The thing about low-probability events is that while many of them are possible, and most of them do not occur, in a system as big as the world, there are always a few occurring. You just don’t know which ones are going to occur. Take Watergate, the Sept. 11 terrorist attacks or Hurricane Katrina. And when they do occur they can have huge impacts, in part because no one saw them coming.
In finance, we often see ventures flopping for failure to see these low-probability events. Sometimes the failures are spectacular in terms of the amount of loss. The jargon many use for such occurrences is “blow up.” Blowing up is losing much more money than ever expected, to the point of going out of business. The collapse of Lehman Brothers in 2008 is one example.
Currently in Juneau, both the Alaska House and Senate are considering transferring between $8 and $14 billion of the Permanent Fund’s earnings reserve account (ERA) into the corpus (principal) of the Fund, where it cannot be touched without a constitutional amendment. They will also take about $3 billion out of the ERA to fund public services and pay dividends. This will be a total of between $11 and $17 billion removed from the ERA.
Between 2014, when oil prices crashed, and 2018, the balances of the state’s two budget reserve funds (separate from the Permanent Fund) were drawn down from $18 billion to $4 billion to pay for government. There is not much left in there now.
Starting this year, the state budget has been funded in part by the percent-of-market-value (POMV) approach, using a percentage of the entire Permanent Fund balance (corpus plus ERA), but only taken from the ERA. Since money cannot be taken from the corpus of the Fund, money can only come out of the ERA. So, for example, assume if the corpus and ERA contained a total of $66 billion, and the POMV draw was 5%, that would come to $3.3 billion available. But, if there were less than $3.3 billion in the ERA, it would not be possible to draw the entire $3.3 billion for public services and the dividend.
Thus the only source of liquidity for the state in case of low revenues is the Permanent Fund earnings reserve account. It currently has about $19 billion. If between $11 billion and $17 billion is removed, it would only leave between $2 billion and $8 billion in reserve.
Let’s look at two low-probability events: low oil prices or poor financial markets. We have seen both in recent memory. Low oil prices like we saw in 2015-16 would reduce state revenues by $1 billion.
Poor market returns would reduce the low-starting ERA balance even more. The Permanent Fund Corporation is forecasting that without the transfer, between now and 2022 there will be about $9 billion available for government and dividends through POMV. That assumes a 7% return on the Fund. All of that will be necessary to plug deficits under budgets that resemble the present.
The Legislature’s proposal to move those massive amounts from the ERA to the corpus may make the politics of future decisions on taxes and dividends easier by eliminating options. It does this by turning the Permanent Fund largely into a savings account you cannot withdraw from, and putting the state in serious liquidity risk should adverse unexpected events happen. While this blow-up would not put the state out of business, it would compel hasty enactment of budget cuts or revenue measures — not the ideal context for managing the direction of state finances.
Roger Marks is an economist in private practice in Anchorage. He formerly served as a petroleum economist with the Tax Division in the Alaska Department of Revenue.
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