- The Washington Times - Monday, March 3, 2003

In their march on Washington, America's governors and state legislators, facing up to $100 billion combined in budget deficits, are clamoring for a federal bailout. Sympathetic congressional leaders are showing some support, arguing a federal bailout would relieve state deficits while providing economic stimulus.
Don't believe it. A federal bailout is the wrong solution to the wrong problem.
While state fiscal shortfalls are very real, they have not primarily resulted from the temporary recession-induced revenue slowdown, but rather from a decade of fiscal excess. Throughout the prosperous 1990s and into this decade, state and local government spending rose sharply faster even than rapidly rising personal incomes.
In 1990, the states (and their local governments) absorbed about $116 of each $1000 in income; by 2002, that figure had risen to roughly $123. In 1999 and 2000, the national output in dollar terms rose slightly less than 6 percent a year, but state spending grew at a nearly 8 percent pace. In 2001, GDP grew less than 3 percent, while state and local spending rose an extraordinary 10 percent. In 2002, state spending again outgrew GDP.
So the problem is on the spending side.
Plato once said, "Necessity is the mother of invention." In the absence of federal bailouts, the states will be forced to reinvent themselves to get spending on Medicaid, schools, corrections and other needs under control.
Without a federal bailout, pressures will mount to privatize Medicaid, empowering recipients to manage their own health care with governmental assistance. Faced with the possibility of higher taxes, the public will revolt against pouring still more money into schools with meager results, and will demand fundamental reforms. If the states can rely on federal bailouts, they will never have incentives to face the fiscal discipline needed in times of budget stringency.
From 1996 to 2001, the price of state and local government services rose 15 percent far more than the price of federal government services or private consumption (10 percent), or private investment spending (one percent). This rise in the price of public goods compared with private goods almost certainly reflects a relative lack of efficiency and productivity enhancement in government. Relative to the rest of the economy, state governments seem to be doing less with more, rather than more with less.
What's worse, our past history suggests bailouts will not solve the state's fiscal problems. In fact, when one looks at the relationship between federal aid to states and their financial condition, increases in federal assistance are associated with bigger, not smaller deficits.
In a recent study for the American Legislative Exchange Council, in one econometric estimation, I calculated that "every one dollar more of federal assistance increases state and local budget deficits by over 62 cents." Federal aid typically comes with strings strings that force the states to spend more money of their own.
But won't federal bailouts avert reductions in state and local spending that will dampen aggregate demand, delaying recovery? Here the modern evidence is abundantly clear: central government deficit-financed demand stimulus policies simply do not work.
Japan is a poignant example. Hoping to stimulate a sluggish economy in the 1990s, Japan massively increased government spending by borrowing, going from massive budget surpluses to deficits and unemployment doubled and the economy languished. Roughly the same thing happened to the U.S. in the 1970s.
By contrast, reducing federal spending as a percent of GDP and the elimination of deficits are widely credited as a source of American prosperity in the 1990s.
In short, federal bailouts are not a solution. They are the equivalent of giving booze to alcoholics providing at best some temporary respite but aggravating fundamental problems, in this case overspending arising from excess special-interest control over government.

Richard Vedder, Distinguished Professor of Economics at Ohio University, is an Adjunct Scholar at the American Legislative Exchange Council (ALEC).

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