California Watch published a very important story last month about the massive debt loads that capital appreciation bonds have heaped upon at least 400 school districts in California. Called CABs for short, many cash-strapped districts have resorted to these types of bonds in order to finance necessary buildings and infrastructure upgrades. Unfortunately without CABs, and because of California’s gutted property tax and slack economy, it would otherwise have been impossible to fund school construction over the last half decade in many regions.
Unlike normal bonds used by local governments to finance capital projects, CABs allow for repayment of interest and principal spread over longer time frames, often with no need to begin paying back principal immediately. This means easy money here and now, but it also means that the borrower will pay back much more over the term of the bonds than a regular loan, sometimes as high as 23 times the original borrowed sum.
There’s one error in how California Watch framed their story, however. Following State Treasurer Bill Lockyer, the reporters and editors imply that CABs shift the debt burden onto future generations – the kids. It’s right there in the story title, “Controversial school bonds create ‘debt for the next generation’,” and then it gets restated in the intro:
[School district administrators] have borrowed $9 billion that will cost taxpayers $36 billion to repay over the next 40 years, according to data compiled by California Treasurer Bill Lockyer. He called it “debt for the next generation.”
“The average tenure of a school superintendent is about three and a half years, so they aren’t going to be around in most instances to worry about paying that off,” Lockyer said in an interview. “Nor will the voters, probably, that enacted it in the first place.”
The idea that California’s children will be stuck paying the the debts of their irresponsible parents might be a catchy news frame, but it’s not economically accurate. It also de-politicizes the issue at hand and gives the story an uncontroversial gloss because it’s the “next generation” in the abstract that is losing out.
What’s actually happening is not a shifting of the burden to future Californians yet unborn, but rather an immediate transfer of income between classes and races, with the working and middle class residents of these various school districts being forced to pay out a greater share of their incomes to a small elite of rentiers who will come to hold these capital appreciation bonds when their investment managers purchase them in the bond market.
The idea that public debt is a burden to future generations rests on the idea that the current generation is acting as a spendthrift, carelessly buying what they want now in a fit of irresponsible pleasure seeking, and allowing the payments to come due in later years. This is wrong, however. We’ve known this generational theory of indebtedness to be wrong for over a century. One of the earlier logical refutations of the future-generations debt burden myth was provided by political economist Arthur Pigou. In his classic A Study In Public Finance Pigou wrote:
“It is sometimes thought that whether and how far an enterprise or enterprises ought to be financed out of loans depends on whether and how far future generations will benefit from it. This conception rests on the idea that the cost of anything paid for out of loans falls on future generations while the cost met out of taxes are borne by the present generations. Though twenty-five years ago this idea could claim some respectable support, it is now everywhere acknowledged to be fallacious.”
Twenty-five years prior to the time Pigou laid out this refutation was 1898.
Rather than constituting inter-generational transfers of wealth, Pigou explains how these are transfers of wealth in the present.
“[…]interest and sinking fund on internal loans are merely transfers from one set of people in the country to another set, so that the two sets together —future generations as a whole— are not burdened at all [….] it is the present generation that pays.”
Like a lot of liberal economists of his era, Pigou unfortunately also managed to obscure the inherently political nature of the problem by referring to “set[s] of people.” By “set” he really means that income and wealth is being transferred via debt between different classes. Large public debts tend to work as redistributive mechanisms that allow the truly wealthy to claim much larger shares of the total national income through the regressive taxes paid the working and middle classes.
This is exactly what’s happened with respect to California’s capital appreciation bonds. After decades of tax cuts, primarily via property taxes, and cuts to federal income and capital gains taxes passed on to local governments as cuts to federal aid to states, the wealthiest Americans now possess more of the income and wealth pie than they have since roughly the late 1920s. Lacking these untaxed dollars that have piled up in the bank accounts of the top 1 to 5 percent of America’s wealthiest residents, local governments have resorted to ever-increasingly desperate forms of debt financing to pay for everything from schools to healthcare. The wealthy have loaned their politically-gotten surplus of dollars to governments that no longer have the power to tax. The result is a current transfer of even more income and wealth to the rich in the form of higher interest rates paid back over longer periods.
What the California Watch reporters did do well is name the names of some of the financial advisors and debt underwriters who have gotten rich off the fees they charge for recommending CABs to school districts. It will probably come as no surprise that the likes of Piper Jaffray and Goldman Sachs, among others, have made millions by facilitating the CAB boom. Financial advisors like Caldwell Flores Winters, Dale Scott & Co., and KNN Public Finance have reaped millions also.
Need I point out that the finance sharks who staff these companies are of course the same high net worth individuals who own the bond funds that gobble up CABs and other debt securities?