The Vicious Circle

TW: We have been discussing the demand contraction and the need for government to maintain its role as spender of last resort. One likely stimulus component will be federal payments to state and local governments to avert massive cut backs in employment and services. Just like employment cutbacks in the private sector, employment cutbacks at the local government level will contribute to the downward spiral in demand.

Unlike the federal government which has the Federal Reserve and other monetary tools (i.e. quantitative easing aka printing money) backstopping the Federal government's ability to fund spending, state and local governments are contrained. Given those contraints state governments when faced with deficits due to declining revenues react logically by reducing spending. While this is a noble approach and one that the Federal government would do well to abide in more proporous times, it is in the time of massive demand contraction a recipe for a death spiral. The measures outlined by MN governor Pawlenty below demonstrate how if MN abides its balanced budget approach and one applies the MN experience to 49 other states, the demand contraction will not improve but worsen on its way to a death spiral.

MN legislators and the governor apparently believe that slashing spending amidst the severe recession will solve their problem. This is exactly the mentality at an individual person and firm level that leads to the economic death spiral. If everyone cuts spending, then incomes plunge, if incomes plunge, there is lower revenue (tax or otherwise), if there is lower revenue then you need to cut more etc. I am truly curious whether the House Speaker has ever taken a macroecon course.

From the Minneapolis Tribune:
"Warning that Minnesotans are facing a time of "pain and sacrifice," officials Thursday said they would slash state spending and rethink the role of government in the aftermath of a towering deficit that tops $5.2 billion over the next two and a half years.

Gov. Tim Pawlenty said that most states in the country are staring into budget shortfalls...For starters, Pawlenty said he is ordering state agencies to cut 10 percent of discretionary spending. Only public safety, corrections, the military and veterans affairs will be spared.

"We can work our way back to prosperity," House Speaker Margaret Anderson Kelliher, DFL-Minneapolis, said Thursday. "We are going to start by making cuts."

Key legislators will begin meeting next week to craft the first round of cuts needed to reverse the state's most immediate problem: a deficit of $426 million in the current budget period, which ends in seven months...But Pawlenty has served notice that if progress drags beyond a few weeks, he will make the cuts himself - a gubernatorial prerogative in times of budget crisis known as unallotment."
http://www.startribune.com/politics/state/35539039.html?elr=KArksLckD8EQDUoaEyqyP4O:DW3ckUiD3aPc:_Yyc:aULPQL7PQLanchO7DiUs