The [Build America Bonds] program can be interpreted as a wealth transfer from the natural holders of municipal bonds, who are individual U.S. taxpayers, to corporations, pension funds, and foreign investors not subject to individual U.S. income taxes.

That is Andrew Ang, Vineer Bhansali, and Yuhang Xing in a new NBER working paper.

The BABs were a part of Stimulus II. They are a new way for municipalities to finance capital projects. Like the traditional method, BABs effectively subsidize state and local borrowing, but the mechanics are slightly different. Traditionally, the interest on muni bonds is not subject to federal taxation. BABs are taxed, but the federal government subsidizes 35 percent of the interest payment. 

(Note that under both cases, local governments receive a special privelege that private borrowers do not.) Ang, Bhansali and Xing trace out some of the less-obvious consequences of shifting the method of finance.

I know the conventional answer: the recession. And surely there is validity to the conventional answer. The recession was the proximate cause: it sent revenues in a free fall at the same time that it put extra demands on the states’ welfare systems.

But the budget gaps were pretty different from state to state. For example, California faced a 2010 budget gap that was 65 percent of its General Fund while North Dakota faced no budget gap at all. Might differences in state policy and differences in state institutions explain the vast difference in gap size? This was the motivation for my recent working paper, State Budget Gaps and State Budget Growth.

In it, I conclude that large gaps were the result of rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules.

To arrive at this conclusion, I performed a series of statistical tests, focusing on the size of state budget gaps, measured as a share of state general funds. In these tests, I controlled for various factors that might influence the size of a state’s gap (its population, income level, demographic makeup, etc.). After controlling for these factors, I was able to estimate the impact of certain policy choices and institutions on the size of states’ budget gaps. In particular, I focused on:

• Budget size relative to state income,
• Growth in per capita spending in the two decades preceding the recession,
• Levels of economic freedom, and
• Stringency of state balanced budget requirements. 

I found that states that spent a large share of state income—and have done so for many decades—had smaller (percentage) deficits. This may be because states grow accustomed to making their budgets balance or it may be because the same factors that permit steady revenue streams also permit large budgets. But this doesn’t mean policymakers should go on spending sprees and expect smaller budget gaps. In fact, a spending spree is likely to make a state’s budget gap worse. Other factors being equal, states whose per capita spending increased the most in the two decades preceding the recession had budget gaps that were nearly 20 percentage points larger than states whose per capita spending increased the least. Since the median state’s budget gap was 23 percent of its general fund, going from the slowest to the fastest-growing state can make a huge difference.

Economic freedom (characterized by low taxes and minimal regulation) makes an even greater difference. Using Jason Sorens and William Ruger’s measure of economic freedom, I found that other factors being equal, the most-economically free states tended to have budget gaps that were 25 percentage points smaller than the least-free states.

Lastly, states with weak balanced budget requirements had larger budget gaps. While every state but Vermont is required to balance its budget, some requirements are weaker than others. It turns out that those states with weak balanced budget requirements encountered larger deficits to begin with: theirs were 8 to 10 percentage points larger than those with strong balanced budget requirements.

So what caused the budget gaps? Policy makers may be all-too-happy to pin the blame on the recession. But my research suggests that policy choices in the decades preceding the recession made a big difference. Rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules caused the gaps. The recession just exposed these underlying problems.

City Journal‘s Steven Malanga writes at RealClearPolitics about the possibility of a municipal bond bailout on the horizon. The canary in the coalmine is the SEC’s cease-and-desist order to New Jersey for misleading investors by omitting key information in their bond offerings between 2001-2007. Specifically, the SEC charges that New Jersey misrepresented the state’s pension liabilities. The state indicated it was taking actions to ensure the solvency of its pension funds when in fact pension deferrals were frequently undertaken.

What’s interesting is that the day after this announcement, New Jersey easily sold an offering of short-term notes to banks. The state didn’t have to pay a premium to attract investors. Why aren’t investors more cautious? And why wasn’t New Jersey fined?

As Malanga noted earlier this week in the Wall Street Journal, for years states have been hiding the true size of their fiscal problems behind a range of fiscal manipulations (for a catalog of those, see my latest paper on Fiscal Evasion). Yet the signal sent by the SEC is that there is no penalty or risk for bad behavior. The question Malanga asks: do politicians and muni bond holders simply expect that in the event a state can’t pay its bondholders a federal bailout will pick up the tab?

The graph compares spending by state and local governments to spending in the private sector by graphing each as a multiple of its 1950 level (all numbers are adjusted for inflation). The differences are startling: since 1950, private spending has increased 5-fold while state and local government spending has increased nearly 10-fold.

State and local governments, of course, receive their revenue from the private sector. In a word, this is unsustainable.

Bloomberg reports:

U.S. House members are returning to Washington from summer recess to act on a $26 billion plan to aid cash-strapped state governments.

The U.S. government has a long history (see pp. 57-60) of refusing to bailout profligate state governments. It dates all the way back to the 1840s when eight state governments (and one territory) came to Congress with hats in hand: Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, Pennsylvania, and the territory of Florida all wanted a federal bailout of their debts. Representatives from fiscally responsible states would have none of it and an important precedent was established. There have been no state defaults since.

Today’s action is not a full state bailout (as far as I know, none of the states are threatening bankruptcy just yet), but the federal assertion that the states are too big to fail does mean that they will face a significantly softer budget constraint tomorrow than they did yesterday. That is: the states have a weaker incentive to be fiscally responsible.

How might we expect the states to behave in this post-bailout world? 

In recent research, Alexander Fink and Thomas Stratmann of George Mason University shed some light on the question. It would be nice to just compare the performance of states that receive federal aid with that of states that do not. But the states that receive federal aid are not random. In all likelihood, they are probably mismanaged to begin with (or perhaps poorer to begin with). In any case, a simple analysis of those that receive aid may not tell us much about the bailout effect itself.

Fink and Stratmann untangle this causal relationship, however, with a clever technique. They look at the German upper chamber, where different states enjoy different levels of political influence. Because political influence makes a state more likely to receive a bailout and because it is unrelated to the states’ underlying fiscal management, this allows Fink and Stratmann to test for the impact of the bailout without accidentally picking up other influences. What do they find?

States with a softer budget constraint [i.e., greater expectation that the German national government will bail them out], have higher deficits and debts and receive more bailout funds.

Furthermore:

The larger the expectation of a bailout, the higher the amount spent in a number of spending categories, and special interests are most likely to benefit from this additional spending. We also find that bailout expectations lead to less efficient state government service provision. 

One wonders if Congress is doing the states any favors.

Writing in Saturday’s edition of the Wall Street Journal, Peter G. Peterson makes the case for tax increases and spending cuts:

While I believe that spending cuts must play a lead role in any solution to our long-term structural deficits, the sheer magnitude of the imbalances requires revenue increases.

The University of Rochester’s Steve Landsburg is a refreshing antidote to this line of thinking:

There is this notion abroad that an extra billion in federal spending can be converted from “irresponsible” to “responsible” as long as it’s accompanied by an extra billion in tax hikes. That’s like saying a $500 haircut can be converted from “irresponsible” to “responsible” as long as you withdraw the $500 from your bank account.

Here, according to Landsburg, is why:  

The government’s chief asset—in fact, pretty much its only asset—is its ability to tax people, now and in the future. The taxpayers are the government’s ATM. Make a withdrawal today, and there’s less available tomorrow.

The bottom line: Under reasonable policy assumptions, government’s share of GDP is set to climb dramatically in the coming decades. We can not solve the problem by taxing ourselves to solvency.

NPR reports that in the city of Bell, California three city administrators agreed to resign after residents expressed outrage over their salaries. City Administrative Officer Robert Rizzo earns $787,637 a year, which twice the salary of the President of the United States.

The former administrators will not receive severance packages but they will collect pension benefits.

Mr. Rizzo will collect $650,000 a year making him the highest-paid beneficiary in the state’s pension system.

What is interesting is how they got their pay raises. The Los Angeles Times reports that the Bell City Council exempted themselves from state salary limits when they placed “Measure A”  on the ballot in 2005 to change the city to “charter status” in a special election that only attracted 400 voters. Since passage, salaries for council members, who serve part-time, shot up by 50 percent to at least $96,996 a year.

The reason for the sudden switch  was a state law passed in 2005 that limited the salaries of council members in “general law” cities. A law that itself was prompted by outrage over the pay of officials in South Gate, California.

Even more interesting is that Measure A didn’t bypass salary limits for serving on city councils. Instead, it gets around the salary limit imposed on boards and commissions. The City Council members receive $150 a month for council service, and $7,873.25 a month for serving on the Planning Commission, Surplus Property Authority, and the Solid Waste Recyling Authority.

How did Bell’s Council get its salaries? By fiscal evasion.

Pennsylvania has put together a $28 billion budget that is balanced through evasive practices. The budget relies on hundreds of millions in not-yet-promised federal money and overstated revenue increases. More disturbing is the $66 million in “WAMs” or Walking Around Money. Pennsylvania’s version of legislative pork politics, WAMs are revenues that are set aside for lawmakers to shower on pet projects in their districts.

WAMs were ruled unconstitutional in 1995. So the legislature renamed them Legislative Initiative Grants (LIGs). Last year, Pennsylvania lawmakers handed out $110 million in WAMs showered on everything from youth baseball to jazz festivals and fire departments. WAMs are generally reviled as a blatant means of buying votes with public dollars. But what makes the appearance of WAMs in recent budgets all the more offensive is summed up by Marc Levy at AP, “PA Lawmakers tapped grants while deficits grew.”

Last week, Michael Powell over at New York Times’s Economix blog characterized my position as one of “tough-love.” That is probably a fair way to put it. 

In an example of un-tough-love, yesterday’s Grey Lady featured an article by Christopher Edley Jr. (dean of the University of California, Berkeley, School of Law). In it, Dean Edley argues that states ought to be allowed to borrow directly from the Treasury:   

[S]tates are managing huge budget crises with the only tools they have, cutting spending and raising taxes — both of which undermine the federal stimulus.

That’s why the best booster shot for this recovery and the next would be to allow states to borrow from the Treasury during recessions. We did this for Wall Street and Detroit, fending off disaster. It’s even more important for states.

From my view, such a policy would permanently enshrine the notion that states are too big to fail. We know that states have a spending problem. According to data from the Bureau of Economic Analysis, for the last 9 years, the inflation-adjusted average annual growth rate of state and local government spending was 2.6%. At the same time, the private economy—on which state and local governments depend for their tax revenue—only grew at an average annual growth rate of 1.4%. In other words, states are already spending at a faster rate than the economy can create wealth. Furthermore, they are doing this without the power to deficit spend (for general operating expenses) or the power of the printing press. 

Allowing states the permanent ability to rely on the Federal Treasury would, of course, change all of that. How might we expect them to behave under those circumstances? Important research by the University of Rochester’s David Primo gives us some idea. It turns out that while all states save Vermont have balanced budget requirements, these requirements vary considerably from state to state. Some are allowed to carry deficits over from one year to the next while others are not. Furthermore, others are required to balance their planned spending, while others must balance their actual budgets at the end of the year. Lastly, some states are checked by independent courts, while others are not. In sum, some states face strict balanced budget requirements while others face weak balanced budget requirements. In his analysis, Professor Primo found that state and local spending in states with strict balanced budget requirements averaged $3,336 per citizen. In contrast, in states with weak requirements, the average was $3,756 per citizen.

The Federal Government’s balanced budget requirement isn’t weak; it is nonexistent (you might say they are on the honor system). So what might we expect spending to look like if every state in the union could borrow from the Federal Government whenever it was expedient?  I prefer tough love.

After my last post, some friends stopped by my office with a few questions: “If, as you say, we are conducting a big experiment in spending, will the experiment produce evidence that finally answers the question of whether or not fiscal stimulus works? Why can’t we just compare the economy’s performance during periods of stimulus with its performance during normal times?  Why mess with military spending as Barro and Redlick do, when what we want to know is whether stimulus spending works, not military spending?” (This latter question gets at Harry Moroz’s point too).   

Here is my attempt at an answer:

Let’s start by imagining the ideal conditions to test for the effect of a stimulus. Suppose the distribution of stimulus money were determined not by the political process, but by a scientist. This scientist would probably randomly assign units of observation two groups: a “treatment” and a “control” group. He would use a coin or some other random process to select some regions to receive money and some regions to receive none. Ideally, he would do this over the course of several years, distributing money both during boom and bust periods to see if the economy responded differently. Then, he would compare various measure of well-being (growth rates, unemployment rates, etc.) in times and places that received stimulus (the treatment group) with comparable measures in times and places that did not receive stimulus (the control group). 

Unfortunately for the scientist (fortunately for the citizen), stimulus money isn’t doled out this way. Instead, politicians make some attempt to target the expenditure of stimulus money to hit times and places that are in need (as my colleague, Veronique de Rugy has shown, they aren’t always very good at hitting their target). But this means that it becomes very difficult for the economist to assess, empirically, the impact of fiscal stimulus.

Why? Because economies in times and places that are in need tend not to grow at the same pace as more normal economies. As standard economic theory teaches us, market-based economies have natural recuperative properties. For example, if aggregate demand suddenly falls, causing a contraction, a chain of events is set in motion that helps sow the seeds of recovery. Spending will fall, lowering prices and increasing savings. The lower prices cushion some of the blow, allowing consumers’ dollars to go farther than before and allowing them to spend more than they otherwise would. As saving increases, interest rates fall and business investment picks up. As these processes work their way through the system, the economy begins to heal. Economists famously argue about how effective this process is, but few would deny that there is some truth to this story.

But knowing that this process happens to at least some degree, we can’t simply compare economic growth in times and places that receive stimulus with that of times and places that don’t. Otherwise, instead of picking up the effect of stimulus, we may just end up measuring the natural recuperative abilities of the market economy. Nor, more generally, can we compare economic growth in times and places where governments spend a great deal of money with economic growth in times and places where governments spend little. This is because there is strong reason to believe that causation runs the other way too: when the economy is humming, state and federal coffers are flush with cash and tend to spend more and when times are lean, states have no choice but to cut back spending.

The problem is analogous to that of understanding the impact of police patrols on crime. We would like to measure crime rates in times and places where patrols are sent with crime rates in times and places where patrols are not sent. But, like politicians distributing stimulus funds, police captains don’t randomly pick the areas where they send their patrols. Instead, they try to target patrols to the places and times where they are needed. Thus, a naïve look at the data shows that places with more police patrols tend to have more crime! This clearly doesn’t make sense, but it is what the data show.    

Which gets us to the question: why study military spending when we are interested in stimulus spending? The answer is that it helps solve the statistical problems I mention above. I won’t get into the technical details of two-stage least squares regression techniques (I’d prefer you finish reading the post), but here is the basic gist of the strategy: start by finding some phenomenon that is correlated with the treatment (the treatment here being cops or government spending) but uncorrelated with the outcome of interest (in this case, crime rates or economic growth). If you can find such a phenomenon, you can use it to study the pure, unbiased effect of the treatment on the outcome.

In the case of police and crime ­­­­­­­­­Steven Levitt came up with an ingenious phenomenon to help unravel the real relationship. He accurately surmised that elections might induce elected officials to increase the number of patrols on the street. And since elections are not directly related to the underlying crime rate, this allowed him to obtain an unbiased estimate of the effect of patrols on crime. As you probably guessed, this unbiased estimate showed that, indeed, more police patrols actually lead to less crime.

So what about stimulus? As I mentioned in my previous post, Robert Barro and Charles Redlick use military spending to assess the impact of stimulus spending on economic growth. Military spending is positively related to overall government spending. But it turns out that it isn’t related (positively or negatively) with economic downturns. Thus, it makes an ideal phenomenon to assess the impact of stimulus. As I mentioned, Barro and Redlick found that stimulus spending isn’t stimulative.

Similarly, Lauren Cohen, Joshua Coval, and Christopher Malloy, make clever use of another phenomenon to assess the impact of government spending on economic activity. They rely on the fact that government spends more in Congressional districts whose members are chairs of powerful committees than in districts whose members are just rank and file. Like Barro and Redlick, they find that government spending isn’t stimulative.   

I suspect that right now some clever economist is working on a study of the current stimulus that relies on a technique similar to these. I sincerely hope that it will bring us closer to a consensus on the effect of stimulus. If Barro and the others are correct, we can’t afford to keep throwing good money after bad.

Last week, Ezra Klein wrote that state budget shortfalls constituted a massive “anti-stimulus” which might overwhelm the Federal Stimulus (implying the need for further federal spending). I responded with a post arguing that, while Klein’s story is plausible, the numbers just don’t add up. The massive increase in federal spending in the last few years has more-than made up for any decreases in state spending.

This, in turn, prompted an interesting response from Harry Moroz over at Huffington Post. Mr. Moroz writes:

Obama’s efforts to counteract the economic downturn…accounted for only 34 percent ($205 billion) of increased spending in 2009. The rest of the increases have little to do with stimulating the economy….A comparison of federal spending and aggregate state spending is irrelevant. Comparing federal stimulus spending and state spending cuts is only appropriate and useful because both are responses to the economic downturn.

In other words, Mr. Moroz would prefer that we not look at overall spending increases because most of these increases were not intended to be stimulative. (I trust that Mr. Moroz will correct me if I am mischaracterizing his assertion.)

I agree with Mr. Moroz’s point that most of the spending increases were not stimulative (that’s kinda the problem). But the much-ballyhooed Keynesian model—on which proponents of increased government spending hang their intellectual hats—makes no allowance for intentions. Instead, they assert that all government spending, no matter what it is spent on, is stimulative. Here is Lord Keynes on the subject:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again…there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

For his part, President Obama made a similar claim in February of 2009:

Then you get the argument ‘well, this is not a stimulus bill, this is a spending bill.’ What do you think a stimulus is? That’s the whole point. No, seriously. That’s the point.

And though Mr. Moroz would not like to count President Bush’s $700 billion TARP bill either, the fact remains that that president, too, thought he was stimulating the economy.

The real question is: Intentions aside, does government spending actually stimulate the economy? Over the long run (when Lord Keynes said we were all dead) the answer is almost certainly “no.”

Using international data, a number of peer-reviewed studies have examined the relationship between government size, somehow measured, and economic growth. Here is a sample: Barro (1991 and 1989); Folster and Henrekson (2001); Romero-Ávila and Strauch (2008); Afonso and Furceri (2008); Chobanov and Mladenova (2009); Roy (2009); and Bergh and Karlsson (2010). Each of these studies finds a strong, statistically significant, negative relationship between the size of government and economic growth.

What about the short run? Here again the evidence seems weak at best. Consider new research by Harvard’s Robert Barro and Charles Redlick. They find that for every dollar the government spends on the military (read: takes out of the private economy), the economy gains just 40 to 70 cents. Spending a dollar to obtain 40 to 70 cents does not a good deal make. Or consider another study by Harvard’s Laruen Cohen, Joshua Coval and Christopher Malloy. They rely on the fact that the federal government tends to spend more money in districts whose congressional members are chairs of powerful committees than in districts whose members are just rank-and-file. They find that firms actually cut capital expenditures by 15 percent following the ascendency of a congressman to the chairmanship. Moreover, firms seem to scale back employment and experience declines in sales.

It seems to me that by just about any measure, we are currently conducting a large-scale experiment in massive government spending. Moreover, I believe the results of previous experiments predict that this one will lead to slower growth and less economic opportunity. This is not the time to worry that perhaps we have spent too little.

I may be missing a nuance in Mr. Moroz’s argument. I hope he will disabuse me of my errors with a reply.

A few weeks ago Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, warned, “Greece is a lesson for us…. We shouldn’t be so arrogant to think that that couldn’t happen to us.” Mr. Hoenig was talking about our “very, very significant deficit” at the federal level.

Mr. Hoenig is right to worry about the Federal Government’s financial footing, but as a growing number of commentators have argued, the comparison between Greece and the U.S. states may be more apt than that between Greece and the U.S. Federal Government.

Like Greece, nearly every state in the union faces a major budget gap. The National Governors Association and the National Association of State Budget Officers estimate that these gaps total $127.4 billion for the remainder of 2010, 2011 and 2012. Like Greece, these gaps manifested themselves during the recession but their underlying cause is unsustainable levels of government spending. Like Greece, the states have made unrealistic promises to their public employees in the form of unfunded pensions and health benefits. Like Greece, these promises loom as the single largest threat to fiscal solvency in the coming years. And like Greece, the states have a limited number of ways to deal with the situation: they may not declare bankruptcy and they may not inflate their way out of the mess.

In both situations, however, the governments can appeal to the next level of government for aid. In the US, the states received some $135 billion from the Federal Government in the stimulus package passed last spring. And in Europe, the EU has promised to bail out Greece to the tune of $146 billion. These actions send the signal that the US and the EU apparently think that some governments are too big to fail. They also establish a strong incentive for US state and EU member nations to live beyond their means.

The Economist recently noted another similarity between Greece and the US states: as in Greece, many leaders at the state government level are reluctant to make the tough choices necessary to deal with the problem.

This last comparison, however, may prove false. That is because the Greeks may finally be on the verge of addressing their problem. This week, the ruling Socialist Party, PASOK, unveiled their reform proposals and on Friday, the government agreed to the bill. According to Reuters, “The reform cuts benefits, curbs widespread early retirement, increases the number of contribution years from 35-37 to 40 and raises women’s retirement age from 60 to match men on 65.”

My colleague Eileen Norcross has just written a paper with AEI’s Andrew Biggs which reveals the scope of the pension problem in the state of New Jersey. They found that the pension system there is underfunded by as much as $170 billion. Note that this one state’s pension problem dwarfs the $127.4 billion sum total of all state budget gaps over the next two and a half years.

Worse, these unfunded liabilities will come due soon. A series of studies by Joshua Rauh (Northwestern) and Robert Novy-Marx (University of Chicago) find that seven states will run out of pension money by 2020. And when they do, the costs will be enormous. When Illinois’s pension system goes broke in 2018, for example, the state’s pensions costs will be nearly half the size of the entire 2008 state budget.

If Mr. Hoenig is right and Greece is a lesson, let’s hope that policy makers in the US learn it before the pension crisis hits.

Eileen has a great response to Ezra Klein’s piece on the “anti-stimulus.” Klein writes that “[state] budget shortfalls are the equivalent of a massive anti-stimulus, which some experts believe has overwhelmed the $787 billion stimulus passed by the federal government in 2009.” Have state budget cuts really overwhelmed federal budget expansions?

The National Governors Association, in conjunction with the National Association of State Budget Officers, recently released their “Fiscal Survey of States“. In it, they show that, indeed, aggregate state general fund expenditures declined by 4.3% in 2009 and 6.8% in 2010. Assuming fiscal stimulus actually works (and that is not a point that should be readily conceded), it is plausible that these huge declines would be enough to offset any increases in spending by the federal government. But the fact is they come nowhere close to offsetting the Federal Government’s massive spending spree.

If you pop over to the White House’s Office of Management and Budget website, you can see what the Federal Government has been up to. At the same time that aggregate state spending was falling by 4.3% and 6.8%, federal spending was increasing by a whopping 17.9% (2009) and 5.8% (2010). This, combined with the fact that the Federal Government spends trillions while states spend hundreds of billions (in the aggregate), means that the state spending contraction comes nowhere close to offsetting the federal spending increase.

In the chart below, I combine the data from NGA/NASBO with the data from the White House Office of Management and Budget. You judge for yourself. Does this look like a massive fiscal contraction to you?

Eileen Norcross and Andrew Biggs have a new paper out this morning entitled “The Crisis in Public Sector Pension Plans: A Blueprint for Reform in New Jersey.” While it’s focused on New Jersey, it does an excellent job of outlining the larger problem with state pension plans nationwide and what policy makers can do about it.

Here’s the abstract:

New Jersey’s defined benefit pension systems are underfunded by more than $170 billion, an amount equivalent to 44 percent of gross state product (GSP) and 328 percent of the state’s explicit government debt. Depending on market conditions, the state will begin to run out of money to pay benefits between 2013 and 2019. The state’s five defined benefit pension plans cover over 770,000 workers, and more than a quarter million retirees depend on state pensions paying out almost $6 billion per year in benefits. Nationwide, state pensions are underfunded by between $2.8 trillion and $5.2 trillion, some 20 to 37 percent of America’s annual output as much as $3 trillion, approximately 20 percent of America’s annual output..

This path is not sustainable. In order to avert a fiscal crisis and ensure that future state employees have dependable retirement savings, New Jersey should follow the lead of the federal government and the private sector and move from defined benefit pensions to defined contribution pensions. While significant liabilities will remain, the first step to addressing the pension crisis is capping existing liabilities and providing new employees with more sustainable retirement options.

Specifically, the paper recommends that policy makers:

• Extend the defined contribution plan already available to state university faculty and staff and the state’s Defined Contribution Retirement Program to all state employees.
• Reduce or freeze cost of living adjustments (COLAs) to reduce the state’s unfunded liability.
• Transition non-vested workers to defined contribution plans.

Whole thing here.

The Washington Post reports how municipal governments in the U.S. are under great strain: state and local governments have doubled their debt loads in the past decade to $2.4 trillion. Factor in state (excluding local) unfunded pension liabilities for another $1 trillion (a figure that is likely closer to $3 trillion).

The future is debt-laden and the question is how will state and local governments respond. Trade-offs will have to be made between money for current services, bond payments, and pension benefits. Taxes will be raised and it’s likely that states will seek more bailouts from a debt-saturated federal government.

It’s hard to see how more federal spending (i.e. debt)  is the way to stimulate cash-strapped states. Yet, that’s the argument made by Ezra Klein in this Sunday’s Post.

Before issuing debt to cover debt it might be worth asking what have state and local governments been doing with all the economic development/infrastructure debt they’ve issued these past years?

Harrisburg issued debt for an incinerator that was supposed to make money. Now called a financial ”fiasco,” the incinerator threatens to sink the city’s budget. Steven Malanga discusses the debts incurred by what should be a profit-making enterprise — the 40 year old New Jersey Meadowlands, as well as the long-running “redevelopment debt” odyssey of California.

There is no magic in debt-financed infrastructure and economic-development, only a deferred tax bill to pay for the government’s gambles.

Delen Goldberg of the Post-Standard reports:

Lawmakers so far have cut about $1.2 billion in state spending for the 2010-11 fiscal year. They’ve come to an agreement on about 50 percent of the budget.

That means they still have to cut $8 billion, and they have only half the budget left from which to trim.

So, to summarize their progress:

Last weekend, President Obama pleaded to the Senate to extend portions of the stimulus bill. As my colleague Veronique DeRugy wrote at NRO, he relied on a tactic known as the “Washington Monument Syndrome”: Threatening to shut-down the most-valued aspects of government first in response to a budget cut. The syndrome gets its name from the Department of the Interior, which has threatened to shut down the beloved (and inexpensive) Washington Monument if its belt is tightened.

I recently learned that this tactic is also sometimes known, more colorfully, as the “shoot the cocker spaniel” ploy.

The idea runs counter to basic budgeting intuition. In economics 101, we teach our students that demand curves slope downward and supply curves slope upward. This is just another way of saying that the last increment of any item you spend money on should be the item with the lowest benefit and the highest cost. So if you cut back, you should cut those low-benefit-high-cost items first.

It also runs counter to the type of budgeting that families and businesses do every day. When a firm’s revenues are down, the least-productive and most-expensive units are the first to go. And when a family’s budget gets tight, they don’t shoot the cocker-spaniel. Instead, they skip a night out.

The Grace Commission famously identified thousands of wasteful spending items at the Federal level and Citizens Against Government Waste continues to point out areas where budgets can be trimmed. Various state think tanks, in conjunction with CAGW, have done the same in a series of “Pig Books.”

The AP is now reporting that the Senate has rejected the President’s pleas. Perhaps the states will crack open the pig books and find something to kill other than the cocker spaniel.

Eileen writes about the fascinating debate in Arlington, Virginia, over how the County should be structured. Under the current “at-large” system, each of the five County Board members is elected by the entire County. But a petition is underway to change that. Under the new proposal, the County would be divided into separate districts or “wards,” each with a council member representing it.

That got me thinking: what are the likely consequences of such a change? At least theoretically, one would expect a ward-organized government to be a bigger government. The reason is that ward representatives can vote to concentrate benefits on their particular districts, and diffuse the costs over the entire County. Public choice economists usually consider such schemes to be inefficient because they permit marginal costs to exceed marginal benefits.

As one might guess, someone has studied this. A 1997 study by Lawrence Southwick of the State University of New York at Buffalo found that, indeed, ward governments were bigger governments. He gathered data from 1,254 cities and controlled for other factors that might affect government size such as the demographic characteristics of the residents and the size of the population. He found that, compared to ward-cities, at-large cities average 11.1 percent lower total expenditures, 14.8 percent lower per-capita taxes, and 53.3 percent lower per-capita debt levels.

The current system, it seems, tends to favor a limited government. This is somewhat ironic because the party whose platform explicitly endorses limited government is apparently one of the groups backing the change.

The budget crisis in New York is getting worse. The state has remained in operation thanks to a series of emergency bills that have included dramatic reductions in some areas of spending. But Republicans, worried that the cuts do not go far enough, have opposed the last three emergency bills.

In the latest development, the New York Times reports that two Democratic Senators have said they will not vote for any more emergency bills if they entail further cuts. That’s a problem because Democrats enjoy a razor-thin 2-vote majority. This prompted Governor Paterson to state that he will not give into “thug-activity,” presumably referring to his fellow Democrats. At least one Democrat in question, Senator Díaz, took it that way: “The Governor called me a thug. When I pick a fight, I don’t go back. Let’s see what a thug can do.”

If the politicians fail to play nice, the Times reports that the state government may shut down. This crisis was brought on by out-of-control-government spending. But a government shutdown is not likely to be a win for those who wish to reign in that spending. In his recent analysis of budget rules, University of Rochester Professor David Primo finds that states with automatic shutdown provisions spend $64 more per-capita compared to states that do not have automatic shutdown provisions.

Primo explains:

This finding relies on a result, first shown by Romer and Rosenthal (1978), that the more extreme a status quo or reversion point, the more advantaged is the proposer in bargaining settings with take-it-or-leave-it offers. By making the reversion point, in effect, zero, states that do not allow for some reasonable level of spending in the absence of budgetary agreement advantage the proposer in the process (in this case, the legislature). This result demonstrates the sometimes surprising effects of budget rules.

Megan McArdle writes:

There’s a saying I’ve heard from accountants:  recessions uncover what auditors can’t…. I supect that this is also the case with the emerging epidemic of governments who cooked the books.  Hungary is the latest culprit, and its official pronouncements are starting to sound, well, worryingly Greek.

Stay tuned. Veronique de Rugy and Eileen Norcross have taken on the brave task of trying to codify the respective ways in which federal and state legislators play tricks with their budgets and evade fiscal responsibility. Look for their papers soon.