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Bailing Out the States Is Smart Economics

Noah Smith
·5 mins read

(Bloomberg Opinion) -- Senate Republicans are beginning to question the need for more economic relief to battle the coronavirus recession, with top leaders saying that the issue won’t be taken up again until late July. One reason is that the economy is showing signs of improving. Unemployment, though still enormous, has begun to fall:

Another reason is concern about the rising federal debt, which is now higher as a share of gross domestic product than it was during World War II. Although President Donald Trump’s re-election bid gives Republicans a reason not to be hawkish on the deficit, many may simply balk at this level of borrowing. It seems as if the Republicans are going to simply wait and see how the economy is doing in June before providing more relief efforts.

Fortunately, the expanded unemployment benefits don’t run out until July 31. And the Paycheck Protection Program, which has proven effective in sustaining small businesses -- and is itself probably responsible for much of the unemployment drop because it allowed employers to call workers back to the job quickly -- has been extended, though it might need a fresh infusion of funds before the end of July.

But the Republican reluctance to craft a new relief bill means that one important policy might get left out: bailouts for state and local governments. And that could mean that the U.S. will end up repeating one of its biggest mistakes from the last recession, forcing states and cities into years of unnecessary, punishing austerity.

States and local government spending represents about 14% of the U.S. economy:

Much of that is spent on either welfare programs or education:

Almost all states are legally bound by some sort of balanced-budget requirement, and all but a handful have balanced-budget amendments in their state constitutions. This forces states to cut spending when a downturn hits. Cities can borrow, but they must pay a premium to do so; because cities can and do go bankrupt if they borrow too much, they’re unlikely to want to spend enough to fill the hole left by cash-strapped state governments in a downturn. This means that when tax revenues fall, state and local government spending typically gets slashed unless there’s a federal bailout. During the recession of 2008-9, the federal government disbursed aid to states through the American Recovery and Reinvestment Act, but this wasn’t enough to make up for the shortfall.

The economically vulnerable will bear the brunt of these cuts, through less spending on social programs and health. Teachers and other school staff will probably be cut, as they were in 2009. Infrastructure will begin to decay. And public universities, which drive the economies of many of the country’s most successful smaller cities, will see their funding -- which never recovered from the last recession -- dwindle further.

This is already happening. Though unemployment is falling, state and local governments are still shedding jobs.

This outcome doesn’t have to happen. After accounting for a drawdown in state rainy-day funds and the modest amount of federal aid that was already given through the first relief bill, the Center on Budget and Policy Priorities estimates that states will face a shortfall of $360 billion during the next three years, plus additional money related to the cost of combating Covid-19 itself.

This shortfall may seem like a lot, but compared to the amount the federal government is already borrowing -- $4 trillion in 2020 alone -- it’s not all that much. Interest rates on long-term Treasury bonds are still at historic lows, meaning that the federal government can borrow cheaply. There’s every reason to bail out states (which will then bail out cities) from this unprecedented and unexpected crisis. And the number of jobs saved could be in the million:

So why not do it? House Democrats want to. But Trump has shown an unwillingness to spend federal money on states that tend to vote Democratic. And some policy makers worry that states will use extra money not to fight the virus or to shore up welfare and education, but to pursue unrelated items on their wish lists (for example, a new statehouse or a bailout for underfunded pensions).

It’s possible to earmark the money for specific causes, but states can easily just shift their budgeting to effectively divert the spending elsewhere. There have already been bitter state-level fights over how to use the $150 billion disbursed in earlier rounds of stimulus spending, indicating how hard it is for the federal government to mandate exactly where the money should go.

But bailing out states is still the right thing to do. If states make bad choices about what to do with the money, that’s their leaders’ fault; they still should be given the option to do the right thing. The alternative -- to force states and cities into budget crunches that cost more jobs -- will prolong the recession, increase human suffering and create greater opportunity for social unrest.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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