With the economy sinking further on the news of drastically increasing unemployment, Scott Walker chose a particularly bad time to preach from the book of fiscal conservatism.  After initially indicating he wouldn’t accept any of the potential $800 billion in Federal stimulus funds because of his belief that only tax cuts are an appropriate way to rescue the national economy, Walker backpedaled after his quote appeared in the Journal Sentinel and public outcry questioned his commitment to county residents over his political aspirations.

Walker’s anti deficit-spending sentiment is all well and good in more prosperous times, but during an economic crisis such as the one we’re in, where private businesses are conserving cash due to the uncertainty of the situation, it’s more important for government to stimulate the economy in order to make up for reduced private investment.  For an immediate example of this, look no further than banks.    Even after receiving billions of dollars in TARP loans, most are hoarding that cash rather than making new loans because of the high certainty that their future losses on commercial and residential loans already made will require further write downs to their balance sheet.  In this situation, like it or not, the only remaining entity that can spend enough to attempt to keep the economy from spiraling down further is the government.

Walker backtracked on his comments later in the week in a letter to Charlie Sykes:

How many people would take a gift of $1,000 and go out and buy a $60,000 sports car? While the gift is nice, it will not make the monthly car payments that are too large for the average budget. The same is true with the (so-called) stimulus package.

Federal money nearly always comes with strings attached. In fact, most federal transportation grants require a 20% (or greater) local match. “Free money” sounds nice but what happens when state and local governments cannot afford the match? If Milwaukee County receives $50 million for infrastructure projects under this formula, taxpayers in the county would have to come up with an extra $10 million. Does anyone think we have an extra $10 million in this budget climate?

The first thing to note is that it has yet to be determined if stimulus funds will require the 20% local match.  Assuming for Walker’s sake that it will, his analogy to receiving $1,000 and spending it on a $60,000 car is wrong – it’s more like paying $10,000 for a $60,000 sports car.   More importantly, Walker’s argument insinuates that the county has no immediate infrastructure projects planned for 2009.   This is false.   From the recommended 2009 Capital Improvements Budget [PDF]:

Major Transportation and Public Works projects include WA094 – Runway Safety Area – NEPA Compliance ($13,221,000), WH086 – West Good Hope Road Rehabilitation ($8,305,400), WH083 – West Silver Spring Drive ($5,912,400) and WA044 – GMAI – In-line Baggage Screening Phase I ($2,815,000).

You can add the I-94 reconstruction and KRM commuter rail proposals to this list and get a better sense of the projects that stimulus money could fund in our area.  Or just ask anyone driving in the city of Milwaukee if we need to fix potholes or rebuild bridges and you’ll realize why refusing this money is a big mistake.

To most people, the seriousness of our county’s situation leaves no room for political posturing.  Walker’s spineless qualifying of his initial declaration only serves to undercut arguments made in his defense and show how transparent his stance was in the first place.

The main goal behind issuing $400 million in Pension Obligation Bonds is for the county to stabilize the funding level of the pension fund by borrowing money in order to prepay 95% of the Unfunded Actuarial Accrued Liability (UAAL) as of July 1, 2008, which is approximately $396 million.     The UAAL is the gap between the assets of the county pension fund and the expected pension benefits it will pay out.   In the 2008 budget, this amount was $329 million; as of September 2008, the UAAL ballooned to staggering $700 million due to the recent stock market collapse.

By issuing taxable bonds that they project will pay 6% interest, the county hopes to achieve an 8% rate of return from the immediate reinvesting of the $400 million bond proceeds.  Over a period of 30 years, the projected savings would be $320 million.   The immediate benefit would be a fixed debt payment of $48.4 million in 2009, rising to a stable $56.8 million payment in 2010 and the years to follow.

Is this the right time for the county to dip its toes in the waters of actuarial arbitrage?  As the Public Policy Forum’s 2009 Executive Budget Analysis describes the situation, it may not matter to Scott Walker or the county board because of the budgetary pressures they’re facing:

Failure to move forward as outlined in the recommended budget would require policymakers to identify an additional $8 million in property tax levy to fulfill the actuarially required pension fund contribution.

The main concern about Pension Obligations Bonds lies in the very narrow spread between the expected interest rate the county will pay in order to borrow the money and the rate of return they hope to earn.  In the proposed Executive budget, the county expects to borrow at 6% and invest at 8%.  At a time when the typical investor likely saw their investments take a 20-30% haircut, the idea of earning such a rate on investments may seem irrational.

In fact, it probably is.

Among investors, none other than Warren Buffet finds the idea of pension funds achieving an 8% rate of return to be illogical and practically impossible under a conservative investment approach.  In his 2007 letter to shareholders he writes:

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets
returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the
20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the
Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

As of July 2008, the Milwaukee County pension fund’s investment portfolio consists of 46.3% fixed income, 50.2% equities and 3.5% in real estate.  Essentially, the county’s pension fund’s investments are more conservative than Buffet’s typical pension fund estimation and would require an even higher rate of return on its more risky investments.   In order to achieve an even higher rate on the county’s stock holdings it would require even riskier investments.  In the rush to achieve higher rates of return, the slightest setback in the next few years would exert far greater pressure on the pension board to push for higher returns, potentially leading to even riskier investments.

Pension Obligation Bonds may be good policy for the county’s investment advisors, who stand to benefit from $400 million in new investment capital and the fees such a large amount of money will generate for them, but in the event that the County’s investments fail to yield an 8% return all we as taxpayers will have financed is a short-term delay.   For should this plan fail, the day will come when the pension fund requires an even greater amount of taxpayer’s dollars and the problem will have only been passed on to the next County Executive and put upon the backs of the next generation of Milwaukee County taxpayers.    Undertaking such a precarious strategy in order to achieve relatively minimal yearly savings requires more scrutiny from the county board and a clearer presentation of the associated risks to the taxpayers.