States have the capacity to be countercyclical and deficit spend during recessions

Importance of state and local government spending for countercyclical policy The fifty state governments and ninety thousand local governments in the United States are responsible for administering and managing essential services such as education, healthcare, and transportation. To this end, they hire public workers, invest in infrastructure, and purchase materials and equipment. State and local government consumption and investment spending rose from 5.5% of GDP in 1947 to 12.5% of GDP in 1975 and has averaged 11% of GDP between 1970 and 2020. The sheer size of the state and local government sector implies that fluctuations in its spending will have significant impacts on the macroeconomy. Figure 1 shows that stagnate state and local spending after the 2001 recession contributed to the weakness of the 2001 recovery and the fall in state and local spending after the 2008–2009 downturn contributed even more greatly to the weakness of the 2009 recovery. In the 2009 recovery, real state-local expenditures declined until 2014 and did not return to the pre-recession level until 2019, a full 10 years after the official end of the Great Recession. This dragged real GDP growth, rather than supporting it. Policymakers are deeply concerned that the current contraction in state-local government spending will once again prolong the recession and delay the recovery. For example, Federal Reserve Board Chair Jerome Powell stated in June, “It will hold back the economic recovery, if [state and local governments] continue to lay people off, if they continue to cut essential services. And in fact, that's kind of what happened, post the global financial crisis.” (Smialek, Rappeport, and Cochrane Citation2020). Figure 1. Real state-local expenditures and real GDP during the 2001 and 2009 recoveries. The solid lines in the figure show aggregate state-local government spending growth during the 2001 and 2009 recoveries. The dashed lines in the figure show real GDP growth during the 2001 and 2009 recoveries. The index equals 100 at business cycle trough. Source: FRED and author’s calculations. Table 1 shows the change in real state-local spending from the prior year for total direct expenditures and for the major categories of spending by function. It shows that education spending fell four consecutive years, accounting for about half of the fall in overall spending in 2011 and about 30% of the overall fall in 2013. This means education spending was a large drag on state-local government spending during the recovery from the Great Recession. Transportation, public safety, and environment and housing spending also declined, dragging overall spending. Public welfare spending, on the other hand, increased every year except 2012, providing a countercyclical stabilizing force. Capital spending is a promising potential vehicle for countercyclical fiscal policy for two major reasons. First, capital spending, unlike current spending, is easier to shift forward and backward in time. Keynes supported the idea the government should pace capital spending such that no business cycle fluctuations could occur. He argued the government should ready blueprints “as ambitious and glorious as the minds of our engineers and architects and social planners can conceive” and then pace capital spending “neither so slow as to cause unemployment nor so rapid as to cause inflation” (Keynes Citation1978, 266). The potential for countercyclical stimulus is only limited to the imaginations of the architects and engineers who create capital project designs. Second, capital spending is one aspect of state and local government budgets that has the potential to operate on a countercyclical basis even in the absence of federal aid. Balanced budget rules legally prohibit state and local governments from deficit financing operating expenditures to varying degrees. This effectively forces aggregate current spending to decrease when revenues decrease, imparting a significant procyclical bias to state and local government budgets. However, the majority of governments can legally borrow to pay for capital investment (National Conference of State Legislatures Citation1999). This means state and local governments could issue bonds during a recession to finance capital spending, providing local stimulus.