effect on state and local budgets;

effect on state and local budgets; in the remaining two cases, the budget erosion was
amplified when other negative influences coincided with the cyclical downturn (column
8). For example, as noted earlier, the sharp decline in net saving between 2000 and 2003
reflected sizable downshifts in both its cyclical and non-cyclical components; the latter
occurred because the positive effects of budget tightening efforts were more than offset
by the drop in capital gains realizations and other factors.
In terms of policy reactions, Figure 4 (with additional detail in Table 5) focuses on the
behavior of our fiscal impetus measure around past business cycle peaks; it shows the
impulse to growth in real GDP from the state and local sector during the two years up to
and including the peak and during the three years after the peak. In all five episodes,
policy was expansionary leading up to the peak. During the period following the peak,
the amount of stimulus usually diminished and was only about half as large, on average,
as it had been in period leading up to the peak; the drop-off in fiscal impetus between the
two periods amounted to about 0.2 percent of GDP. The one outlier occurred after the
1973 peak, when fiscal impetus remained virtually the same as it had been preceding the
peak.12 This atypical policy response may reflect the high level of net saving in 1972-73,
which gave governments some scope for dissaving and stimulus. In addition, in the early
1970s, the state and local sector was expanding in many dimensions—education, welfare,
environmental cleanup, etc.; these expansions were supported in part by increased federal
grants, which lowered the implicit prices of some of these programs.
THE CURRENT SLOWDOWN AND LIMITATIONS OF THESE ANALYITCAL
TOOLS
State and local budget positions have deteriorated sharply in recent quarters.
Much of the pressure apparently has been on state budgets. State tax bases are more
cyclically sensitive than those of local governments, and states are largely responsible for
cyclically sensitive transfers such as Medicaid and TANF. If history is a guide, states
will act to satisfy their balanced budget constraints over time and will use one-off
12 The period after the 1979 peak was also unusual because of the steepness of the drop in FI. In fact,
policy became outright restrictive—that is, FI turned negative—as state and local governments cut
expenditures in response to both a deep recession and reductions in federal grants.