Federal largesse was countered by state and local cutbacks

In looking back on the efficacy of stimulus in the United States, Ezra Klein has a few thoughts in the Washington Post’s "You’ve seen the stimulus. Now, meet the anti-stimulus."

A multiple choice question for you: Did the stimulus a) work; b) fail; c) end up locked in an unexpected battle with the massive anti-stimulus that’s ripped through the states?

Most people would choose "a" or "b" (though I’d say "a" has the better of it). They probably haven’t heard of "c." But ask Bruce Bartlett, a conservative economist who worked for Ronald Reagan, George H.W. Bush and Jack Kemp, and you’ll hear all about it. "When the history of the current crisis is written, much of the blame will be placed on the sharp fiscal contraction of state and local governments," he says. "I think economists will view this as a preventable error equivalent to the Fed’s passive shrinkage of the money supply in the early 1930s."

The thing is Klein explains this as if this is news. Of course, states and municipalities have applied anti-stimulus. And the Obama Administration should have known this was going to happen from the word go. I want to review what happened:

1. It was obvious that states and local governments would have to apply anti-stimulus since at least 2008.
2. It was obvious that unemployment would rise much higher than 8% and the economy would suffer much more than the Obama Administration suggested since at least February 2009 when I said we should expect double-digit unemployment.
3. It was obvious the stimulus Obama applied wouldn’t get the job done since at least February 2009.
4. It was obvious from a very early stage that, as with many issues (including healthcare and the disaster in the Gulf), the Obama Administration doesn’t grasp the gravity of a situation until it the problem is well-advanced.
5. Now, on the politics of stimulus and deficits, there are few options left.

Witness comments on the state and local governments from my 2 Jan 2009 post written before Barack Obama even took office.

There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption.  In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.

But, in the United States, there is a bit of a problem: state and local governments.  They will not, and often cannot, spend.  In fact some will be cutting.  Will local government budget cuts undercut federal fiscal stimulus?

To answer that question, we need to know why local governments in the U.S. are not spending more money.  The answer is two-fold.  First, state and local governments don’t have access to a printing press.  It’s not like they can tell their teachers, “wait a minute, let me just run out back and print off a few dollars to pay you.”   The federal government intends to do exactly that – print money.  This is what is commonly known as inflation, now given the hifalutin designation of quantitative easing.  So inflating one’s way out of crisis is not an option on the table for municipalities.

The result, of course, has been the massive anti-stimulus from states and municipalities in the US of which Klein speaks, something that was totally predictable. The question back when Obama entered office was whether he was going to do anything about this.

With the automakers and the banks already receiving handouts en masse and with the Obama Administration committed to massive fiscal stimulus, one can see that the United States is in for some trillions of dollars of deficits.

The question is whether states and municipalities should be welcome on the bailout gravy train as well. California is on the verge of bankruptcy and I have predicted at least one state will default and go bankrupt. Do we want that? Do we want teachers, police officers going without pay, firefighters being let go or trash collection being curtailed?

This is a predicament that was easily predicted as a result of the housing bust. However, with its consequences looming, there are no easy answers.

At a minimum, cutbacks at the state and local level would be very much working at cross purposes with federal stimulus. Ostensibly, state governors could play chicken with the Federal Government if they don’t get some bailout money. How the Obama Administration chooses to tackle this problem will be a contentious issue going forward.

–Will federal largesse be countered by state and local cutbacks?, Jan 2009

I assumed the Obama Administration would acknowledge this problem and address it. But I was wrong. Just as the Obama Administration made the entirely ludicrous prediction that the unemployment rate would only rise to 8%, it also failed to understand the gravity of the problem at the state level. Moreover, as people like Paul Krugman argued, the stimulus was too small and not well-targeted. I warned in February 2009 that a middling-size ($787 billion) and ill-conceived stimulus package mixed with bailouts all around for the banks and auto companies would discredit stimulus as a policy tool.

In my view, it has become ever more apparent that the Obama administration is caught in some sort of muddle, trying to fudge between the calls for fiscal discipline from conservatives and the calls for stimulus from liberals.  Obviously, it is in Obama’s nature to lead by consensus, and he has looked for an inclusive political and economic strategy since he came to office.  However admirable these intentions may be, this middle path is unfortunate because it will leave no one satisfied.  Moreover, taking this middle path on the economic front — some stimulus but not massive stimulus, some tax cuts but also some increased spending, increased spending now but tax increases or budget cuts in a few years – is the worst of all outcomes; the economy will not gain enough traction to get the desired ‘jump-start’ and stimulus will ultimately be seen as ineffective.  If the Obama Administration later attempts to return to Congress for more of the same after a failed stimulus bill, it will find a more skeptical response.

–Obama takes middle road on stimulus and taxes that leads nowhere, Feb 2009

And this is exactly what has happened.

Obama had one shot to fix banking and to apply stimulus. And he did not get the job done. Despite the belief during the election of 2008 that Barack Obama actually understood economics better than John McCain, I am not so sure. Sometimes Barack Obama gets it. Sometimes he doesn’t.

I happen to believe that Hillary Clinton, John McCain, Sarah Palin or Mitt Romney would have done pretty much the same thing as Obama regarding stimulus and bailouts, frankly. The healthcare situation is where the Democrat-Republican divide lies. So, on stimulus and bailouts, it’s not as if Obama was doing something that other politicians would not have. He was a conventional politician, taking a conventional route.

But, that route is what has led us to where we are. If Barack Obama had wanted to be "change we can believe in" he would need to have taken a different path.

Klein has well-reasoned arguments. But he is fighting a losing battle. Now stimulus is out and austerity is in.