Across the nation, state 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 than general prices. 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 overall 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. Determining 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.
Start with the short run. If some unit of government were to lay off a substantial fraction of its workers 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, mostly on nonessential things like eating out and on things 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, the greater the drop in consumer spending.
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If the layoffs were permanent, however, 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 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 greater value to society than the goods and services that might be produced in the private sector with the same resources, then society suffers.
More fundamentally, does government "create value" or "generate wealth" for society? Would a society's output, and thus its ability to meet its people's needs and wants, 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 slogan but is irrelevant to the question at hand. An economist would not make this argument because it implies there are absolutely no "public goods," things society needs but that 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, including education, regulation to protect workers and consumers, natural resource conservation and parks.
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 such "public 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 most states, 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.