Clever use of debt enriches debtors

It seems certain beliefs come hard wired - from the idea that imports destroy jobs (in the long run they help create them) to the idea that “the government should do something” in response to every possible social and economic ill.

Yet economic reform has taken on those fallacies. As a result we don’t regulate rents, imports, bank interest rates or fees, or shopping hours. And we’re much richer for it.

But though an informed economic framework has triumphed generally, in one area policies have gone backwards - driven by plausible populist economic fallacies.

This is the reflex aversion to debt.

Of course other things equal who’d want to owe someone money? But we borrow not for the sake of it, but to achieve greater benefits than the cost of the loan. Who would escape their mortgages by selling their home?

Governments used to do what companies and households still do - borrow to build assets. Of course the scope to spend money with future generations paying the bill can tempt governments into bad projects and unsustainable borrowing to consume.

But rather than build the institutions to independently vouchsafe that debt is funding high quality assets rather than consumption or pork barrelling we simply got a bi-partisan political reaction which anathematised debt.

That’s produced debt reduction strategies variously good, bad and ugly.

Governments sold some assets - which is good where the private sector is a better manager. But reducing debt by under-investing in infrastructure is bad. And things turn ugly when governments use Enron-style accounting to push debt off the books with private financing which involves higher future payments of taxes or charges, inadequate risk transfer and/or dodgy undertakings - for instance to divert traffic onto new privately funded roads. Quick trip under the city anyone?

The Owen Report recently recommended substantial privatisation of the electricity industry. When approached by the New South Wales unions, we insisted that we wouldn’t oppose this recommendation per se, but that we were as ropable as they were about one of the arguments used to justify it.

Remember how we were reducing state debt? Well debt’s now increasing - but we still haven’t institutionally safeguarded the extent of borrowings or the soundness of the projects it’s used to finance.

Instead we’ve got the State government’s commitment to retaining its AAA credit rating. In fact it’s clear that NSW can hang onto that rating as well as the electricity assets it already owns. It can very probably fund the industry’s $12 billion expansion as well. And if it was unsure it could either have this privately supplied or build new assets in a form that could be sold if and when it became necessary to protect NSW’s credit rating.

But whether or not there’s a legitimate case to privatise the electricity industry on productivity grounds, if NSW were being run like a prudent business, it would use the strength of its balance sheet to expand its investment in assets which generate higher returns than the interest cost of funds it borrows.

And as would occur in the private sector, the decision about what credit rating to target would emerge from a proper financial analysis taking into account the costs and benefits of securing AAA rather than populist political posturing.

As Professor John Quiggin puts it:

A government will generally improve its credit rating by forgoing investment opportunities, even if the investments have an expected rate of return well above the cost of capital. The same is true for corporations, and it is one reason why very few corporations now seek to maintain a AAA rating - the cost in terms of foregone investments exceeds the benefits.

If NSW took a single downgrade - to AA which Standard and Poor’s describes as “very strong” - differing in strength to AAA “to a very small degree”, it could massively increase its investment - providing it was for prudent, productivity enhancing, growth enhancing investment. Whether or not it retains its electricity assets, I'd like to see it borrow to fully fund its superannuation liabilities, and any other infrastructure assets which proper analysis suggests are cost beneficial.

The returns would build up to billions within just a few years. Indeed Professor Quiggin calculates that rejecting the last proposal to privatise the industry in 1997 has already netted the NSW public sector about $5-10 billion.

That’s not to endorse the loose practices of the past or to oppose privatisation per se. I’ve argued elsewhere for greater independent scrutiny or even control of both the operating and capital aspects of the budget. Governments fear this for the disciplines it would impose. But they would be different and better disciplines than those of the rating agencies. They might encourage higher surpluses now, but if there’s a downturn they would better enable governments to justify and prudently maintain the substantial deficits that are warranted in such circumstances - deficits the rating agencies won’t fancy.

If a substantial part of the Unsworth Committee’s justification for privatising electricity assets is protecting NSW’s AAA credit rating, you’ll know they still don’t “get it”. I'm guessing that if you wait for hours each week in traffic jams or pay mortgages inflated from lack of infrastructure on land on which we could otherwise have built more houses you probably “got it” some time ago.

The Government speaks of the privatisation as building for the future. Perhaps. But AAA or no, I'd rather face the future without a financial structure best suited to a retired couple.