No economic rationale for the hostility to government debt

The Prime Minister and Treasurer frequently criticize the States for going into debt and warn that it will put pressure on interest rates (e.g. see Rudd torpedoed twice: PM Weekend Australian 16-17 June). It is disappointing that the Coalition is running such an irrational line.

This criticism makes no sense from a prudential viewpoint. State governments are still showing big operating surpluses and very strong balance sheets: the states current borrowing program will bring total state debt levels to only 4 or 5% of state GDP over the next five years (compared with 25% in the early 1990s). More importantly, borrowing for infrastructure will leave the states’ net worth the true test of a sound balance sheet unchanged or even improved.

From a wider economic perspective, such infrastructure (expanding water facilities, relieving ports infrastructure etc,) will add to productive capacity over time.

In the longer term such investment, will ease pressure on interest rates. In the interim (investment gestation) period, the Federal Government, which after all has ultimate responsibility for macroeconomic management, needs to defer some tax cuts or spending programs if it wants to avoid inflationary pressures or interest rate increases. If it does that, we end up with unchanged interest rates and a better balance between public and private investment and between investment and consumption and a more productive economy or at least one which better meets the preferences of Australians.

Every other government in the world (and every sensible corporation) recognizes that, where governments are better at managing the infrastructure risks than the private sector, long-life capital spending should be funded out of debt – not revenue. It is good economics because it avoids overloading the tax burden up-front or the need to use more costly private financing alternatives or deferring essential investment.

And it is more compatible with inter-generational equity. Sure, it means bequeathing more debt to future taxpayers but they will also inherit more wealth – and all the associated benefits e.g. long-lived infrastructure, improved knowledge, a better public health care system, superior economic, cultural, political and legal institutions, a more stable and cohesive society etc. Nor should it worsen the long term revenue gap stemming from an ageing population as the tax base will benefit from the new infrastructure.

Instead of damning the States, the Federal government should be taking much more responsibility for infrastructure financing than it does for two reasons. Relative to the States, it has gained much more revenue from the commodity price boom (some $300 billion better off since the late 90s) and its revenue base will benefit most from the boost to the economy generated by new infrastructure.

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cs
cs
14 years ago

Hear! Hear!

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Government debt is inflationary and it is good economic policy to maintain low inflation. The Reserve Bank may be charged with maintaining low inflation, but it is the Federal Government that gets blamed for interest rate rises by the electorate. So it is entirely rational for the PM and the Treasurer to be critical of state debt.

Jc
Jc
14 years ago

Fred
Why do you think the government is better at supplying these services to the public?

We are in a mess with water presently because the government is unable to supply what is demanded and doesn’t know the price at which it ought to be sold. This is the soviet model in operation, Fred. All we do is keep proving it doesn’t work.

Nearly all infrastructure is better supplied by the private sector as it is more qualified to price risk and potential return than the competing interests that buffet government decison making.

Patrick
Patrick
14 years ago

JC raises the question I always have in these cases – it does seem appropriate for the State to take on debt in the manner you describe, but that itself suggests that it would be equally approriate for the private sector to do so.

Maybe we just need to manage state-public contracting better?

Fred Argy
Fred Argy
14 years ago

Brendan, as I said in my posting, it has always been the responsibility of the Federal authorities (fiscal and monetary) to smooth economic fluctuations. They are much better equipped to do so. The States need to run a sound balance sheet and promote longer term structural goals such as on infrastructure. This is what they are doing.

JC and Patrick ask: why not just leave it to the private sector? It is a legitimate question and the best way to answer the question is to reproduce below a segment of a recent paper of mine on Fiscal Policy for the Future.

Excerpts from my paper follow.

Private ownership, through so-called public-private partnerships (PPPs), Build, Own, Operate (BOO) arrangements or other similar devices, makes good sense where
(a) there is a genuine transfer of risk involved;
(b) the private sector is clearly better at bearing and managing the risk than the public sector;
(c) private capital markets function efficiently; and
(d) the public interest can be safeguarded.

These four conditions are hard to fulfill in practice. With explicit or implicit government guarantees of output, the effective amount of risk transferred is often small (but often inflated, as noted later). The private sector is generally better than the public sector in design and construction and at times in maintenance and operation – but it is not necessarily better at managing ownership risks. This is especially so where the risks of the project are mainly regulatory and political rather than commercial in character. And any risk management advantage by the private sector needs to be weighed against the high up-front transaction expenses commonly adding 2 to 4 per cent and often more to capital costs.

Again, capital markets do not always function efficiently. Apart from questions about the size of the equity premium, Australias infrastructure financing market has not been fully competitive in the past. …. the small number of bidders have been able in the past to demand an excessive risk premium – and this could have inflated the risk-adjusted public sector comparator used by the public sector to assess private financing offers.

Nor is it easy to build tight public interest safeguards into private sector contracts and regulation. Private sector involvement makes sense if it generates competition; but often all we end up with is a private quasi-monopoly replacing a government monopoly, requiring burdensome regulation which then becomes the subject of intensely hostile lobbying. Again private equity sometimes raises serious accountability and transparency concerns because of the commercial in confidence constraint and the incomplete information often available to the auditor-generals, including in relation to the public sector comparator. And, in the case of roads, governments are often forced to offer guarantees which have a distorting effect on patterns of usage and fail to allow for the impact on non-users of new motorways.

The problems associated with public-private partnerships are particularly great for social infrastructure. It is usually less feasible to shift substantive risk to the private sector and private ownership of social infrastructure is more likely to confer a high degree of monopoly power.

In the light of the above, it is not surprising that State governments in Australia have become much more cautious and demanding about PPPs. But it would be a pity if the backlash went too far. There is now a historical track record for PPP;s and BOOs and much more institutional familiarity with infrastructure investment. There are also many more financial intermediary players and more scope for genuine competitive bidding. As well, governments are learning to deal directly with superannuation funds instead of working through agents who demand their cut. Provided adequate safeguards can be built in to protect the public interest (e.g. reserving the right to review arrangements every five years or, in specified special situations, to withdraw contractual guarantees subject to agreed compensation), there may be potential benefits from private ownership such as in management of costs, maintenance and innovative design. And if private equity can sensibly be used to finance economic infrastructure, it releases government resources for social investment and lessens the risk that an increase in government borrowing will incite a financial market backlash.

End of excerpts.

In short, JC and Patrick, it’s all a matter of horses for courses. I am not against private sector ownership of infrastructure in appropriate circumstances – but governments have an important role to play nonetheless.

Fred Argy
Fred Argy
14 years ago

Brendan, I need to make a further point in response to your comment. Peter Costello is being self-contradictory. He says he objects to public financing of new infrastructure because of its impact on interest rates – yet in the same breath he says he has no objection to bank financing of new infrastructure. Even a first year economics student would tell him that the macroeconomic effects are virtually identical in both cases.

Patrick
Patrick
14 years ago

Thanks for the response Fred.

I agree with the first. I can’t say the same for the rest – (c) in particular. At one stage there were over a dozen bidders for the X-city tunnel, for example, and there are at least four domestic constructors who could do an entire freeway on their own these days, amongst them Cintra (the world’s biggest), ABN-Amro and Leighton in consortium (the winner), Transurban, Macquaire, B&B, some singapore company, etc. Infrastructure is one of the hottest asset classes around.

I suspect that (d) is really only (a) and (c) rehashed. If the risk is effectively transferred, then the market, assuming (c), should safeguard the public interest.

Finally, in practice, private ownership is public – in practice, it means our super funds, especially with infrastructure assets. Like Drucker said, private pension funds made America the world’s first socialist country.

Jc
Jc
14 years ago

Fred

The Sydney cross-harbor tunnel is currently in receivership because the private owners failed to estimate usage. It cost $1 bill+ to construct and now is being sold for $700 mill.

You’re implying that the taxpayer should be taking a lot of these risks and get bagged with the national loss when it doesn’t work out. The government would have hidden that loss in its books, Fred.

What infrastructure projects are we short on anyway?

Water? The governments don’t let anyone go near these businesses because they make so much money out of them. The Victorian government pulls out over $1 billion a year from water. It’s a very profitable enterprise, yet they have still allowed shortages and forced restrictions. Moreover they have been using the profits to fund higher levels of recurring expenses so an expansion now has to be funded by increased water fees.

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Fred,

Public debt is not the same as private debt because the risk associated with the debt is considerably different. It is much more likely than the state will find financing for a pipe dream than a private organisation, at least with regards to stable governments such as is found at Australian federal and state level. So although you are correct that public and private debt have the same effect on money supply, the likelihood of private debt is significantly lower because the capital market can’t rely on future private shareholders paying for the mistakes of current shareholders.

I have some serious misgivings about PPPs as well, in so far as companies that negotiate exclusivity clauses into their PPPs are simply exercising a form of rent seeking. PPPs are still a case of the state allocating resources, and I don’t have faith that the state has the ability to do so.