Congress must fund another major economic relief package

By Maurice Obstfeld and Laura D’Andrea Tyson, Special to CalMatters

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Just a month prior to the onset of the COVID-19 pandemic, the U.S. and California were reporting historic low unemployment rates of 3.5% and 3.9% respectively. With historically low interest rates, low inflation and stable financial markets, most forecasters predicted that output and employment growth would continue through 2020-21. Gov. Gavin Newsom’s January forecast also assumed continued growth and projected a state budget surplus for 2020-21. 

In just a few weeks, the economic outlooks for the U.S. and California dramatically deteriorated. All major sectors of the economy plunged into a slowdown. At least one in five are out of work, with job losses falling disproportionately on lower-income workers. According to the governor’s most recent forecast for California, total personal income will fall by 8.9% in 2020 and won’t return to 2019 levels until 2023. The unemployment rate will remain at double-digit levels through 2023, with the highest rates among the most vulnerable lower-income workers with few financial resources.    

At the end of 2019, the U.S. and California were wealthier than ever, but there were stark inequalities in the distribution of opportunities and access to health care. With its disproportionate effect on the health and incomes of disadvantaged workers, the pandemic has shed a harsh light on these structural inequities. Without effective policy remedies they will likely worsen, as they did during the recovery from the Great Recession. 

Unlike the federal government, state and local governments are constrained by balanced-budget laws. Without additional federal funds, states and local governments will have to raise taxes or implement deep spending cuts. There are no other options, and both will exacerbate the recession. Moreover, spending cuts will overwhelmingly fall on essential services where states spend most of their revenues, including public education, public safety and public health.  While Newsom’s May Revision is guided by prudent fiscal management to protect these priorities, the size of the budget gap implies painful spending cuts without federal support. 

Under current conditions, the macroeconomic rationale for significant additional federal funding for state governments is compelling. If plummeting revenues force states to slam on their fiscal brakes, that will undermine the federal government’s own countercyclical measures, resulting in a deeper recession, more unemployment and a slower recovery for the entire nation.

The lessons of the Great Recession confirm these alarming predictions. Between 2008 and 2014, state government revenues fell $600 billion, but states received only $150 billion in federal aid. States had to draw down their accumulated reserves, increase taxes and cut “discretionary” spending. These austerity measures were a significant drag on growth, and had an estimated negative multiplier effect of 1.7 – each $1 reduction in spending led to a $1.70 loss of economic activity. Worse, austerity had long-lasting effects. Inflation-adjusted state spending and state and local payrolls did not return to pre-recession highs until 2019, just before COVID-19 arrived.

Scarred by this trauma, most states have built up their reserves, which reached all-time highs in many states at the start of the 2020 fiscal year. On the eve of the pandemic, California’s budgetary situation was robust, with historic revenues, record reserves including a $16 billion rainy-day fund, and a projected budget surplus of $5.6 billion. Now, due to plummeting revenues and increased pandemic costs, the state faces an estimated budget gap of $54.3 billion – nearly 37% of the state’s general fund.  

Not even massive rainy-day funds are sufficient to fill the huge budgetary holes created by the COVID-19 pandemic. Nor is bankruptcy an option for states. The U.S. Constitution prohibits state governments from “impairing the obligation of contracts,” including their own debts. However, municipalities can declare bankruptcy and there is good reason to worry they may need to do so, further destabilizing U.S. and global financial markets. 

Investors around the world are willing to make long-term loans to the federal government at very low interest rates. The Federal Reserve is committed to unlimited purchases of U.S. securities and Fed Chair Jerome Powell has warned of deep and lasting economic consequences without more fiscal support. Under current and foreseeable economic conditions, the federal government can and should fund another major economic relief package and include at least $1 trillion in flexible funding for state and local governments. 

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Maurice Obstfeld is a member of the Governor’s Council of Economic Advisers, and Class of 1958 Professor of Economics at the University of California, Berkeley, [email protected]. Laura D’Andrea Tyson is co-chair of the Governor’s Council of Economic Advisers, and Distinguished Professor of the Graduate School at the Haas School of Business, University of California, Berkeley, [email protected]. They wrote this commentary for CalMatters.

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