Why didn't the stimulus work as expected?

With 500,000 new people applying for unemployment last week, the most number since November, it appears that the economy, propped up by temporary census workers and last year’s stimulus package, is falling again. The Right is saying that the stimulus was a waste of money, the Left is saying it wasn’t big enough. The truth is, even if it helped a little, it’s not doing enough. Eric Martin at Obsidian Wings does a great job of pointing out one of the most important reasons:

Further weakening the effort, a self-styled group of “moderates” in the Senate pared back the already-too-small stimulus package – cutting, of all things, aid to the States, which money was badly needed and is used, among other things, to keep teachers, firefighters and police officers on the job.

Speaking of the States, at a time when reduced tax revenue sent many budgets plunging into the red, and due to the mandates of State laws that require balanced budgets, States needed more, not less, aid from the federal government just to tread water – or, rather, not cut services and jobs too deeply.  Due to the economic downturn, and absent a sufficient injection of aid from the Federal government, States cut back massively on spending, largely wiping out the stimulative effect of the already-too-small stimulus.

Put simply, while there was an injection of stimulus from the Federal government, on the State level, there was a massive contraction, leaving only a slight net stimulus – certainly too small to counteract the considerable recessionary effects.  So while the federal government was engaged in a Keynesian effort to gin up demand, there were, to paraphrase Atrios, 50 Little Hoovers implementing austerity measures at precisely the worst time in terms of economic cycles.

In short, the stimulus wasn’t as big as it should have been, according to leading economists inside and outside of the administration (at least, those not still hopelessly devoted to Friedman). Multiplying that problem is that the states had to contract their spending, further straining the demand problem. This is why last week’s state aid package, while relatively inexpensive by stimulative measures at $26B, was so important.