Obama's Half Measures Won't Save the States

02/09/2011 04:33 pm ET | Updated May 25, 2011

The New York Times reports that President Obama has proposed aid for state unemployment insurance programs burdened by debt because of high unemployment rates. At the margin, no complaints here about the idea. But it's fairly limited in scope and may not make that much of a difference.

The President is likely to encounter a political problem here because his proposed policy may well prevent things from getting worse without actually generating significant gains in employment or the condition of state finances. So he will encounter the same difficulty he experienced when he passed his $800 billion fiscal stimulus bill in 2009: he will be in the invidious position of trying to prove a negative (i.e. "things would have been much worse had we not passed this legislation"). Meanwhile, the GOP will have a field day touting the proposal as yet another instance of "kicking the can down the road" at the expense of far greater debt for our grandchildren.

In an ideal world (you know, the one where Democrats actually had control of both houses of Congress and acted like, well, Democrats, rather than the GOP Lite), there are any number of state aid programs that could take effect instantly and actually do much to generate higher levels of employment. The only prerequisite is the need for the federal government to start making serious investments. A few examples:

  1. Start by making sure state and local governments do not lay off workers or cut back on vital programs, which avoids big losses to communities and helps local government to fight the recession.
  2. Add emergency revenue sharing to states and cities by picking up increased shares of Medicaid, which has suffered drastic cuts in eligibility and coverage, and enables states to restore benefits to more people, which relieves household budgets.
  3. Have government temporarily pay most of the cost of COBRA coverage for laid off people who lose their health insurance, and allow people over age 55 to buy into Medicare.
  4. Expand unemployment insurance to cover part-time workers, extend the eligibility period, and increase benefit levels.
  5. Roll back tuitions at state universities and community colleges, and increase Pell Grants -- contingent on universities not increasing costs to students -- which enables young people to spend the recession in college, rather than clogging unemployment rolls or graduating with huge debt burdens.

Why does the current political climate make measures that would help grow the economy non-starters? There is still an inability to understand that irrespective of one's views about the role of government (its scope, size, etc.), the fortunes of the non-government sector are still heavily dependent on the conduct of fiscal policy. The GOP and the allies in the Tea Party want to pursue budget surpluses as an expression of their ideological preference for small government. But they fail to spell out the consequences of that choice and what it means for the private domestic sector. Whether we like it or not, in a modern monetary system the fortunes of government and the non-government sector are intrinsically related.

If households try to net save by spending less than they are earning, and businesses do the same by reinvesting less than their retained earnings, then nominal incomes and real output will be likely to fall if the government is cutting back fiscal stimulus at the same time Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household budgets as incomes fall) or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies -- that is, unless creditors are generously willing to renegotiate existing debt contracts en masse.

That has certainly not been the case so far. In fact, our current policy can be succinctly summarized as "bond holders uber alles." Debts have to be repaid. (Except, of course, when it applies to unions or public sector employees, in which case renegotiation is a given.)

It's very simple: To reduce unemployment you have to increase aggregate demand. If private spending growth declines, then net public spending has to fill the gap. As Randy Wray has argued:

If we say that the government can run budget surpluses for 15 years, what we are ignoring is that this means the private sector will have to run deficits for 15 years -- going into debt that totals trillions of dollars in order to allow the government to retire its debt. Again it is hard to see why households would be better off if they owed more debt, just so that the government would owe them less.

Quite the opposite in fact: When private debt service levels reach some threshold percentage of income relative to earnings, the private sector will "run out of borrowing capacity" as incomes limit debt service. The government doesn't face comparable limits. The whole thrust of policy here should be to ensure there is sufficient growth in nominal aggregate demand consistent with the real capacity of the economy to respond and consistent with full employment. Until we understand that, we'll have to be content with the half-measures proposed by the President.

Cross-posted from New Deal 2.0.