State and Municipal Debt: The Coming Crisis? Part II

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Chairman McHenry, Ranking Member Quigley and Members of the Committee. Thank you for offering me the opportunity to testify with regard to state and municipal debt.

My name is Andrew Biggs and I am a resident scholar at the American Enterprise Institute. However, the views I express today are my own and do not represent those of AEI or any other institution.

The fiscal crisis at the state and local level has many causes. The proximate cause is the significant economic recession from which the U.S. economy still struggles to recover. However, the recession has revealed a number of underlying trends which pose dangers to the future of state and local finance and, in the most extreme cases, may cause these governments to turn to Washington, D.C. for assistance.

The focus of my work has been on financing for public sector pensions, that is, pensions provided to employees of state and local governments. Unlike in the private sector, where the traditional defined benefit pension has been overtaken by defined contribution 401(k)-type plans, in the public sector defined benefit pensions are, if not going strong, at least the predominant form of retirement income provision for government employees.

The accounting standards applied to public sector pensions are far more forgiving than those required for use by private sector pensions or those that economic theory and the financial markets would recommend. Public sector pensions are allowed to discount future benefits, which are guaranteed for workers, using the high expected rates of return on risky portfolios containing stocks, international investments, private equity and hedge funds. Private pension accounting, economic theory, and the practice of financial markets dictate that the appropriate discount rate applied to a given liability is based upon the risk characteristics of the liability, not of funds that may be set aside to fund that liability.

Put simply, public pension accounting standards encourage state and local governments to promise too much, fund too little and take too much risk with their investments. Adequate disclosure of the true state of pension financing will provide markets the opportunity to impose discipline on municipal governments and give policymakers the incentive to act responsibly with regard to these obligations.

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