State countercyclical spending key to recession recovery

Turning to the substance of our argument, the standard goal of macroeconomic policy in general is to be "countercyclical," stabilizing the economy by moderating both booms and busts. 7 Extremes in either direction can lead to unwanted effects, whether they be job loss or excessive inflation. 8 During downturns, this means that government may have a role to play in stimulating the economy, such as through increased spending, tax cuts, or expansionary monetary policy. 9 Traditional microeconomic theory also offers similar prescriptions, counseling that transfers of wealth from richer periods (booms) to poorer periods (busts) increase overall social welfare. 10

States are in a difficult bind when it comes to stabilization policy, however. Their revenues are tied to the business cycle, so that budgets get tighter just when the need for countercyclical spending increases. 11 Raising taxes to make ends meet is contrary to the usual macroeconomic recommendations and is especially difficult in a modern climate where tax increases drive away productive citizens and businesses. Whereas Congress can largely avoid this dilemma simply by borrowing, states risk driving out citizens with excessive debt, and nearly all state legislatures face legal constraints to maintain a balanced budget. Those legal constraints, moreover, are sensible responses to the incentives of legislatures in prosperous times, which would otherwise likely take on excessive debts. 12

[*191] The result is that state finances tend to contribute to, rather than mitigate, the pain of economic downturns. 13 And in a world where states are so closely economically interdependent, these effects are felt well outside any one state's borders. 14 As recent events illustrate, state budget crises contribute to national economic woes.