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Friday, October 28, 2016

Be Careful with the Rainy Day Fund

With the latest CREG report in mind our governor and some legislators seem open to using the Rainy Day Fund to bridge over the state's revenue shortfall. This is a natural reaction, and using the money now is a good idea - but only under strict conditions. If the legislature does not recognize those conditions, the use of Rainy Day cash will actually make matters worse for our state. 

To understand the proper use of a Rainy Day Fund, let us start with the basics. The theory behind a government cash reserve is that:

a) revenue is cyclical, fluctuating with the ups and downs in the business cycle; but
b) spending is not cyclical.

Right here, we have a problem. 

Government spending, including that of the state of Wyoming, comes mostly in the form of spending commitments promising citizens money (cash or, mostly, in-kind) that government may or may not have. The very recognition that revenue is cyclical while spending is not, is a recognition that there will be times when government cannot cover its own expenses. 

In other words, there is a de facto deficit built into the very nature of government spending. 

Wherever there is a deficit discrepancy built into the state budget, there is a potential for protracted deficits. The prudent response would be to reduce government spending to a level and kind of spending where the state is no longer at risk of protracted deficits. This is not what the state has chosen to do. 

The alternative, therefore, is to build a cash reserve. The bigger the state's spending commitments, the bigger its cash reserve has to be. In the case of Wyoming, that principle is going to be put to the test this coming session. 

One important element in the basic theory behind a Rainy-Day Fund is the cyclical nature of revenue. By definition, cyclical fluctuations in revenue mean that when revenue drops, the decline is temporary and - here is the kicker - followed by a reasonably predictable upturn. The concept of the cyclical revenue fluctuation has its origin in early macroeconomic business-cycle theory: growth periods and recessions followed one another with regularity and, again, reasonable predictability. 

For a sustained period in the mid-20th century the American economy experienced such regular business cycles, giving both economists and legislators good reasons to assume that it was not such a big problem with budget deficits. After all, they were regularly followed by surpluses.

Which leads us over to the practical side of Rainy Day Funding. In order to have a cash reserve, government must first have a surplus to build from. Since the Wyoming state government has been awash in cash for a long time, it has had the opportunity to build considerable cash reserves - not just a formal Rainy Day Fund. 

Now, though, the revenue situation has changed - and changed dramatically. It is natural to continue the cash-reserve planning from building the fund to spending the fund. 

There is just one problem, a problem that has not yet been discussed thoroughly. In order for the Rainy Day Fund to properly fulfill its purpose, the state legislature has to be reasonably certain that there is a revenue upturn coming at some point. Then, and only then, can the legislature rely entirely on the cash reserve.

If there is no predictable upturn in revenue in the foreseeable future, then almost by definition the Rainy Day Fund will be insufficient as replacement for tax revenue. A finite source of cash cannot pay for an infinite amount of Big Macs.

This is not a rhetorical point. It is highly practical. The state government is suffering from a revenue decline that is not cyclical in nature. Spending, at the same time, is set to continue largely unchanged and will do so until the legislature initiates reforms. By any reasonable account, this precipitates a deficit that will last - again - for the foreseeable future. 

Under these circumstances, it is reasonable to use the Rainy Day Fund, but only if it is coupled with:

1. the explicit recognition that we simply do not know when there will be a change in the current downward trend in revenue; and
2. an action-oriented plan to structurally reduce government spending to match a permanently lower level of revenue. 

If the legislature spends the state's Rainy Day Fund under these two conditions, the money will have been used responsibly. If, on the other hand, the state depletes its cash reserves under the illusion that tax revenue will soon return to comfortable levels again, then it will put itself on the same path to a major fiscal crisis like the one Alaska has been trapped in.

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