Restraint cuts borrowing costs


North Carolina is one of only a handful of states that enjoy the highest credit ratings from all bond-rating agencies. When investors looking for safe returns from government bonds do their shopping around, in other words, they consider our state to be one of the best buys. Because higher credit ratings bring lower interest rates, it costs us less to borrow money to finance roads, schools, or other infrastructure.

If we want to keep it that way, there are certain things that we can do. We can build up and maintain large savings reserves to ensure that bondholders get paid during fiscal emergencies. And we can maintain strict balanced-budget rules to make such fiscal emergencies less likely or severe. Fortunately, Gov. Pat McCrory and the General Assembly have done both.

According to a new study, however, there are two more things keeping North Carolina’s borrowing costs in check. One is that public-sector unions in our state aren’t particularly large and don’t enjoy formal collective-bargaining power. The other is that Republicans are firmly in control of the state legislature.

In a paper published in the latest edition of the Journal of Economic Policy Reform, Harvard University researchers Sounman Hong and Daniel Nadler sought to explain gaps in interest rates between high-risk and low-risk states. They were particularly interested in understanding why interest-rate spreads tend to increase during times of fiscal stress, such as the Great Recession.

In September 2008, for example, the interest rate on California bonds was only 15 basis points higher than that of Texas bonds. Then the credit markets seized up. By January 2009, the spread between California and Texas bonds had grown to 110 basis points. Why would investors increase their perception of the risk of buying California’s debt by so much in such a short period of time?

To answer the question, Hong and Nadler constructed an equation that modeled state bond yields using a variety of economic, institutional, and political variables. They ran the numbers to look for statistically significant relationships. They found them.

States with strong public-employee unions — which they measured with membership rates, collective-bargaining rights, and the presence or absence of right-to-work laws — tended to have higher-cost debt, all other things being equal. So did states that had Democratic legislatures. Indeed, the higher the proportion of Democrats, the higher the interest rates investors demanded for their money. “Market participants seem to treat these variables as indicators of the probability that a given state government will choose to default on its debt instead of initiating politically costly austerity measures,” the researchers concluded.

I found the results surprising, to be honest. In theory, investors shouldn’t care whether states finance their debt service by cutting other spending or raising taxes. I agree that in places where public-sector unions are weaker and Republicans control the legislature, it is easier to respond to fiscal emergencies with budget savings. But in states with strong unions and Democratic legislatures, it’s easier to raise taxes.

As I considered the findings of this new study in the context of other academic research on state fiscal policy, however, an explanation presented itself. Investors do have a preference here. While tax increases allow bonds to be repaid in the short run, they may also act as a warning sign of chronic budgetary imbalances. Moreover, states that resort to big tax increases during economic downturns are likely to experience less income and job growth over time than states exercising fiscal restraint. This suggests the existence of a feedback loop. Fiscally conservative states enjoy better economic prospects in the long run. That reduces the risk they will ever default on their bonds.

Regardless of which party controls state government in North Carolina in the future, I hope policymakers will take these insights to heart and maintain fiscal discipline. We can finance the necessary infrastructure to deliver public services and foster economic growth in our state while also keeping taxes low. In fact, the two goals aren’t just consistent with each other. They are mutually reinforcing.

John Locke Foundation chairman John Hood is the author of Catalyst: Jim Martin and the Rise of North Carolina Republicans.

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