In November 2009 we and the National League of Cities (and many others) warned that steep state and local public sector cuts loomed on the horizon, and that these cuts could undermine any nascent economic recovery just as the federal government’s unprecedented stimulus spending wound down. 

Well, from the looks of July’s disheartening jobs report, this prognosis is now the new reality. 

The economy shed 131,000 jobs on net in July, as a modest private sector gain of 71,000 jobs was dwarfed by a public sector loss of 202,000 jobs thanks to the expiration of 143,000 temporary census positions and the shedding of 48,000 state and local government workers. And let’s not forget that the official employment numbers exclude the 181,000 disgruntled job seekers who left the labor force altogether last month.

In view of that, it was welcome if belated good news last week that the Senate finally bestirred itself to pass a $26.1 billion state aid package to stem the coming tide of teacher, police, and firefighter layoffs. That meant that the House could at last seal the deal yesterday by passing the bill in a characteristically partisan 247-161 vote and pass it on to President Obama for his signature.  

And yet, notwithstanding the modestly good news, a bitter sense of belatedness--of too-little, too-late--pervades Congress’ long-delayed action.

Not only is the new $26.1 billion deal less than half the size of the package President Obama originally requested. Even worse, analysts’ auguries about the future spur only foreboding and fears that a widening public employment crisis really does have the power to weaken the nation’s already faltering economic recovery.

For example, if the conclusions of a survey released in July by the National League of Cities are borne out, then local governments alone will shed up to 500,000 more workers by the close of fiscal year 2012--on top of the 300,000 already laid off between August 2008 and July 2010. Such layoffs could well drag the troubled economy closer to the dreaded trough of a second recessionary dip. 

How is it that the local government fiscal crisis threatens the entire economy’s recovery? Essentially because every local or state cut acts as a stroke of “anti-stimulus” by reducing demand. 

To begin with, individuals without a job--even if they receive unemployment benefits--spend less, and this takes demand directly out of the economy. And then these layoffs are all accompanied by across-the-board budget and service cuts. A front-page New York Times article last week documented how residents are coping with darkened streets and the shutting of transit systems. But less visibly, local governments have curtailed investments, reined in subcontracting, and cut back on a whole host of activities that normally prime the economy but are ultimately executed by the private sector. These cutbacks suck further demand out of regional economies and guarantee additional layoffs. In the end, the Economic Policy Institute estimates that 30 private sector layoffs accompany every 100 public sector ones.

So if the situation is set to worsen (typically the full effects of a recession on local government tax receipts are felt with a two to three year lag) and Congress has no appetite for further stimulus, what politically feasible actions can be taken to defuse the local government fiscal crisis before it undercuts the recovery?

One interesting idea comes from Ed Glaeser, the Harvard polymath, in a thought-provoking post over at Economix last month. Glaeser proposed tying additional state aid to governance reform and stipulations to encourage longer-term budget discipline, like mandatory saving in good times, to minimize the moral hazard involved in any bail out--much in the style of International Monetary Fund conditionality agreements. That would allow needed aid to flow and minimize job losses now while ensuring that states and localities better position themselves to weather future crises.

The problem is Glaeser was not very specific about the proposed conditionality and how it would work. (We’d love suggestions).

In the meantime, nobody should feel much relief this week now that Congress has responded to the looming state-local government shakeout. What Congress did was too little, too late.