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How Economics Causes Budget Cuts in Local Government Today, Capstone Project Example

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Capstone Project

Introduction

While it has long been accepted that the nature of government spending affects the state of the economy, it is sometimes understated how reciprocal this causal relationship is. The health of the macro economy can and does influence the amount that the government spends. As the economy slips, tax revenues will fall and due to unemployment benefits and other automatic fiscal stabilizing programs, spending will increase. Another factor that can force higher government spending is bond vigilantism. This is when bond buyers lose confidence in the government ability to repay their debts or anticipate future inflation. In response, they either buy fewer bonds or sell bonds they already hold. If the government is forced to pay higher interest rates, their debt serving costs will rise and the problem can begin to compound on itself.

Not only do these non discretionary programs create more spending, but governments often make decisions to increase spending to try and improve sagging economies. Examples of this type of spending that have been seen during this current economic crisis include extensions to unemployment benefits, large stimulus packages consisting of tax cuts, tax holidays, or increased spending, and bailouts to at risk financial institutions.

The result is that budget deficits will increase as the economy continues to falter. Usually, these deficits are accepted as necessary counter cyclical actions to improve the economy, but in some cases legislation is passed in an attempt to lower the deficit. This can be done for a number of reasons. One possible reason is a freely made decision by the legislature to lower the budget deficit. Another is a rule that forces balanced budgets onto the legislature, giving them no choice but to close the deficit somehow. Finally, if the budget deficit gets so bad that the government must turn to outside help, then the organizations willing to help may force budget balancing in return. This is usually done largely through expenditure cuts with some help coming from revenue increases.

Overview

In fact, during the current economic crisis, budget balancing forced upon governments has often been undertaken. While the federal government has aggressively pursued expansionary policies, lower levels of government, mainly state and municipal ones, have been largely cutting spending during this period. This is happening for reasons such as bond vigilantism and balanced budget amendments. Local governments do not have the ability to borrow the way the federal government does, due both to their smaller sizes and their lack of control over the money supply. For this reason, they avoid running large deficits as the debt servicing prices would be prohibitively expensive.

Examples of this budget balancing are plentiful. In fact, one study conducted by the Organization of Economic Cooperation and Development, or OECD, shows that no country other than the United States had such a large cut in spending amongst sub national governments during the recession. This is extremely impactful as in 2007, the last full year before the recession, the United States had the third highest level of sub central government spending amongst government spending out of OECD countries.

The pain was not just felt by smaller cities that would theoretically have the most trouble acquiring credit needed to run a deficit. Large city governments were also shown to undergo budget balancing attempts. To do this, they mostly significantly cut their payrolls during each fiscal year of the recession to close their budget gaps. On top of that revenues were increased through fees, tax rate increases, or the creation of new tax programs. Usually these revenues were gained through taxes on very small portions of the population or rather small taxes such as a few cents per can of soda. However, there were times when this was not enough, such as in Philadelphia which increased their sales tax 14.3% from 2009 to 2010 (Ginsberg).

The most common reason the economy forces budget cuts on the state governments of the United States is balanced budget rules and amendments. Currently, forty nine of fifty states feature some sort of rule that limits their spending in relation to their revenue levels, Vermont being the lone exception. These measures seem to be effective with significant effects seen between the existence of this type of statute and deficit levels. Usually, the financing comes through budget cuts and not increased taxes (Bohn and Inman). This is perhaps due to the political ease of the former relative to the latter. According to prominent economist Paul Krugman in an article entitled “Fifty Herbert Hoovers”, these regulations were extremely impactful during the current recession. He not only criticized the idea of fiscal contractionary policies during a rough economic period, hence the title, a reference to Herbert Hoover attempting to balance the federal budget during the Great Depression, but also the long term effects cuts to important programs could have. In the paper “On the Ease of Overstating the Fiscal Stimulus in the U.S., 2008-9”, the size of the national stimulus was analyzed in combination with the slowdowns in local government spending levels. The result was that in the stimulus of over seven hundred billion, less than fifty billion was left over after accounting for other spending cuts (Ainzenmann and Pasricha).

Although they occurred outside of the United States, the recession is global and similar cases of budget cuts in response to the downturn. Perhaps the most prominent example of this occurring is the situation currently going on in many European countries. Countries such as Greece and Portugal had been running deficits and building up debt in the years antedating the economic recession that began in 2008. Others, such as The Republic of Ireland and Spain had actually been lowering their debt levels previously (Trading Economics). When the recession began slowing down the economies both in these nations and others around the world, all of their deficits and therefore their debt levels grew. The problem spiraled out of control when bond buyers lost faith in their ability to repay, causing their debt servicing expenses to rise significantly. Due to this, these countries, specifically Ireland and Greece had to turn outside for help to avoid a default. Organizations such as the International Monetary Fund and the rest of the European Union stepped up to help, but demanded significant budget cuts in return for their support.

These new budgets passed by these countries, referred to as austerity budgets were significant. The Irish budget for 2011 featured eight billion dollars of cuts compared to their 2010 budget (The Economist). With a GDP of just over two hundred billion annually, this represents approximately four percent of the country’s national output. To put that in context, this would be the equivalent of cutting over five hundred billion from the United States budget, more than the entire cost of Medicare in 2010 (CBPP). Yet, further cuts are expected as they have set on a four year plan to cut their deficit. Greece has passed several austerity measures, which are hoped to save thirty billion Euros, or one eighth of their GDP prior to the recession (Buiter).

Impact

The pertinent question is what type of effect these attempts to balance the budget will have on the economies and political institutions that undertake them. These actions go against the economic orthodoxy expressed by Keynesian macro economic theory. The namesake of this school of thought John Maynard Keynes, wrote The General Theory of Employment, Interest, and Money in the midst of another economic slowdown, The Great Depression. In this work, he introduced his theory regarding the workings of the business cycle. Keynes felt that during recessions and especially depressions, governments should undergo expansionary policies. On the monetary side this means cutting interest rates and trying to increase the money supply. For fiscal policy, he called for the government to intentionally run deficits by cutting taxes and increased spending. Through the multiplier effect, in which the dollar spent by the government would be spent many times over, this could spur economic growth. Keynes also suggested that during economic expansions, governments run budget surpluses to finance the deficits during recessions. Unfortunately, this advice has rarely been heeded.

With this in mind, it would seem clear that these budget cuts are the opposite of what is needed. However, there are some theories that doubt the effectiveness of any kind of stimulus. One such view that goes against the idea of stimulus is the crowding out effect. Since the government needs to borrow money to spend more than it has, they must turn to bond markets. This increase in the demand for credit increases the price for credit, making it more difficult for private investors to secure any, reducing private sector spending and counteracting the effects of the initial stimulus. Another is that by running deficits, it will be clear that at some point spending cuts and tax increases must come. With that in mind, private actors may feel uncertain about their future ability to gather income and try to save larger amounts of money. Both of these would suggest that Keynesian style stimulus is counter effective and that budget cuts are good at this time.

Ultimately the impact of budget cuts is dependent on which side is correct in this debate, Keynesian stimulus proponents or those who argue for balanced budgets. This debate has been undertaken amongst politicians and economists continuously for decades, especially during recessions when the policy implications are most important. Obviously then, this is not an argument that can easily be settled. The effects of cuts are even more difficult to ascertain in the case of local governments due to the many factors influencing local economies outside of the spending levels of their respective governments. However, despite this difficulty, this is an important topic with great deals of impact on how local governments should act.

The two austerity movements thrust upon Greece and The Republic of Ireland provide interesting case studies that can be extrapolated to many other levels of government. This is because they are perhaps the most significant budget cuts ever passed that were not related to the end of a large government expenditure program, such as a war. Also, in the case of local government cuts in the United States, it is very difficult to untangle their affects from the policies enacted by the national government. Ireland and Greece, while still impacted greatly by the global economy and actions of the European Union, are easier to analyze on their own. For this reason, studying them is likely to give a great deal of insight into how government cuts of this sort affect the economy. However, there are caveats. The economic concept of ceteris paribus, meaning all remaining things equal, must be remembered. While there is certainly the possibility of learning important information from these observations, the differences between Ireland and Greece as opposed to a municipal government in the United States shouldn’t be forgotten.

The Irish economy has expanded well to their forced austerity measures. The GDP has grown in the past two quarters, the first consecutive quarters of growth since 2006. However, there has been no increase in Ireland’s own aggregate demand meaning this growth is largely export driven. It could be argued that the improved fiscal situation has brought foreign companies back to the nation; it was this practice that was so successful for Ireland in the decades before the recession when the economy boomed. However, it would be ideal for an Irish economic recovery to come somewhat from within, eliminating their dependency on other nations. In fact, Paul Krugman a critic of these global austerity movements points out that their Gross National Product has fallen during this growth (Krugman, Irish Pfizer Smiling). This means that the majority of wealth created by the growth is being captured by foreigners and therefore not increasing Irish quality of life. The effect of austerity on Irish distribution of income is easier to interpret than the effect on growth. The sacrifices were mostly put on the highest earners in the country through significant tax increases.

The Greece austerity measures began on a negative point as the parliamentary vote on those measures was greeted with a labor strike. This was similar to the Latin American experience, where austerity efforts as well as market reforms were largely hampered by the social conflicts they created (Lustig). From there, it continued to go poorly as they say four consecutive quarters of negative growth more severe than any seen before the austerity (Trading Economics). The most recent quarter saw some growth, but it must be sustained much longer than just one quarter before it can be seen as having positive effects.

As of now, the return on austerity measures in Europe is not yet conclusive. Greece has mostly undergone economic contraction since the austerity measures and Ireland has seen growth, but mostly fueled by its unique standing as a haven for foreign companies to operate in. The distributional effects are clearer, with the decreases in income coming largely from higher income classes. While it is easy to see these effects, the correct level of income and wealth distribution is not something with an empirically provable answer and therefore does not help much with how budget cuts should be seen.

Due to the temporal proximity these austerity measures have to the present, it is difficult to truly studying how they are affecting the economies they are occurring in. For this reason, it is likely beneficial to turn to studies of a more historical nature on the effects of fiscal stimulus. Luckily, there has been a great deal of research into this topic, specifically the fiscal multiplier effect a dollar of government spending has. The multiplier effect is tied to the marginal propensity to consume, which is how much of an extra dollar of income the average person will spend opposed to saving. The more people spend of the money they receive from the government the more the economy will be multiplied by spending.

One study into this topic was performed for the IMF in 2009. “The Case for Global Stimulus” concludes that fiscal stimulus can be very effective when conducted properly. Namely, this means cooperation between several governments and monetary policy following the same path. It cites a study conducted by David and Christia Romer in which they controlled for the economic conditions surrounding the fiscal stimulus and found that over the long term the multiplier effect is approximately between two and three, meaning one dollar of government spending will increase GDP by three dollars over a three year period (Romer, Romer).

Another IMF study, simply titled “Fiscal Multipliers” is more bullish on the benefits of stimulus. One condition they call essential is for the economy to have a low tendency to import. In the case of municipal or state governments, this does not apply as they have practically no trade barriers with the areas surrounding them. For this reason, it would take a coordinated effort by many sub national governments or for a larger government to undertake the actions in their case. It also conceded that the effect of stimulus can be negative if it puts the government on an unsustainable path which decreases confidence. This leads credence to the theory proposed by anti Keynesians about the importance of confidence.

So far these studies have mostly been concerned with the effects of stimulus, usually increases in spending. However, that does not mean it is safe to assume that the opposite of austerity measures and budget cuts are necessarily the opposite. One study regarding the so called “expansionary fiscal contraction” theory, which is the theory supporting budget balancing during recessions, found that it does come with some benefits. The final conclusion was that if done in a way that convinces private parties that there is an actual commitment being made to sustainable budgeting austerity can increase consumption and investment, but that unemployment will not fall, an issue due to the high probability that it is unacceptably high during the recession (Barry and Devereux).

Due to their current situation in which their high debt levels have forced them into undertaking austerity measures, it is ironic that one of the often cited success stories for contractionary fiscal expansion is the Republic of Ireland. During the late 1990s, their government cut its size and the economy began expanding rapidly during their Celtic Tiger era. After these events occurred, a narrative developed in which the former event was the cause of the latter. However, an alternative proposed theory is that Ireland opened its economy towards the rest of the world, which was experiencing growth at the time. Combined with the peace that came to the island in the wake of the Good Friday Agreement of 1998, the economy was set to boom from these factors. John Bradley and Karl Whelan studied this economic ascension of Ireland from the perspective of Ireland as a small open economy, a designation that could fit states and also municipalities. Their conclusion is that the contractionary fiscal expansion did exist, but was ultimately much less responsible for Ireland’s economic growth than events occurring outside of its borders (Bradley and Whelan).

Of course, there is another way to look at the effects of government spending that must be considered. The point of government is not simply to have assets that can be turned into expansionary policy when it is needed. Cutting government spending, regardless of its ability to affect the short term economy, will come with other impacts. This is because these cuts obviously must come from programs. Some may point to waste, fraud, and abuse as areas to cut, but this type of wasteful spending is often difficult to find. The unfortunate fact is that these potentially cut programs are difficult to objectively analyze. However, they should significantly influence any decision to cut spending. Due to the nature of compromise anyone proposing spending cuts will have to accept that some of their preferred programs will likely see the cuts they are advocating. Ways that allow the government to avoid spending cuts are likely to be beneficial as they will be able to be made based on cost benefit analyses and not made out of compulsion.

Conclusion

While it is common for government spending to fall in the wake of a recession or similar economic struggles, the impact of this is not very clear. Ultimately, the effects of decreased government spending during recessions are not easy to calculate. The evidence seems to lean towards this being a harmful practice especially in the short term, but examples such as the turnaround in Ireland and certain studies seem to contradict that. Fiscal stimulus by a large government that does not need to worry about default or high borrowing costs, such as the United States federal government, seems to be the most effective type. For that reason, it may be prudent for them to capitalize on their low cost of raising money while allowing smaller government levels to avoid the need for stimulus.

Outside the stimulating effects that spending can have on the economy, it seems counterproductive to have one level of government contracting while the other attempts to expand at least temporarily. Reforms should be taken to better coordinate the spending that is done by these different levels of government. If the national government is going to commit itself to expansionary policy during recessions, it should try to get states to undertake the same or at least avoid contractionary practices. One potential reform with this aim in mind is to remove the final onus for important programs such as education and Medicare from sub national governments. With fewer financial resources being dedicated to these programs, the states may be able to avoid large cuts. However, if cuts do need to happen, the primary priority of fiscal stimulus undertaken by the federal government should be to help state, county, and municipal governments avoid the need for cuts. If the point of stimulus is to employ workers, then preventing these government workers from losing their jobs in the first place will be more efficient and result in more ideal fits between workers and their jobs.

 Works Cited

Ainzenman, Joshua, and Gurnain Kaur Pasricha. “On the Ease of Overstating the Fiscal Stimulus in the US, 2008-9.” National Bureau of Economic Research (2010). Web. 10 Dec. 2011.            <http://www.nber.org/papers/w15784>.

Barry, Frank, and Michael B. Devereux. “The ‘Expansionary Fiscal Contraction’ Hypothesis: A  Neo-Keynesian Analysis.” Oxford Economic Papers 47.2 (1995): 249-64.

Blochliger, Hansjorg, Monica Brezzi, Claire Charbit, Mauro Migotto, Jose Piniero Campos, an   Camilla Vammalle. “Fiscal Policy Across Levels of Government in Crisis.” OECD(2010). Print.

Bohn, Henning, and Robert P. Inman. “Balanced-budget Rules and Public Deficits: Evidence   from the U.S. States.” Carnegie-Rochester Conference Series on Public Policy 45 (1996): 13-76. Print.

Bradley, J. “The Irish Expansionary Fiscal Contraction: A Tale from One Small European Economy.” Economic Modelling 14.2 (1997): 175-201. Print.

Buiter, Willem. “Greek Sovereign Debt Restructuring Delayed, But Not Avoided For Long.”Willembuiter.com. Citigroup Global Markets, 5 May 2010. Web. 10 Dec. 2011. <http://www.willembuiter.com/greekflash.pdf>.

Callan, Tim, John Walsh, and Brian Nolan. “The Economic Crisis, Public Sector Pay, and the     Income Distribution.” IZA Discussion Paper (May 2010). Web.      <http://ftp.iza.org/dp4948.pdf>.

Freedman, Charles, Michael Kumhof, Douglas Laxton, and Jaewoo Lee. “The Case For Global Economic Stimulus.” IMF Staff Position Note (2009). Print.

Ginsberg, Thomas. “The Recession’s Continuing Impact on Big City Taxes, Services, and Pensions.” Philadelphia Research Initiative (2010). Print.

“Greece Government Debt To GDP.” TradingEconomics.com – Economic Data for 196  Countries. Trading Economics. Web. 10 Dec. 2011. <http://www.tradingeconomics.com/greece/government-debt-to-gdp>.

“Ireland Government Debt To GDP.” TradingEconomics.com – Economic Data for 196 Countries. Trading Economics. Web. 10 Dec. 2011. <http://www.tradingeconomics.com/ireland/government-debt-to-gdp>.

“The Irish Budget: A Tight Squeeze | The Economist.” The Economist – World News, Politics, Economics, Business & Finance. 9 Dec. 2010. Web. 10 Dec. 2011. <http://www.economist.com/node/17675960>.

Keynes, John Maynard. The General Theory of Employment Interest and Money,. New York: Harcourt, Brace, 1936. Print.

Krugman, Paul. ” Fifty Herbert Hoovers NYTimes.com.” The New York Times. 28 Dec. 2008. Web. 10 Dec. 2011. <http://www.nytimes.com/2008/12/29/opinion/29krugman.html>.

Krugman, Paul. “Irish Pfizer Smiling.” Economics and Politics by Paul Krugman – The  Conscience of a Liberal – NYTimes.com. 6 Dec. 2011. Web. 10 Dec. 2011.  <http://krugman.blogs.nytimes.com/2011/12/06/irish-pfizer-smiling/>.

Lustig, Nora. Preface. Coping with Austerity: Poverty and Inequality in Latin America. Washington, D.C.: Brookings Institution, 1995. Print.

“Policy Basics: Where Do Our Federal Tax Dollars Go?” Center on Budget and Policy  Priorities. 15 Apr. 2011. Web. 10 Dec. 2011. <http://www.cbpp.org/cms/index.cfm?fa=view>.

“Portugal Government Debt To GDP.” TradingEconomics.com – Economic Data for 196 Countries. Trading Economics. Web. 10 Dec. 2011. <http://www.tradingeconomics.com/portugal/government-debt-to-gdp>.

Romer, C., and D. Romer, 2008, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks” (unpublished; University of California at Berkeley).

“Spain Government Debt To GDP.” TradingEconomics.com – Economic Data for 196 Countries. Trading Economics. Web. 10 Dec. 2011. http://www.tradingeconomics.com/spain/government-debt-to-gdp

Spilimbergo, Antonio, Steve Symansky, and Martin Schindler. “Fiscal Multipliers.” IMF Staff    Position Note (2009). Web

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