Like the Fed, states and local governments appear to be between a rock and a hard place, and like the Fed’s QE2 program now aimed at Main Street, solutions for state and local governments have been so far less than palatable. One such solution known as “infrastructure privatization” has been rapidly gaining momentum in recent years and involves the sale and/or lease of public assets to private interests. These assets include such things as airports, parking meters and parking garages, public water and utility systems, toll roads and bridges, sea ports, zoos and other outdoor spaces, and more — all originally built by taxpayers and paid for with taxpayer monies.
Metered municipal street and garage parking spaces are among the most popular of recent municipal privatization schemes with one of the first taking place in Chicago “where the city received $1.16 billion in 2008 to allow a consortium led by Morgan Stanley to run more than 36,000 metered parking spaces for 75 years.” Essentially Chicago residents and visitors will, for the foreseeable future, be paying Morgan Stanley and cohorts for the privilege of using parking meters that had already been built and paid for by taxpayers – the income from which heretofore had been used primarily for governmental operating expenses.
This particular parking meter deal, similar to many such “privatization” schemes, immediately translated into higher fees – which not only resulted in a huge public outcry but prompted the inspector general to assert that “the city was short-changed by about $1 billion” based on the new fee structure. Meanwhile alderman, Scott Waguespack, who voted against the lease, noted dryly that “The investors will make their money back in 20 years and we are stuck for 50 more years making zero dollars.” But perhaps the biggest blow to the city came when Fitch Ratings downgraded Chicago’s bond rating to “AA” from “AA-plus” last August, a move which could – happily enough for the banks – raise the city’s borrowing costs. This downgrade, Fitch said, was due in part to Chicago’s “accelerated use of reserves to balance operations.”
Chicago’s experience is not an isolated one but many nevertheless insist that such privatization schemes may now be an essential element of the fiscal pie, one important ingredient of which includes, disconcertingly enough, foreign investors. Overall the results aren’t pretty even when analysts such as Robert Kurtter, a managing director at Moody’s, opine that: “We view these asset sales as 1-shots…that create structural budget imbalances in future years, but that may be necessary actions to bridge the time gap until revenue stabilization or growth returns.”
Not only is this privatization trend “being spurred by a cottage industry of consultants, lawyers and bankers” but even more importantly, it amounts to a fire sale that could help plug budget holes now but worsen their financial woes over the long run.” Some have gone so far as to say, not wholly without justification, that this collective governmental move toward privatization of public assets amounts to little more than corporate fascism – ruled by government proxy through state appointed regulators, rather than citizen votes.
The Debt Crisis, Real and Imagined
Curiously, and at the same time that local governmental entities have been selling off public assets to buyers far and near through “infrastructure privatization,” many have also been actively acquiring a wide variety of assets as investment vehicles and profit centers. These assets, taken together, show that “collective government has controlling interest in all Fortune 500 companies and most other major corporations in and outside of the United States.” Documented evidence of this can be obtained through careful study of at least a portion of some 185,000 governmental entities – everything from school districts to city and county governmental bodies to state government – now using CAFRs, or the Comprehensive Annual Financial Reporting System.
Used by investment rating companies such as Moody’s and Standard and Poors to determine a state’s fiscal integrity and set bond rates, these CAFRs are an accounting tool meant to reflect “a thorough and detailed presentation of the state’s financial condition.” The Institute for Truth in Accounting describes the CAFR mechanism this way (emphasis mine):
While typical state budgets are often created without much regard to sound accounting practices state annual reports are subject to established accounting principles… This collection of “best practices” is known as “Generally Accepted Accounting Principles” or “GAAP”….
In our view, private sector GAAP is more comprehensive and mature than the GAAP established for state and local governments and the GAAP established for the federal government.
Each state budget is its annual blueprint for how the state resources will be spent, while the Comprehensive Annual Financial Report (CAFR) is the document that reports how the resources were employed…
The CAFR is prepared using state and local GAAP established by the GASB. GASB GAAP requires that the CAFR consists of two major sections: introductory and financial…
Included in the financial section are the financial statements for eleven funds which are categorized as governmental, proprietary and fiduciary funds. Every major fund in each of these categories is presented separately. (italics mine)
For all governmental entities using it, the CAFR accounting system in effect functions as a catalog of various types of funds, including institutional funds, enterprise funds or financial holdings, assets and investment funds. These are divided into three main categories, and one additional called “component units.” Pension Trust Funds and Investment Funds are examples of Fiduciary Funds; Unemployment Insurance and University Funds are examples of Proprietary Funds; and the General Fund and Road Fund are examples of Government Funds.
The budget we most often hear about only involves the Government Funds category. It is within this category that we find revenues received – including investment and tax revenue – for the financial period, together with expenditures for specified units of government, including education and social services plus police, fire, park and transportation services. In other words, the most basic functions a governmental entity provides are accounted for here.
Surprisingly, the budget as reported in the CAFR does not always include all of the governmental-type funds within that category — and the funds within the remaining three CAFR categories are never part of the budget. Moreover, and because CAFRs are often published after the next year’s budget is considered and sometimes even after it has been approved, expenditures and unused revenues detailed within that CAFR cannot properly be taken into consideration in the preparation of the next budget. In other words, the budget as we know it covers only a small and somewhat misleading portion of a governmental entity’s financial condition.
According to Lt. Colonel Gerald R. Klatt, who had worked as both an auditor for the US Air Force, and later as a federal accountant with 15 years of CAFR experience:
This is the most deceiving topic that governments, politicians, and the news media have conveyed to the public about governmental financial matters. In reality, a government can simultaneously have a budget shortfall and a financial surplus of the taxpayers’ money.
The now deceased Klatt, whose website is maintained by former Commodities Trader and fellow researcher, Walter Burien, made note of the fact that most of the surpluses in question are located NOT in the Government funds category where the (usually out-dated) operational budget is found, but rather in the other three categories. Mr. Klatt defined surpluses as “funds that are not required or needed for the operation of all government operations, funds, accounts, agencies, etc., directly or indirectly, for the year(s) covered by the budget which is usually one to two years.”
He goes on to say that “what we have found is that most governments have huge amounts of cash and investments on hand at the end of the fiscal year. And somehow these cash and investments are not being recycled back through the budget process the next year, but are being held year-after-year.”
While most Americans assume that local, state and the federal governments are non-profit organizations operating on a “pay-as-you-go” basis, a fair study of the CAFRs shows that this is simply not the case. Klatt maintains that – except for retirement/pension funds – they should be, and further, that reform of the CAFR system properly belongs to experienced accountants and not to lawyers.
According to the Institute for Truth in Accounting — which focuses on the budget portion of the Governmental Funds CAFR category — major operational budgeting problems stem both from the fact that most such budget reports are not released in a timely fashion and also because most state budgets employ two different accounting mechanisms for the CAFR accounting categories. The accrual accounting method is used for the fiduciary and proprietary funds, while the modified accrual method (which is very similar to the cash-based or pay-as-you-go method) is applied to the Governmental Funds category.
While there would be no significant difference between accrual-based and cash-based budgeting for transactions such as grant payments, salaries and other general expenditures, the situation changes when it comes to long-term assets such as infrastructure or commitments such as post-employment health care benefits which are typically handled in the operational budget. In these cases, says the IFTA, “an accrual budget would recognize costs earlier, when the commitment is made, and thus enhance the legislature’s ability to understand and control these costs.” This is because the “accrual system’s major goal is to properly define and match revenues with the actual costs and expenses incurred during the fiscal period.”
Klatt, in apparent partial opposition to certain IFTA positions, maintains that governmental entities should operate on a zero-based budgeting procedure, with little or no cash and investments on hand at the end of each fiscal year. However, and while not specifically addressing accrual accounting, Klatt essentially agrees with IFTA’s relevant points when he writes: “Budgeted expenditures should be last year’s expenditures (as shown in the CAFR) with an adjustment for increase in requirements (costed out) or reductions in requirements.” In other words, revenues should be properly defined and matched with the actual costs and expenses incurred during the fiscal period.
Mr. Klatt’s research sheds important light on the little understood CAFRs by explaining in clear terms the manner in which profit centers are often set up under fund categories that are separate from the reported budget. This is accomplished by applying unrecognized surpluses carried over from previous budgets — and within funds themselves — toward the purchase of a variety of investment vehicles. This situation goes a long way towards explaining charges of government corporatism, oligarchy and even fascism running through the public discourse.
No small degree of credibility is given to theses charges when one understands that — just as increasing numbers of municipalities have been incorporating themselves1 , 2 over the past few decades — so too are increasing numbers of governmental agencies and even pension systems organizing themselves under corporate charters. Most participate in global financial opportunities and some are, themselves, organizing under international guidelines for corporations, apparently in order to gain greater unfettered access to international markets.
For example, on March 18, 1996 the California Public Employee Retirement System adopted an international corporate governance program “designed to increase returns on the System’s international equity portfolio [which could potentially] generate an additional half billion dollars annually.” A few months later, on December 18 Calpers “announced an historic partnership with the prestigious Asian Development Bank (ADB) to make long-term, direct private equity investments in the emerging markets of the Asian-Pacific region.”
Describing itself as “the largest U.S. public pension fund, with assets totaling $201 billion spanning domestic and international markets as of February 28, 2010,” it stated in a 2004 document on its global corporate governance principles that “[a]t Calpers, corporate governance is about making money, not changing the political or social environment.” Proving its point in 2007, Calpers, as “the 13th largest holder of Berkshire Hathaway stock, sided against an investor who want[ed] Berkshire to sell its stake in PetroChina as a statement against violence in Sudan.”
It is important to understand that stock market fluctuations are essential to the long term health of these behemoth funds because they are able to profit from down markets by taking advantage of low asset (fire sale) prices and “cheap” money — and by selling high in up markets. Yet somehow the oftentimes significant financial holdings of these governmental units are both poorly understood and vastly under-reported.
In sharp contrast, the general operational budget is discussed without respite every minute of every day, with short-term, and thus wholly inadequate or inappropriate, solutions haggled over by increasingly divided factions. On its Issues Update page the Illinois Retirement System (a much smaller behemoth than Calpers) explains the “public debate” this way:
In recent months, while reporting on the financial problems faced by Illinois and other states, several news organizations, including the New York Times and Fox News, have focused attention on public pension systems throughout the country as one reason why states are facing multi-million-dollar revenue shortages.
The common thread in these stories is that public pensions are too generous, are mismanaged, make too many risky investments and force states like Illinois to spend billions of dollars every year on retirees instead of state services, and that increases the potential for budget deficits and higher taxes.
TRS has not been immune to these complaints, but in most cases the criticisms have been outright falsehoods. TRS can refute the inaccuracies . . .
Over and above the untold millions spent annually on borrowing costs associated with bond debt, untold millions – even billions – of dollars, are going toward fees and commissions to manage and purchase investments for these various funds. For example, for FY2000 the manager fees for CALSTERS alone was $55 million. Domestic broker commissions totaled $4.8 million, and international brokers commissions totaled $11 million for that same pension fund.
While too few are aware of these assorted fees and commissions, some may nevertheless recall the scandal that arose in August 2005 after federal prosecutors raised concerns about the $4.5 million in fees that had been offered by The Carlyle Group, self-described as a leading defense contractor, to one Robert Kjellander for his help in landing business with the Illinois teachers pension fund.
A spokesman for Carlyle, of course, maintained that Kjellander’s fees weren’t unusual and in any case the average returns on these fund’s investments was at that time 45% per year. The underlying message of this was: who could complain about high fees in the face of such returns, even if the returns, themselves, had the unmistakable taint of blood and corruption written all over them? The same Kjellander had previously raised eyebrows in 2003 when he received an $809,000 consulting fee from Bear, Stearns Inc. after Democratic Governor Rod Blagojevich picked that investment house to handle $10 billion in pension fund bonds. The firm, itself, received $8 million for handling the bond issue.
Over the decades, these various CAFR funds have, when taken together, reportedly accumulated ‘liquid’ investment assets conservatively as of 1999 exceed[ing] 60 trillion dollars and as of 2010 within its continued growth over 100 trillion dollars has been reached.” This according to research done by Walter Burien, mentioned earlier.
The biggest shock per Burien’s research is that two thirds of total government income is now actually coming from non-tax sources, with major revenues coming from the defense industry, big pharma, big banks, agribusiness, big oil and gas, foreign currencies and emerging markets — through the investment activities of these various funds. Moreover, massive profits from these investments have led to equally massive levels of corruption, about which neither the public nor most government officials nor most of those involved in the financial industry have first hand knowledge.
The most recent example of such corruption is coming from SEC efforts to identify fraud in the nearly $3 trillion dollar muni bond market and to crack down on pay-to-play schemes that continue to infect the pension fund arena. While traditional pay-to-play schemes have “involved securities firms providing campaign contributions or other benefits to government officials to obtain underwriting business . . a new wave of pay-to-play has now been uncovered in numerous states, including New York, California, Illinois, New Mexico, and Kentucky, where firms provide kickbacks to individuals at public pension funds in exchange for an agreement to invest capital with the securities firm.”
One example of such pay-to-play schemes came to light as a result of New York Attorney General (now governor-elect) Andrew Cuomo’s investigation against several individuals in the New York State Comptroller’s office, including former Comptroller Alan Hevesi. The investigation was concluded last October when Hevesi pleaded guilty to accepting almost $1 million in kickbacks. In exchange for the kickbacks Hevesi admitted that he had approved $250 million in pension funds investments with a California private equity firm. For its part, “[t]he SEC has filed its own pay-to-play case alleging kickbacks against Hevesi’s former deputy comptroller and a top Hevesi political adviser, which is still pending, and is also reportedly investigating the pay-to-play practices at CalPERS. ”
Such scandals notwithstanding and as Gerald Klatt clearly pointed out, the single biggest problem associated with the manner in which various CAFR fund categories are handled is that the majority of fund-associated investments — including foreign companies and currencies, derivatives, and multi-national corporations — actually draw much needed money away from the community and into the international arena via the financial economy. Profit-making government owned corporations involving the development of community projects such as golf courses and community swimming pools are another part of the mix, but again, the focus is squarely on profit-making rather than broad-based community service. Moreover, and since these community projects are virtually always privately financed, the financial economy again benefits far more than the local community which must pay not only the debt principal and all associated project maintenance and oversight costs, but also all interest and fees associated with the debt as well.
All of which means that the local economy loses while the financial economy wins BIG TIME, effectively diverting Mr. Bernanke’s QE2 “money” spigot away from Main Street and toward Wall Street yet again. Moreover, and given the fact that Mr. Bernancke’s “money” spigot depends on credit creation, it is difficult to imagine how Main Street citizens, whose wealth is being siphoned out of the local economy through government investment accounts and bond debt, can recover enough to benefit. If by some miracle or other QE2 (or 3 or 4) should take hold and trickle down into the real economy, there is that pesky question concerning the debt it creates — which must, of course, ultimately be shouldered by citizens.
Debt, itself, is a dramatic indicator of the depth of Main Street woes. Unimaginably massive as the federal debt may seem and troublesome as state debt appears to be (assorted investment pools aside), all is positively dwarfed by total private debt, particularly that of ordinary individuals whose household debt-to-income ratio reached an all-time high of 133% in 2007 after having doubled over the previous twenty-some year period. This at the same time that personal savings declined.
By late 2009, millions of homeowners who had been using their homes as personal ATM machines were financially shattered by the bursting of the housing bubble. As inflated home prices went into free-fall, households began to deleverage — both unwillingly through default on mortgages and more or less willingly as a result of job uncertainty. The same uncertainty is forcing domestic businesses to deleverage and banks to tighten their lending practices. According to economist, Gary Shilling, and others this deleveraging is likely to last for a decade or more.
Massive deleveraging has led to a shrinking jobs market which, in turn, has increased the demand for student loans. These loans have been adding to household debt at the same time that consumers and households have been paying down credit card debt and otherwise deleveraging. So huge has the student loan market become that, for the first time in history “the total balance of student loans has just surpassed the total balance of credit card debt…..The bad news, of course, is that student loan debt is much more severe than credit card debt, because it can’t be discharged in bankruptcy.” For those who find they can’t manage their loans, the only recourse is default. With defaults averaging 40% and higher for these students, a student loan bubble is emerging.
Ultimately the bursting of this bubble, like the housing bubble, will lead to less, rather than more, lending to individuals, a situation that would further dampen Bernancke’s effort to get the Main Street “money” spigot satisfactorily flowing. Even the banks take a hit in this kind of situation. Whether the student loan bubble bursts or deflates slowly, the collective overload of private debt combined with declining credit scores and a stagnant jobs market means that neither banks nor borrowers will be willing or able, as the case may be, to pull their share of the load in getting the economy back on its feet by taking sufficient advantage of “easy money” Fed policy.
For its part, Congress — whose stimulus projects (with the possible exception of the recent tax cut bill) are being met with the increasing ire of a debt-weary public — likewise appears unlikely to comply with Bernancke’s plea. Similarly, the increasing clamor for austerity does nothing to help open the Main Street money spigot and so mere weeks after the Fed announced QE2 last fall, whispers of additional rounds of easing had already begun to surface. These whispers are particularly noteworthy because QE2, while staunchly defended by Bernancke, had met with a firestorm of criticism from as far away as Brazil, Germany and China as well as here at home.
The problem, as Nobel-prize winning economist and former Chief Economist and Senior Vice President of the World Bank, Joe Stiglitz, explains:
Money isn’t going into the American economy. The lending is actually below what it was in 2007. In a globalized economy, the money is looking for the best place to go. And where is it finding it? In the emerging markets. The irony is that money that was intended to rekindle the American economy is causing havoc all over the world. Those elsewhere in the world say, what the United States is trying to do is the twenty-first century version of ‘beggar thy neighbor’ policies that were part of the Great Depression: you strengthen yourself by hurting the others.
This criticism, whether justified or not, pinpoints a crucial fault line inherent within our current monetary system. This is to say, how can the Federal Reserve, as the nation’s designated monetary authority, balance the internal needs of the world’s largest — and menacingly weak — economy with the inevitable impact that that economy has on the global economy, all through a monetary system precariously built on debt?
Stay tuned for our conclusion.
- The legal status of municipal corporations was first settled by the U.S. Supreme Court, in the 1819 decision Board of Trustees of Dartmouth College v. Woodward. Here the Court “invented a legal distinction between corporations chartered by states. Ruling that a charter granted to private citizens for personal interests is not a conveyance of privilege from the sovereign (which now meant the People and not the king) to the incorporators, but rather a contract between the state and the incorporators, the Court argued that the state could not change, limit or revoke the charter once issued. To do so would be to violate the Contracts Clause (Article 1, Section 10) of the U.S. Constitution, John Marshall’s court argued. Henceforth, private business corporations would have an increasing share in American sovereignty. Business corporations gained legal independence from state legislatures as a result of the Dartmouth College case. But this ruling played-out quite differently in terms of public corporations, like municipalities… Municipal corporations have no incorporators other than the legislature itself, claimed the court. Neither the people living within the jurisdiction of the municipality, nor the local governing officials were recognized as the legal recipients of a charter from the state. In fact, residents living within a municipal jurisdiction were deemed to be mere “tenants” of the municipality. Therefore, although the state legislature could not presume to govern the actions and behavior of a business corporation, once chartered, the state could unilaterally change municipal boundaries, revoke or impose local laws, or even dissolve the municipality unilaterally, according to this long-standing theory of corporate law. It is supported by precedent that has little opportunity to gather dust as it is regularly pulled from the shelves by corporate attorneys and state judges who argue for the sanctity of a legal tradition that denies the fundamental right of people to govern themselves in the places where they live.” (Emphasis mine) [↩]
- Here is a “list of the 276 most populous incorporated places in the United States. As defined by the United States Census Bureau, an “incorporated place” includes a variety of designations, including a city, town, village, borough, and municipality … PLUS a list of the 7 incorporated municipalities (municipios) of Puerto Rico with a population on July 1, 2009, greater than 100,000 as estimated by the United States Census Bureau, and the rankings they would have if included in the above table.” Note that the preceding is a list of only the “most populous” incorporated places! [↩]