01 April 2013

Damn the finances! Full spend ahead! #nlpoli

We don’t know precisely what economist Wade “the Can-Opener”  Locke is doing to earn his loonie from the Newfoundland and Labrador taxpayers.

Finance minister Jerome Kennedy hired him this year to give advice on how to manage the province’s financial mess.  According to the Telegram his contract caps of his pay at $75,000 for a couple of months work.  Locke says regardless he’ll only bill a dollar.  That’s decent of him given that the university is giving him 80% of so of his usual paycheque now that he is on paid research leave from his usual job.

Locke has given the provincial government advice before on everything from Equalization to the annual budget to Muskrat Falls.  We don’t know what, if anything, he got paid for those other stints, but that’s really neither here nor there.  The thing is that Locke is closely tied to the current administration and to what they are doing.

We may not know what else he has been doing the past few weeks but Kennedy released a short memo Locke sent him on March 25, the day before the provincial budget.  It’s a telling little document in many ways.

A Structural Finance Problem

For starters let’s understand that the provincial government has a serious structural problem on its hands.  “Structural” means that the government spending will produce deficits regardless of how much cash is coming.  The fact that some revenues are currently dropping just highlights the problem.

In a nutshell, the source of the structural problems are easy to identify:
  • An aging population will demand increases in health care and other services that are already sucking up huge chunks of the budget. [2008: Hebron and old people]
  • We are heading to a period where the resident workforce will likely be smaller than the resident dependent portion of the population.  That means that the workforce will have to be more productive than in the past to generate the kinds of revenue government needs from all sorts of taxes. [2007:  Buzz kill]
  • Government has been spending all of the one-time cash from volatile – and hence unreliable - oil royalties.  The huge boost in spending after 2005 is all built on oil. [2013:  The debt is passed]
  • Despite a temporary increase in production within the next couple of years, oil production will decline.  Prices will vary unpredictably at the same time.
  • Newfoundland and Labrador has a political culture that encourages over-spending. [2013:  The origins of rentierism]
  • The provincial economy is heavily dependent on the added oil-fuelled spending to the point where the provincial government cannot cut without creating significant economic and political problems in many parts of the province. [2010:  …and two steps back…]
  • In addition to inflationary pressure from private sector projects, the provincial government is ploughing ahead with the risky Muskrat Falls project.  That will further escalate costs in the province, including costs of the project. 
  • At the same time as all that, the provincial government is committed directly to more than $3.0 billion in new spending for the equity stakes on offshore oil project and for a chunk of Muskrat Falls.  Once it is in production, Muskrat Falls will drain an average of $450 million in potential tax revenue from the provincial economy each year.  That may cover the project costs but the tax increase will only generate modest amounts of new money  - theoretically – for provincial coffers until sometime around 2050. [2013:  Delayed dividends, more equity needed]
  • The provincial cabinet expressly, explicitly and decisively rejected any suggestion that any oil money be used to set up income stabilization funds, to create revenue-generating investment funds, or be used to pay down debt. [2007:  Spend ‘em if ya got ‘em]
Increased costs and limited new revenues that likely won’t match the increases, with the potential for revenue declines, coupled with a specific rejection of ideas that would have produced new income for the provincial government.

That Was The Plan

As difficult as it might be for some to realise, that was the government plan.

All those details have been known in this province for a couple of decades even if they haven’t been generally known in public.  The new elements, like the equity stakes, certainly came with predictable features that changed the provincial government’s cash flows negatively.  SRBP has written about it before.  The links at the end of each bullet above is to a previous SRBP discussing the issue.

Where the provincial government is in 2013 is where the current administration’s plan led.  The cabinets who backed it may not have realised some of these details but to one degree or another, all of this was predictable and, in many respects inevitable.

The Coping Plan

While Locke and others talk about a plan to fix the structural problem, their actual plan is merely to cope with the short-term income shortages. They have no plan to deal with the structural problems. They’ve described their short-term plan over the past couple of years and the past couple of budgets show the plan at work.
  • Government will budget for annual deficits of about $500 million (accrual)/$1.0 billion (cash), if necessary.
  • The money to cover that deficit will come from borrowing.  That is, government will borrow from lenders, as Tom Marshall said in 2012, or government will take money out of temporary cash reserves, with no apparent intent to re-pay that own-source borrowing.
  • Government will make up any shortfalls beyond that deficit level by cutting spending in one area and shifting the spending to other areas. 
They are basing this coping plan on the expectation, based on Locke’s advice, that oil prices and production will generate significant additional cash within the next two to three years.  That’s implicit in the shifting forecast of some years of deficit followed by a (theoretical) return to surplus.  You can see it, as well, littered throughout Locke’s memo.

The initial forecast of two years of deficit as since been revised to three.  In 2012, finance minister Tom Marshall announced an anticipated a deficit of $123 million (accrual) in 2013.  That has now been revised upward by a factor of five to more than a half billion dollars.  The 2012 deficit almost doubled from $258 million to about $430 million.

Note as well that the coping plan is entirely tactical,  i.e. short-term.  The coping plan doesn’t address any of the structural - i.e. strategic, long-term - causes of the financial problem.

Stick to what you know

Tellingly, the first piece of advice from economist Wade Locke is about an area he knows nothing about:  communications.  He gives Kennedy a supposedly simple way to explain what being a “have” province is as a way of coping with the issue of a “have” province also having a financial problem.

Two things about Locke’s advice:

First, the communications problem Locke refers to as a “misunderstanding” by ordinary folk is a direct result of government communications since 2009 that heralded “have” status as meaning something far more than what it ever meant.  Locke is now saying publicly what others have been saying for years about the 2009 charade the Conservatives planned to celebrate with a party.

The problem for Kennedy is that Locke’s explanation of what “have” means is both tortured and unhelpful.  Locke’s advice doesn’t address the fact that the Tories – and Kennedy himself – as finance minister said something that sounded much different.  Locke’s advice emphasises the huge credibility gap between reality and what Kennedy and his colleagues have said all along.

Second, Locke relies on a falsehood as part of his explanation:  “This [fiscal problem], in turn, requires the province to reduce its expenditures to a more manageable level that is in line with its revenue expectations.”   Government doesn’t plan to reduce its spending.  In 2013 government plans to spend as much as it did in 2012.  Any accounting discussion of how inflation factors into this is totally useless in light of the fact that thousands have either been laid off or will be in the future but spending stays the same.

People who are supposedly having a hard time understanding the subtle nuances of Equalization aren’t likely to grasp the notion that while two numbers are the same, the second one is actually less because there’s no allowance for inflation.

Stay the Course

Locke then turns attention to praising the plan he helped create. 

It is “Balanced, Flexible and Possessing the Right Degree of Specificity.”

The elements are:
The short-run goals are, for example, deficit reductions within the first two years; an operational efficiency review of the Regional Health Authorities; and a post-secondary education review.  The medium-term objectives are to return to budgetary surplus within three years and to review pensions and post-retirement benefits.  The long-run target is to bring the province’s net per capita debt gradually down to the all-province level within ten years.
Let’s take that last one first.  Government’s strategic goal is to rely on the same net debt fallacy that has helped mask the current financial problem.  This is not a plan so much as a continued game of smoke and mirrors.

Then there is the plan for two to three years out, namely a “return to surplus”.  This is not so much a plan as a hope entirely based on an expected return of oil revenues.   The revised forecast of two to three years back to surplus is the same one government announced last year and they are already two years behind. The deficit didn’t decline and the surplus is supposedly now going to take an extra year to find.

The retirement benefits “review” is tough to manage politically since tens of thousands of voters rely on the benefits either today or plan to rely on them in future for their income.  Heading into an election year, the odds of government cutting the unfunded pension liability by anything but normal market valuations are slim and none.

You can say much the same for the health program review. The fact that government is pushing off the big money problems until later is a good sign they really aren’t interested in tackling it.

At the end of this section, Locke notes that the overall government plan is wonderful because it offers the “ability to alter the specific initiatives adopted in any given year and to not be locked into an arbitrary and mechanically-derived schedule for reducing deficits and debt.”  He launches into an entire paragraph lauding the virtue of having a statement that says where you would like to go but that allows you to go somewhere else if things don’t turn out as you had hoped.

What will happen then?  Locke doesn’t say because the plan has no firm objectives.  Everything in the plan is elastic. It is this malleable firmness, this unspecific specificity that Locke finds so compelling.  Presumably, someone will figure out what to do next when we get there, presumably, just as government has already shifted its targets and forecasts. 

Locke uses lots of weasel words of the sort politicians love to hear.  “Best interests” is the best example.  Pols and their supporters like Locke can rationalize any changes in their commitments as being in the best interests of the people.  Not surprisingly, “best interests” is the excuse the current administration has used for their systematic mismanagement and overspending that caused the current mess.  If they haven’t pointed to an imaginary world they inherited that required salvation through spending in the best interests of the people, then they note that the recession compelled them to continue their admitted unsustainable overspending after 2009 and every year since.  More best interests, dontchya know.  And the current deficits and future deficits, as Locke’s current projections prove to be as accurate as his recent ones, will all be explained away blithely with the same reference to “best interests.”

Locke has devised a strategic plan unhindered by having a defined objective and as such it is neither strategic, nor a plan.  Where are we going?  the people ask.  Over there! Wade says.  And how will we know where there is? they inquire. I’ll let you know when we get there, says Wade.

This is a plan in the same way that a caricatured economist develops a projection:  it is based entirely on assumptions that are subject to change at any moment.  Just as such nonsense can never be wrong, it can also seldom be right as a guide to any action.  Had government hired a psychic from a late night infomercial, they couldn’t have done much worse.

Then Locke turns to debt and deficit plan, which he praises as the “right” choices.
It is important that you set a 10-year target to bring the province’s finances in line with a net debt per capita target that matched the all-province average net debt per capita.
Locke lays out the potential threat of the debt and deficit by noting that more debt servicing  will eat into money that could be better spent on delivering programs and services.

That’s true, but here again, Locke’s comments are so vague as to be meaningless.  Is the net debt per capita target the 10 province average in Year 10 or the same average for Year One?  No one has said, least of all Locke.  If, as we might easily suspect, Locke is talking about the future goal, then we clearly have a moving target.  Locke’s comments and the “plan” itself are subject to all the vagaries, unknowables, and imponderables implicit in trying to aim for something without having the foggiest clue where it might actually be and then closing one’s eyes for good measure.

If the debt target is the current one, there’s no sign of whether they mean this year or a year or two ago when they first announced this “plan” to meet a target for net debt.  If we are talking about the average net debt today, then today might turn out to be the sort of moving target these politicians have loved since the days of Tom Rideout.

This plan – with no firm targets and no firm actions – is what Locke praises as “an optimal and balanced strategy for the current economic environment.”

Current environment.

That’s really a clue to what Locke and the provincial government are  thinking.

Surpluses for Muskrat Falls

In general, Locke’s memo contains all the internally-contradictory thinking inherent in government planning thus far.  The plan sets no limits and yet Locke praises the fiscal “discipline” the plan will bring.  Locke does recognise the problem inherent in their approach, even if he does nothing to show how to guard against it:
when surpluses start to manifest themselves again in three years, as they are expected to under this plan, it will be relatively easy to slip into a “big spending” mentality.
Indeed, it will and Locke’s rationale thus far, complete with the loose language and the “best interests” caveat provides enough off-ramps to guarantee the big spending mentality can continue unhindered. 
Just before he says that, though, Locke tells you that the “surpluses …will be allocated in part to strategic and necessary infrastructure investments…” - code for Muskrat Falls -  “with the residual surpluses applied to reducing net debt per capita to the all-province average within 10 years.”

Debt reduction is the secondary goal.   The primary reason for generating surpluses is to make cash available for the government (and Locke’s) pet project at Muskrat Falls. 

And, of course, actual debt reduction is not the government/Locke objective either.  Locke keeps talking about net debt.  But that is just an accountant’s calculation of assets minus liabilities. It doesn’t affect annual debt servicing costs that, as Locke notes earlier on, can eat into cash that would be better spent delivering needed services and programs.

The Net Debt Fallacy Again

Debt servicing costs are influenced by things like the interest rates on the debt and the total amount of debt.  The 2013 debt servicing cost is forecast as $357 million compared to $550 million a decade ago.  It’s been higher than that in the meantime, based on roughly the same amount of money.  What government has been doing is refinancing existing debt at lower interest rates. 

That drops the annual cost somewhat over time, but the debt and its cost is still there.  The annual interest payments aren’t affected by any assets  - part of the net debt calculation - any more than your mortgage payment goes down every year when the value of your house goes up.  The inherent absurdity of Locke’s comments on debt and debt reduction are glaringly obvious.  As obvious as it is, though, Locke confuses the two issues throughout this document, drawing wrong conclusions as he goes.

Less Analysis, More Hucksterism

The rest of Locke’s memo focuses on specific issues that are more political than analytical. Here again, we see Locke’s love of playing around with words and his emphasis on subjects that are truly outside the scope of his professional competence.  The guy’s an economist and yet he sounds, in places, like a huckster.

Locke’s assessment of government revenue sources – taxation – argues for the status quo.  At the same time, he is unhindered by an apparent needed for internal logic and consistency. 
It is also important to note that these industries [that some want to tax more heavily] have been the driving forces behind the current prosperity that have generated huge revenue for government, facilitated weekly wages that exceed the Canadian average, created historic employment levels, instilled consumer and business confidence at unprecedented levels and created growth in the housing and new vehicle markets to levels never imagined previously. 
Locke does not note that the “unprecedented levels” are also unsustainable levels that have precipitated the current crisis.  He also does not note that the 2007 energy plan commits the government to introduce new oil and natural gas royalty regimes designed expressly to increase the public share of oil and gas revenue. 

Locke discusses the question of oil prices and production, a public issue related to last year’s increased deficit.  Pay close attention to why Locke is concerned about this issue:
It is important for planning purposes to pick a price that is neither too high nor too low.  A price that is too high will likely generate optimistic estimates for royalties and oil-related corporation income taxes tax cannot be met in reality.  The consequence of this is that the realized deficit will be larger than estimated at budget time.  This will influence people’s perception of the credibility of the sustainability plan and reduce their acceptance and buy-in of meeting the long-term debt target.
The problem is not so much that getting the numbers wrong will produce wrong budget projections.  It is that frigging it up will undermine government credibility. He is right, a loss of public confidence is one result of making a big mistake in forecasting or from making a distorted and misleading presentation on a project like Muskrat Falls, for example.

In this instance, Locke argues for using an average number over a period of time. That approach doesn’t avoid the potential that the forecast will be wrong in any one year.  The forecasts are predictions, after all, and no one has a lock on getting it right, least of all Locke himself.  No matter what method they have used over the past decade, the provincial finance officials have gotten their forecasts wrong just about every year. The only issue has been how far they are wrong.  They have been no better at forecasting surpluses that they have at deficits.

Rather than focussing on the accuracy of forecasts, one could avoid a credibility problem by explaining to people clearly, in advance, what the range of possible outcomes are. One could design a plan that did not rely – as the recent Conservatives have – in predicting the unpredictable. Locke has his clients on a fool’s errand. 

What’s more, credibility is directly related to truthfulness. What tends to destroy credibility is claiming to have a plan when one doesn’t, or talking about cuts to spending when spending remains the same or rises. 

The other part of the Locke’s hucksterism comes in his preference for words rather than analysis and clear language.  He loves phrases like Prosperity Plan, for example, or Sustainability Plan as if a good name for something was good enough.  You can see the same tendency in section headings in this memo: 
  • Minimizing the Maximum Damage, While Setting a Sustainable Course for the Future.
  • Picking Prudent Oil Prices for Planning Purposes.
By the time you reach the end of Locke’s memo, you realise that these superficial phrases are just about all that it contains.

You also realise that if Locke bills taxpayers a buck for all that, we still got ripped off.


Coming up on Tuesday (7:30 AM):  The Road Not Taken

Had the provincial government applied a sound financial strategy almost a decade ago, they could have achieved much and avoided the current financial crisis.  SRBP will show you the path not taken and compare the current situation with the results of taking the other route.