Wall Street has applauded our state-level efforts to manage long-term liabilities — the rating agencies are giving the Commonwealth its highest ever bond ratings. But we should consider carefully whether we should accept Wall Street’s metrics for financial health — not that I doubt the need for financial discipline, but rather that we should, perhaps, reduce our exposure to financial risk.
The Patrick administration has done excellent work, with the Treasurer and the legislature, to understand the state’s long term liabilities and develop transparent policies as to each major category of liability:
- limiting debt issuance based on how future debt service costs will compare to state revenues (see this excellent discussion from the Federal Reserve on debt limits);
- accelerating the funding of the state’s pension liability and also managing that liability downwards through reform;
- leading a very thoughtful commission about the size of the state’s liability for retiree health care;
- developing, to the extent possible, a long term financial forecast for the state.
In addition to quantifying and planning for those liabilities, the administration has worked with the Treasurer and the legislature to make the capital and operating budgets both more transparent and less dependent on gimmicks.
While the state’s financial policies are each individually sound, if you step back and squint, what you see is a program will that render us ever more dependent on Wall Street and ever more exposed to financial risk.
On the one hand, we’ve concluded, with rating agency approval, that we can afford to issue additional indebtedness of $2 billion per year to fund our capital programs — mostly for transportation and public buildings. At the same time, we’ve concluded, also to Wall Street applause, that we should divert almost the same amount ($1.8 billion per year) from our operating revenues into our pension reserve funds.
The money we put in our pension reserves ends up invested in a relatively risky portfolio of assets — stocks, real estate and some commodities. The state has made the decision to seek high returns. High projected returns allow the state to put less money away in reserve, the assumption being that the stock market growth will cover future pension liabilities.
Does it really make sense to borrow $2 billion every year and put that money into the stock market? That’s in effect what the state is doing. The combined result of our debt and pension reserve policies, if things go as planned, will be that, in 2036, the Commonwealth will be fully funded as to its pension liabilities, holding perhaps $100 billion in high risk assets (see the Commonwealth’s pension liability reports), but at the same time, will have debt perhaps close to half that amount — see the debt affordability policy and the state’s indebtedness reports.
An alternative — equally disciplined — approach would be to prioritize debt reduction over pension fund accumulation. If we put in place a legal policy that limited our debt issuance to necessary cash management borrowing, we could run our debt to near zero on roughly the same time frame that we will “fully fund” our pension liability. Of course, we would continue to meet our pension liabilities, but we wouldn’t seek to fully advance fund all of them. We would be much less exposed to adverse market movements. The obvious downside is that we would be forfeiting the expectation of high earnings in the stock market, but we would also avoiding the risk of catastrophic loss.
Over the past few decades we have developed a high tolerance for debt and a sense that financial virtue means managing a huge debt carefully while building up a huge pension reserve. I’m increasingly intrigued by the idea that we’d better off funding our capital programs on a pay-as-you-go basis, shrinking our debt to zero over time and growing our pension reserve more modestly. This approach would reduce our dependence on Wall Street and our exposure to financial markets.
At this stage, it’s just a thought, and not one I’m prepared to marry as a recommendation, but one that I intend to seek more discussion of over the years to come. I’d welcome your thoughts, as always.
Are there easy answers to what servicing the debt will cost and what the expected gain on Wall Street is??
The conventional wisdom, born out by decades of experience, is that, in the long run, the equity markets will out perform the debt markets. That means the state should come out ahead by borrowing to be in the stock market. The state has good credit and issues tax exempt bonds, so it can do even better than other leveraged investors.
On the other hand, that means that more and more of the state’s future is tied to the financial markets — with the risk and management bandwidth which that entails.