Monday, September 27, 2010

School Districts Becoming State's Banker: Danger Ahead

Friday's Strib carries a story that the state budget office announced earlier this month that it's tapping K-12 education funding for $142 million. The way this works is that money that should be paid out of the State treasury to school districts to meet payroll and other expenses will be held back. School districts will still have to meet their payroll, of course, but they will have to go into their reserves to pay for them. The state will "owe" the unpaid funds to school districts, but pay them at some undetermined time in the future, possibly in May of next year. This is actually a drop in the bucket: the state has already delayed payments to school districts totaling $1.9 billion. So what's another $142 million?! The State is using school districts as a bank, but a bank that makes loans, interest free, with no payment due date, and on demand.

This is a form of deficit spending. The state is causing school districts to spend more than the state is currently funding. But, under the Minnesota Constitution, the State is required to balance its budget. What that means is, of course, that the State of Minnesota cannot borrow (or bond) to keep its operations going. The State can borrow to build a bridge or road, because bridges and roads are capital assets that last over a long period of time. So, the authors of our Constitution deemed it appropriate to allow the State to borrow for road and bridge building over a long period of time (borrowing by issuing long term bonds), just like you might borrow to buy or build a house. When you borrow to build a capital asset, your liabilities go up, but your assets go up as well. So you haven't reduced your State's financial position.

On the other hand, borrowing to pay for current operations was deemed dangerous by the authors of our Constitution, because the legislature might be tempted to spend more than it was willing to tax for. But in recent years, the leadership in St. Paul has re-discovered an evasion of this Constitutional principle. Instead of borrowing by issuing bonds, they tell school districts to borrow instead. And so, all over the State, when teachers work for school districts, they will be paid with funny-money, funny because the school districts will pay the teachers with money borrowed through the issue of aid anticipation certificates, a form of short term bonds, or by drawing down their reserves. Now because interest rates are low right now, these aid certificates carry relatively low interest rates. But even so, the cost of this borrowing device can mount. Anoka Hennipen School District has already made $400,000 in interest payments this year.

To be technically accurate, some of the borrowing isn't strictly borrowing. Because some school districts have large unreserved fund balances, and the State can draw on these fund balances--suck them up as it were--to assist the State in its operational budget. One has to consider the probability that at some point a Governor who doesn't much care for paying these funds back, will decide that these school districts had too much money in the first place, so why pay it back, ever.

Now as the State digs itself deeper and deeper, and school district borrowing mounts, the risk to the State's financial viability increases. Republican Governor candidate Emmer has stated that if he is elected, the State will not begin to repay these state-forced loans until 2014. That allows him to tell the public that he has a plan to hold school districts harmless and still avoid painful taxation. But there is a grave danger in continuing to go down this path.

The success of this aid shift routine all depends upon continued low interest rates, and currently short term bonds are drawing extraordinarily low interest rates. But what will happen to the cost of this borrowing if the interest rates rise significantly? The State is playing a dangerous game here. If we continue to borrow and shift, we become addicted to it, because its so easy to make people happy when you can provide government services going without having tax for them. People are very angry about taxes right now. They also get angry if we increase class sizes, or cut back on nursing care assistance, and so on. So the solution is to find tricky ways of borrowing that don't technically violate the constitution. The risk will mount that if interest rates rise precipitously, the cost of this borrowing will rise extraordinarily and the house of cards will collapse.

Municipal bond interest rates, and related interest rates are now at historical lows. At any time in the next months or years, those rates could rise significantly. When that happens, the value of currently issued long term municipal bonds will fall precipitously, and the cost of new issues of short and long term borrowing will also rise precipitously. At that point, the folly of our current delusional finance system will become manifest.

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