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Feb. 24, 2011, 12:00 p.m. EST
By Jeffry Bartash, MarketWatch
WASHINGTON (MarketWatch) "” Aggressive spending cuts by states such as Wisconsin and California are likely to trim U.S. growth in 2011, but the potential drag would be far too small to sidetrack the recovery.
States are under the gun to slash spending to close large budget gaps, a problem made worse by a shrunken tax base and the end of massive federal aid.
Wisconsin Gov. Scott Walker laid out his strategy for pressuring state Senate Democrats to return from Illinois, in a prank telephone call by a liberal activist posing as conservative donor David Koch. Joe Barrett has details.
The effort by Wisconsin to force government workers to pay more for health care and pension plans is the latest example of a state taking dramatic action to put its finances in order. Unlike the federal government, states are required by law to balance their budgets.
Yet economists doubt state spending cuts or tax increases pose a threat to the recovery. While those actions could trim the nation's growth this year by about 0.3 percentage points, the U.S. is still expected to expand by more than 3%, according to most economic forecasts. That would be the fastest rate of growth since before the last recession started.
The biggest drivers of expansion are seen as rising exports, higher consumer spending and more business investment. The federal government is also expected to prop up demand by running another massive deficit despite renewed pressure in Washington to curb outlays.
"We are not looking at significant restraint, at least at the federal level," said Ben Herzon, senior economist at St. Louis-based Macroeconomic Advisors.
States have been grappling with big budget holes since the 2007-2009 recession, but fiscal 2012 "” the upcoming 12 months starting this summer "” could be especially difficult. Medicaid costs keeping rising fast, a flood of federal aid is about to dry up and tax revenue is only now recovering to pre-recession levels.
The end of federal aid, averaging $64 billion over the past two years, is a particular blow. In fiscal 2011, federal aid is the single biggest means by which states are closing a combined deficit of $111 billion, based on the latest estimate of the National Conference of State Legislatures.
States were not without warning. Even before Republicans captured the U.S. House in November, Washington made it clear that aid would cease and states would be largely on their own. Three straight years of trillion-dollar plus federal deficits and an exploding national debt have unnerved the public and put pressure on Congress to restrain spending.
"It's certainly not something that should have come as a surprise to the states," said economist Dan White of Moody's Analytics.
The dilemma for states, as the political showdown in Wisconsin shows, is whether to close budget holes mainly by spending cuts or tax increases. Economists say each has pluses and minuses and there's no guarantee one approach will always work better than the other.
"There's the old adage, if you have two economists in a room you're likely to get four opinions," said Neil Dutta of Bank of America Merrill Lynch. "Nobody really knows."
The impact of state spending cuts tends to be felt right away "” and that explains why economists of all political leanings have shaved growth forecasts for 2012. Reduce spending means state governments or their laid-off workers are buying fewer goods and services.
"If the restraint takes place on the spending side, it will have a more immediate impact on demand, " Herzon said.
Yet states would have to raise taxes to keep spending at current levels, resulting in other problems. Money is drawn from the more productive private sector into what economists generally view as a less efficient public sector. That could hinder the growth of business, especially in a weak economy, and stunt a state's longer-term growth.
"A tax increase will have an adverse affect on economic activity," said David Resler, chief economist of Nomura Securities.
The argument within states over tax increases vs. spending cuts mirrors a global debate. Germany, for instance, has sought to restrain spending and avoid excessive debt, while the U.S. has spent massive sums financed by borrowing to try to stimulate the economy.
In Washington, Republicans assert that the approach taken by the Obama administration and congressional Democrats hasn't worked. They insist the federal government start cutting spending right now to avoid a situation in which large tax increases become necessary to reduce U.S. debt.
States have tried a combination of approaches in past recessions with mixed results. A recent study by Moody's, for example, found that states that cut taxes in the 1990-91 recession outperformed those that raised taxes, but the opposite was true in the 2000-01. Miller said it's unclear why that was the case.
At the very least, Resler said, the different approaches take by the states will eventually provide further evidence as to which strategy is best. Yet the longtime observer of the U.S. economy also warned that experts can't be sure the real economy will always perform like their models assume.
"The economy is so complex and interconnected that no human or computer can predict how everything will turn out," he said.
Jeffry Bartash is a reporter for MarketWatch in Washington.
With the extradition of WikiLeaks founder Julian Assange, the world may be safe from future scary WikiLeaks bulletins, writes Jon Friedman. At least for now.
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