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special issue: federations and the economic crisis
Where the crisis began, governments pass creative laws
REUTERS/Kevin Lamarque
U.S. President Barack Obama takes a question at the 2009 Fiscal Responsibility Summit in Washington . Obama’s administration pushed through a $787 billion economic stimulus package aimed at jolting the country out of recession. Seated behind Obama are Vice President Joe Biden (right)., and Peter Orszag (left), the director of the Office of Management and Budget.
By alan greenblatt
In 2007, California Governor Arnold Schwarzenegger and New York City Mayor Michael Bloomberg appeared together on the cover of Time magazine under the headline “Who Needs Washington?”
Just two years later, that cover looks like an artifact from an entirely different era.
The reason, of course, is the economic downturn. “Now Washington is everything,” says Jennifer A. Bradley, a senior research associate with the Brookings Institution’s Metropolitan Policy Program. “Everyone is looking to Washington to save the day and prime the pump.”
The economy had been weakened throughout 2008, largely due to the pricking of a housing bubble that had been inflated by misguided lending policies. It plunged into freefall in September 08, following the decision by officials of then-president George W. Bush’s administration to let brokerage firm Bear Stearns go out of business. That triggered a collapse in financial markets, with the Dow Jones Industrial Average posting its worst annual performance since the early 1930s.
In response to the economic meltdown, the federal government approved a $787-billion stimulus package in February 2009 aimed at countering the recession. Nearly all the money is being spent through transfers to states and local governments. The result was that in this year’s first quarter, Washington became for the first time the largest single source of revenue for state and local governments.
Stimulus bill aimed at unemployment
It was initially hoped that the stimulus program would at least temporarily reduce the U.S. non-farm unemployment rate, which had climbed to 9.5 per cent in June 2009. However, this is a two-year bill, and when this money runs out, the states will be in trouble. During the budget-writing season that mostly concluded in July 2009, states relied on stimulus funds to cover roughly 40 per cent of their shortfalls. Few will have the same resources available in 2010 – and the money will nearly all be gone by 2011. State revenues, meanwhile, will take longer than the overall economy to recover.
“The action is here in Washington because the money is here in Washington right now,” said Donald J. Borut, executive director of the National League of Cities. “This is a unique moment in terms of the scale of expenditures, because we have an economic crisis.”
When job losses tapered off to an average of 436,000 in April through June 2009, it was considered good news – so rapid had the growth in unemployment rates been in prior months. Since the recession began in December 2007, the U.S. has lost a total of 6.5 million jobs across nearly every sector.
The stimulus package, known as the American Recovery and Reinvestment Act (ARRA), was enacted in February. Although its primary focus is job creation, the administration of President Barack Obama took advantage of the opportunity to promote policy goals, notably energy efficiency. About 10 per cent of the stimulus funds are devoted to green initiatives such as making public buildings more energy efficient, smart grid projects and loan guarantees for advanced battery research and renewable energy.
Rescuing mortgages and the auto sector
ARRA followed on the heels of a $700-billion financial sector bailout package approved by Congress in October 2008, known as TARP (Troubled Asset Relief Program). The Federal Reserve Bank has separately devoted $1.2 trillion to buy financial assets and issue emergency loans, while reducing its federal funds target rate – in effect, the rate at which banks lend money to each other – essentially to zero.
Washington has also become a major shareholder in the automobile industry and home mortgage sector, taking over Fannie Mae and Freddie Mac, the U.S.’s leading mortgage lenders.
Obama has outlined plans to tighten tax rules governing multinational corporations. In addition, the administration and Congress are expected to push for tighter regulation of the financial sector The insurance industry is regulated by the states but the central role in the financial meltdown of American International Group (AIG) – in which the U.S. government now owns an 80-per-cent share – led to renewed calls for federal oversight. The Obama administration has rejected that approach for now.
The federal spending spree has helped shore up the finances of subnational units of government, which have seen sharp declines in their major revenue sources – sales, income and property taxes. State and local budgets are always constrained by balanced-budget requirements and continuing political resistance to tax increases is leaving them short of funds. Collectively, the states will face a shortfall of $350 billion this year through fiscal 2011, according to the National Governors Association.
Such financial shortfalls typically force the federal government during recessions to step up and become a more important actor in the system. In 2003, Washington sent $20 billion to states for general funds and Medicaid.
Obama tries co-operative federalism
That package has now been dwarfed by ARRA, which devotes more than $150 billion to heading off cuts in state spending, particularly in Medicaid and education. In fact, the extraordinary amount of money Washington is devoting to the present crisis has put intergovernmental relations front and centre in U.S. domestic policymaking.
Obama has devoted far more attention to intergovernmental relations than did his predecessor, and aims to foster greater federal cooperation with states and localities than any president in the past 40 years. The White House and federal agencies have taken unusual steps in opening up formal dialogues with state, city and county officials. Obama has created a White House Office of Urban Affairs while giving his blessing to state initiatives that Bush had blocked, such as California’s regulation of greenhouse gas emissions from vehicles.
However, the Obama administration also has made clear its position that Washington must retain its grip on the reins. Both Obama and his vice-president, Joe Biden, have publicly warned governors and mayors that they will “call them out,” as Obama put it, if they spend stimulus funds on wasteful projects. The ARRA legislation itself contains vague language warning subnational government units not to spend funds on “imprudent” projects.
While national leaders want states and local authorities to spend the stimulus dollars quickly, they don’t entirely trust them to make the right decisions. “We’re saying to them, ‘you can’t have it both ways,’ ” said Larry Naake, executive director of the National Association of Counties. “You can’t have us rush out and spend the money and then slap our hands after it’s done.”
Injecting the stimulus
The stimulus program is acting as a sort of dye injection highlighting where federalism currently stands in the country. States and local authorities spent the Bush years acting as quite autonomous entities, taking the lead on domestic issues that Washington was unable or unwilling to address, such as health care and climate change. This led to bold initiatives by figures such as California governor Arnold Schwarzenegger and New York mayor Michael Bloomberg, who addressed the vacuum by dealing with problems at a subnational level.
But the financial crisis – combined with the policy ambitions of the Obama administration and a Democratic Congress – have put Washington back in a position of clear dominance over the national agenda. “You’ve got two things going on – a change in administration and an economic downturn,” said John Dinan, a political scientist at Wake Forest University. “Both of those are leading toward a greater centralization of power and an enhanced federal role.”
Washington’s response to the recession, while ambitious, will not match that of the Great Depression in terms of federal growth and its effects on federalism. Under President Franklin D. Roosevelt, Washington became involved in a much wider range of domestic affairs, including regulation of the banking and securities sectors. Government spending, measured as a share of domestic output, doubled between 1929 and 1939.
The widespread creation of federal-state-local programs transformed them into a dominant model with Washington becoming, for the first time, the senior fiscal partner. Over the ensuing decades, in response to the need to hold up their end of the bargain, states revamped both their constitutions and government operations. “Modernization of state finances, with increases of state income as well as sales taxes, really got a jolt in the ’30s,” said Timothy J. Conlan, a professor of government and politics at George Mason University.
Will you love me when the money runs out?
Observers are wondering what will happen to the relationship between Washington and the states once the stimulus dollars begin to run out. State sources of revenue are typically lagging indicators, meaning state budgets will still be hard-pressed, even assuming the U.S. economy pulls out of recession soon.
A recent study by the State University of New York’s Rockefeller Institute of Government suggests that two years from now, states might face a collective shortfall exceeding $100 billion. Although there has been talk of a second stimulus package, members of Congress already complain of “bailout fatigue” and, with federal deficits already soaring past $1.5 trillion, states will probably have to struggle on their own to repair their deficits.
Several prominent Republican governors initially balked at accepting parts of the federal ARRA money, complaining it would create future obligations for which they would remain on the hook. Political pressure and their own budgetary problems forced them to take the money, however.
All but two states faced shortfalls in the fiscal year that ended June 30, 2009, with the biggest coming in Sunbelt states such as California, Arizona and Florida where the housing bubble had grown largest. Unemployment nationwide is expected to enter into double digits.
In California, the rate reached 11.6 per cent in June 2009 and could climb as high as 15 per cent by next year, according to economists at University of California, Santa Barbara – easily breaking the state’s postwar record.
California, facing a $26 billion shortfall in July 2009, began issuing IOUs bearing interest of 3.75 per cent to people and businesses it owes money to.
States tighten their belts
Tough times have led to some tough measures. In Hawaii, the governor ordered three days a month of unpaid leave for two years for state employees – the equivalent of a 14 per cent pay cut – but the order was overturned by a Honolulu judge. In California, Governor Arnold Schwarzenegger proposed closing 220 state parks in September 2009 and releasing thousands of inmates early from state prisons to meet revenue shortfalls.
In Illinois, the Democratic majority in the state house voted down a bill by Governor Patrick J. Quinn to raise the state income tax by 50 per cent. The State of Maine – while reducing the state income tax – put a tax on candy, haircuts and movie tickets. Wisconsin’s house passed a bill taxing oil companies, but the state senate cut that tax and instead repealed the tax break on capital gains. The bill had yet to go to a committee of the two houses to resolve the differences. Kentucky is now taxing alcohol and cell phone ring tones. California is considering legalizing marijuana and charging a tax on it of $50 per ounce.
Nationwide, the balance of trade remained weak, with exports declining faster than imports early in 2009. The U.S. trade deficit shrank a bit in the spring and stood at $26 billion, then grew to $27.6 billion in May 2009. Obama has cooled some of his protectionist rhetoric since last year’s campaign, when he floated the idea of renegotiating the North American Free Trade Agreement.
REUTERS/Rebecca Cook
A large ‘Buy American’ sign, in support of Detroit’s failing auto industry, is seen in the back of an auto scrap yard in Detroit, Michigan.
“Buy American” trumps free trade
But the stimulus package contained a “Buy American” clause specifying that only U.S. iron and steel can be bought with stimulus fund. That clause has angered other nations, and provoked fears of a legal challenge by Canada and Mexico under the North American Free Trade Agreement or of tit-for-tat retaliation by other trading partners. And in May, Obama proposed the elimination of tax incentives for U.S. companies that outsource jobs overseas.
“It’s a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York,” Obama said.
As is typically the case during a recession, tensions have increased between states and local governments. Strapped states are cutting their aid to localities. The bulk of the federal stimulus money also passes through states, leaving them to juggle competing demands from their cities and counties.
What’s clear is that the economic downturn has made states and localities more dependent on federal money and therefore more vulnerable to federal whims. The United States is entering into an era of what might be called “golden rule federalism” – whoever has the gold makes the rules. “When the feds have the money and the states don’t, then of course the feds are going to be able to better dictate the rules of the game,” said Bradley, of the Brookings Institution. 
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