As you know well, the deep recession of 2008 through 2009 and the subsequent slow recovery have battered state and local budgets. As the recession took hold, revenues dropped precipitously, especially at the state level. Driven partly by balanced-budget requirements under their constitutions, many governments have responded by cutting numerous programs and reducing workforces. As necessary as these cuts may have been, they have left some jurisdictions struggling to maintain essential services. The fiscal problems of state and local governments have also had national implications, as their spending cuts and tax increases have been a headwind on the economic recovery.As Bernanke points out, there are really two problems caused by this wave of budget-cutting. The first is the sharp reduction in the actual services that S&L governments are expected to provide to their residents. Voters do not like electing politicians who raise taxes, of course; but will they reward politicians that have substantially reduced government services? I'm not sure, but I am quite sure that these cutbacks by state and local governments will become even more noticeable to voters over the coming year than they already are, particularly since the vast majority of S&L spending is on quite visible things like roads, police and fire departments, and of course the biggest single element, education.
The following chart shows the number of state and government employees per 1,000 people in the US since January 2003 (which is when the US economy was at a roughly similar point in the business cycle, emerging from recession but not yet enjoying a strong recovery). The blue line is all S&L employees, while the red line (measured on the right axis) shows only educators. The picture speaks for itself.
The second issue highlighted by Bernanke is the headwind that these S&L government cutbacks create for the US economy. In the final quarter of 2010, S&L government budget cuts reduced annualized GDP growth by about 0.3% -- by far the biggest negative effect of any sector of spending in the US economy. In terms of employment, layoffs by S&L governments have reduced employment by more than 400,000 over the past two years. While clearly not large enough to push the economy back into recession, losing hundreds of thousands of additional jobs while the US economy struggles to regain its footing certainly can't help.
These things are cyclical, of course. Back in the early 1990s S&L governments also savagely reduced spending on basic services - including education - in response to the fall in their tax revenues, resulting in horror stories about neglected infrastructure and neglected children. With the strong economic growth of the late 1990s some of these deficiencies were repaired -- but permanent damage was done to countless lives along the way. It's too bad that politicians and voters seem unable to resist following the same path all over again.