Montag, August 02, 2010

Understanding State and Local Government Debt...

This is an object lesson on the challenges facing state and local government, explaining just how these entities got where they are today.

It is important to understand what is going on here at a higher level, because it is also one of the key reasons why debt is going to be such a problem and why it will keep growth rates down, making any recovery that much more difficult.

Put simply, any economic entity, be it personal, business or government, has a cash flow associated with its economic activity. You can really only do one thing with this cash flow: use it in one way or another to finance what you want to do.

Interest rates - normally - are a price signal: the interest rate is the price of money. If the signal comes along that money costs nothing, or that the price can be passed on to someone else, then something strange happens. People don't think about what they are doing, much, any more, since there is, in their perception, no risk: they are doing what they want with something that appears to have no cost (except, of course, for the capital: however, bear with me on this).

Hence if you can borrow $25k for 1% interest, that makes buying a new car attractive, rather than borrowing $5k for a used car instead (at the same rate). Being able to finance a large municipal bond issue by pledging future cash flows makes it attractive to spend the money for pet projects now, relying on either being out of office or on a fanciful business plan to generate the future cash flows. Being able to finance a large corporate bond issue for a new line of business, when the interest rates are artificially low, means that risk analysis won't be so important, since almost any return on investment will be able to finance the project.

This leads to a fundamental sin in the economic world: misallocation of capital. It is what dooms planned economies to necessary failure (by ignoring demand, or, more exactly, making consumption decisions for a population fully capable of making those decisions by themselves, as no one likes to be treated as a child) and it is, at least for the Austrian school, one of the major reasons for recessions, since bubble-driven demand during a bubble expansion will invariably invest in areas that are not capable of providing any returns when the bubble bursts.

Who is to blame?

Well, in the realm of the consumer, it is you and I, if you've financed more car than you can really afford with home equity. You bought a consumer durable, which is nonetheless consumed (it's called a durable because it lasts more than one year, unless you bought something from Detroit), by using a theoretical value of your equity (if you had sold the house and bought the car with your profits, that's another story entirely) to get a loan that you now can't pay back.

If you are a business, blame the folks who did the business planning with their brains turned off, as well as those who approved the spending. GM is building the Volt car, which will require significant subsidies to be sold (a compact car for $41k, folks, in the middle of a recession: what were they thinking? Might have great gas mileage and be all environmentally righty-ho, but if no one can afford to buy one, it's the new Edsel), a great example of misallocated capital spending that will result in GM not making money even longer.

If you are a government, it is invariably a cabal or two of politicians who, for whatever reason, have a grand vision and want the taxpayers to pay for it. A new stadium? Why not, the money will flow in from all the games (ignoring the fact that it's not where people want to go and there's no professional team in the town). A seventh swimming pool for a town of 200 000, where the other pools aren't filled up? Sure, let's make sure that things won't be too crowded, and what the heck, it's only taxpayer money.

Human stupidity knows no bounds, and indeed will bring down any system if greed and corruption are not held at bay by prudence and by the ability of people to control what their duly elected officials do, or, alternatively, to ensure that the board is held responsible by the shareholders or that a spouse knows what the other one is doing with the family's savings.

Being prudent and being responsible are, compared to the realization of grandiose dreams and sweeping changes, boring.

Odd, that. It's almost as if you were asking people to stop goofing off and act like adults.

Were that they would.

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