Hurricane Katrina confirmed the power of nature to destroy the built environment. This built environment includes the capital assets of government, especially the infrastructure items of roads and highways; water and sewer systems; bridges; canals, waterways and levee systems; educational facilities; and other government buildings. Public infrastructure plays a key role in econom- ic growth and productivity. New Orleans is a vivid reminder of what happens to a community when its public infrastructure disintegrates.
This devastating event helps focus our attention on fiscal federalism, or the financial relationships between central and sub-national governments, and among those sub- national governments. By sub-national government, I mean Canadian provinces and their municipalities and, in the US, the states and their local governments.
Federalism carries a bias for decen- tralization, and that is consistent with theory and practice. However, efficiency is not the economic principle that comes to mind when we think about govern- ment budget decisions. A major policy question for both countries is the extent to which higher levels of government respond to local infrastructure needs. As we see on the American Gulf Coast, there is a desire to get others up the federal hierarchy to bail-out local governments.
In contrast to hierarchy, markets are efficient mechanisms for allocating resources. In terms of capital markets, self-interested borrowers and lenders approach each other with opposite goals. The borrower wants money at the lowest cost, while the lender wants the highest possible return. Institutions and rules help bring these two diver- gent positions together into a complet- ed market transaction.
Sub-national governments in the United States and Canada have long enjoyed the power to enter capital markets to finance capital assets and, in some cases, to finance operating deficits. A key policy question is how do sub-national governments navigate the market place to obtain money at an acceptable price within the confines of a federal form of government? Moreover, the loss of the most recent ”œbattle of New Orleans” raises the stark question of how a communi- ty without a tax base can pay for its come-back through market mecha- nisms. The quick answer is that gov- ernments have never relied solely upon markets, so why start now?
This article examines the role that hierarchy and markets have on the provision of infrastructure in our two countries. While New Orleans is expe- riencing an infrastructure crisis unlike any other in North America, the mis- match between needs and funding is not confined to a disaster zone. I want to link these two areas. First, I will clar- ify key differences between US and Canadian sub-national capital market practices. Then, I will examine the role of market and hierarchy in dealing with the infrastructure crisis of a disas- ter zone. Hierarchy and markets have a role, both in the New Orleans stress case and in the normal course of gov- ernment finance in both countries.
Infrastructure is more than long- lived physical assets (such as roads, bridges, water systems, schools and air- ports) owned by governments ”” although that is the standard defini- tion. As recent events (from 9/11 to New Orleans) illustrate, critical infra- structure extends beyond that owned by government to include privately owned energy and communications systems essential for a functioning society.
In 2001, the C.D. Howe Institute published a study advocating a broad definition of infrastructure to include ”œthe physical and human capital that broadly facilities production, con- sumption, and further investment.”
Based on a more traditional defini- tion, research conducted for the Infrastructure Canada program calcu- lates that the public infrastructure gaps in Canada and the US are comparable when adjusted by population.
In both countries, higher-level gov- ernments are looked upon as the pre- ferred funding source for locally conceived projects, and the national governments of both countries have responded with limited programs. Getting others to pay for one’s needs and wants is an ageless desire. A current example concerns who will pick up the price tag for the clean-up and recon- struction of New Orleans (and other devastated areas of the Gulf Coast).
Markets can supplement federal- ism. A key advantage of debt markets is that these competitive, risk- bearing institutions are less prone to accept questionable projects and weak financial plans than are politicians up the federal hierarchy. A corollary that most politi- cians forget is that markets reward the strong and penal- ize the weak. They are not a redistributive mechanism.
Since the early 1990s, Canadian provincial and municipal governments have changed their capital market behaviour. That decade started with aggressive debt accumulation to offset balance sheet deficits, debt placement with internal pension accounts, and extensive for- eign borrowing for both general gov- ernment and hydro-electric operations.
Net debt reduction is the current practice along with a winding down of private placement in government pen- sion accounts, the deregulation of hydro-enterprises, and a crowded (tax- able) domestic capital market. Moreover, there is a renewed focus on the need for infrastructure financing, of which the federal Infrastructure Canada program is a good example. Canadian provincial and municipal governments continue to use direct and guaranteed bonds (both, in essence, general obligation bonds).
In contrast to Canadian changes over the past decade, there has been little change in the basic US trends during the same period. American state and local governments continue to issue what are termed ”œmunicipal securities” ”” all in their own domestic tax-exempt capital market.
US federal tax laws specify that the interest on the obligations of a state, a territory, a possession of the US or any political jurisdiction of any of the fore- going or the District of Columbia is not subject to federal income taxes as part of gross income. This definition permits an ever-increasing number of sub-state ”œpolitical jurisdictions” (including lim- ited purpose districts) to enjoy the ben- efit of issuing tax-exempt debt
Currently, there are over $2 tril- lion in municipal securities outstand- ing. Other borrowers (namely, the US Treasury and corporate borrowers) issue debt where bondholder interest is taxable. The federal government fore- goes about $35 billion a year in the taxes that would be due on interest earned. This loss of revenue, termed a tax expenditure, is a major feature of American fiscal federalism.
This loan subsidy program was over- looked earlier in October by the Toronto- based Institute for Competitiveness and Prosperity in its report entitled ”œFixing Fiscal Federalism.” That report sought to compare US and Canadian public invest- ment spending, but somehow missed this most significant element of public investment practices in the US.
American governments are not big users of general obligation bonds that carry a legal pledge of the full faith and credit taxing power. In fact, only 20 percent of the debt volume each year carries this broad repayment pledge. The other 80 percent represents bonds that are secured by a legal pledge of a dedicated revenue stream ”” thereby earning the ”œrevenue” bond label. Examples of pledged revenues include net receipts of public enterprise opera- tions; expected receipts from dedicated local taxes (such as tourism-related taxes); agreements to pay lease obliga- tions sufficient to retire the debt on a building, facility or major piece of equipment (with or without a mortgage on the property); and obligations secured by some other type of contractual agreement.
Revenue bonds require more investor scrutiny, since the collateral is tied to specific, but estimated, revenue flows. There is no legal recourse to the general taxpayers.
In Canada, sub-national debt is direct and unconditional ”” meaning they are ”œgeneral obligation” bonds in American terminology. Traditionally, even provincial enterprises, such as the capital-intensive hydro-electric opera- tions, get to pledge the general credit of the controlling province instead of bor- rowing on its own credit quality.
How does the bond process work? Well, issuers sell their debt in an aggre- gate amount to a wholesale purchaser (typically an investment banking group), which then remarkets the bonds in smaller denominations to the ultimate investors. Canadian provincial and municipal governments negotiate the price with the fiscal agent. In America, a similar practice is followed for nearly all revenue bonds due to their unique ”œsto- ries,” but ”œplain vanilla” general obliga- tion bonds usually require an auction.
Who invests in these bonds? Most of the US municipal bonds are held directly by households or in retail-trad- ed financial instruments. I have not confirmed the details for Canada, but there are differences regarding at least two classes of institutional investors.
First, pension plans in America (including the social security trust fund) have no economic incentive to invest in lower-yielding, tax-exempt securities. Thus far, legislative proposals to create an incentive program have failed.
In contrast, the Canada Pension Plan, for example, offers a pool of patient capital that has been used to invest in provincial bonds (since they are priced higher than the federal government’s bonds). Some of the CPP’s holdings are placed there by quota, and others are purchased on the open market. Of course, it is best to have an arms-length arrangement in order to avoid market-making manipulation, as happened with some provincial pension plans in the past.
A second type of institutional investor is the financial inter- mediary that fosters home ownership. In this country, the Canada Mortgage and Housing Corporation (CMHC) is a significant presence in the sub-national bond market. The similar govern- ment-sponsored corporations in America ”” Fannie Mae and Freddie Mac ”” have no incentive to invest in tax-exempt securities, unless it is for social purposes. It is for that reason that Freddie Mac has announced that it will buy up to $1 billion of housing bonds from Mississippi and Louisiana, as a way to foster the rebuilding of the hous- ing stock in those states.
Default on a sub-national govern- ment debt instrument is rare. A bank- ruptcy filing covering the entire political jurisdiction is even less frequent.
Yet, in the US, 50 percent of the municipal bond volume carries bond insurance as an additional credit support. The debt issuer pays an up- front premium to provide investors with protection for the life of the bond. Bond insurance companies, in essence, rent out their triple-A credit. The bond insurer is betting that the debt will not go in default. Bond rating agencies, such as Moody’s Investors Service, subject these bond insurers to strict depression-scenario stress tests to make sure that the bond insurer can withstand multiple defaults.
Of the bonds from the disaster zone that Moody’s had immediately placed on credit watch following the hurricane, Merrill Lynch estimated that bond insurance covered 69 per- cent of the 51 bond ratings (totalling $9.4 billion). In the case of New Orleans, most of the public infrastruc- ture bonds carry bond insurance.
The bottom line is that American state and local governments borrow money in the domestic tax-exempt market at a cost of capital that since January 2000 has averaged 40 basis points below comparable length securi- ties issued by the US Treasury in the tax- able market. In contrast, over the same period, based on data provided by Scotia Capital, Canadian provincial and municipal bonds have yields about 55 basis points above Canadian Treasury instruments, because all debt instru- ments generate taxable interest. This difference in quality spread constitutes a significant fiscal federalism advantage for US infrastructure development.
So, what is Canada doing on the infrastructure front? The Canadian government’s recent infrastructure fund- ing programs ”” under the Infrastructure Canada banner ”” represent an aware- ness of the sub-national infrastructure problem. Despite this start, it is unlikely that existing hierarchical programs will relieve local communities of the need to access capital markets.
At least one Canadian financial firm (TD Bank Financial Group) dismisses a Canadian tax-exempt bond program as a viable option for addressing the infra- structure gap. The firm’s 2004 report highlights three primary concerns; namely, the loss of federal government revenue, disproportionate bene- fits accruing to taxpayers facing higher than average tax rates (thereby a regressive outcome), and the money saved by the sub- national government borrower paying a lower interest rate may not equal the federal loss of rev- enue (meaning the fiscal agent, and others, pocket the differ- ence). Moreover, the only test of a tax-exempt bond in Canada ”” the Ontario Opportunity Bond program, which provided an exemption only from Ontario income taxation ”” was termi- nated after only one bond sale. Details are needed about this financial experiment to judge its effectiveness.
I now want to address hierarchy and market options for dealing with the infra- structure crisis in a disaster zone. Most of these comments address the situation fac- ing one local government in particular, the City of New Orleans/Parish of Orleans (it is one and the same). But these com- ments generally apply to other sub-state political jurisdictions, including city, counties (or parishes), independent school districts, and other special author- ities and districts.
The New Orleans case illustrates the fragmented nature of local governments in America. In New Orleans Parish, polit- ical jurisdictions have an estimated $2.7 billion in debt obligations outstanding, with most of it not general obligation debt but rather Revenue bonds backed by a dedicated revenue source. In addition, there is about $7.5 billion State of Louisiana debt outstanding.
My framework is that a distressed city must deal with (1) increased expenditures, (2) decreased revenues or the loss of the tax base, and (3) a portfolio of debt obligations.
I assume the subject city has cut its budget, as New Orleans has done and will likely continue to do. Moreover, I assume the city will not raise the tax rate to preserve the pre-disaster revenue flow. Remember the basic tax formula: tax rate X tax base = the amount of taxes collected (assuming no delin- quencies). For example, unless the rules are changed in Louisiana, tax rates will have to go up on the remain- ing (smaller) tax base in order to cover the existing debt.
In terms of ”œincreased expenditures,” the Federal Emergency Management Agency has an existing program allow- ing the president to make contributions to repair, restore, reconstruct or replace (4R) a damaged public or nonprofit facility, and for associated expenses. This grant program covers items from debris removal to overtime of police and fire services. The federal share of assis- tance is at least 75 percent, but the pres- ident can expand that percentage. Debate now centers on the period for full funding, with an early end to it pre- ferred by those concerned about the budget impact. Devastated areas, of course, prefer a period of full coverage, perhaps up to a year.
The President’s discretion is limited by the amount of funds appropriated by Congress. In late October, it was report- ed that FEMA has only spent or signed contracts for a quarter of the $62.3 bil- lion in disaster aid that was rushed through Congress within 10 days of the hurricane.
It is unclear if President Bush can use this account to cover the cost of repairing the levees above the existing standard ”” a category 3 hurricane. To build New Orleans’ levees to a higher standard will require a new congressional appropria- tion of an estimated $3.5 billion. That decision is likely to be the subject of much debate among newly concerned fiscal conservatives in Congress, but the early expectation is that the money will be provided by Congress. Moreover, the early reports from the independent forensic engineering investigations organized by the National Science Foundation suggest that the Corps of Engineers allowed the flood walls to be built without driving the anchors, or steel pilings, down into solid ground. Instead, the pilings stopped at a shallow level where there is weak soil. I suspect that if this finding holds up, the burden will be on the federal government to cor- rect this Corps of Engineers design flaw, instead of shifting the blame or financial burden to the state or local government. There is little need for the state govern- ment to make contributions for 4R work, given the FEMA role. However, if the State of Louisiana has to participate in the funding of these programs, it will have to borrow the money.
Local governments also have the option of going to the market, but the market may not be receptive at a price that the government can afford.
Federal grant actions carry strings, whether the grants are for 4R or to meet new standards. A few lawmakers from other parts of the country have said that since Louisiana, in general, and New Orleans, in particular, has a colourful history of political and legal misdeeds, there is a need for more accountability for the federal dollars. From the very beginning of the feder- al dollar response, the federal and state governments have assigned audi- tors to keep account of the funds.
In terms of ”œdecreased revenues,” there is an existing FEMA structure for community disaster loans. The president is authorized to make loans to any local government that may suffer a substantial loss of tax or other revenues as a result of a major disaster, and has demonstrated a need for financial assistance in order to perform its governmental function. In its Katrina legislation, which passed Con- gress on October 7, Congress funded a Katrina loan program, but in a move that infuriated Gulf State public officials, Con- gress removed the traditional presidential option, frequently used, to forgive such loans. Efforts by regional interests have been unsuccessful thus far in restoring the president’s discretion for Katrina loans.
It is not uncommon for govern- ments to borrow money to get over a liquidity problem by, for example, bor- rowing in advance of the receipt of tax collections. But, the problem caused by a disaster is different ”” the tax base is ”œunderwater,” both in financial and physical terms. Borrowing against a pre- established line of credit is possible. The State of Louisiana is doing that. Moreover, one of the City of New Orleans investment banking institu- tions has provided a line of credit that even the firm says would not be possi- ble if it used normal credit guidelines.
Mississippi created a state loan pool for its local governments to access for liquidity and capital projects related to Katrina. Louisiana is in the process of setting up a similar program.
Congress has provided several avenues to deal with the need for housing and business redevelopment. I will not go into all of the details, but suffice it to say there are calls for additional programs. One model is the Liberty Bond program authorized for New York City’s Ground Zero recovery zone. This program waived certain rules that limit the way private firms can access the municipal securities market. For example, the Liberty Bond program lifted the state volume cap, exempted the bonds from the Alternative Minimum Tax, and permitted the bonds to be purchased by banks under special terms (the so-called bank qualified status). These provisions expanded the market for Liberty Bonds, thereby permitting affect- ed firms to borrow at lower cost than they might otherwise have to pay. These bonds are not backed by the government. For this and other reasons, these types of bonds are privately placed and not sold to retail investors.
Another set of programs targets the housing crisis through the stimu- lation of single-family and multi- family mortgages. FEMA has a transitional housing program that includes rental assistance and mobile homes. Under long standing tax law, state and local governments can estab- lish mortgage loan programs that are funded by housing bond proceeds and secured by mortgage repayments. The local government agency is not the ultimate obligor (payer) on these hous- ing bonds, but instead, serves as the conduit for these entities to access the municipal securities market. For the disaster zone, Congress has eased up on some of the rules.
In addition, Freddie Mac ”” a large financial intermediary set up by the national government to provide pri- vate mortgage loan liquidity across the country ”” has announced that it will buy up to $1 billion of new housing bonds from Louisiana and Mississippi, at below market rates, for the next two years. Merrill Lynch anticipates that the Freddie Mac program will ”œproba- bly absorb the total new supply” of housing bonds from those states.
If the federal government does not guarantee local debt, what can it do to help local governments such as New Orleans? Congress is likely to allow state and local governments in the disaster zone to refinance debt ”” a change in sub-national debt rules. This is termed an ”œadvanced refund,” because the old debt remains outstanding, with the new debt proceeds used to buy risk-free US Treasury securities that will mature at the yearly dates when the old debt’s principal and interest payments are due. There is a limit of one advance refunding per gov- ernmental purpose bond issue, because of the loss of federal taxes on the interest payments received by the investors of (now) two bond issues that are outstand- ing for the same capital project. After 9/11, Congress granted New York City this second refunding, and it is expected to be used for the Gulf zone too. The tax expenditure ”œcost” to the federal govern- ment is manageable, and it offers a mar- ket-based solution instead of a federal grant of money.
One possibility is the creation of a federal recovery agency like the Tennessee Valley Authority. As one of FDR’s New Deal agencies, the TVA brought electricity and economic development to the southern Appalachian Mountain area. It has had a significant impact on the region’s economy. Today, it is the largest public power company in the US.
In that vein, President Bush has proposed a ”œGulf opportunity zone,” but the details are sketchy.
Assuming Congress provides munic- ipal bond issuers a second advanced refunding, then the state and its local governments can seek to push off the repayment into out-years and free up near-term resources. Congress is likely to provide this flexibility.
Eighty percent of state and local government bonds are revenue bonds. This means that the general taxing power does not serve as collateral. Rather, a dedi- cated stream of resources is all that supports the bonds. For example, New Orleans Convention Facility bonds are backed by an excise tax on hotel occu- pancy and restaurant sales. When there is no money flowing from those sources, then the bonds are at risk. While these bonds may not have defaulted on the timely payment of principal and interest, most are likely to have triggered an ”œevent of default” by not abiding by some condition of the borrowing agreement. This is termed a technical default instead of a financial default, and it can have a negative influ- ence on secondary prices paid by investors and the cost of future borrowing by the government itself.
One option is bankruptcy. Under the US Constitution, the Congress sets bankruptcy law. There is a special sec- tion (chapter 9) devoted to municipal bankruptcy. The key difference between municipal and business or individual bankruptcy is that creditors cannot force a municipality into bank- ruptcy. Municipal bankruptcy must be voluntarily entered into, and under federal law, the respective state gov- ernment must first permit the local government to file for bankruptcy.
State and local governments may seek to borrow money, but they will like- ly face new credit criteria. Of course, those governments affected will have to demonstrate the ability to repay the debt.
But, there may be a market-wide change in the works. As noted by a recent Merrill Lynch analyst, bond-rating agencies may need to revise their credit criteria to incorporate the probability of a natural disaster striking a community. One logi- cal result would be the requirement of a contingency reserve. This would not be welcomed by government borrowers.
The private economy rests upon public infrastructure, and it is this infrastructure that must be pro- tected from nature and other risks, such as terrorism. How a federal struc- ture fosters the provision of the pub- lic infrastructure is an important policy issue. Hierarchical programs, such as Infrastructure Canada, are unlikely to solve the infrastructure deficiency. Neither is the answer to turn completely to the credit markets. While the decentralized credit market orientation in the US has not solved its infrastructure gap, the discipline of the marketplace supplements hard constitutional rules and soft manage- ment polices.
Both the Canadian and US constitu- tions are silent on the role of municipali- ties and other local governments. Each province retains a strong hand on the affairs of its municipalities, even extend- ing in many cases to a mandatory review of local tax and debt plans. In such a framework, any local financial problem is bound to be considered a problem of the province. In America, cities borrow on their own credit, meaning that the bond investors have no recourse to the state treasury. Since most municipal debt is in the form of revenue bonds, neither do the investors have recourse to the gener- al property tax. Bond insurance has fur- ther separated the investor from the plight of the underlying city credit, much less from the state, which created the city in the first place.
Unlike the stability of constitutions, capital markets are fluid, with the cost of capital changing literally by the minute. In America, globalization trends, fair trade requirements and the possibility of fundamental federal tax reform are risks to the domestic tax-exempt market for American state and local governments. Therefore, Americans can learn from the Canadian taxable market experience. Canadians, in turn, can learn about the unique American tax-exempt market and the innovative power of this decen- tralized market-based approach to infra- structure finance.
Citizens in both countries are left in awe of the sudden disintegration of New Orleans and its infrastructure. As with infrastructure questions elsewhere, the solution is likely to be found in a combi- nation of federalism and capital markets.
This article is adapted from his Fulbright Lecture at McGill University on October 28, 2005. firstname.lastname@example.org