Volatile States: Institutions, Policy, and the Performance of American State Economies

Introduction: Economic and Fiscal Performance in a Mean-Variance Perspective

Introduction Economic and Fiscal Performance in a Mean-Variance Perspective American states ended the twentieth century on a winning streak. Most had participated in an uninterrupted eight-year economic expansion that lifted living standards to record levels and reduced unemployment rates to thirty-Ave-year lows. This string of favorable economic events, coupled with a progressive tax structure, caused a surge in state government coffers. State legislators and governors wrestled over what to do with this Bood of new revenues, relishing the choice between cutting taxes and expanding their favorite projects . The forces favoring new spending basically won that contest. The typical state budget in the 1990s outpaced state income growth by nearly 1 percentage point annually.At the same time, federal government spending declined as a share of national income, effectively shifting power from Washington to the states. Those were heady days in the state capitals. Thousands of state politicians had never shared responsibility for a revenue shortfall. Fewer than half of elected state lawmakers had held ofAce long enough to experience hard Ascal times. The economic winning streak ended early in the new millennium, and the Ascal tide began to turn. In 2001 many state economies began to sputter even before the terrorists attacked the World Trade Center and the Pentagon and new risks to homeland security became a reality . In that year, 44 states reported revenue collections that were below expectations, requiring unpleasant choices not confronted for a decade: spending cuts, tax increases, increasing debt, and dips into rainy-day funds. Looking back at the 1970–99 period, one Ands recurring episodes of major economic stress that squeezed state revenues: 1990–91, 1982, and 1975. Even in these earlier periods of national recession, we discover vast differences in how the individual states fared, how each reacted to changing economic circumstances, and how their economies and budgets bounded and rebounded. As a general matter, few states mirror the “national” economy. Yet the notion of a “U.S. economy ” routinely dominates the way we encapsulate, aggregate, and characterize economic conditions that are actually quite unalike at the state level. In the Anal three decades of the twentieth century, living standards in the United States increased by 50 percent, or by about $11,500 per person (in 2000 dollars). In North Carolina, the state growth champion , real income rose by nearly $13,000 per person, a 64 percent rise. In Alaska, the state laggard, income grew by 28 percent, less than half the rate in North Carolina. Of course, one might write off Alaska’s poor showing to the vicissitudes of oil prices. But what about California ’s relatively anemic 37 percent growth or Ohio’s below-average 42 percent growth? Economic performance in these and other states paled in comparison to the 60 percent plus real growth in states such as Colorado, Massachusetts, and Virginia. Why do the American state economies grow at such vastly different rates and manifest wide differences in living standards? This question rightfully occupies a prominent place in the history of economic analysis. Few issues in social science are more worthwhile than the sources of rising living standards.This study joins the discourse by examining the economic and Ascal history of the American states in the last three decades of the twentieth century. It dives deeply into these historical data in search of new insights about the factors that stand behind state economic success. The Role of Volatility in State Economies and Fiscal Policy The central point of departure is the elevated role of volatility. This departure from traditional analyses of economic performance tracks the perspective in modern Anancial theory that emphasizes a twodimensional , or mean-variance, criterion for evaluating portfolios. Just as rates of return alone provide an incomplete basis for gauging portfolio performance, the level or growth in state economies reveals an incomplete and perhaps distorted picture of performance. Taking the volatility of state economies explicitly into account reAnes the whole notion of “economic success.” This book explores and illustrates the considerable promise of a two-dimensional or mean-variance criterion for assessing state economic performance. For example, the empirical analysis Ands that high-income states tend to be signiAcantly more volatile than lowincome states, which raises a host of doubts about the adequacy of tra2 Volatile States ditional models of economic development. Some citizens may simply prefer a low volatility to a high volatility environment, even though this choice requires...