The state of Minnesota faces a large budget shortfall, estimated at more than $6 billion for the next biennium. Should we also borrow an additional $1 billion for long-term infrastructure like new buildings at the University of Minnesota or community centers in Rochester or St. Cloud? How about for a new stadium for the St. Paul Saints?
Gov. Mark Dayton and some DFL members of the Legislature say yes. Most Republicans, who now control both houses of the Legislature, say no. Who is right? And does it make any difference that we are still coming out of a recession with unemployment still high and clouds still hanging on the horizon of the global economy?
If you can quantify the benefits to society of some government construction project, the benefit-cost analysis is pretty straightforward and similar to financial analysis of projects in the private sector. You convert the stream of societal benefits over time to a “present value.” (This is the lump sum right now that is equal to a series of payments over time, just as $200,000 of mortgage principal is the present value of 360 payments of $1,199.10 per month over 30 years at 6 percent.) Then do the same with costs. On physical infrastructure, most costs are up front.
Then compare the value of benefits to society in 2011 dollars to costs, also in 2011 dollars. The first hurdle is that benefits of the project must exceed costs. The second is that the benefits should be greater than the benefits to society that would result if the money were left to be spent in the private sector.
The last isn’t easy to estimate, but in ordinary times, interest rates are an indicator. The higher the interest rate, the greater the return private businesses must anticipate before they will borrow money to buy new machines or build new buildings.
The higher the interest rate, the lower the present value of any stream of benefits. Something that would produce $1 million in benefits per year for 50 years has a present value of $18.3 million at an interest rate of 5 percent. At an interest rate of 8 percent, however, the present value would be only $12.2 million. Using the interest rate equal to rate of return expected in business investments adjusts for the value that would be produced if the money were left in the private sector.
Thus, if you can make a reliable estimate of benefits and costs to society over the life of a project, you can reach a judgment about whether it should be built. This is relatively easy for roads and bridges but much harder for things like convention centers or recreational facilities.
As in business, having a project that will return more in benefits than it will cost is only one part. You also need to have the funds to pay for it. A business can estimate future cash flows the project will generate. A government project depends on current and future voters’ willingness to support the taxes needed to make principal and interest payments on the money borrowed. That varies with the collective public mood as much as economic realities. Right now, the mood is running against government spending.
Should a slow economy or high unemployment change any of this?
First of all, no Keynesian advocate of government fiscal and monetary policies to provide broad economic stimulus to the whole economy ever argued it would work at a state rather than national level. But government building projects may put some unemployed people back to work, which is a somewhat different proposition.
Labor is a flow rather than a stock resource. People who cannot find jobs for some period of their life don’t get extra years added to their working lives to make up the difference. The goods or services their labor might have created had jobs been available is lost forever, unlike unburned coal left in the ground.
When an economy is booming, building a new road or university building must draw labor away from other uses. Whatever they might have produced elsewhere is an “opportunity cost” that is reflected in their wage rate.
This “opportunity cost” to society as a whole is zero, however, for workers who are unemployed. Society does not lose production elsewhere. Their wages are a transfer from taxpayers, but society doesn’t lose other production.
That fact may be meaningful only to economists, however. Many taxpayers will argue that a cost to the state treasury is a cost to the treasury.
Interest rates are yet another issue. Low interest rates are a signal that capital is plentiful and not finding alternate uses. Low interest rates make the benefit-cost ratios of public construction higher and reduce their costs to taxpayers. Rates are at historic lows now because of Federal Reserve policy and will not stay this low forever. So building now may be cheaper than building in the future.
Ultimately, the decision is a subjective one. Part of the governor’s proposal is for maintenance and updating of existing facilities. We have a backlog of such work, and keeping up existing facilities generally has as high a return in the public sector as in the private one. There also are many too-long-deferred transportation projects that would have a high payoff.
However, building a new stadium for the Saints or facilities to foster greater convention business in regional centers is more iffy. The only argument for using state-level borrowing for projects of purely local impact is that it has been done in the past, largely to the benefit of the Twin Cities, and that it would be unfair to cut it off now.
Spending public funds only on those projects where the benefits to society exceed the cost should be the rule in good times and bad. What citizens deem an appropriate level of total infrastructure spending is something that must be determined by the political process.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.