The recession, the states, and economic stimulus

If the current package is enacted and fails to do the trick, a second stimulus package—one that includes state countercyclical funding to neutralize pro-cyclical action by states—will be needed.

Unfortunately, three major factors have intersected simultaneously to produce a recession. First, the price of oil is up dramatically, and as we approach the summer driving season, the price of a gallon of gasoline will approach $4 per gallon. This increase acts like a tax on consumers and will force them to reduce their purchases of other goods and services. It is worth noting that almost every post-World War II recession has been preceded by a major increase in the price of oil.

Second, after five years of rapidly escalating prices for housing, home values are dropping precipitously. This not only has put a damper on new residential construction, it also has reduced consumer purchases of furniture, carpeting and similar goods because individuals and families can no longer upgrade to larger and more expensive housing. This, coupled with the fact that consumers also can no longer pull money out of their houses with home equity loans, is depressing personal consumption, the largest component of gross domestic product.

Third, and perhaps the most important, the subprime meltdown has dramatically reduced the liquidity of the entire U.S. banking system, and although it already has written off $100 billion in bad debt, the system may only be a third of the way through the process.  Finally, this chaos in the financial market may have limited the effectiveness of the Federal Reserve’s interest-rate reductions, which were intended to stimulate the economy.

During the week of Jan. 14, the National Governors Association surveyed states to update their fiscal outlook. Eighteen states now expect shortfalls in fiscal 2008 totaling more than $14 billion. In 2009, 18 states are projected to have shortfalls totaling $32 billion.

History, however, suggests that the number of states facing shortfalls—and their severity—will grow even after the downturn ends. For example, in 1991, the same year the recession of the early 1990s ended, 28 states cut budgets. The following year, as the economy began to recover, 35 states had to make cuts. Similarly, in 2001, the year that the last recession ended, 16 states were forced to cut their budgets, and in each of the next two years, 37 states made reductions to eliminate shortfalls. If the current downturn follows the path of previous recessions, 35 to 40 states could face budget cuts in 2009.

To make any fiscal stimulus program effective, it must be timely (i.e., occur at the very beginning of the downturn), targeted (to the people and programs most affected) and temporary (lasting for only a year to 18 months).

In a rare display of bipartisanship, the Democratic leadership in Congress and the White House reached a quick agreement on a plan for tax reductions. The plan includes tax rebates of $300 for individual taxpayers and $600 for married couples with no children, and rebates of up to $1,800 for married couples with two dependent children. The total rebates are all phased out at certain income thresholds, and checks will likely be sent in May or June. The package also includes provisions for bonus business depreciation and expensing that should stimulate capital investment. Assuming that this agreement is enacted by Congress and signed by the president by early March, it will meet the criteria of timely, targeted and temporary.

The combination of aggressive monetary policy in lowering interest rates and the quick enactment of this stimulus may head off the recession, or at least limit the decline. If the downturn continues, however, and the state budget shortfalls grow, states will be forced to cut spending and raise taxes, which will offset much of the positive impact of the stimulus.

If the economy continues to weaken, Congress is likely to consider a second package that would include enhanced benefits for high-risk populations and state countercyclical funds. To maximize its effectiveness, such a package would need to include extended unemployment benefits for those individuals who have lost their jobs in the downturn. It also would need to include additional food stamp funds for low-income individuals.

State countercyclical funds would also be a critical component of any subsequent stimulus packages. The nation’s governors have put forth just such a proposal. Their proposal includes $6 billion in additional federal money for Medicaid, the health-care program for low-income individuals, and $6 billion in a flexible block grant. The additional Medicaid funding is critical, as the rolls will begin to swell once unemployment begins to increase. The block grant also is crucial because it allows states to postpone cuts in elementary and secondary education, higher education and other health-care programs. In addition, it allows states to use some of the funds to help individual homeowners avoid default as well as to initiate or sustain some construction projects—such as for schools, highways and bridge repair—that can generate jobs. A similar $20 billion package was enacted in 2003, so there is precedent.

Congress and the president are to be commended for reaching a quick agreement on a bipartisan basis. However, if the economy continues its downturn, a second package that includes state countercyclical funds must be implemented.

Raymond C. Scheppach, Ph.D., is the executive director of the National Governors Association. The views expressed here are those of the author and do not necessarily represent those of the National Governors Association.