Vol. 1, No. 5, Published September 9, 2015
Debt: Its Proper Level, Growth and Uses
By Lynn Reaser
The concept of debt can quickly stoke emotions since its misuse has led to personal and company grief, financial crisis and national decline. Yet, it also has been pivotal to allowing individuals, businesses and nations to invest in the future. Many students have invested in education to start successful careers, young families have been able to purchase their own homes, entrepreneurs have been able to launch entire new industries and governments have been enabled to provide infrastructure to support thriving economies. Debt can be abused and it can be wasteful, but it can also be valuable.
This article looks at the trends of different types of debt and then focuses on debt issued by the State of California. By showing the actual trends and numbers, its purpose is to better inform the public and decision makers so that appropriate choices can be made.
Debt Over Six Decades
The last 60 years have witnessed major shifts in demographics along with periods of economic boom, recession and a major financial crisis. The growth of debt held by all parts of the economy -- households, business, and government -- slowed substantially from an average annual rise of 8.6 percent between 1954 and 1984 to an average gain of 6.6 percent in the subsequent 30-year period between 1984 and 2014. All of that deceleration was due to a moderation of annual inflation, which was nearly cut in half from an average of 4.2 percent to 2.3 percent.
Abstracting from the slowing in inflation, the growth of debt in real terms averaged 4.2 percent per year in the first 30 years and an identical 4.2 percent in the second 30 years. This consistent pace in the total masked substantial shifts among the various constituents. (See Figure 1.) Notably, real debt growth moderated in three sectors: business, households and state and local government. In contrast, it accelerated for the federal government. This faster growth rate reflects the rise of entitlement programs at the federal level (especially Social Security and Medicare) and the lack of a major budget constraint at the national level. The federal government is not required to formally balance its budget as are most state and local government entities, and does not face the constraints in capital markets that households, businesses and state and local municipalities encounter.
California�s State Debt
California�s debt stood at $87.0 billion as of July 1, 2015.2 This amount encompasses long-term bonds backed by the State�s general fund and includes two major types of debt securities: general obligation (GO) bonds are those approved by voters, and stood at $76.0 billion; lease revenue bonds (LRBs), which the Legislature authorizes, stood at $11.0 billion.
GO bonds are used to finance the construction of schools, hospitals, housing, highways, mass transit, parks, water facilities and other projects. Backed by the full faith and credit of the State, principal and interest payments are paid out of the State�s general fund. LRBs are also used for various public improvements, such as State office buildings, public universities, prisons and food and agricultural facilities. The State Public Works Board (SPWB) issues the bonds, constructs the facility, and then collects lease payments from the government agency using the facility. These payments are then used to make interest and principal payments on the bonds.
To view California�s debt in perspective, it is useful to look at it after adjusting for both population and inflation. In today�s (2015) dollars, real debt per capita stood at $352 in 1975 versus today�s level of $2,240. (See Figure 2.) This rise has reflected the State�s growth in school-age children and low-income households, together with the public�s commitment to providing education, health care and social services to Californians.
Personal income is an important benchmark since personal income taxes represent about two-thirds of the State�s general fund revenues. Although the ratio of debt to personal income had been trending higher for many years, during the past five years it has moved lower. (See Figure 3.) Between 2010 and 2015, this ratio has fallen from a peak of 5.0 percent to a current estimated 4.25 percent.
Comparison to Other States
Comparing debt levels between various states can be difficult and often misleading because of differences in demographics and uses of public finance. For example, some states may fund infrastructure or education using bonds issued by local governments versus state entities.
Moody�s Investors Service calculates per capita debt by state each year, based on its own definition of net-tax-supported debt. It includes bonds that Moody’s characterizes as supported by statewide taxes and other general resources net of obligations that are self-supporting from pledged sources other than taxes or operating resources. Relative to others in the group of the nation�s most populous states, California stands roughly in the middle. (See Figure 4.) Its per-capita debt burden is below that of both New York and Illinois. In contrast, its number is substantially higher than that of Florida or Texas, which some might argue are underinvesting in their futures.
How much debt is too much and what is the right level? That answer is neither simple nor straightforward. Two factors are important.
First, creditors must be willing to finance the State’s debt level. That is true for California at the present time, with the State benefiting from low interest rates and a solid credit rating (including a recent credit upgrade from Standard & Poor’s). However, this may not always be the case or creditors may require much higher interest rates to support the state’s financing demands
Second, funds raised from bond issues need to be put to work in productive ways. A careful assessment of the current condition of the State’s assets is necessary along with a ranking of priorities. As the Treasurer argues in the first article of this month’s Intersections report, it is vital that we take an inventory of California’s various assets, including its roads, bridges, and water systems, and determine where the largest gaps may exist both in terms of quantity and quality. Alternative means of finance, such as public-private partnerships, should be analyzed as a part of a possible portfolio of solutions.
All debt should not be viewed negatively, but it should be used prudently and wisely. This is true for individuals, companies, and governments.
Lynn Reaser is chief of the Treasurer’s Council of Economic Advisors and chief economist at the Fermanian Business and Economic Institute for Point Loma Nazarene University. The opinions in this article are presented in the spirit of spurring discussion and reflect those of the author and not necessarily the Treasurer, his office or the State of California.
2Debt data used here and in Figures 2 and 3 includes only non-self-liquidating general obligation bonds and lease revenue bonds. These are gross figures and do not account for any offsets to debt service. Also not included are other net tax supported debt that some rating agencies include in their calculations, such as general obligation commercial paper, State Grant Anticipation Revenue Vehicle (GARVEE) bonds and tobacco bonds with a General Fund backstop.
(Average Annual Percent Change)
Sources: U.S. Federal Reserve Board, Fermanian Business & Economic Institute
Sources: California State Treasurer’s Office; U.S. Bureau of Economic Analysis; California Dept. of Finance Demographic Research Unit; Fermanian Business & Economic Institute
Sources: California State Treasurer�s Office, California Dept. of Finance and Fermanian Business & Economic Institute.
* All state-supported debt
Sources: Moody�s Investors Service; Fermanian Business & Economic Institute