AAAnathematising Debt

http://power.ece.uiuc.edu/Gross/EEI/index.1.jpgA week or so ago I was rung by the NSW Unions and asked to speak to the Unsworth Committee which is looking at the NSW’s proposal to privatise retail and generating assets in the NSW industry. They wanted me to speak on the AAA rating. I said I wouldn’t oppose the privatisation because I doubted I was against it – though I’d not looked at it closely.

But I jumped at the opportunity to talk about the AAA rating because this is a spurious reason to sell the assets. What’s wrong with its use? A lot. It would have been a good thing to build some institutions to tackle misuse of borrowed funds on infrastructure investments. If we were really concerned about fiscal rectitude I’ve argued we should move some way towards independent oversight of fiscal policy by an independent body – along the lines of what we do with monetary policy.

In fact what’s happened is that while economic reformers were taking on a lot of the nonsense in the world view of what David Henderson called ‘do-it-yourself economics’ we got a huge dose of ‘DIY’ thinking when it comes to debt. Debt was the new mauve – or as Paul Keating said about getting older – “nothing good about it”. So governments of all shapes and sizes, persuasions and levels in our federation got on with the job of getting down debt.

But the idiocy of this position gradually made itself manifest. Peter Costello ridiculed the idea of investing in equities – just as Paul Keating had done – and proposed to liquidate the bond market as debt fell below $50 billion. The bond market was unimpressed, and enough people of good sense (pdf) led by Ric Simes held a conference that did in the proposal. The bond market, believe it or not provides certain public goods. And it generally returns healthy profits to the government in any event because the benefits of the investment from the money raised in the bond market exceeds its (interest) cost. Since then the Federal Government has got into Future Funds and Education Endowments to invest surplus cash – this is what Costello (and before him Keating) said was ridiculous.

Meanwhile the states crowed about how low their debt was getting by cutting back on investment in infrastructure and by pushing debt off the books with dodgy means of bringing private financiers in to finance the investments (often at much higher cost than it would have cost governments to borrow even allowing some margin for risk). But this wasn’t sustainable as infrastructure became more sorely needed. And so State Governments have begun increasing their borrowings.

It would have been relatively easy for the states to build institutions to cement fiscal rectitude at the same time as prudently expanding debt to build assets. That would be good for the states in which it happened and core government business. I’ve argued previously (pdf) that even if they can’t find infrastructure to invest in, states should manage their balance sheets like private companies and expand borrowing where investments can be found (including portfolio investments) that generate substantially higher returns than the cost of borrowing and they should do this to some prudent point at which it is regarded that risk may become excessive.

So the request from the NSW Unions to speak up on the AAA credit rating was something I was happy to take on. Below the fold is the original draft for an op ed which was rather well edited down to about 120 odd words less than the draft. So take your pick from the today’s SMH and the slightly longer draft below and if you follow this link, you can download the submission to the Committee. (pdf).

Clever use of debt enriches debtors

It seems that certain beliefs come hard wired from the idea that imports destroy jobs (in the long run they help create them) to the idea that the government should do something in response to every possible social and economic ill.

Yet economic reform has taken on those fallacies. As a result we dont regulate rents, imports, bank interest rates or fees, or shopping hours. And were much richer for it.

But though an informed economic framework has triumphed generally, in one area policies have gone backwards driven by plausible populist economic fallacies.

This is the reflex aversion to debt.

Of course other things equal whod want to owe someone money? But we borrow not for the sake of it, but to achieve greater benefits than the cost of the loan. Who would escape their mortgages by selling their home?

Governments used to do what companies and households still do – borrow to build assets. Of course the scope to spend money with future generations paying the bill can tempt governments into bad projects and unsustainable borrowing to consume.

But rather than build the institutions to independently vouchsafe that debt is funding high quality assets rather than consumption or pork barrelling we simply got a bi-partisan political reaction which anathematised debt.

Thats produced debt reduction strategies variously good, bad and ugly.

Governments sold some assets which is good where the private sector is a better manager. But reducing debt by under-investing in infrastructure is bad. And things turn ugly when governments use Enron-style accounting to push debt off the books with private financing which involves higher future payments of taxes or charges, inadequate risk transfer and/or dodgy undertakings for instance to divert traffic onto new privately funded roads. Quick trip under the city anyone?

The Owen Report recently recommended substantial privatisation of the electricity industry. When approached by the NSW unions, we insisted that we wouldnt oppose this recommendation per se, but that we were as ropable as they were about one of the arguments used to justify it.

Remember how we were reducing state debt? Well debts now increasing but we still havent institutionally safeguarded the extent of borrowings or the soundness of the projects its used to finance.

Instead weve got the State governments commitment to retaining its AAA credit rating. In fact its clear that NSW can hang onto that rating as well as the electricity assets it already owns. It can very probably fund the industrys $12 billion expansion as well. And if it was unsure it could either have this privately supplied or build new assets in a form that could be sold if and when it became necessary to protect NSWs credit rating.

But whether or not theres a legitimate case to privatise the electricity industry on productivity grounds, if NSW were being run like a prudent business, it would use the strength of its balance sheet to expand its investment in assets which generate higher returns than the interest cost of funds it borrows.

And as would occur in the private sector, the decision about what credit rating to target would emerge from a proper financial analysis taking into account the costs and benefits of securing AAA rather than populist political posturing.

As Professor John Quiggin puts it:

A government will generally improve its credit rating by forgoing investment opportunities, even if the investments have an expected rate of return well above the cost of capital. The same is true for corporations, and it is one reason why very few corporations now seek to maintain a AAA rating – the cost in terms of foregone investments exceeds the benefits.

If NSW took a single downgrade to AA which Standard and Poors describes as very strong differing in strength to AAA to a very small degree, it could massively increase its investment providing it was for prudent, productivity enhancing, growth enhancing investment. Whether or not it retains its electricity assets, I’d like to see it borrow to fully fund its superannuation liabilities, and any other infrastructure assets which proper analysis suggests are cost beneficial.

The returns would build up to billions within just a few years. Indeed Professor Quiggin calculates that rejecting the last proposal to privatise the industry in 1997 has already netted the NSW public sector around five to ten billion dollars.

Thats not to endorse the loose practices of the past or to oppose privatisation per se. Ive argued elsewhere for greater independent scrutiny or even control of both the operating and capital aspects of the budget. Governments fear this for the disciplines it would impose. But they would be different and better disciplines than those of the rating agencies. They might encourage higher surpluses now, but if theres a downturn they would better enable governments to justify and prudently maintain the substantial deficits that are warranted in such circumstances deficits the rating agencies wont fancy.

If a substantial part of the Unsworth Committees justification for privatising electricity assets is protecting NSWs AAA credit rating, youll know they still dont get it. I’m guessing that if you wait for hours each week in traffic jams or pay mortgages inflated from lack of infrastructure on land on which we could otherwise have built more houses you probably got it some time ago.

The Government speaks of the privatisation as building for the future. Perhaps. But AAA or no, I’d rather face the future without a financial structure best suited to a retired couple.

Dr Nicholas Gruen is CEO of Lateral Economics and appeared before the Unsworth Committee on Monday. His visit was funded by Unions NSW.

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16 Responses to AAAnathematising Debt

  1. Jacques Chester says:

    As a result we dont regulate … shopping hours.

    WA doesn’t seem to have received that memo yet. Any chance of sending some cluestick over?

  2. Jacques Chester says:

    And as for AAA ratings — aren’t they handed out by the same crotch-holders who said subprime mortgages were swell if you just doled them out in big lumps? How they have any credibility left is beyond me.

  3. conrad says:

    From a cynical point of view, the good thing about governments not borrowing large amounts of money is that it makes it far harder to find money to waste on pork-barelling investments. Perhaps that’s a good trade-off. We pay more for projects that we need, but we don’t pay for all the projects we don’t (or at least it’s harder to waste money). This is why government debt should not be equated with private company debt. The goal of private companies is generally to make money. The goal of governments is to make people happy in the short term. Borrowing money for the first has different implications to borrowing money for the second.

  4. James Farrell says:

    Conrad, that argument can easily be turned on its head: if the government understakes the borrowing necessary to fulfil its responsibilties to upgrade infrastructure, it will be harder to justify additional borrowing for arbitrary, politically motivated projects .

  5. AND if that’s your concern, you can at least advocate developing the institutions to deal with it rather than hobble one of the most important economic institutions we have – the government.

  6. Patrick says:

    I agree with you entirely on this (which is your main point):

    But whether or not theres a legitimate case to privatise the electricity industry on productivity grounds, if NSW were being run like a prudent business, it would use the strength of its balance sheet to expand its investment in assets which generate higher returns than the interest cost of funds it borrows.

    And as would occur in the private sector, the decision about what credit rating to target would emerge from a proper financial analysis taking into account the costs and benefits of securing AAA rather than populist political posturing.

    I think it does make sense for governments to borrow, or stop. Ie if you don’t own any roads (or whatever else) fair enough you don’t need to borrow – the private sector owners will. But if you do, then presumably you expect a sufficient return on them to justify borrowing to sustain them.

    Where we may differ is

    – I believe that governments should also be ready to abandon any (ie) roads that it doesn’t expect a sufficient ROI on to justify borrowing to maintain, and
    – that I believe in at least some privately owned assets per se as I believe that a competitive market is very very very likely to be more efficient and innovative than a purely state-owned market in any medium or long run.

  7. derrida derider says:

    I agreed with all you say, Nic, except that I can’t see why you’d want to borrow to fund superannuation liabilities. Aren’t you just shifting from one liability to another (the value of future loan repayments) doing this?

    And in any case, as I keep saying, if you think the present value of future superannuation liabilities should figure on your balance sheet then surely the present value of future tax revenues – the means by which they were always intended to be funded – should also be on the balance sheet. To put one on without the other gives a most misleading picture of your net asset position.

  8. DD – you’re second para is fair enough. But the reason you’d fully fund super – from debt – is because it leaves your balance sheet better off by the difference between the return on the super portfolio and the cost of the debt including some margin for risk. It’s quite a sum. But after you’ve fully funded your super portfolio I’d still be in favour of borrowing to invest as I argued in one of the pieces I linked to. The basic point is that where the state has excessive capacity to bear risk, not bearing it is a wasted asset. Of course in my model I’d create independent institutions who’s job would be to ensure that while the state took on more risk if the returns were there one still ended up with a prudent and strong balance sheet with which the state can bear its many burdens of risk bearer of last resort.

    Patrick, I’m a little taken aback that you think you differ with me on the proposition that a market is a good idea – in other words that we shouldn’t pursue the North Korean model. Am I missing something?

  9. SJ says:

    A well written piece, Nick.

    I note that you describe John Q as a “research economist and commentator”, rather than an “economic journalist”, as you once referred to Paul Krugman. ;)

    Bob Walker of U Sydney has made a similar point (about debt, not about John Q) in his submission, noting further that the net government debt in Oz is negative, and it’s kinda silly to be so preoccupied with government debt levels after it’s essentially all been paid off.

  10. Actually it was the SMH that referred to JQ as that. I think I referred to him as economist Prof JQ. Krugman is both an economist and an economic journalist. He’s a very good economist but not one who is (IMO) in the Nobel category – though they’ll probably give him one sometime. As an economic journalist however, I’m in awe of his ability to pump stuff of great clarity and insight out – 2 per week – on top of lecturing, writing textbooks and other books. It’s incredible!

  11. SJ says:

    So what’s your position on John Q vis-a-vis the Nobel?

    (No need to answer.) :)

  12. JQ’s economics is better than Krugman’s. Not because he’s cleverer, but because it’s more use, more directly related to policy problems and more directly applicable. Krugman’s new trade theory was done because it could be – not because it looked like turning up anything much that was useful to policy makers.

  13. conrad says:

    “you can at least advocate developing the institutions to deal with it”

    Its not clear to me what institutions could deal with it since it seems to me that the basic problem is a cultural one (I’d be happy to read suggestions) — Australians don’t appear to care much for political corruption in the form of pork baralleling (or perhaps politics in general for that matter — I imagine if voting wasn’t compulsary, we would get turnouts like the rest of the Anglosphere to prove this). From casual observation, if Iemma can stay in power and Bracks can dredge the bay and build a slow train to Ballarat, I really wonder what these guys would have to do for people to care.

  14. Patrick says:

    The difference I perceive is not in a market – but in the utility of having a significant market share held by (or at least open to) private competitors. Which in practice is often only possible by scrapping (or, to the same effect, selling) the existing State operators.

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  16. Mark Heydon says:

    I cant see why youd want to borrow to fund superannuation liabilities. Arent you just shifting from one liability to another (the value of future loan repayments) doing this?

    I totally agree. If it is so simple to borrow money, invest it at a higher rate and watch the money roll in, why don’t we take this to the logical (but absurd) conclusion (i.e. borrow a few more $trillion) and then we can all sit back with our feet up.

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