Leading States in the Fiscal Two-Step

[Note on the cartoon:  My technical and blog etiquette expert Diana Kimball tells me it is proper etiquette to acknowledge the origin of photos by linking to the source.  I won’t go back and do that on all of my earlier posts, but I wanted to give you the link to this one because I found it early on, and then was frustrated that I couldn’t find it when it came time to post “Leading States in the Fiscal Two-Step."  I love this cartoon.  It is much better than the cartoon I previously had of Uncle Sam dancing with Lady Liberty.  Here is the link.  From the site, it looks as if you can ask people online to draw pictures for you pro bono–something useful for every blogger to know.  Has anyone had any experience with this?]

In his article "The Federal Reserve Turns Left,” Bill Greider tells how the Fed is currently one of the institutions arguing most strongly that the Federal Government should spend more now.  Since the Fed has not departed from its long-term recommendation that the Federal Government spend less in the future, this amounts to recommending that the U.S. Federal Government execute what I will call a “fiscal two-step”: spending more now, while promising to spend less later.

I have serious misgivings about this recommendation.First and foremost, I think it is politically very hard for a sovereign nation to do this:temporarily higher spending is likely to get built into the baseline.Second, even if such a fiscal two-step as usually envisioned is executed as intended, it will lead to a path for the national debt that is considerably higher over a substantial length of time (with all the risks that entails) than an alternative policy I have put forward on this blog of Federal Lines of Credit (FLOC’s) now combined with National Rainy Day Accounts (NRDA’s) down the road.

The combination of FLOC’s and NRDA’s effectively encourages people to do the individual version of the fiscal two-step.By providing lines of credit, people are encouraged to spend now if spending now is attractive to them.Later as part of the FLOC program they are required to repay this debt, and later still, they are required to save a modest amount each month by payroll deduction (or for the self-employed, in their quarterly estimated taxes) to go into their National Rainy Day Accounts–money that they are only allowed touse in the wake of a recession or other declared economic emergency or in case of a bona fide, documentable personal financial emergency of high order.With the combination of FLOC’s now and NRDA’s later, the FLOC’s now would provide stimulus now; while later on, in recessions down the road, stimulus would be provided by releasing some of the accumulated funds in the National Rainy Day Accounts.(If this combination of policies is followed, and it is a long time before the next recession, FLOC’s might only be needed once, since releasing funds from National Rainy Day Accounts could provide the needed stimulus in the future.But an additional round of FLOC’s would always be available as a backup policy.)

To give an idea of the possible magnitudes in National Rainy Day Accounts, suppose each adult were required to set aside $20 per month in NRDA’s.Then if it was five years between the institution of NRDA’s and the next recession, compound interest would mean that each adult would then have a warchest of more than $1200 in their NRDA , minus the amount that went to take care ofdocumentable personal financial emergencies.That amount would be available for release to fight that future recession.

Why am I repeating all of this, when I said it already?I am recapping all of this as background for a corresponding policy proposal for the states, which has a non-obvious name: Federal Medicaid Contribution Prepayment and Escrowing. The idea is to have the Federal Governmentgive the states more money now, while in effect requiring them to repay it later, then to build up a balance that would legally belong to the states, but remain in escrow until a recession, when some or all of the funds would be released.(Also, in situations where under current policies, a state might be bailed out–or otherwise rescued–with Federal money, the money in a state’s Medicaid Escrow Account could be released, so that at least the state was being bailed out or rescued with its own money.)

Interest would be assessed on the prepaid amount and earned by a state on the escrowed amount at the 3-month Treasury bill rate.Up to some target maximum for the Medicaid Escrow Accounts (specified in the original legislation), the interest would be paid as an addition to escrowed funds, but if a state’s account reached its target maximum, the interest would be paid to that state as unencumbered funds that the state could spend at will.The reason for insisting that the Federal Government pay the states interest in an unencumbered way once some predefined target maximumis reached is to reaffirm the states’ property rights in their Medicaid Escrow Accounts.Without ongoing reaffirmation of the states’ property rights in these Medicaid Escrow Accounts, the Federal Government would be very strongly tempted to confiscate the money at some future time in order to deal with its own fiscal problems.The Federal Government could always unilaterally cut its transfers to the states, but it is important that it be discouraged from penalizing a state for being especially thrifty with its Medicaid Escrow Account or for being slow to beg for a bailout or rescue.

Let me say with the utmost clarity that there is no real connection between this program and the purposes of Medicaid itself.I am imagining the rules of the Medicaid program itself to be totally unchanged.The only thing that would change is the timing of when the Federal Government pays its share, as defined under current law.

The main reason I am envisioning this program happening as a modification to the existing flows of Medicaid money from the Federal government to the state governments is simply for the sake of political plausibility.I think it is much more likely, politically, that the Federal Government would change the timing of its Medicaid contributions than that the Federal Government would explicitly set up the equivalent of FLOC’s and NRDA’s for the states.

The second reason for working through a modification of the existing system of Federal Medicaid Contributions is that this approach makes it easier to work around the balanced budget requirements in state constitutions.I do believe that macroeconomic stabilization is an appropriate use of the Federal Government’s power to regulate interstate commerce, and the Supremacy clause in the Constitution of the United States should allow the Federal government to override balanced budget requirements in state constitutions in any case.But with a policy of Federal Medicaid Contribution Prepayment and Escrowing, this can be handled simply by saying in the legislation

“This change in the timing of Federal contributions for Medicaid shall not be construed as borrowing or as saving when any State or Federal court interprets balanced budget requirements that states impose upon themselves.”

Thus, the policy would actually have the effect of tightening existing state balanced budget requirements in non-recessionary times, while loosening those requirements during recessions.

Along these lines, let me emphasize one more time the importance of the Federal Medicaid Contribution Escrowing down the line, as well as the Federal Medicaid Contribution Prepayment now.It is important for states to have the funds in those Medicaid Escrow Accounts to fight future recessions.And it is just as important to keep the states from overspending in good years as it is to encourage them to spend in bad years.

Why do I think the fiscal two-step will work for states, when I don’t think it will work for the Federal Government? Because fiscal discipline is hard for governments—so hard that most governments are not capable of fiscal discipline without balanced budget requirements that are so inflexible they cannot easily handle economic emergencies.Given the unpredictability of real-world events, it is not possible to fully define what constitutes an economic emergency in advance as flexibly as would be desirable, but in the absence of hard and fast, but inflexible rules, governments have a temptation to chronically declare economic emergencies.

The solution I am proposing here is to let a higher government(facing different political incentives) enforce the fiscal discipline in a way flexible enough to deal with recessions or other genuine economic emergencies. I think a government can lead in a fiscal two-step, and I think a government can follow in a fiscal two-step.  (Though they may do so clumsily, stepping on each other’s toes.)  But it takes two to tango, and two to dance the fiscal two-step.Almost no government can lead itself in such an intricate dance.