Squeezing States and Cities

One number stands out in today’s estimate of second quarter GDP, and it isn’t the overall real GDP decline of 32.9%, on an annualized basis, even though the headlines will focus on that figure.

Instead, it is the much smaller decline of 8.2% in the nominal GDP for state and local government spending. That is more than twice the previous worst in that category – a 3.5% drop in the fourth quarter of 2008, as the financial crisis devastated the world economy.

The decline reflects plunging tax revenues – particularly those from sales and income taxes. And it seems likely there will be more cuts coming in the rest of this year, and perhaps next year.

As an article in The New York Times reports today, the first round of federal stimulus spending included $150 billion in aid for state and local governments. The Republican proposal for the next round includes nothing. The plan passed by the Democratic House includes $915 billion.

The Republican plan does have some money for schools, but overall it seems likely there will be have to be more spending cuts. Many state and local governments are barred by law from deficit spending.

State and local governments used to be a beacon of stability. You wouldn’t get rich working for the state or town, but your job was safe. From 1947 through 2000, such spending declined in just four quarters, and always bounced back quickly. Such spending might not always keep up with inflation, but America seemed to view local government services as essential.

That changed. Since 2000, there have been 14 quarterly declines in quarterly GDP for state and local governments. After the financial crisis, many such governments were repeatedly squeezed, as politicians proclaimed they would cut waste rather than impose taxes. In nominal dollars, state and local government GDP was smaller in the third quarter of 2012 than it had been four years earlier.

That led to cutbacks in, among other things, state health departments and state unemployment insurance departments. We saw the impact of some of them this year.

The actual cut in such spending was just 2.2% in the second quarter. The 8.2% decline reflects what the annual decline would be if spending kept falling at that rate for the next three quarters. If some in Congress have their way, that number might prove to be prophetic.