Making the State Cyclical

by: Max Fraad Wolff
Market economies are prone to pronounced and often painful boom bust cycles. The National Bureau of Economic Research NBER is the official agency that dates and determines the start and end of each business cycle in the US. Since 1854 we have had 54 boom bust cycles. Since 1945 we have had 11 boom bust cycles.[i]This is the pattern across American history and the histories of modern market capitalisms the world over. At the heights of upswing there has long been a tendency to celebrate free markets and to unbridle their ability to generate booms. This usually comes very quickly before the fall. This pattern is so common that many special names have been coined for this event. Topping-out, frothy markets, bubbles, apex, peaks, crack-up tops are all widely used phrases. Sadly, near the top many will announce a new era or a permanently elevated plateau. The next act is usually rough. We saw this pattern in 2000 and again in 2007. We may be seeing this for state economic involvement topping out in 2009-2010.
Political demands and stability desires have fueled the development of blunt, imperfect and often expensive efforts to cushion and control business cycles. The latest and greatest attempt, popular throughout the world since the Great Depression, is for governments- at all levels- to act counter cyclically. The idea is that when largely private market economies boom, the state increases taxes, pushes up savings and acts to restrain economic growth. This is done to avoid inflation, general increases in prices, and to mediate the peaks of private market activity. When economies turn down, state agencies cut taxes, increase spending and make more credit available at lower prices. We have come to rely on government to offset the extremes of the private market business cycle.
The boom 2003-2007 was largely driven by policies of various government agencies. Huge tax cuts, major spending increases, vast quantities of cheap credit were offered. The boom relied heavily on borrowed money- exemplified by the housing bubble. Across the entire expansion cycle Federal, state and local governments cut taxes, spent like crazy and encouraged everyone else to do likewise. That is pro-cyclical behavior, pro-cyclical because it fuels private activity instead of acting to counter-balance it. When the boom became bust, once again, all levels of government attempted to lean against the winds of decline. Of course, they had been doing that for years.
Today we see massive deficits and budget issues at the Federal, state and local level. These shortfalls have built across the recent economic upswing and downswing. Thus, they are historically large. Now we face very aggressive calls for cuts. The great struggles in Wisconsin, Indiana, New Jersey, California, Tennessee and elsewhere speak to this. We are seeing demands to make the role of government smaller and more pro-cyclical. Slashing spending in tough times shrinks the role of government and makes our counter cyclical state actions pro-cyclical. In short, public sector books are designed to deteriorate in bad times and strengthen in good times. That is how the system has been designed and run. Not surprisingly, this is never part of the discussion. Across the boom years state and local books deteriorated structurally but were made to look ok- in some cases- by creative accounting and revenue surges from the housing/spending bubble. State and local pensions- a major issue area- well illustrate the new pro-cyclicality of the public sector. These pensions are heavily dependent on equity investments, a very pro-cyclical dependence.
The really big struggles to come will be at the municipal and Federal levels. Of America’s 20 million state and local workers, 3 quarters are local workers. Over 35% of the municipal budgets in America come from state spending, which is heavily funded by Washington. States are in the middle of this crisis and are where the attention is now. By spring 2011 the great struggles will be in Washington and by summer they will be at the local level. National media may ignore these stories, they will be hugely important.
We now risk redesigning the state to be pro-cyclical even as we rely on it to act as counter cyclical break on private sector activity. The rate of US economic growth, our competitiveness and investments in state and muni instruments hang in the balance. Or perhaps we should say, hang in the imbalance?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.