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By Anonymous Mike, pseudonymously.

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Wednesday, March 26, 2008
Budget Follies, The Fun of "Investment"

Somewhere over the last 15 years or so, I began to notice more and more politicians and public policy wonks using the term "investment" as a means of justifying either current or increased levels of spending. Over time it has spread to all areas of public spending and it seems to comes from across the political spectrum, but it pops the most frequently among Democrats when talking about domestic spending.

There's a certain logic to it, spending some money now in order to forestall larger spending down the road or better yet to generate larger returns later. The latter argument is used for things such as increased spending for education or transportation infrastructure. The former argument usually takes the form of "if we spend x amount of money now to send little Jimmy to Head Start, we won't have to spend 10x down the road to put him in jail when he turns out to be master criminal."

The problem with using "investment" with public spending is that presupposes a level of precision analogous to the private sector, which just isn't true. Let me explain.

When investment is used in the private sector, it's usually used in 2 areas; to decide how to allocate scarce resources and how to monitor and manage the ongoing investment.

In the first case, a business will have to decide how to allocate scarce resources among a wide array of investment options: expand capital plant, perhaps boost wages in an effort to attract a better workforce, marketing, R & D, etc.... The decision to invest among those options is predicated upon a number of external factors such as the strategic position of the company but all investments are built around a rate of return and span of time to recapture the initial capital.

The second case, a business has to monitor and manage the investment to make sure it achieves its anticipated return. Many a good plan is mucked up in the execution or even worse, what seems to be a good plan turns out to be bad idea and needs to be abandoned.

I know I'm providing a dramatic simplification to stuff that many people who are smarter than me dedicate their lives to perfecting, but the point is that investing requires good information and solid management.

There are legions of schools of public administration and armies of government analysts who work on creating that information and developing those managers, but it's not the same. The reasons is that when push comes to shove, decisions on public investment aren't going to be made on the basis of return as much as on politics. For the same reason, it's hard to manage public investments; look how long it took to reform welfare or public housing after it was clear to many that they were dysfunctional.

I could go on and try to explain that governments, with their ability to tax, don't face the same sort of competitive pressures as do businesses but instead I want to connect the above point with what is going on in Arizona.

The Governor and her Democratic allies in the Legislature have proposed to close the FY2008 and 2009 budget deficits in part by financing school construction. The State of Arizona is responsible for the construction of public schools and the cost runs the better part of a half a billion dollars. Currently that money is paid as cash out of the budget and the Governor wants to instead change that to a financing scheme, much like you would use a mortgage for a house. The immediate financial benefit of that maneuver is clear, you take that half a billion dollars off the budget and instead replace it with a much more modest financing fee. The problem is that, much like a mortgage, after not too many years of this, your annual financing fee starts to equal what you used to pay in cash and your total cost to acquire the buildings in question goes up dramatically.

The Governor and her legislative buddies, notably Steve Gallardo, justify this maneuver by using a twin barreled notion of investment. The first is that current levels of investment/spending must be continued because radical budget cuts would set Arizona back, to what effect it would be set back or how many years is not clear. The second is to point to the fact that no level of government and very few businesses pay for buildings out of cash, but instead either finance or lease. The argument continues that it's better to use the cash to keep operational spending up than use it for capital projects.

First look at the decision whether to pay cash or finance the purchase of school buildings. The reason why K-12 school districts used financing in the form of bond issues to pay for new schools is that they had neither the tax structure or cash flow to buy buildings outright. An individual district simply cannot absorb the occasional, yet large, costs of school construction. However the State of Arizona does have the necessary revenue base to allow it to choose to either pay cash or finance.

A business faces some of the same cash flow issues as a public entity on how to pay for its buildings but with the added complication that it is forced to generate a certain return on the capital invested in the budget. It is accountable to its investors on whether each and every dollar paid in the form of a building purchase couldn't generate more revenue if invested in some other way.

So the idea that a public entity has to finance its buildings is nonsense. Yes it might be a good idea under certain circumstances but the question that the Governor and the Legislature was facing these past several months was whether those circumstances were now in existence. By proposing to finance rather than cut State spending, the Governor is in effect using debt to pay for operational costs. More relevant to this dicsussion she is using the financing cost as an investment to achieve some sort of return from the preserved State spending. The question is whether those services are worth the costs of financing that debt and the short answer is we don't know the Governor has not shown any justification whether it's better to spend those marginal dollars in that way.

The school finance issue as political matter is moot anyway since it appears that given the length and depth of the budget crisis, the Republican leadership in the Legislature is going to cave on the issue. The Governor has stalled and vetoed on any alternative and yet another chance to do battle on the myth of "public investment" has passed.