If you’ve been watching the finance committees work this session, you’ve almost certainly heard an argument about not taking “excess” draws out of the earning reserve account (ERA). There is some truth to the assertion. But, there’s a larger false narrative afoot. Today, I want to take a moment to explore the issue – both the true and the false arguments.
Briefly, here’s the issue at hand. Alaska’s oil revenues collapsed when oil prices crashed. At this point, the state doesn’t raise enough “traditional” revenues (from taxes, fees, etc.) to cover our current spending. However, we do have about $70 billion in the bank – which earns billions of dollars in investment returns each year.
As I pointed out a month ago, those investment earnings count as state revenues on our financial reports. Therefore, our actual financial position has not been nearly as bad as people think. Still, after this coming fiscal year, the state’s Constitutional Budget Reserve will be completely empty.
At the same time, there are billions of dollars in designated accounts, which pay for a variety of government programs. And, when fiscal year 2022 starts in July of 2021, the ERA should hold around $12.5 billion of unspent investment earnings and unpaid dividends.
When the next legislature starts debating the FY22 budget, they are going to run into a serious dilemma. There will not be enough revenue to cover current expenses, there will not be any money in the budget reserve, and there will be accessible money sitting in the earnings reserve that they aren’t supposed to touch. Raising taxes will take too long to solve the problem – if they can even get the votes to pass one.
That leaves some combination of four options to address the near-term budget. Either reduce the PFD to nothing, cut hundreds of millions of dollars from the budget, sweep the designated funds, or violate the limit on using investment revenues. None of these options will be popular.
The Argument Against “Overdrawing” the ERA
The limitation of using investment earnings comes out of fact that they are volatile. In the last decade, our investments have earned rates of return from -17.96% to +20.56%. It’s impossible to budget when you have $7 billion of earnings one year and less than zero the next. The Percent of Market Value (POMV) approach, adopted by the legislature in 2018, is supposed to smooth out that volatility.
The argument against changing that approach was highlighted in testimony from the new Legislative Finance Director. “With each $1 billion above the POMV that we spend, we lose $50 million per year – FOREVER.” That statement comes from the mathematical fact that $1 billion invested in the fund’s portfolio should generate the target return of 5%.
Using the balance means losing the returns.
The Part That’s True
There is an undeniable truth that eating a chicken results in losing its eggs. Likewise, spending every penny you earn will not lead to a very comfortable retirement. That’s as true for Alaska as a state as it is for you as an individual. Failing to save, and spending what we saved in the past, comes with an opportunity cost of fewer future earnings.
The Part That’s Wrong
Despite the underlying truth, there is an incorrect interpretation leading policy-makers to arrive at an incomplete conclusion. It comes from three directions.
First, It’s Not Necessarily Forever
The idea that using savings today results in permanent earnings destruction is false. It falls in line with all of the other vacuous arguments that rely on assumed finite quantities. It would be like saying that exercising is bad because it uses up heartbeats.
No. There are not a finite number of heartbeats – or dollars. That’s not how things work. Using savings doesn’t result in a permanent loss. Saving money results in investment earnings until those savings are required for use. You don’t lose investment earnings when you replace your broken boiler. Rather, you make investment earnings while you hold money in savings until you need them.
Dipping into savings while oil prices are at a record low doesn’t cost anything long-term. It just uses the money we saved for exactly this type of emergency until things get back to normal. So long as we don’t increase spending when the commodity cycle swings back the other way, the savings accounts can be replenished without a permanent loss of earning power. We just need to be careful not to set our spending at an unsustainable level (which is how we got into this mess).
Second, It’s Not “Above the POMV” That Matters
It’s true that spending $1 billion out of the ERA rather than putting it in the principal account has an opportunity cost of its earning power going forward. But, that statement extends to any spending – not just spending above the arbitrary limit the 30th legislature imposed.
I’ve not heard any advisor pointing out that using $1 billion out of the CBR will result in millions of lost investment earnings per year. Yet, it does. Leaving a billion dollars in the CBR would earn between $20 and $200 million per year.
Of course, the legislature was perfectly content losing future earnings when they opted to use $1 billion of CBR money while saying that it was irresponsible to take those same funds out of the earnings reserve.
Further, the idea of losing investment earnings is just as true about using the first billion out of the earnings reserve as it is the fourth. We have already decided that spending $3 billion is ok. However, spending that $3 billion comes at the expense of $150 million per year in earning potential.
But, we don’t hear about the fact that spending $1 billion on education results in $50 million of lost revenues. Or that $1 billion in public employee wages costs us $50 million per year in lost earnings. That’s because we weigh the use of those funds against those lost earnings and decide that it’s worth the trade-off.
We wouldn’t be better off without education funding and a bigger bank account. This fact is intuitively true. Just like you wouldn’t give up your car so you can have a bigger retirement account. The benefits are worth the cost.
This observation should highlight the fact that we aren’t talking about the earnings per se. We are talking about the cost-benefit of a particular use of money. In other words, legislators are saying that spending $4.8 billion on government services is worth the lost earnings.
Meanwhile, they are saying that paying Alaskans their dividends isn’t worth the cost. That is exactly equivalent to saying we should take one billion dollars out of people’s paychecks and put it in the bank. The entire argument doesn’t make any sense. Especially not right now.
Third, the earnings don’t exist if the structure doesn’t work
It is absolutely true that putting one billion dollars into the principal account of the Permanent Fund converts that money into a revenue generating vehicle. Behind that constitutional protection, the money is no longer accessible savings and only has earning power.
But, money in the earnings reserve has no protection other than a statutory guideline. The money can get spent at any time for any reason with a simple majority vote. That means that money in the ERA is not a guaranteed revenue generation vehicle. Withholding money from Alaskans to keep it in the ERA provides no assurance whatsoever that the money doesn’t get used by future legislatures.
Imagine for a moment that the legislature in 2026 decides to use the ERA balance to build AstroTurf soccer fields at every school. In that scenario, our withheld PFDs didn’t go to ensuring all future Alaskans enjoy the low taxes we pay today. Instead paying the PFD today comes at a cost of those soccer fields. And, the lost earnings weren’t FOREVER. There were just four years of lost earnings before the state ends up in the exact same financial position.
While I hope future legislators are fiscally responsible, there’s no guarantee. And, we already know the current structure isn’t going to work. From where things sit today, it’s far more likely that reduced PFDs end up as larger operating budgets than as future revenue streams.
There is absolutely, undeniably, indisputably a long-term cost associated with spending money. And, it’s completely true that future generations of Alaskans won’t have the oil revenues than we have enjoyed over the last 40 years. Therefore, it makes complete sense to contemplate providing our grand-children and their grand-children with a trust account rather than blowing through our resource wealth.
But, we need to start the conversation with that goal in mind. Then, build a structure that actually accomplishes that aim. That structure must consider the current circumstances as much as the future ones. We should not hang our decedents out to dry; but, we should also not martyr ourselves on their behalf either.
There is a balance between the extremes. It is located in a place that acknowledges the problems of the present and the future. Our current system is broken and is about to fail. Our current economy is collapsing from under our feet. And our current revenues are artificially low. The false narrative about the ERA will not solve any of these problems – It will make them worse. Alaska would be better served with a new structure that accomplishes our long-term goals while acknowledging our short-term problems. Rethinking the ERA is a critical component of getting to that place.