State, Local Finances in a Global Economy

State and local fiscal fortunes are now linked to the ups and downs of markets on every continent.
November 2011
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

The economic recovery from the Great Recession of 2008-2009 has been so slow and fitful that the last four years are now being dubbed the “great contraction.” Economic “experts” these days often don’t agree on much, but there is consensus that recessions caused by financial crises like this last one are long-lasting and hard to cure.

State and local governments have been deeply affected and their own financial uncertainties are feeding into the overall economic malaise. The loss of 700,000 jobs in the state and local sector over the last couple of years has offset much of the slow increase in total employment and is a depressant to purchasing power. Overall, the sector’s spending grew by less than 1 percent per year between 2008 and 2010, and is now growing by about 1 percent a year. Tax receipts in many states have not returned to the levels of 2008. Nonetheless, there are more spending (and tax) cuts on the way, as visions of smaller, downsized government are implemented.

States and localities now swim in an economic fishbowl, their fiscal fortunes wrapped up in what’s happening around the globe. The prognosis is not good. The U.S. Congressional Budget Office, one of the few impartial founts of economic knowledge, says the country’s key economic uncertainties are in six major areas:

  • the level to which households want to reduce their debt burdens further;
  • the timing and magnitude of a recovery in house prices;
  • the pace at which employers hire workers and invest in infrastructure;
  • changes in stock prices and long-term interest rates;
  • a resolution of fears that European governments may default; and
  • the future path of U.S. government fiscal policy.

Currently about 70 percent of the nation’s gross domestic product (GDP) is driven by household consumption spending. Unless that grows, we are in trouble. Consumption spending depends on disposable income. That has lagged due to slow growth in wages and the desire of households to reduce their indebtedness. The financial crisis, however, brought deep losses in housing values and a deadly overhang of foreclosed properties. At the same time, declining stock markets brought large losses to household balance sheets. The reduction in consumer spending, including that on new residential housing, has plagued the economy.

With rapid loss of demand, employers rapidly reduced employment in 2008 and 2009. Faced with poor prospects, they have failed to add jobs subsequently or invest in facilities here at home. Nonresidential business investment by early 2011 had dropped from 16 percent of the GDP in 2007 to 12 percent. Unemployment rates seem stuck at 9 percent. Not surprisingly, the nation’s poverty rate is increasing and the distribution of income favors the better off. The top 10 percent of households get 42 percent of the nation’s income.

As to the economic risk of European bond defaults, such defaults would obliterate the European banking system and send tidal waves across the Atlantic just as the U.S. financial meltdown of four years ago engulfed Europe. The international banking system is deeply intertwined. If much of Europe goes into deep recession, the loss of wealth and export markets for the U.S. would be devastating, much as was experienced some 80 years ago during the Great Depression.

The last risk concerns what fiscal and monetary polices will be employed in the United States. Cutting taxes has not worked thus far in reviving the economy. Shrinking governments to fit reduced revenue is a popular recipe. But will weaker, more passive governments restore confidence and produce a buoyant economy? Finding the right balance between effective government and stable markets will be a supreme test in the coming years. We can’t afford to fail it.