As the Northam administration’s point man in negotiations with the New York bond-rating agencies, Secretary of Finance Aubrey Layne spends much of his time worrying about the Commonwealth of Virginia’s credit-worthiness. The state nearly lost its sterling AAA bond rating last year. It was a close thing, he says. Even now, he adds, Virginia isn’t out of the woods.
Layne sees many things that could go wrong. The economy could slip into recession and projected tax revenues could decline. A stock market crash could boost unfunded pension liabilities by billions of dollars. The politicians in Washington could get serious about dealing with the $22 trillion national debt, curtailing the defense spending that undergirds Virginia’s economy.
The risk that “keeps me up at night,” says Layne, is of a Category 5 hurricane ripping through Hampton Roads. An Old Dominion University study published late last year found that a Florence- or Katrina-scale hurricane would cause $17 billion in wind and water damage and another $25 billion or more in lost economic activity. The state would be on the hook for evacuating and sheltering hundreds of thousands of residents, cleaning up tens of thousands of truckloads of debris, and repairing state-maintained roads and other infrastructure, even as disruption to Virginia’s second-largest metropolitan economy cost millions of dollars in state tax revenue.
The Commonwealth faces huge risks, both short-term and long-term, but few of those risks are accounted for in Virginia’s $21 billion-a-year General Fund budget. The state’s “rainy day” fund and cash reserves are too paltry to buffer the budget from a fiscal shock of any magnitude. Under many scenarios Layne can contemplate, balancing the budget would require horrendous spending cuts.
“There’s no one looking into the future,” Layne says of the state’s biennial budget cycle. “Nobody’s looking beyond two years.” If revenue shortfalls loom more than two years out, he adds, “the attitude is, we’ll deal with that in the next budget.”
The Commonwealth has a constitutionally prescribed “rainy day fund.” If revenues come in ahead of budget estimates, a portion of the excess automatically goes into the fund. But the use of that fund, designed to help the state cope with a recession, is restricted. It can’t be tapped unless revenues actually decline. It can’t help if, say, a hurricane or other natural disaster triggers hundreds of millions of dollars in emergency expenditures.
To weather a hurricane the Commonwealth would have to draw upon cash reserves. The state constitution allows the state to accumulate reserves equivalent to 15% of General Fund budget expenditures, or about $3.2 billion currently. Virginia flirted with a bond downgrade last year because the state had let its cash reserves dwindle to $281 million — less than any other AAA-rated state. Layne’s goal is to build reserves back up to 8% of annual General Fund expenditures, or about $1.8 billion. The recently concluded budget negotiations for Fiscal 2020 adds significant new monies and will get reserves up to about 5.6%. That represents progress, Layne says. But it’s not enough.
“Government doesn’t assess risk very well,” he says.
As president of Great Atlantic Management, a real estate development firm before entering public service, Layne spent a lot of time thinking about risk. In the private sector, companies routinely take out insurance or self-insure by setting aside reserves to cover potential liabilities.
Layne introduced rigorous thinking about risk to the public sector when he signed up with the McAuliffe administration as Secretary of Transportation. The Commonwealth was planning billions of dollars in transportation mega-projects without clearly identifying which types of risk — the risk of design and construction overruns, for instance, or the risk that toll revenues might not materialize as projected — that it made sense for the state to take on itself or to slough off to a private-sector partner.
Virginia needs to think more rigorously about risk in its budget process, Layne says. In one analysis that he conducted in response to a General Assembly inquiry, he asked what the fiscal impact would be if Virginia experienced another recession like the financial crisis of 2007. That is not an unreasonable question to ask given that Moody’s the bond-rating firm, recently said that the U.S. economy has a 48% chance of falling into recession next year.
A recession as severe as the last one could wipe out $9.3 billion in revenue from a $21 billion General Fund budget over three years. And that doesn’t include the impact on Virginia Retirement System. Under a “shock” investment scenario replicating the stock market crash of the last recession, according to a different analysis, the state’s share of the unfunded pension liability would surge by $6.9 billion and contributions into the fund would have to increase by roughly 50%, creating a huge new drain on state funds while tax revenues were in free-fall.
The point is not that a recession of that magnitude will occur, it’s that Virginia is extraordinarily vulnerable if it did occur. No one foresaw the 2007 recession, so it’s not a stretch to think that the next financial crisis could catch economic forecasters unaware as well.
Similarly, it’s not “likely” that Virginia will get hit by a Category 5 hurricane. Virginia hasn’t suffered a storm of that magnitude since 1821. But some climate scientists fear that the frequency and intensity of hurricanes will increase with global warming, so anything is possible. While the Federal Emergency Management Agency would provide significant aid to Virginia in the event of such a natural disaster, it would take a couple of years for all the money to come in. With such a pitiful level of reserves, where would Virginia get the money to deal with immediate needs?
Layne also finds risks embedded in the routine budget process. Growth in sales taxes and payroll withholding has slowed this year, he says. “If our [econometric] model is wrong, we’re screwed.”
Billions of dollars in the budget are predicated upon actuarial models that may or may not prove to be accurate. The project for Medicaid spending was off by $420 million last year. Actuaries made assumptions that a certain percentage of Medicaid patients would enroll in managed care plans that would cost the state less money. The projection was way off — and nobody bothered to compare actual enrollment figures with the forecast until late in the game. “They got the report then put it on the shelf. No one paid attention to the fact that they weren’t hitting the assumptions.”
Layne will make sure that particular oversight doesn’t happen again. But he sees state and quasi-state institutions as riddled with moral hazard — from Medicaid administrators to the Virginia Retirement System to the Virginia House and Development Authority. The political pressure to increase spending is relentless. “I had $3 billion in [unbudgeted] requests from the agencies in an off-budget year.”
The Commonwealth is benefiting this year from an influx of tax revenue resulting from federal tax cuts that may or may not be extended when the current authorization expires. Layne proposed using the temporary revenues to bolster financial reserves or to fund one-time spending programs, as opposed to boosting ongoing programmatic spending or enacting tax cuts. Says he: “We’ll look back at these temporary moneys one day and regret that we didn’t use the chance to shore up our balance sheet.”
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