As Minnesota toys with a “shutdown” of state government due to the budget impasse, many people wonder what effect a layoff of thousands of state employees will have on the state’s economy.
Nationally, many states and local governments are reducing numbers of workers because of budget constraints. The Obama administration’s stimulus bill transferred more than $160 billion to state and local government, most of which was used to avoid layoffs. But that money is running out. Overall states’ tax revenues remain $25 billion below 2008 levels, and prices for the goods and services states buy have risen faster. So more layoffs are in the cards, and with sluggish growth of output and employment, the question of how such layoffs might play in the general economy is a legitimate one.
The answer isn’t simple. First, it depends on whether one is concerned about the short run or the long run. Second, it depends on the societal value of what the government employees produce. This is difficult and subjective, to put it mildly. Fundamental disagreements on the value of government lie at the root of our ongoing political stalemate, and these disagreements are not likely to be resolved soon.
Let’s start with the easy part, however. If Minnesota were to lay off a substantial portion of its workers, say, the 30,000 number bandied about, the immediate effect would be to slow the economy.
The affected households would have less income and would spend less. This would reduce retail sales. The effect would be greatest on nonessential things like eating out and on consumer durables like appliances or autos. The effect on sales of groceries and other necessities would be much smaller. However, the longer the layoff, actual or anticipated (some employees already are cutting back in advance), the greater the drop in consumer spending.
Yes, such layoffs would raise the state’s unemployment rate. But this needs to be put in perspective. Minnesota has about 190,000 unemployed out of a labor force of 2.9 million for an unemployment rate of 6.5 percent. Add another 30,000 laid-off state workers to the unemployed and the rate would go to about 7.5 percent. This is not bad by national standards, but it certainly would increase the drain on an already-strained unemployment compensation fund.
If the layoffs were permanent, over time the displaced workers would find other jobs. Fundamentalists who believe markets always work perfectly and quickly to reallocate resources think this would not take long. Skeptics familiar with real-world problems of imperfect information and institutions are not as optimistic.
This leads to the broader question of what a substantial reduction in state spending would do to the economy as a whole. There is no definitive answer to that subject.
To the extent that government is an inefficient producer of unnecessary goods or services, a reduction in government spending will shift resources to the more productive private sector and give society a greater level of satisfaction of people’s needs and wants for the same use of resources.
However, to the extent that public safety, the civil and criminal legal system, education, health care, care of the elderly, environmental protection and so forth are of value to society are of greater value to society than the goods and services that might be produced in the private sector, then society suffers.
More fundamentally, does government “create value” for society? Would output and thus consumption be as large or larger without government? One commonly hears the assertion that government cannot create wealth because every dollar it spends must first be taxed from the private sector. It’s a nice theory, but it is a fallacy irrelevant to the question at hand. An economist would not make this argument because it implies there are no “public goods,” things society needs but won’t be produced at optimum levels by a free market in the absence of government. Without such public goods, output is lower, resources are used less efficiently and society is worse off.
The extent of such public goods is highly debated. Milton Friedman and other libertarians would see only a handful, including public safety and administration of a legal system to enforce private contracts. Paul Krugman and other liberals see many of them.
But on the question of the existence of such goods without which total output and the satisfaction of society’s needs would be lower, there is no debate. Economic theory and economic history both demonstrate that societal goods do, in fact, exist.
There are economies with low levels of taxation that do not provide much in the way of education, health, or infrastructure. Paraguay, Uzbekistan and the Congo are good examples. But there is no example of a wealthy nation that does not put considerable resources into these government-provided goods. There is great variation within the wealthy countries, Sweden and Germany spend a lot; our country and Japan spend less.
The conclusion is important. Modern economies cannot be productive without some level of government provision of public goods. That is another way of saying that government can indeed create wealth.
Not all government spending necessarily falls into that category, however, and in a budget as large as that of Minnesota’s, some spending will fail the test. Deciding what falls into socially productive and nonproductive categories is not a science. That is why we have to rely on the political process, messy and frustrating as it may be.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.