John Taylor is wrong on the impact of federal transfers

John Taylor has been a long time critic of the fiscal stimulus measures in the US. In a recent post, he puts forward more evidence to support his claim. He points to his research findings on the impact of temporary transfers to state and local governments in the 2009 stimulus,

"state and local governments did not increase their purchases of goods and services — including infrastructure — even though they received large grants in aid from the federal government. Instead they used the grants largely to reduce the amount of their borrowing as the following graph dramatically shows. As American Recovery and Reconstruction Act (ARRA) grants from the federal government rose, the amount of net borrowing by state and local governments declined."

And concludes,

"the 2009 stimulus package did little to stimulate the economy, despite its large size... the temporary increases in transfers... in the 2008 and 2009 stimulus packages did not work to stimulate the economy."

Now, by any objective reading, it is plain incorrect to arrive at this conclusion from the aforementioned research observation. Let me illustrate with the example of Urbania Municipality. In normal times, Urbania's annual expenditure is $100 m, of which $50 m comes from property and other tax and non-tax revenues, $10 m from federal grants, and $40 from different types of debt. The expenditure break-up is $15 m interest repayments, $25 m operation and maintenance, $30 m salaries, and $30 m capital expenditure.

Now recession strikes coinciding with a financial market crisis. Internal revenues fall from $50m to $30 m. Frozen credit markets coupled with a ratings downgrade dramatically increases Urbania's cost of accessing debt. Its net annual borrowing halve to $20 m. Assuming a $100 m annual expenditure and the annual $10 m federal grant, Urbania is left with a $40 m deficit. The only available source of funds is the federal government.

Since interest repayments and maintenance expenditures, amounting to $40 m are unavoidable, without additional external support, Urbania is left with just $20 to pay both salaries and expenditures on new roads and waterlines. Retrenchment of municipal labor and deferring investments are the inevitable result. Replacement of the leaking sewerage line and water lines to the newly constructed housing colony will have to wait for another year.

It is in this context that the federal government decides to step in with an additional $30 m grant to local governments like Urbania. Though, this incremental $30 m will still leave Urbania with a budget spending deficit of $10 m, it is now considerably better off that without it. It will not be able to increase its purchases of goods and services beyond the targetted $100 m. But Urbania will now be able to atleast retain all its workers and even spend $20 m on important infrastructure investments. And the contractionary impact of the recession will be considerably mitigated.

Now substitute Urbania with American states and the flaw in Prof Taylor's sweeping conclusion about the failure of federal transfers in the stimulus package becomes evident. The counterfactual is difficult to construct and the benefits of the intervention even easier to overlook. But it cannot be denied that in the absence of federal transfers, there would have been mass lay-offs, cuts in services, and large-scale postponement of important civic investments. And the effect of all this would be a self-fulfilling downward spiral of declining aggregate demand and decreasing tax revenues.

Is it an ideological blindness that causes eminent economists like Greg Mankiw and now John Taylor to come with such obtuse arguments? Or is it yet another manifestation of the dark age of macroeconomics?