One-half of US government spending is managed at the state and local level. Only 3 OECD (developed economy) countries have a higher share at the local level. The median level is one-third of the total and some countries limit local spending to just 10-20% of the total. The US federal government model ensures that a significant share of government is managed closer to “the people”, which is even more important today with 330 million people than it was 200 years ago.
State and local expenditures as a percentage of GDP is 19% for the US, on the high side compared with other OECD nations as expected based on the 50/50 local/national split.
Government employment is even more concentrated at the more responsive state and local government level. State and local government employees comprise three-fourths of total government employment. This total increased from 21 to 23 million across 20 years while total US employment grew from 132 to 152 million. The share of government to total employment eased down from 16% to 15%. Note that this is much lower than the 38% government share of GDP.
The share of total government spending to GDP is the most important ratio to track. Since the 1960’s the federal government has moved spending responsibilities to the state for many programs. Spending drifted up to 25% of a growing post-war GDP by 1966. The Vietnam War and the Great Society programs pushed this up to 29% in 1975. The oil crisis, Japanese competition, inflation and recession pushed it up to 32% in 1976. Spending was still 33% of GDP 30 years later in 2007. The Great Recession drove spending up to 40% of GDP and then it declined back to 34% in 2014. State and local government spending has been relatively constant since 1976.
States and local governments routinely deliver solid budget surpluses in normal years and greatly exceeding the deficits encountered in recessionary years. State and local governments rely more on property and sales taxes which do not vary as much as income taxes. States have proactively reduced spending budgets whenever they have encountered recessions.
States have built up a nearly 3 month cushion of reserves to buffer recessionary periods. States and local governments did much better during the pandemic recession than anyone expected. They reacted quickly to ensure fiscal stability and found ways to put the federal government transfers to good use. Some states have provided rebates to their taxpayers.
State and local governments have continued to accumulate valuable assets, especially in the last 10 years.
States have generally improved their credit ratings since 2006, before the Great Recession. At that time, 9 states had the very highest AAA rating. 39 held very strong AA ratings. Just 2, Louisiana and California held “upper medium” A ratings. Recent data shows 7 more states, for a total of 16, at AAA ratings. 29 have strong AA ratings. 3 are at single A: Pennsylvania, Connecticut and Kentucky. 2 have fallen a step lower to BBB: Illinois and New Jersey. The median rating has improved from AA to AA+.
State and local government spending per capita varies widely, reflecting local preferences. The mideast and far west are 15% above the national average while the southeast and southwest are 10% below the national average.
State spending varies even more widely. The national average is $6,900 per capita. California is 12th highest at $9,000 but neighbor Washington is much lower at $7,000 (26th). Massachusetts is also at $9,000 but its neighbor New Hampshire is at a very low $5,000 (46th). New York is lower than might be expected at $8,600 (15th). Nearby New Jersey, Pennsylvania and Virginia spend $7,200-7,500, a bit above the national average. Michigan, Ohio and Illinois spend less than the national average at $6,100-6,300, but nearby Indiana ($5,500), Kentucky ($8,500) and West Virginia ($10,300) have much different priorities. Georgia ($5,700), Alabama ($6,300) and Mississippi ($6,700) spend less than the national average. Texas spends only $4,700 per capita (48th) while its neighbor Arkansas spends $9,200 (10th). Florida is the lowest spending state at just $4,000 per person, an amazing 42% less than the national average.
Another way to look at these differences is to compare the spending of 5 states. Rhode Island $10,400 (6th), Kentucky $8,500 (16th), Washington $7,000 (26th), Colorado $6,200 (36th) and New Hampshire $5,000 (46th). Rhode Island spends twice as much on state government than New Hampshire, a few miles away. This is the range in the US, reflecting vastly different local priorities.
Summary
In our federal system, state and local governments are called upon to manage one-half of total government spending. They routinely deliver budget surpluses and adapt during recessions, even the pandemic driven recession. They have accumulated significant real and financial assets to buffer difficult times. They have managed pension liabilities appropriately and improved their bond ratings and ability to borrow. They have taxed and spent to match local preferences. In aggregate, their spending has remained at the same percentage of GDP for many years.
The May YTD deficit for fiscal year ending in September, 2022 was $426B, down 79.4% from the $2,064B level of FY 2021. The total FY 2021 deficit was $2,772B, so the same percentage reduction for the whole year estimates a $572B deficit for FY 2022. Visually, the year-to-date pattern most closely matches 2017 which ended with a $666B deficit. In fiscal years 2018 and 2019, the additional deficit for the last 4 months of the year was $245B and $247B, respectively. That gives us a forecast of $672B for FY 2022. DC insider, Wrightson ICAP, recently forecast a deficit of $600-700B.
The conservative forecast of $700B deficit for FY 2022 is 2.8% of the CBO estimate of FY 2022 GDP at $24,694B. The CBO forecast Deficit/GDP ratios of 3.8% and 3.9% for the next 2 years, roughly the same as the pre-pandemic 2018 rate.
Good News: Government Fiscal Stimulus is a 3.5% Annual Drag on the Economy
The reduced federal deficit and state/local deficits compared with history provided a very large drag on first quarter GDP, but the economy recovered in the second quarter and is forecast by the CBO to deliver 3% overall real GDP in FY2023 after a very strong 4.4% in FY2022.
Revenue increases are not sustainable, coming in as much as 2% of GDP higher than trend or expectations. The 2021 economy was very healthy, resulting in spillover tax receipts in 2022 that will not continue.
Our economy has operated effectively for the last 4 decades with a federal budget deficit averaging 2.5% across the business cycle. Starting with 2.8% in 2022 is an unexpectedly good place. Congress and the president will struggle to maintain this level without significant spending or revenue changes in the next budgets.
North Dakota, Wisconsin, Oklahoma, Kansas, South Dakota, Minnesota and Nebraska form a low unemployment core in the Great Plains area. Utah, Idaho and Montana represent the Rocky Mountains. Vermont and New Hampshire lead in New England. Alabama leads the South, while Indiana leads the Midwest.
Jan, 2016: 4.8% through Feb, 2020: 3.5%. 4 years “below full employment”.
Estimates of Natural (Non-accelerating Inflation) Rate of Unemployment (NAIRU) Have Been Biased Upwards and Influenced by One Period of High Inflation and Supply Chain Disruptions
In retrospect, the period before 1976 (oil, trade, inflation shocks) should have used a 4.5% NAIRU for policy decisions. The jump to 6% in the late 70’s and early 80’s is supported by history. The NAIRU was deemed to be 5% or higher as late as 2010, but could have been pegged lower. Based on the lack of inflation during the teens, the rate probably should have been set at 4% or lower.
Macroeconomic Theory
Classical economics asserted that labor markets will naturally find equilibrium wages and quantities of labor employed at the individual labor market (micro) and total economy level. The Keynesian view, embraced by 90% of professional economists, is that there are market imperfections at both the individual market level and total economy level. Most importantly, wages are “sticky downwards”. Currently employed workers resist “losing” wages by accepting pay cuts when demand is lower. Aggregate supply (production) does not automatically create an equal amount of aggregate demand in the short-run, as businesses, individuals, banks and governments often choose to save more during economic downturns or periods of greater risk. Hence, a downturn in the economy caused by any source may result in a prolonged negative spiral, rather than automatically delivering lower prices in product, money and labor markets, which could help to recover these markets.
Microeconomic Theory: Why is There Any Unemployment?
Economists point to frictional and structural factors. Frictional unemployment occurs because labor market information and decisions are not perfect and instantaneous. As with other markets: housing, commercial real estate, offices, bank loans, farm fields, airport gates, container ships, utilities, R&D, IPO’s, private equity, M&A, retail inventories, etc, labor markets are imperfect. It takes time for equilibrium to be found. Given the increased concentration of labor in major metropolitan markets and internet-based recruiting systems, frictional unemployment has decreased in the last 20-30 years.
Structural unemployment occurs because of mismatches between the current skills possessed and skills demanded in a given place or due to legal or regulatory limitations. Binding minimum wages have been a smaller factor in the last 40 years but may have greater impact in the future. Regulatory requirements for professional licensing have increased significantly in the last 50 years (with some “liberalization” seen in recent years), slowing the ability for individuals to move between professions.
The overall labor force participation rate increased for many years as women entered the workforce, but has declined significantly in the last 20 years for men and for women. I’ll provide a detailed analysis of these factors next week. For our purposes, focusing on short-term changes, recent history shows that the labor force participation rate can be 1-2% higher overall. Some workers have not returned from the pandemic challenges. Some early retirees may return to the labor force. Teens and college students may join the labor force at recent wage rates. Marginal groups (elderly, long-term unemployed, handicapped, drug/alcohol recovery, crime history, minorities, limited language skills, inexperienced) may be considered for more positions.
The media tends to emphasize the increased specialization and technical content required for modern jobs. This has resulted in greater structural unemployment, especially among lower-skilled individuals who held and lost manufacturing jobs between 1970-2000. It has also reduced movement between industries which require a core base of knowledge to be effective, with health care being a prime example.
On the other hand, modern corporations that worked through a dozen post-WW II business cycles eventually adapting to the “business cycle”. First, based on Japanese manufacturing, TQM or lean six sigma manufacturing principles, they reduced their operating leverage. Companies devised factories, offices, distribution centers, product lines and national businesses that could be equally profitable from 70-95% of capacity, rather than 85-95% of capacity. Second, they reduced their unavoidable “fixed costs” by importing goods, outsourcing business functions (manufacturing, IT, accounting, legal, marketing, distribution, sales, R&D) and employing temporary labor. Third, businesses systematized their processes so that core production processes could be operated by individuals with limited specialized or tribal knowledge, including managers and support staff. Fourth, businesses increasingly used matrix and project structures to effectively redeploy staff to any areas of need. So, while variable production staff is a smaller share of employment, the remaining “fixed cost” support staff can be more flexibly deployed. Fifth, after 40 years of process re-engineering, data warehouses, activity based costing and balanced scorecard reporting, companies deeply understand variable costs and incremental benefits driven by sales, production, product lines, facilities, territories and projects. “Knee-jerk” reactions to business cycle downturns are less common as firms better understand short-term incremental profits and medium-term costs of hiring and training. Sixth, firms have improved their ability to define “critical success factors” for every position. This has eliminated many irrelevant experience, degree, culture, personality and other factors from hiring screens. Seventh, firms have increasingly rotated staff through line and staff roles, allowing talented individuals to move between these roles and function effectively. Eighth, firms are more strategically oriented, growing profitable product lines and territories and dropping or “selling off” marginal channels. This means that the incremental positive value of most positions persists, even in an economic downturn.
Overall, firms have learned their “applied intermediate microeconomics” and clearly defined the marginal benefits and costs of every position. They understand exactly what incremental profit can be delivered from each position. Hence, the demand for labor services is significantly greater than it was historically, including through the downside of the business cycle. That means that the natural unemployment level is lower than in the past. Firms can profitably put more people to work than ever before.
Economists, Forecasters and Pundits are Reluctant to Predict Unemployment Below 3% Because it Was Rare Historically.
Lobbyists, Journalists, Politicians and Analysts Highlight the Downsides to “Very Low” Unemployment
From a firm’s perspective, a low unemployment labor market causes increased recruiting, hiring and training costs. It results in less well-matched staff to job roles resulting in lower initial productivity. Companies might even, aghast, inadvertently hire some staff with marginally negative profit results. Hence, very low unemployment rates will increase labor costs, reduce profits, reduce demand for labor and possibly bankrupt previously functional firms.
Trade-off Between Unemployment and Inflation: The Phillips Curve
In the 1970’s fight between Keynesians and Monetarists/Classical Economists/Rational Expectations teams, the Keynesians emphasized the historical existence of a short-term trade-off between unemployment and inflation, especially when unemployment was very low due to a high level of aggregate demand. The conservative side noted that the historical data was inconsistent. The “rational expectations” camp emphasized that unexpected increases in inflation would lead to increased wage demands by labor. In the long-run, there is no such thing as a “free lunch”, so effective real wages would return to the level determined by the “marginal productivity of labor”. Based on recent data (pre-pandemic), it appears that the US economy can run at 3.5-4.0% unemployment without triggering significant upward wage pressures. In the post-pandemic world, the “natural” unemployment rate (NAIRU) is unclear. The labor supply has basically recovered to the pre-pandemic level. Wages are up 5% in nominal terms but are down 2% in real terms (see below).
There are Many Unemployment Measures. They Move Together.
Underemployed individuals provide the logical next best full-time employees. The current slack measure is 3.5%, (7.1% – 3.6%) on the low side, but not so low that conversions from this underemployed group to full-time employment cannot be expected.
Jun, 2020 – Jun 2022. Nominal wages up 4.7%/year. CPI up 6.1%. 1.4% real wage decrease.
Dec, 2020 – Dec, 2021. Nominal wages up 4.9%. CPI up 7.3%. 2.4% real wage decrease.
May, 2021 – May, 2022. Nominal wages up 5.2%. CPI up 7.9%. 2.7% real wage decrease.
Nominal wage rates have increased by 5% annually in a period of 7% inflation. Employers have been able to economically justify these increases while adding 7 million people to the labor force.
Beveridge Curve: Job Openings Versus Unemployment Rate.
Historically, there was a well-defined relationship between the national level of job openings as a percent of the labor force and the unemployment rate. Job openings were a low 2-2.5% of the labor force at the beginning of the business cycle, accompanied by higher (6-10%) unemployment, but improved to 4% openings and 4% unemployment. The current labor market has far more job openings, up to 11 million, almost twice as many job openings as unemployed workers, but the unemployment rate has only fallen to 3.6% so far. This is uncharted territory. There are more voluntary quits, so employees are switching jobs at a faster rate. The labor force participation rate has increased with these jobs and higher wages offered. But firms have not found enough acceptable hiring matches to significantly reduce the open positions level. Through time, they are likely to achieve their hiring goals, driving the unemployment rate down below 3%.
The demand for labor already exists. 11 million open positions is 7% of the labor force. We have enough active demand for ZERO % unemployment.
The supply of labor increased by 7 million people since the depths of the pandemic. The rate of monthly additions has slowed from 500-600,000 to 300,000, but that is still 3.6 million jobs added on an annual basis. We only have 6 million total people unemployed!
3. The labor force participation rate is only 62.5%. There is room for millions to return to the labor market. Before the “Great Recession” in 2008 it was at 67%. Many metro areas, large and small, enjoy labor force participation rates above 65%.
4. The underemployed population can provide up to 3% of the total labor market’s full-time jobs.
5. Frictional unemployment is minimal in the internet age. Structural unemployment may be lower than described in the media, as firms have been adapting to the “information age”, high technology and the service economy for 40-50 years.
Finally, many states and metro areas currently have unemployment rates in the “twos”. Nebraska and Utah stand at 1.9%. Minneapolis (1.5%), Birmingham (1.9%) and Indianapolis (2.0%) demonstrate that otherwise unremarkable (!!!) metro areas can function with very low unemployment rates.
US income and property taxes are relatively higher than other developed countries, but corporate taxes are half as high, and the US does not use value added taxes (VAT) to quietly collect revenues.
Record high of 6.6 million hires per month, above pre-pandemic record 6.0M.
Record low layoffs at 1.3M per month, down from 1.8M pre-pandemic record. Yes 5 new hires for every layoff!
Record 11 million plus, up from pre-pandemic record of 7 million.
Record 7% of jobs are open, far above pre-pandemic 4.4% record level.
Job seekers to open positions ratio is less than 1/2, all-time record low, down from pre-pandemic record that was just below 1:1.
Average hourly wage up 12% to record $31.95.
Hours worked is slightly higher than before the pandemic.
Record high 2.9% versus pre-pandemic record of 2.3%.
Unemployment rate is 3.6%, just above pre-pandemic 3.5%. Prior 3.5% rate was in 1969. This is the best in 50 years.
Underemployment rate at 7.1% is just above 7.0% pre-pandemic level. Underemployment rate was last this low in 2000.
Long-term unemployment is at 1.2%, same as pre-pandemic level. The economy last delivered this positive level in 2000.
African-American unemployment rate is at a near-record 6% low. It was a little lower briefly before the pandemic.
Initial unemployment claims reached the pre-pandemic low of 190,000 during 2022, but has increased slightly to 210,000. This compares with typical levels of 400,000 in recent decades.
Continued unemployment claims are at a 50-year record low of 1.3 million, down from the pre-pandemic level of 1.8M. 1.3M was last seen in 1969!
Civilian labor force at 164.4M is just below the all-time record of 164.6M.
Prime age labor force participation rate fell from 84% to 81% by 2014. It recovered to 83% by the end of 2019. It has reached 82.5% so far in 2022.
Teen labor force participation has slowly increased for a decade.
College age labor force participation has remained the same.
“Older” age labor force participation hit an all-time low of 29% in the early 1990’s, and then began to climb all the way to 41% in 2012. It remained at 40% throughout that decade. It dropped with the pandemic and has since recovered to 39%.
Female labor force participation continued its long climb to a peak of 60% in the late 1990’s. It dropped below 57% by 2014. It increased to 58% in the last 2 years of the decade. It has recovered to 57% after the pandemic.
The male labor force participation rate has been declining for 70 years. It reached 69% in 2014 and remained there, without falling, throughout the decade. The rate dropped to 66% during the pandemic and has since recovered to 68%.
Labor force participation has declined by about 10% for HS grads, some college and college grad groups. Non-HS grads’ participation has actually increased. The similarity of participation changes by education and gender points to broader social factors playing a major role in these “economic” changes.
Summary
The measures of demand for labor are all at record levels. Unemployment rates are at long-term lows, just above the pre-pandemic levels which were driven by a decade long economic recovery. Labor force participation is down by 1% compared with pre-pandemic levels. Overall, this recovery from the pandemic challenges exceeds all expectations.
Most states and local governments have chosen to pay their employees less than market salaries and higher than market fringe benefits since the WW II era. The Republican focus on reducing the size, pay and power of government has increased significantly in the post-Reagan era. Grover Norquist summarized this in 2001: “I don’t want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub.” Hence, Republicans have focused the spotlight on the “underfunded” status of state and local government fringe benefit plans, especially defined benefit pension plans.
Although the rhetoric is sometimes grating to the “left” ear, this spotlight does serve as a disinfectant, requiring political leaders to be more accountable for their decisions, especially in “one party” states where accountability was lacking historically.
On the other hand, pension accounting, funding, goals and policies are inherently complex and difficult to simply summarize or explain. This is true for both government and corporate defined benefit pension plans. It is easy to “cherry pick” pension statistics and overexaggerate the “crisis” in state pensions.
I will focus on the data and commentary from just 2 sources: Reason.org, a right-leaning policy group that cleverly adopted a left-side name and Pew Research, a centrist research group that has chosen to emphasize right-leaning data and commentary on this topic.
The average state pension plan funding level, the ratio of assets to forecast liabilities, is expected to reach 84% when final 2021 data is summarized. This is a huge improvement from the 70% average of the prior 5 years. It is the highest level since 2008.
2. The system is working. Plan assets were $2.3T versus $2.8T in 2008. Assets grew by $1.5T to $3.8T, while liabilities grew by $1.8T to $4.6T. Since the added $1.5T/$1.8T is 5/6ths or 86%, the overall ratio increased. The “system” of policies, accounting, audits, contributions, investment strategies and actual investment returns, etc. appears to be functional across a quite challenging economic period. The funding ratio was relatively consistent throughout this period, even if it was not at the 100% level highlighted by some as “the goal”.
3. The gap between estimated liabilities and funded assets is less than $1T for the first time since 2014.
4. For the first time in this time period, the minimum expected funding level has been met. This is defined as a year in which contributions exceed benefits plus the “amortized” funding requirements based on past funding shortfalls. In 2014 only 17 states met this standard. In 2019, 35 states complied. Again, this is not perfection, but it is significant progress.
5. Overall contributions have increased by 8% annually. The states with the lowest funding ratios have increased their contributions even faster. The lowest 10 rated states growing by 15% annually and the 4 worst states by 16%.
6. A measure of benefits paid minus funding contributions, as a percentage of plan assets, has improved from 3% more benefits to 2.5% more benefits paid versus new funding contributions.
The Funding Gap (2016). Funding ratio 66%. Few states reach 90%.
Bond interest rates have fallen faster than pension plan expected returns. Of course, because equity returns are much higher, more volatile, difficult to forecast and a higher share of plan assets.
State pension plan returns trail the S&P 500 returns. Of course, because plans hold significant (30-40-50%) in lower yielding bonds.
A lower “discount rate”, the assumed future interest rate used to calculate the present value of future pension benefits/liabilities, will increase current liabilities and the current net liability. Yes, this is how discounting works. As market interest rates and stock returns have been reduced with lower inflation rates, the discount rate used by financial professionals in all applications has slowly declined for the last 20 years. This “sensitivity analysis” is misleading. The sensitivity of present liabilities is inherent, it cannot be avoided.
Some states have amortization rates, the amount of new contributions required to eventually offset prior funding or investment return shortages, that are quite high compared to their annual payrolls. This is true. 7 are above 5% deficits, but 7 are above 5% surpluses.
Pew highlights what they call the “operating cash flow” ratio as another sign of trouble. Contributions minus benefits paid as a ratio to assets is the definition. The result is negative!!!! And increasing to negative 3%! Contributions should almost always be less than benefits paid in a long-term (20-30-40 year) pension plan because the plan trustees assume that there will be some positive return on plan assets. Given a 2/1 equity to debt mix, with 7% to 3% expected returns, the expected plan return is more than 5%, so a 3% “negative” return is not a concern. The insurance industry operates in the same way with “negative” operating ratios being offset by investment returns.
Reason.org Graphics
This group highlights the extraordinary 100% ratio in 2001 versus the more normal ratios of 82% in 2005, the quite low level of 66% in 2012 and the still below average 74% level in 2019. They provide state by state graphics to highlight the decline since the very high 2001 baseline and to emphasize the count of states that are below 90%, 80% and 60% “funded”.
Their websites do not allow their graphs to be linked/captured.
Reason.org breaks 2 rules. First, they implicitly assume that a 100% funding level is the “obvious” goal. That is untrue. Historically, US corporations and actuaries considered 80% to be a “fully funded” target. More was better. A little less was worth watching (70-75%). Much lower required increased focus and contributions. Due to the inherent uncertainties in investment returns and participant assumptions (lifespan, retirement dates, turnover, average salaries, etc.) short-term movements of 2-3-5% were never considered to be an issue. Long-term or persistent ratios significantly below 80% were considered to be a concern.
Second, they assume that all states will perform at the same level. The “laws” of probability prohibit this “ideal” result. In a normally shaped (bell curve) probability distribution, there will always be underperforming and overperforming states. This is inherent in a multiple probability-based system. Of course, if a state remains at the bottom of the funded percentage list for more than 5 years, it probably does have a challenge to face.
Greater state pension contributions have “crowded out” other spending and reduced states’ ability to respond to emergencies. Well, you can’t have it “both ways”. States have responded to the shortfalls highlighted since 2000 with greater contributions. This has improved the funding level despite the Great Recession, the slow recovery and the pandemic challenge.
The recent funding level improvement is due to a “one-time” stock market return in 2021. Yes, stock market returns, both gains and losses, are volatile. That is why pension plans use long-term expected returns for stocks and bonds. That is why pension funds use longer time periods (10 years) to amortize the annually calculated gains or losses into the “required” contributions. Yes, a significant part of the increase from 70% to 84% funded is a short-term increase of investment returns, and probably unsustainable.
The stock market is volatile. Recently. Yes, a once in a century pandemic drives increased volatility. Stock market volatility through time and across markets is well understood as a probability function with mean expected real percentage returns and a predictable range of returns volatility. All investors face this volatility and manage portfolios accordingly. As state pension plans have grown in value, they have been able to hire competent investment advisors.
4. Economic growth is slowing. Some assert this. Others disagree.
5. Future stock and bond returns will be lower, per Pew. The long-term decline in inflation does drive investment returns lower. The increased efficiency of financial markets, including global investment flows, also drives returns lower. However, pension plans have reduced their expected annual returns. Recent stock market volatility indicates that equity returns may not decline.
6. Increased funding of underfunded pension plans can be portrayed as “increased spending”, rather than the required adjustments for those plans which had historically lower investment returns, contributions or higher ultimate benefits.
Summary
State and local governments are faced with managing inherently variable pension plan decisions. They have choices to make about plan policies, goals, funding, investment policies, audits, advisors, etc. An 80% funded level goal (not 100%) is supported by 100 years of experience around the globe, in public, private and not for profit sectors. The increased publicity/focus on underperforming states and municipalities has forced these public bodies to make tough choices regarding defined benefit versus defined contribution plans, benefit levels, retirement ages, investment policies and advisors. Following the Great Recession, states struggled to increase their funding, but they did not allow the average funding level to fall below 70% for more than a year at a time. On a cumulative basis, they have increased their contributions, reduced benefits and captured the long-run benefits of equity investments.
The increased scrutiny of funding levels in state and local government defined benefit pension plans has forced elected officials and their professional advisors to address shortfalls in pension funding. This is very good news.
I have mapped this data onto the “Red vs. Blue” states list based on current senators.
Red (Republican) States Benefit Greatly
Democratic states pay 63% of all taxes, 5% more than their population share and 13% more than their senators’ (power) share.
Federal expenditures in Democratic states are 58% of the total, more than 4% less than their share of revenues contributed. Federal expenditures in Republican states are 42% of the total, more than 4% above their share of revenues contributed. Hence the total gap is almost 9% of the total.
The referenced article focused on two measures: net dollar subsidy (expenses > revenues) and net dollar subsidy per person.
I’m going to use a slightly different measure. The large (20%) difference between total expenditures and revenues skews these figures. I’d like to assume that the “equal” situation is one in which each party’s states pays the same ratio of revenues to expenses (or conversely, expenses to revenues). I’ve standardized the figures assuming that the “neutral” state receives 10.6% more expenditures than it pays in taxes, the same level as the Democratic states. Hence, by definition, the Democratic states, in total, are “neutral”. Their $2.155T expenditure is 10.6% higher than their $1.948T revenues.
The Republican states have $1.168T of revenues paid to the federal government but receive $1.555T of local expenditures. This is 33% more expenditures than revenues, a huge extra (22%) budget deficit. If the Republican spending was just 10.6% higher than revenues, it would be $1.292T, with a deficit of “just” $0.123T. This is $0.264T less than the actual deficit of $0.387T.
Subsidized States (>$10B)
6 Democratic states receive subsidies of more than $10 billion, totaling $180B.
Georgia (15), Michigan (16), New Mexico (17), Arizona (26), Maryland (29) and Virginia (78). Most of this is due to the DC employment and contracting bias.
Twice as many Republican states receive major subsidies, totaling $246B; $66B more than the Democratic states.
Indiana (10), Oklahoma (13), Arkansas (13), Louisiana (14), Tennessee (19), Mississippi (19), Missouri (19), South Carolina (21), Florida (26), North Carolina (26), Alabama (29) and Kentucky (38). Ironically, much of this excess spending was started when Democrats controlled southern states through much of the twentieth century.
Subsidizing States
Texas sends $19B more revenues to the federal government than it receives in expenditures, the only large subsidizing Republican state.
Seven Democratic states provide major subsidies to the federal government, totaling $218B, for a net subsidy versus Republican states (Texas) of $199B.
Washington (10), Illinois (19), Connecticut (20), Massachusetts (26), New Jersey (34), California (46) and New York (63). These states have the highest per capita incomes, so with a progressive income tax system, they pay a disproportionate share of federal taxes. (The state and local tax limit on deductions for federal taxes is a big issue in these states).
Summary
The Senate’s seats are based on geography, providing a major benefit to states with more rural and less urban/metro populations, benefitting the Republican party today more than in previous decades when Democrats were competitive in some of these states. Southern and rural states (Red, Republican) have lower incomes and receive more federal spending than coastal states (Blue, Democratic). In total, the Democratic states are paying 63% of taxes, while receiving 58% of federal expenditures, yet have just one-half of the senators and political power to determine taxing and spending policies. This discrepancy serves to reinforce the increasingly polarized political environment in the US.
6-month time limit. A dozen or less bipartisan dignitaries. Retired ambassadors, investors, CEO’s, federal reserve presidents, etc. Make Mitch Daniels the chair.
Assign 2 projects. One to cut government waste. The other anti-inflation policies. No more than a dozen recommendations in each half. Presented to congress for simple yes/no vote, without major amendments allowed.
2. Spend Less Government Money
Fiscal spending is too expansionary for the current situation. Back off. Reduce infrastructure spending for now, spend it in the next recession. Reduce marginal defense programs that only have political reasons. Cut state government spending by 3%, which is budgeted to increased by 9%.
Increase immigration to improve labor supply. Cut tariffs to reduce supplies costs. Lean on local regulators to reduce zoning restraints and one size fits all building codes. Strategically require a higher share of affordable housing and multifamily permits annually in each metropolitan region. Phase-out the mortgage interest tax deduction for second homes.
Loosen regulations for 5 years to encourage increased “all of the above supplies” energy through drilling, coal, oil and nuclear. Suspend federal gas tax for 3 years. Negotiate oil price minimums/maximums between US/Europe/Japan and OPEC.
Reducing inflation is a complicated policy area. The solutions proposed by “experts” are rarely politically appealing. Competing political parties hesitate to provide “wins” to the other. However, 8% inflation after a 2-year pandemic while the US faces Russian war actions is a “national emergency”, worthy of an FDR like approach to “try a few things”. It is an opportunity to overcome individual industry opposition to things that make sense for the country. It is an opportunity to try some left and right solutions.
The “real” interest rate is the nominal interest rate minus the inflation rate. It reflects the “real” cost of borrowing. Prior to the “Great Recession”, 2% was a typical “real cost” of borrowing money. To entice lenders to lend, borrowers had to pay some “real” amount extra per year, 2%.
The Federal Reserve did what it could to “ease” monetary conditions and lower interest rates to offset the negative impact of the Great Recession in 2008-9.
By the end of 2011, real rates were ZERO or negative. In other words, the Fed went too far. By June, 2013, rates returned to positive territory, but only reached 0.5%, where they remained through the end of 2017, despite president Trump’s complaints that the Fed was constraining the Trump economy. Monetary policies were “easy” for a very long 7-year period.
By May, 2019, real interest rates were back to just 0.5%, having reached a peak of just 1% for 3 months at the end of 2018. With further “easy” money policy, real rates dropped back to ZERO percent by August, 2019. The economy was now 9 years into recovery. Interest rates should have been higher.
The Fed found new ways to “ease” monetary policy as the pandemic struck in 2020. Real interest rates dropped to -1% and stayed there. Monetary policy has been “easy” for more than a decade. Time for inflation. “Too much money chasing too few goods”. “Inflation is always and everywhere a monetary phenomenon”.
Supply Chain Disruption
The recovery has been faster than anyone expected, but most critically, with consumers less eager to buy “in-person” services, they have greatly increased their purchases of goods. The modern US economy relies on imports and modern manufacturers and retailers hold lower inventories to buffer changes.
Standard macroeconomic theory focuses on aggregate demand versus aggregate supply as the key driver of output, unemployment and inflation. When total demand grows faster than remaining excess capacity of total supply, inflation results. The biggest driver of changes in aggregate demand is the level of government spending (demand) minus government taxation (reduces demand).
Historically, various pressures have kept the federal budget deficit between -3% and +3% of GDP, allowing the government to buffer change in private demand through the business cycle. The large drop from -2.5% to -5% in 1979-82 was a factor that contributed to the last major round of US inflation. A similar decline from -2.5% to -4% in 1989-91 increased inflation, but not on such a large scale. It also served to convince President Clinton and congress to reduce the deficit to ZERO by 1997 and run a surplus for a few years.
The 2001 recession caused a 2.5% decrease in this ratio, from a surplus to a deficit. Bush tax cuts, foreign wars and congressional agreement lead to deeper deficits at 3.3% in 2003-4, before some recovery to -1% in 2007, prior to the Great Recession.
Bush, Obama and congress agreed to spend more to fight the Great Recession, pushing the deficit to a worryingly low -9.8% in 2009. There was no agreement on a second major round of spending, so the deficit improved a bit to -6.6% by 2012 and then to a more reasonable -2.5% in 2014-15. Instead of continuing to improve with the economic recovery, it fell a little, to 3.1% in the last year of the Obama economy.
President Trump’s first order of business was to enact “job creating” tax cuts. Unfortunately, the desired boost to economic growth to fund these tax cuts did not occur. The budget deficit increased from 3.1% to 4.6% of GDP, as the economy reached a record long recovery period of a full decade.
To address the pandemic, congress and Trump agreed to spend money to protect the economy and workers, leading to very large budget deficits of 15% and 12% in 2020 and 2021, respectively. Too much aggregate demand for the level of aggregate supply, so we have major inflation.
Summary
Easy money, easy fiscal policy and a 20% increase in demand for goods leads to major inflation. Like a frog getting boiled as a pot slowly warms up, we became complacent based on the apparently “just right” conditions of the late teens (2012-19). The federal budget deficit needs to get back above -5%, real interest rates need to become positive and consumers need to rebalance to consume more services and less goods. I don’t think we’ll see 7% inflation for 2022, but it looks like 4-5% is a good bet. Hold on.
Politics
Biden deserves a good share of responsibility for the government spending budget deficit, as he was seeking to make it even larger. I give him a “pass” on consumer demand for durable goods since it mostly occurred before he started. I also give him a “pass” for the loose Fed monetary policy which has been going on for a decade or so. He was wise to reappoint the Fed chairman, who I believe will raise interest rates as needed to get the real interest rate back to a proper level. In the meantime, Biden will pay politically for higher inflation, which has a “real” impact on the wallets of voters.
I summarized the data in this table into 5 year buckets, just 4 years for the most recent 2016-19 period, to make it easier to review.
The poverty rate is the number of families out of 100 who meet the Census Bureau’s evolving standard of being poor, based on family size and location. For the last 4 years, 9.0% of families were considered poor.
The adjusted rate in the 3rd column calculates what the poverty rate would be in each period, if the nation had a constant 10.2% of families in the female head of household, no spouse present category (single moms), as was the case in 1965.
The adjustment is shown in the fourth column, reducing the average measured poverty rate.
The poverty rate for only single moms is shown in the 5th column.
The share of ALL families headed by single moms is in the 6th column.
The share of all POOR families headed by a single mom is displayed in the 7th column.
The poverty rate for families headed by a male is listed in column 8.
The OVERALL poverty rate dropped sharply (by 42%) from the early 1960’s at 16% to nearly 9% in the early 1970’s. The overall poverty rate was finally a shade lower in the 2016-2019 period, down to 9%. The overall poverty rate was in the 11% range throughout the 1980’s and first half of the 1990’s. It improved to 10% at the turn of the millennium, but rose back to 11% for the next decade. Overall, the rate was roughly flat for 50 years, ranging from 9-11%.
Partisans love to argue about the “war on poverty”. This data indicates that the early war was effective, but the enemy fought the proponents to a draw for the next 50 years.
Table 13 highlights the growing number and share of single female headed households. Single moms were just 10% of all households in 1965. They increased by 80% to 18% of the total by the early 1990’s, and have stayed in the 18-19% range thereafter.
The single mom poverty rate was unusually high in the early 1960’s at 40%. From 1970 through 1995 it averaged one-third. Single mom poverty rates were reduced by 10% to 30% for the next 20 years. The rate has fallen again, to 25% in the latest period. However, the single mom poverty rate has consistently been 4+ times as high as the male head of household group. Single mom headed households doubled their share of all poor households, from 26% to 52% in the last 50 years..
The male head of household group started with a 13% poverty rate. It dropped to 6% by 1970 and generally remained there for 40 years, aside from 7% rates in the 1985 and 2015 periods. Note that this is a greater than 50% reduction in the share of poor families. The “war on poverty” appears more successful from this vantage point. The rate edged down to a record low of 5.4% in the most recent period, as the extended economic recovery reduced unemployment and started to increase wages for lower skilled workers. This is a 60% reduction in poor families since the early 1960’s for this subgroup.
Column 4 shows the negative impact (mix variance) of having nearly twice as many families in the 33% poverty rate group versus the 6-7% poverty rate core group. By 1980, this change increased the poverty rate by 1%. By 1995, the impact was 2% and has remained in this range.
The adjusted poverty rate, standardized at the 1965 10.2% share of single moms may be a better measure of the effectiveness of overall policies and economic results. The adjusted rate starts with the same 16%. The effective poverty rate drops to 10% in 1970 and further to 8.5% in 1975-80. There is a spike back up above 10% in 1985 before falling back to 9% for 1990-95. The revised rate drifts down to 8% for 2000-2005 (50% reduction from 1965). It pops back up to 9% for 2010-15, before falling to 7.4%, a record low, finally less than half of the starting rate.
Adjusting for the mix of single mom households versus others provides a better view of the country’s effectiveness in reducing poverty. The adjusted poverty rate has been reduced by 60%, not just by 44%.
We can review poverty rates by age, race and education another day. The recent COVID-19 funding bills appear to be very effective at further reducing the US poverty rate. A relatively small amount of money seems to be working. The causes of more single mom headed households and focused policy solutions is also a topic for another day.
Good News 
