Recognizing the full extent of liabilities is always a good thing, even if what emerges is pretty scary.  But it’s better if the discovery process also includes surfacing (or at least looking for) less-obvious, newfound public assets that can be used as raw material for real solutions. This is the immediate relevance of a new book, Public Wealth of Cities, by Dag Detter and Stefan Folster.  The authors’ central point is that cities — even US ones going through hard times — have a lot more assets with significant commercial value than people think.  Detter & Folster then describe how the value of these assets can be maximized if they’re kept separate from the usual political and fiscal constraints in an ‘Urban Wealth Fund’.  As you’d expect, I’m glad to hear the former and I agree completely with the principles of latter as applied to infrastructure recapitalization.

The prospect of putting together a single big wealth fund for a lot of public-sector assets might sound a bit daunting, especially in US state and local jurisdictional context. But I think most of Detter & Folster’s concept is scalable to managing one or a few basic infrastructure assets. That’s certainly realistic – if people are willing to look at P3s for some assets, then why not a ‘mini-urban-wealth-fund’?

For states & localities that have a budget-crushing ‘GASBzilla’ problem*, the best return on newfound assets might be as part of a solution to manage unfunded pension liabilities — in effect, ‘profit maximization’ for many places is actually ‘fiscal stability maximization’.

Whatever gets ‘maximized’, public asset management should include three principles that Detter & Folster list:

1. Transparency
2. Clear objective of value maximization [I’d add: “for all stakeholders and for the long-term“]
3. Political independence

None of those are easy to achieve in the real world, but they’re crucial in the context of any newfound value of existing public infrastructure.  There’ll be plenty of (completely understandable) temptation to monetize unanticipated value in a quick way to solve a current budget crisis.  And there’s so much money looking for infrastructure assets — especially at fire-sale prices — that monetization will be all too easy.  That short-term approach might keep “GASBzilla” temporarily at bay, but he’ll soon be back, more-accrued than ever.  Using newfound assets for long-term solutions to unfunded pension liabilities requires a lot of discipline, innovation & grit, but I think that’s the only way to really defeat the monster.

*For an excellent summary of the technical background and impact of GASB 68 and 67 on state & local finances, see ‘State and Local Government Pensions at the Crossroads‘ in The CPA Journal, May 2017

The July 2017 edition of Rockefeller Institute of Government’s (RIG) By the Numbers series on state fiscal issues has an especially interesting description of the difficult budget dynamics caused by the time frame of April-May tax revenues and June 30 fiscal-year-end for most states.

The whole thing is worth a read (as ever) but here are the most relevant sections (emphasis mine):

An April income tax shortfall or windfall comes at the worst time of year for three
reasons. First, by the time it is recognized in late April or mid-May, there are just six to
ten weeks before the end of the fiscal year for forty-six states. For states without large
cash balances, April windfalls or shortfalls can create a cash flow crunch or even a cash
flow crisis. There is not enough time to enact and implement new legislation to cut
spending, lay off workers, raise taxes, or otherwise obtain resources sufficient to offset
the lost revenue before the June 30th fiscal year end. As a result, a state without
sufficient cash on hand to pay bills must resort to stopgap measures to “roll” the
problem into the future. For example, states may delay income tax refund payments.
Such actions do not save any money, but they do temporarily avert a cash flow crisis. In
so doing, they increase the budget problem for the fiscal year about to start (by pushing
payment requirements into that year), requiring greater action to close that gap.

This sheds a lot of light on the motivation behind many can-kicking maneuvers. It seems less about conscious political gamesmanship and more related to getting a complex set of numbers to balance in a short period of time – call it ‘bureaucratic expediency’ as opposed to premeditated fiscal mismanagement. I’d guess that most short-term budget-balancing tactics are well-intentioned — and in any case I’m sympathetic to the officials that have to make government work in current economic conditions. Perhaps the bureaucratic aspect of time-pressured tactics also suggests why rainy-day funds don’t get used or expanded as much as you’d expect in the post-2008 world? I could see there might be some additional (and time-consuming) procedural and political hoops to jump through to access a reserve fund, and the fund might be formally or informally restricted to real emergencies or more profound budget shortfalls. If the shortfall is relatively small, unpredictable and has to be dealt with in a hurry, officials might find it easier and effectively more efficient to just quietly kick some maintenance down the road with the sincere intention to make it up later.

Second, an April surprise can have a “double whammy” effect on state revenue in the budget negotiation period. If the shortfall was caused by income that is lower than
had been estimated, then income may be lower in future years, and the state will have
to lower its forecasts for future years as well.[…]

This aspect of the time dynamic – the indications from a bad April surprise about next year’s budget – might explain the choices about which cans to kick. Delaying tax refunds or contractor payments might work for a few weeks or months but not much longer, so repayment has a hard edge in next year’s budget. Deferring maintenance or delaying pension contributions are fuzzier and more forgiving options.

Third, the April income tax shortfalls or windfalls come late not only in the fiscal year but in the budget process too, often as states wrap up their budget negotiations. It takes time for revenue analysts to evaluate the shortfalls or windfalls, and for budget forecasters to revise their forecasts, and for elected officials to come to grips with the magnitude of the new problem they face. The April surprises, whether good or bad, for elected officials can unsettle carefully balanced budget plans already tentatively negotiated.[…]

This kind of negotiation, where after protracted gives-and-takes people are suddenly disappointed or feel they could have got more, is never easy about anything, never mind politically-sensitive spending. The context doesn’t favor careful re-optimization of costs and benefits. Instead, the result is driven by raw power dynamics and horse-trading where the quietest party usually loses. What’s quieter in this sense than infrastructure? Deferred maintenance might indeed cause a lot of life-shortening ‘physical suffering’ to assets, but roads and buildings don’t complain. No surprise they often lose.

I don’t know what a practical solution for the overall April-June budget dilemma might look like. I’m sure that obvious ideas – e.g. just change the fiscal year-end – are equally obvious to public sector officials in the trenches, and they’ve not been pursued for good reasons. And since the RIG report did not mention any discussion of possible overall reform, I’m assuming that nothing is likely to change anytime soon.

So the April-June dilemma can be seen a permanent, highly-specific fiscal constraint in the Value for Funding framework. How much does it matter for infrastructure? I’d guess that a short-term budget scramble actually doesn’t have much effect on decisions to delay major infrastructure investment. These are probably made in the context of “carefully balanced budget plans already tentatively negotiated” by April with respect to longer-term and more predictable constraints like statutory debt capacity, rating agency metrics and overall voter mood.

Not so for deferred maintenance and delayed minor capex. In fact, from RIG’s detailed description, the mechanics of an April-June budget problem almost paint a target on these aspects of infrastructure spending as exactly the type of temporary solution that’s consistent with bureaucratic expediency. These cans may be kicked quickly and quietly as minor adjustments, without apparent immediate impact on the infrastructure itself or any obvious budget metrics, and the affected ‘constituents’ suffer their degraded efficiency and shortened lives in silence.

Obviously the cumulative effect of deferred maintenance and delayed capex is insidiously expensive and dangerously hidden, often emerging from the sub-budget depths only when it’s a serious problem. But in the heat of the budget process, this long-term result is easy enough to forget, especially because the cost of many other last-minute alternatives (failed budget process, skipped pension contribution, etc.) is just as bad or worse.

In the real-world budget environment of time pressure and bad options described in the RIG report, I don’t think that ‘just say no’ is a practical proposal to reduce deferred maintenance and delayed capex. But in effect, this is what P3 availability-payment (AP) proponents are suggesting by pointing out that the third-party AP contractual obligation requires adherence to (and regular payment for) an optimal whole-life maintenance and capex schedule. That’s clearly better in the long run – something I’m pretty sure most public sector officials already know. But if the solution was so simple why wouldn’t they have done it themselves – either as a matter of practice or perhaps by putting maintenance and capex in a restricted fund that was difficult to access for any other purpose? The fact that they haven’t is best explained I think, not by ignorance or political cynicism, but by the idea that the budget process needs some informal flexibility to function in an uncertain world – and the ability to defer some infrastructure spending is among the least bad options to accomplish this.

If this perspective is correct (and I think it’s worth some empirical work to find out), then proposals to keep infrastructure maintenance and capex on a whole-life schedule must include some way to replace the budget flexibility that’s lost by doing so. This is more subtle than it sounds. An effective replacement needs to provide the same features that made deferring maintenance such a ‘bureaucratically-expedient’ option in the first place:

*  Cash is available on short notice and without further procedures if the April/May numbers come up short

* The source of cash is informal (i.e. from delayed spending, not formal indebtedness) but still relatively certain to be there

* The source is outside the scope of formal budget negotiations and can be flexibly applied to last-minute adjustments

* Repayment does not automatically impinge on next year’s budget

The ‘built-in rainy-day financing facility’ (RDF) seems to dovetail into these requirements pretty well, at least on the surface. The basic idea of the RDF is to act as a generalized budget ‘shock absorber’ built into an infrastructure project financing in order to mitigate the effect of long-term fixed commitments in an environment of revenue volatility. But it might work even more precisely to provide replacement flexibility for April-June budget issues if (as should always be the case) deferred maintenance and delayed capex are not allowed in a Public Project Financing:

The RDF revenue index would be tied to the surplus or shortfall of the actual April/May results vs. official forecasts. If a shortfall occurs, scheduled project payments would be automatically reduced for the last payment of the current fiscal year and all but the last for the next. The last scheduled payment could be customized to be much larger than all the others – so a reduction makes a bigger impact for the June 30 numbers. That would free up cash for officials to work with in their efforts to make everything else balance, but it’s not a formal request from a reserve and it’s outside the budget process.

Project costs under the reduced schedule are financed with a built-in line of credit. That will need to amortize per a contractual schedule – no open-ended can-kicking allowed – but repayment via higher project payments won’t start until the end of the next fiscal year. And maybe not even then, if another unexpected shortfall occurs. Beyond two or three years of reduced payments triggered by shortfalls, I think some sort of trend line can be assumed – and so higher expected project payments can be included in the main budget process.

I’m sure there are many devils in all these details. Maybe some other approach would work as well or better. But one thing I remain convinced about – and even more so after reading the latest RIG paper – innovative alternative financing for infrastructure should focus as closely as possible on actual fiscal and budget realities for the US state and local public sector. If the ‘customer’ has a problem, the ‘product’ has to provide a practical solution – or it will simply stay on the shelf.

Great column by Liz Farmer in Governing last week:  States Get Creative on Pension Funding

My guess is that New Jersey’s transfer of lottery revenue is driven in part by disclosures required by GASB 67 – see pages 5-6 of the latest Center for State and Local Government Excellence report (which makes dismal reading in general).  GASB 67 applies lower discount rates to severely underfunded plans.  So the NJ Teachers Fund goes from actuarially funded status of 47% to (a probably a more realistic) 22%. Ugly enough as a balance sheet metric, this also makes the inadequacy of ADEC pension contributions even more obvious in annual budgets. As GASB 68 and 67 intended, the pension elephant in the room (and its growth trend) is getting harder to ignore.

Future lottery revenues, in contrast, don’t have the same forward-looking accounting reality.  So I can see the temptation to use a relatively invisible asset to reduce an increasingly visible and embarrassing liability.

You could argue the pensions need to be funded from revenue over the long run anyway, so regardless of motivation, dedicating the lottery (a long-run source of revenue) might make sense – in theory. In reality, if the deal in driven by short-term accounting fears, then the plan is unlikely to be optimized for long-term cost and benefits, especially with respect to the near-term loss of fiscal flexibility – note what Matt Fabian says about the $1bn hole starting next year. Has NJ really planned for spending cuts to deal with that? Or have they just kicked-the-can in the hope that tomorrow’s revenues will be better? There’s a high chance that this ‘creative’ tactic just adds to the vicious circle of kicking the can into an ever-more challenging future.

California’s creative one-timer is even worse – in effect, it is a floating-rate POB being funded by raiding a special liquidity fund. The usual POB arbitrage story with a twist – a leveraged carry-trade bet that relies on consistent positive-slope yield curve and low rates in general. An inverted yield curve followed by a general rise in rates will cruelly whipsaw this bet – probably exactly at the same time the state really needs the special fund’s liquidity. Another time bomb.

Note the ‘that was easy’ rationale for raiding the special fund:

Some governmental organizations, such as the California Budget and Policy Center, have also offered positive reviews, comparing the move to a refinancing of debt without the risk and exposure associated with owing money to bondholders.

Because the ‘risk and exposure’ of owing money to taxpayers on a non-transparent basis is easier to deal with?

One of the column’s conclusions is also especially worth noting:

With both of these approaches, much of their success depends on how well the pension investments perform. But no matter how that plays out, more governments are likely to follow with their own creative funding solutions.

I think that’s an admirably subtle and diplomatic way of saying: Long-term outcomes apparently don’t really matter to government officials. What counts is if a creative gimmick works in the short-term and solves today’s budget problem. Since budget crises are the ‘new normal’ condition for state and local government, more gimmicks are inevitable. Get used to it.

Creativity itself is not the problem – if anything we need more of that. The problem is the common underlying objective of many innovative tactics: to transfer today’s funding problem to tomorrow without either being sure or ensuring that tomorrow’s funding situation is actually better. In times of strong and steady economic growth, kicking a pension contribution into the future as a quick solution for a current budget shortfall might reasonably be expected to be manageable, by way of growing tax revenues and pension earnings. But in current economic reality – volatile tax revenues, slow growth, unpredictable investment returns and tapped-out central banks – betting on a rosy future is exactly the wrong move.

Instead, creative solutions to short-term problems should be structured around the expectation that the future will be worse, with a conscious sole objective to buy some time in the context of implementing a serious long-term plan for continued uncertainty and low growth.

Not easy, but not impossible. Obviously I think recapitalizing infrastructure to provide giant ‘shock absorbers’ to the budget system could provide flexibility with discipline so that real solutions can be worked out for the long-run. There are others not involving infrastructure, likely based on innovative ways to expand and use rainy-day funds. But whatever the approach, in addition to calling out ‘bad creativity’ we need to explore and define what ‘good creativity’ might look like. I think (hope?) most public sector officials already know that current set of creative one-timer options are bad, but feel they have no choice. If offered a path to something better, the ferocious pressure of pension liabilities could drive real reforms.

The Value for Funding hypothesis is that fiscal and budgetary constraints are a major impediment to public infrastructure investment for US state & local governments.

These constraints can be a more a much important factor than the typical ‘Value for Money’ project-level inefficiencies that most current non-traditional infrastructure alternatives are designed to reduce.  This is especially the case for social and relatively simple basic infrastructure assets.

A different type of problem requires different types of solutions — here are five implications for alternative infrastructure financing innovation that come from the VfF hypothesis:

1) Public-Sector Capital:  Improve Deployment, Don’t Replace

One explanation for inadequate infrastructure investment is that the cost of public-sector capital is higher than it was before even though financing rates are at historic lows.  The idea is that taxpayers want a higher return on the resources that they provide to the government to build infrastructure or pay off infrastructure debt, and that this factor overwhelms low interest rates.

This sounds like it might be true in distressed places where capital is scarce, but I think it’s a stretch for most US state and local governments.  There are solid reasons why the cost of public sector capital is low in relatively rich and politically stable communities and despite all their ‘new normal’ challenges that still applies.

I think the VfF hypothesis might offer a better explanation about what’s preventing more public sector capital being put to work.  Even if taxpayers are willing and able to commit to providing capital for infrastructure, I can see voters getting really angry if financing the commitment results in endless budget crises, frequent debt cap rises or ratings downgrades – all the noisy political hot points.  And it’s easy to see why public-sector officials want to avoid all that.  I think that what’s changed since 2008 – not the cost or availability of public sector capital, but the environment where it would be put to work is really uncertain and politically volatile – so fiscal constraints are really binding.

If this analysis is correct, then alternative financing should not try and replace capital that is actually pretty cheap – but instead look for ways to improve how that capital is deployed and financed with respect to fiscal constraints.

2) Risk and Uncertainty: Risk Transfer Rarely Necessary, But Uncertainty Transfer Often Needed

Risk transfer is often talked about as a rationale for alternatives.  I think this is correct in situations where the risk involved can actually be reduced by private-sector expertise or specialized management – in high-tech processes, some complicated construction projects or retail-store type operations.  In these cases, reducing risk means fewer bad outcomes and wasted resources for everyone – it’s a win-win for both the public and private sectors.

But a lot of the long-term risk involved with basic and social infrastructure can’t be reduced by anybody — public or private – because it comes from factors that aren’t manageable, like macroeconomic cycles or environmental conditions.  If you transfer this kind of risk, it’ll be a zero-sum win-lose situation – maybe the private sector will lose a round like ITR, but they’re playing the game to win, so I don’t think this will be typical.  So I think it’s debatable whether risk transfer really works for the public sector for a lot of cases.

But the VfF hypothesis does point to something that’s conceptually related to risk but not at all the same thing – uncertainty itself.  There’s a lot of technical economic literature about risk vs. uncertainty but the basic idea for our purposes is pretty simple – you can be very comfortable with the risk of your overall income over the next 5 years, but very uncomfortable with the uncertainty of sudden expenditures.  There’s no need to sell or insure your income to deal with that – instead you have some savings or a credit card that acts like a shock absorber to smooth out the impact

The public sector – in liberal democracies anyway – is institutionally bad at dealing with uncertainty – they’re really designed for long-term consensus and planning.  In contrast, the capitalist private sector is pretty good at dealing with uncertainty because in effect that’s their everyday environment.  So I think the VfF implication here is that transferring uncertainty – especially in the current new normal — will be a more broadly applicable rationale than risk transfer.  Basically that means looking for shock absorbers to add to alternatives, like rainy-day financing facilities and keeping debt limit and rating agency powder dry to help the public sector cope with uncertainty.

3) Funded Equity:  Contracts for Specific Performance Often a Better Fit for Public Sector

I can see a role for an equity component in an alternative financing when reducing risk or increasing performance efficiency really requires a significant amount of control over the asset and operations.  So again, complex systems, hi-tech or retail-type infrastructure makes sense.

I can also see a role for some small amount of equity with limited control even for the kind of basic or social infrastructure where risk can’t be reduced and performance improvement is pretty straightforward – like just sticking to a maintenance schedule.  In these cases, the equity is there to align incentives – so private-sector has some skin in the game.

That also makes sense – in theory.  But in practice, it seems that if performance contracts can do the same job in terms of incentives and alignment this might be the less controversial approach, even if the net cost/benefit is the same.  As you all know, there’s just a lot of politics out there right now.

I think the main VfF implication here is like a rule of thumb – if most of the benefits of an alternative proposal is coming from Value for Money and control over the asset is necessary to achieve that, the private-sector funded equity makes sense, even if controversial.

But if most of the benefits are coming from Value for Funding so control over the asset is not so necessary, then performance contracts might be the simplest choice to achieve some Value for Money benefits and avoid controversy at the same time.

4) Expanding Debt Options:  Many Fiscal Constraints Can Be Reduced with Innovative Debt

The biggest – and simplest – VfF implication is that different kinds of debt options might go a long way to helping the public sector reduce fiscal constraints, and since the infrastructure debt capital markets are hungry and pretty innovative, that might be a path forward to for alternative design.

There are two reasons I’m coming to this conclusion.  The first is that most currently binding fiscal and budgetary constraints are related to the debt financing of an infrastructure project – the fixed debt service obligations against volatile revenues, using up debt limits, fear of downgrades, etc.  So it makes sense to explore whether different debt structures might have less impact.

Second – and more fundamental — is that although debt is really bad at absorbing risk because the pay-out is asymmetric, it’s actually pretty good at absorbing uncertainty – specifically, the uncertain timing of cash flows – as long as a credit-worthy entity is on the hook to ensure final repayment.  Think of a line of credit.  In the current market, it’s also really cheap, and the US public sector is mostly very highly-rated investment grade, so plenty of capacity.

So if uncertainty transfer has value to the public sector, I think there’s a lot of scope for development in the debt capitalization side of an alternative proposal.

One important thing to note – none of this should preclude using as much traditional muni-bond financing as possible.  You don’t need the whole debt structure to be a shock absorber – just enough to deal with typical levels of uncertainty.  So the innovative debt I’m talking about should only be a small part of the overall capitalization and the alternative framework should not preclude tax-exempt debt issuance.

5) Federal Infrastructure Policy:  Focus on Reducing Constraints and Inefficiencies, Not Form

Finally, current federal infrastructure policy is a bit vague at the moment to say the least, but I think the overall objective of trying to support more non-traditional options for US state and local governments and get more private-sector expertise and capital involved is totally on target.

But I think also that focusing policies on specific forms and frameworks – like revenue-risk P3s – is a mistake.  That’s completely understandable in terms of what’s been talked about for many years, but it’s unnecessarily limiting and runs into some political preconceptions.  It’d be better to focus policy on the actual challenges that state and local governments face and where the federal government has some unique capability to help.

The VfF implication is of course that it would be very effective to focus some federal policy on specific challenges of fiscal and budgetary constraints if they’re the real impediment to local governments deploying their own capital.  Since mitigating these constraints doesn’t really require risk transfers or subsidies, some carefully thought out policies might be relatively practical in terms of the federal government’s own spending constraints.  In particular, I think there’s a lot of scope for federal loan programs to help deal with uncertainty.

State governments are subject to many self-imposed fiscal constraints, including ones that require the state budget to balance each year. Since state economies in the US generally have GDPs similar to those of entire countries elsewhere, and state governments have a high degree of sovereignty to access resources from these economies, budgetary rules are a serious matter. Over the long run, following the rules has resulted in what we see now: Despite the economic travails of recent years, states still enjoy tremendous access to credit markets and own significant portfolios of valuable public infrastructure.

But in the short run, the rules can also tempt state officials to use credit capacity or public assets for transactions that are primarily motivated by the need to balance the budget during a tough year. These one-time fixes – scoop-and-toss refundings, capitalized interest, infrastructure sale/leasebacks and the like – seem to go against the spirit of the prudential rules that made them possible in the first place. Still, the deals follow the letter of the law and are mostly individually innocuous enough in terms of scale and cost. The short-term motivations and budgetary circumstances surrounding one-timers don’t exactly encourage careful optimization, but at least inefficient last-minute spending cuts can be avoided. So although one-time fixes are universally frowned upon, they’ve often enough been accepted as an occasionally necessary evil in the budget process.

This mindset of pragmatic acceptance now risks becoming dangerous, however, because things have changed since the financial crisis of 2008. The use of one-timers needs to be revisited in light of the current economic outlook. The recent fiscal reality of many state governments – revenue volatility, uncertain federal funding, insidiously accruing long-term liabilities for pensions and health care and deferred infrastructure investment — is increasingly looking like it has become the “new normal” for the foreseeable future. The pressure on state officials to rely on budget-balancing borrowing and asset sales more frequently and in larger scale — and with less embarrassment – than before will only intensify. It’s not realistic to believe that many can resist the pressure, regardless of their good intentions, when passing every year’s budget becomes a crisis. Since future economic growth is far from assured, the liabilities built up by the repeated use of one-timers in the past will only add to the pressure to use them again in the future, laying the foundations for a costly and dangerous vicious circle. Over time, the state’s credit capacity and portfolio of public assets could be significantly eroded – exactly the result that the prudential budget rules were put in place to avoid.

The essence of the problem is that budget-balancing transactions are most tempting – and most legitimately useful – during uncertain times, but that’s also when the practice may be most destructive. Since there’s every indication that the economic future for all states, even those in robust fiscal health, will be plagued by uncertainty, heightened awareness and increased scrutiny of any practice that solves a budget problem today by incurring liabilities for tomorrow is more than justified. Regardless of a state’s past tolerance or relatively benign track record in using them, one-timers are inherently problematic and should be recognized as especially dangerous in the current environment.