Creative Time Bombs

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.