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.

Here’s a presentation that summarizes the main conclusions and implications of the Value for Funding project.

All the concepts seem to lead in one direction:  the next generation of infrastructure delivery and financing alternatives will look more like a ‘Public Project Financing’ than a ‘Public-Private Partnership’

The Trump administration is talking about an Australian infrastructure concept as a way to jump start more private investment in US infrastructure.  It’s called “asset recycling” – the idea is that the public sector can “monetize” (by privatization or sale/leaseback) the value of existing revenue-producing assets and “recycle” the proceeds to further infrastructure investment.  Sometimes this happens on its own – the Indiana Toll Road sale/leaseback in the US is an example – but the federal policy angle is that adding some incentives to the mix might spark more deals.  In Australia, this took the form of a 15% incentive payment to the states for recycling deals under a program started in 2014.

Would it work in the US?  I’m not so sure.  Recapitalizing existing infrastructure is (of course) something that I think can add value to the public sector in many cases, but specific policy to encourage that result might need a different approach in the US.

The actual Australian recycling incentive program was in fact ended prior to its expiration in May last year.  Lack of demand due to local resistance to privatization was apparently the problem, even though Australian has a good track record of successful “social privatizations”.

The US doesn’t have that track record.  Of the (very few) deals that have actually been completed, some water system leases might be considered to have created net value, but all were more in the nature of recapitalizations and the proceeds mostly went to reduce expensive liabilities.  The ITR sale looks successful in retrospect because the private-sector took the bullet when demand crashed during the 2008 financial crisis, but obviously neither side anticipated that Black Swan event.  If “Great Moderation” growth had in fact continued on trend, Indiana would have lost the value of higher revenues and the deal might well have been a net loser for the public.  The chance of winning a bet against sophisticated private-equity investors is not a very compelling argument for privatization, even if occasionally happens.  And the Chicago Parking sale is a well-publicized example of the public losing that bet (big time) on the day the deal was signed.

Resistance to privatization is, if anything, increasing in the US, despite all the money available for it and the efforts of the P3 industry to “educate” (i.e. advertise) the public about its benefits. The polarizing nature of the Trump Administration just adds fuel to the rhetorical fires.  So my guess is that an Australian-style asset recycling program (which didn’t even really work there) is pretty much DOA in the US.

A Different Approach — Good Debt, Bad Debt and Expanded Federal Loan Programs

Still, since Australia is on the Administration’s radar screen, it is worth looking at the Turnbull government’s  latest fiscal concept:  acknowledge that infrastructure spending is necessary and will be federally supported with deficit financing, but highlighting a clear distinction between this as “good debt” (i.e. for capital investment) vs. “bad debt” (i.e. deficit financing for recurrent expenses).

The good/bad debt distinction is basically a political tactic (not a proposal for budget reform), but the interesting part is how it gets translated into the Australian 2017-18 budget – while infrastructure grants to the states are still a recurrent expense, when the national government makes an equity investment in a project (with the intention for future sale), it is characterized as a capital investment.  (see also page 4-8 in the Budget)

This Australian government equity investment/future sale approach might make a lot of sense in the US too – mainly because I think the obstacles to infrastructure investment at the state and local level are (per my Stanford Value for Funding work) not a matter of real value and long-term resources, but fundamentally short-term constraints.  In effect, it is a kind of asset recycling in the sense that the federal equity will be sold at some point (either to private sector or back to the states).  I think the idea works even better for existing infrastructure that needs major upgrades and has future monetization potential – the fed equity program would be bridging the gap between the immediate need for investment and the long time frame involved in the political dynamics of monetization.

Of course, US federal government doesn’t often make equity investments.  But there is a sort of practical precedent – Overseas Private Investment Corp.’s private-equity finance program.  OPIC’s program actually makes loans to qualified private-equity funds, but in the project capital stack the investment is effectively equity.  Since the equity program was started in 1987 uptake is over $4bn, mostly infrastructure related.  The loans are FCRA scored, but somehow OPIC consistently “makes money” overall on a cash accounting basis – doesn’t seem to have been any Solyndra-type stories.  I saw that Trump’s budget cut OPIC, but I assume that was related to foreign aid aspect, not philosophy re supporting private-sector investment.  On a purely programmatic basis, OPIC’s private equity initiative looks like a low-key but solid success story.

So, if the Administration is intrigued by Australian solutions and could see OPIC as a successful US federal precedent, why not a “Domestic Infrastructure Private Investment Corp” (DIPIC) that could back-leverage equity in P3-type infrastructure projects?

I think it would fit into existing loan program frameworks pretty well – re TIFIA, WIFIA, the investment-grade rating requirement would obviously need to be modified, but US projects are generally so low-risk that doesn’t seem crazy, especially if the senior debt is investment-grade.  Interestingly, this is consistent with what Chicago’s mayor, Rahm Emanuel, was calling for in his Politico article.  Maybe some sort of pilot?

Re federal budget scoring, I assume DIPIC loans would be FCRA measured so much less expensive than tax-credits or grants for equity – and a future Administration in better economic times could always add tax-credits or grants to the sale.

Even if bulk of project equity is provided by loan from federal program, there’s still a big role in DIPIC for private-sector equity investment/management – that’s also in the OPIC precedent, where at least 50% of equity was from qualified fund managers.  Could be lower percentage in US (10%?) to be politically attractive and make the numbers work, but still a lot of volume even before eventual full sale or DIPIC loan repayment.

It might be relevant to this approach that the Trump team’s budget fact sheet about infrastructure mentioned that the “Administration supports the expansion of TIFIA eligibility” – but didn’t talk about asset recycling per se despite their reported interest.

The Government Financial Officers Association (GFOA) recently posted a succinct advisory about the dangers of issuing a taxable bond to reduce unfunded public pension liabilities (a “Pension Obligation Bond” or POB).

Infrastructure recapitalizations have been successfully used to pay down pension obligations in the past — and will be increasingly used for this purpose as the public sector’s need increases and more efficient options for the recap structure expand.  I thought a quick “compare and contrast” with the GFOA advisory point would be interesting (click to enlarge):

 

 

Magical thinking about P3s may be inevitable in the current political climate.  The real harm is that it obscures the real value of non-traditional approaches to public infrastructure investment — here’s my current op-ed in Apolitical Magazine on the problem.