid package must be contingent on doing it right in the next business cycle. For example, California's massive budget deficit may not look so deserving of a bailout to legislators from states where conservative financial policies prevail. A level playing field for the future would require that 2009 countercyclical assistance funds be repayable to the federal government if future surpluses are not set aside into a state-level rainy day fund once the economy begins to expand and revenues exceed current levels. Governments that accept federal aid should agree to fund the rainy day account before hiring more workers or expanding services — or else repay Uncle Sam for the 2009 handout.
Rainy day funds are a good idea in the first place. The Governmental Accounting Standards Board has given special attention to these reserves in its latest exposure draft on fund balances. As a matter of state-level fiscal policy, they are the best way for states to tame the economic cycle and avoid running back to Uncle Sam every time there is a recession. By socking money away during the next economic expansion, states can help assure that we are not put into this same position again in the next recession. Fiscal conservatives would applaud this requirement, which makes it easier to gain bipartisan support for a timely intergovernmental assistance bill right now.
And don't forget about housing! No matter how much aid the Congress gives the states, the first priority of any stimulus package needs to be the nation's housing markets, as suggested in one of my previous columns. Until housing markets stabilize, state and local governments' tax revenues will decline and negate the federal aid they receive. States should push for a 2009 waiver of the federal volume caps on state housing finance authorities' bond issues so that they can provide lower-cost, tax-exempt mortgage money to new homebuyers.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities.
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