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Friday, November 4, 2016

Amendment A: Wishful Budget Cosmetics

When the M/S Titanic was taking in water, that fateful night in the North Atlantic, did the captain order full speed ahead? No. He stopped, assessed the situation and tried to find a solution. 

In his case, there was none. Mathematically, the Titanic was doomed. 

When a government is hemorrhaging money, the exactly wrong thing to do is to order full speed ahead. The right thing to do is to pause, assess the fiscal crisis and find appropriate solutions. 

Unfortunately, the captain and bridge crew of the M/S Wyoming have not yet stopped to make that assessment. The governor and the legislature forge ahead, as if they were trying to ignore the hole in the budget. 

Now they have a new tool to help them. Amendment A, proposing a quicker, easier way to invest state savings in the stock market, has an air of full-speed-ahead thinking built into it.

Frankly, the timing of this amendment could not be worse. Our state has just suffered a hit with a fiscal iceberg, we have a big hole in the budget and the best that our legislature, our governor and - especially - the people of Wyoming could do is to stop, assess the damage and look for solutions.  

Currently, the Wyoming Constitution allows the legislature to authorize the investment of public employee retirement systems funds and permanent state funds in equities, such as stock or shares in private or public companies. Permanent funds of the state include funds designated as permanent funds by the Constitution. The Wyoming Constitution does not allow the state to invest any other funds in equities. The adoption of this amendment would allow the legislature, by two-thirds vote of the members of both houses, to authorize the investment of additional specified state funds in equities.
A closer look at this amendment peels away its harmless nature. There are, primarily, two problems with this amendment.

The first problem has to do with basic investment-portfolio theory. Amendment A suggests that the state should invest more of its savings in stocks, which all other things equal means less money invested in bonds. The basic principle for balancing investments between the two is that stocks return more money than bonds, but are correspondingly also more risky. Put simply, this means that the state is taking more risks to make more money.

In reality, the trade off between risks and returns is not that simple. There are stocks that over the course of time have become as reliable an investment as many bonds (Toyota and Coca Cola are often mentioned in the financial literature). There are also bonds that have fallen into disrepute, and that includes more than the classic 1980s "junk bonds". Governments that have failed to prudently manage their budgets have seen their treasury bonds plummet into the financial junk yard. Just four years ago, investors in Greek treasury bonds lost up to one quarter of their investments as the Greek government simply wrote off a big chunk of its own debt...

Nobody is suggesting that Wyoming invest its money in foreign treasury bonds. That is not the point. But it is important to keep in mind that even investments that seem to fall into the low-risk category can lose your money for you if the debtor mismanages his own finances. 

With all this in mind, though, the stock market is generally a more risky environment for any investor. It is subject to specific risks associated with individual corporations and industries, as well as market-wide risks related to the performance of the national economy, fluctuations on global financial markets, currency fluctuations and even macropolitical events such as but not limited to presidential elections. As much as these variables can balance each other out, they can also work in tandem, especially when there is a perception of increased risk for recessions, nationally as well as internationally.

Even the most experienced and prudent stock-market investor is vulnerable to systemic instability - a point that has not been given a fair consideration in the debate over Amendment A.

Which brings us to the second problem with the amendment. The purpose behind it is to increase the state's annual bottom line; if we had not been losing severance-tax revenue recently, and if the forecasts did not show further losses, this amendment would be entirely unnecessary. However, in order to increase the state's revenue the shift from bonds to stocks in the state's portfolio would have to be substantial. In other words, the state would have to expose itself to significantly higher risks over time in order to get a meaningful boost in return on its portfolio.

There is a premise hidden in this desire to move more money into equity, a premise that has not been discussed openly. By putting this amendment on the ballot, the state legislature de facto declares that it is hoping to gain enough new revenue from its new investments to compensate for a substantial part of its lost severance tax revenue. But this means, in plain English, that the stock market must be as reliable a revenue generator as the severance tax has been - or any other tax, for that matter. 

How do our state lawmakers believe that is going to happen? If a steady stream of revenue is what they are looking for, then their target should be high-dividend stocks. The problem is that those tend to be concentrated to a few industries (telecom comes to mind), which actually increases the risk inherent to the stock market. On top of that, it takes time to acquire enough stocks to produce dividends of the substance needed to make an impact on the state budget. Since the state's revenue problem is "here and now", this seems like a feeble strategy to replace lost severance tax income.

If, on the other hand, the state would rely predominantly on capital gains to produce revenue, it would more or less  have to expose itself to the tidal waves of the market itself. (We assume that the state is not going to go after highly risky, potentially very profitable individual stocks, or otherwise act as a shadow venture capitalist.) That may look good when interest rates are low, as they have been recently, and the stock market rallies like it's 1999 again. 

But what happens when interest rates rise, both here and in Europe; when the U.S. economy continues its slow slide into a new recession; when Brexit draw near and European politics gets more tense; when the election of a new president sparks uncertainty as to the near-term political future of our country?

To put this question in perspective, in the fall of 2008 the Dow Jones Industrial Average fell 23 percent in just over two weeks (September 29 to October 15). Imagine, now, that this happens with a substantial part of our state's savings invested in the stock market. Furthermore, imagine that this happens right when there is a recession. (It is not at all unrealistic to assume that the stock market plunges in a recession - on the contrary, the two correlate quite well.) A recession means a decline in tax revenue from sales, use and excise taxes. It also means stagnant or declining revenue from severance and property taxes. 

Bluntly put: right when the state needs its capital gains from the stock market, those capital gains are wiped out. The fiscal purpose behind Amendment A is defeated by macroeconomic realities. With this obvious risk taken into account, the proposal of the amendment looks more like cosmetics aimed at concealing the budget deficit than a serious attempt at structurally improving state finances. 

Let me, again, stress that the reasoning in this blog article is not aimed at persuading anyone on how to vote on Amendment A. The purpose is simply to raise pertinent, economically crucial questions that have not been given nearly the consideration they deserve in the debate leading up to Tuesday's amendment vote. 

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