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How Governments Can Survive Recessions

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Rebecca Hendrick
March 10, 2020

Professional and government watchdog organizations and public interest groups have recognized many budgeting methods to improve the financial condition and fiscal stability for states and localities. Two techniques are particularly noteworthy for their ability to guide budgets down the path to true balance. First is good financial forecasting that improves planning on both the spending and revenue side. Second are rainy-day funds to supply additional resources for financial emergencies and unexpected tax shortfalls.

The Government Finance Officers Association recently published a book and set of supplementary materials on forecasting methods, and they have maintained a statement of best practices on forecasting since 2014. More recently, the Volcker Alliance has funded teams of researchers to document and grade state governments’ budgeting practices in forecasting, their maintenance of reserve funds, including rainy-day funds and other areas as part of its project on the Truth and Integrity in State Budgeting. Moreover, the Pew Charitable Trusts has published numerous reports on states’ rainy-day fund practices and balances to promote policies and practices that support rainy-day funds and their use to mitigate resource volatility.

Over fifty years ago, Herbert Simon, who received both the Turing Award in 1975 and the Nobel prize for economics in 1978, proposed good reasons for governments (and organizations more generally) to have good forecasting and rainy-day funds. In his ground-breaking book entitled The Sciences of the Artificial (1969), he conceptualized organizations as entities that adapt to their environments in similar ways as biological organisms and other types of systems (1969). He defined adaptation as homeostasis, balance or equilibrium of a system’s internal and external environments.

As applied to the finances of government or financial condition, a government is adapted financially when its financial structure and practices are balanced with its fiscal environment. For instance, a fiscally balanced government levies taxes at a level that does not overburden its tax bases and provides services at an, “Acceptable,” level to meet the health, safety and welfare needs of the public. It also balances revenues with spending, assets with liabilities, risk management with risk exposure and so on.

What types of actions can governments take to re-establish or maintain fiscal balance if they are facing shrinking revenue bases and/or increasing spending demands in their external environment? The most obvious actions are raising more revenue through decreasing expenditures and increasing taxes or charges. However, decreasing expenditures is disruptive to the functioning of the government in the short-run, and raising taxes does not generate immediate resources. Thus, these actions are ineffective, not to mention, politically unpopular.

Fortunately, as Simon indicates, there are far more effective and politically accepted routes: effective forecasting and environmental buffers like rainy day funds.

Accurate forecasting anticipates future changes in the environment that allows a government to implement financial strategies that adapt to these changes before they occur. To the extent that government does not accurately forecast changes in the external environment, it can buffer these effects by maintaining surplus or slack resources that allow it to adapt after the fact and, if necessary, give it time to make more fundamental changes internally to bring it back in balance with its environment. Rainy-day funds and fund balances are, probably, the best buffers governments have for providing additional resources for spending when recessions hit, and they also provide additional resources for investment when opportunities arise.

Such positive attitudes about rainy-day funds and forecasting are based on assumptions that these practices will be used in a way that allows governments to adapt and makes them function better financially and operationally. There is a great deal of research on state rainy-day funds that shows these funds help to stabilize spending over the business cycle. That said, research on rainy-day funds also shows that the depth of their benefits depends on the stringency of state statutes affecting deposits and withdrawals. Moreover, rainy-day funds will not provide the benefits available if adequate funds are not maintained in them.

The key here is to begin to identify what level of rainy-day funds or fund balances are necessary to provide an adequate buffer for emergencies and forecast error.

There is not similarly deep investigation into whether good forecasting will improve governments’ financial condition, service delivery, and other outcomes. Instead, research on forecasting focuses on two broad issues: the accuracy of revenue and spending forecasting and the methods used.

The utility of forecasting is likely to depend on the legal context in which these methods are used and whether they are used appropriately or even used at all. Even good forecasting will be valueless if the forecasts are ignored by legislators and budgeters. Moreover, all mis-forecasts are not created equally. Under-forecasting of revenues and over-forecasting of expenditures may be a good thing if they help governments generate surpluses for rainy day funds and fund balances that functions as rainy-day funds in many local governments. Future investigations should also examine what legal structures are likely to promote appropriate use of forecasting and financial reserves and adequate levels of reserves.


Author: Rebecca HendrickProfessor, Department of Public Administration at University of Illinois at Chicago and Faculty Advisory Board Member, GFRC.

 
 

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The American Society for Public Administration is the largest and most prominent professional association for public administration. It is dedicated to advancing the art, science, teaching and practice of public and non-profit administration.

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