Advancing Urban Policy:
Public Finance & Budgeting June, 2013
This edition of Advancing Urban Policy, the monthly e-newsletter of the Maxine Goodman Levin College of Urban Affairs at Cleveland State University, features research and thought leadership from across the country related to Public Finance & Budgeting. It highlights articles on innovation's impact on public finance, the impact of global financial crises on cities and local public services, Public Financial Management and Procurement (PFMP), debt, fiscal decentralization, poverty reduction strategies, and more... Future editions will feature topics related to Economic Development (July), Community Development & Housing (August), Nonprofit Management (September), City Management (October), and Environmental Policy (November). We welcome your ideas and submissions. They may be sent to

Edward (Ned) W. Hill, Ph.D., Dean


Ecology of Innovation


Public Financial Management and Its Emerging Architecture

If a single word could encapsulate public financial management (PFM) in the first decades of the 21st century, it would be innovation. Today's policymakers must deal with the increasing complexity of managing public resources. Therefore, critical questions must be asked about innovations: What has been achieved? What issues and challenges have appeared along the way? How can the ground be prepared for the next generation of PFM reforms? The sheer volume and pace of innovations and their widespread adoption give the sense that they add up to a fundamental change in the way governments manage public money.

Public Finance Management is seen as an "umbrella" definition, covering a set of systems aimed at producing information, processes, and rules that can help support fiscal policymaking as well as provide instruments for its implementation. Having in place inappropriate budgetary processes and rules can cause unsustainable increases in expenditure and unbudgeted liabilities. Poor or nonexistent financial information, yielded from unrealistic projections of economic growth or nondisclosure of fiscal risks, can undermine government finances. It is this linkage of policies and processes that highlights the importance of Public Finance Management and has stimulated recent innovations in Public Finance Management practices.


Seizing the Day: The Impact of the Global Financial Crisis on Cities and Local Public Services

A recent report from the PricewaterhouseCoopers Public Sector Research Centre reports that in response to the global financial crisis, local government leaders have already seen a significant impact on their organizations and brands, and a collapse in revenues. Fears of a protracted global recession, over-regulation, lack of access to capital markets and a rising tide of protectionism dominate business concerns across the world. In contrast, governments at all levels have seen the demand for their services rise inexorably which has led to a significant increase in public sector spending.

But all this is about to change. The insulated environment for cities and local government will not survive, with large budget cuts on the horizon. Local government leaders who believe that the growth days for public spending will continue risk complacency and failure to put in place the foundations for a very different future from the first decade of the 21st century. However, there is a potential window of opportunity for local government leaders to prepare for transition and ensure that they have positioned themselves to take advantage of a resurgence of global economic growth as the private sector takes off again. City managers and local government organizations around the world are facing tough choices and need to innovate, collaborate with their neighbors, and build effective and durable organizations.



Economic Development Strategies and Policy

The Hard Road to Fiscal Responsibility

Numerous committees and commissions have offered policy options that would stabilize the debt-GDP ratio in the long run. The proposals of the President's National Commission on Fiscal Responsibility and Reform and the Bipartisan Policy Center's Deficit Reduction Task Force have offered such policy options. Elected politicians have not been enthusiastic about the work of these bodies. Only the House has passed a budget that would stabilize the debt and that proposal is analyzed as is the president's response.

The United States' debt is partly due to the country's unsustainable, long-term fiscal trajectory resulting from a large structural mismatch between current tax and spending policies that are predicted to worsen over time with the aging of our population and rising health-care costs. Unless these policies are changed dramatically, the already rapid growth rate of our national debt will accelerate toward the end of the decade and thereafter far outpace that of the economy. Recognition of this prospect, and of its damaging consequences for our future standards of living, has led in recent years to the formation of numerous groups-under both private and public support-to recommend concrete policy options for achieving fiscal sustainability. Addressing the challenge also has become a recent preoccupation of our national political leaders and, due to the starkly different views of the two parties regarding the role.

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Capital Flows to Emerging Market Economies: A Brave New World?

According to economic theory, free movement of capital across national borders is beneficial to all countries, as it leads to an efficient allocation of resources that raises productivity and economic growth everywhere. In practice, however, large capital flows can also create substantial challenges for policymakers. These challenges have recently come to the forefront again for emerging market economies (EMEs). After tanking during the global financial crisis of 2008-2009, net private capital flows to EMEs surged in the aftermath of the crisis and have been volatile since then, raising a number of concerns in recipient economies.

The Federal Reserve projects that, to the extent that the volatility of the market is driven by the fickleness of international investors, it creates a risk of financial instability. Large inflows can also make more difficult the pursuit of appropriate macroeconomic policies to maintain solid economic growth without rising inflation. If, in response, authorities raise policy rates while allowing their currencies to appreciate, this leads to a loss of international competitiveness which could hurt export and growth performance. But if they slow the pace of monetary tightening to deter inflows, or if they resist currency appreciation pressures through intervention, the ability to follow appropriate independent monetary policies is compromised. Such a course of action could result in excessive liquidity and economic overheating, creating vulnerability to boom-bust cycles. And finally, if they resort to capital controls, not only is it an open question how effective these may prove based on the past historical experience, but the use of such controls also risks creating economic distortions that could weigh on economic activity over the longer term.




Public Budgeting and Finance


Citizens have been demanding more public accountability of their governments and governmental programs, particularly in regard to stewardship of public resources. This pressure for more accountability has been driven, in part, by decreasing citizen trust in government and increasing citizen dissatisfaction with government performance. As governments have grown in size and complexity, citizens increasingly view government as inefficient and wasteful in the delivery of public services. Statistics from the American National Election Studies found that in 2008, 72 percent of respondents thought that people in the government waste a lot of money paid in taxes, compared to 61 percent in 2004 and 48 percent in 2002. Similarly, the average score on the trust in government index has been declining since 2002. This growing citizen distrust and dissatisfaction, coupled with the perception of government inefficiency and waste, has resulted in a greater demand for transparency and accountability.


Popular financial reports (PFRs), a reporting mechanism that has seen recent popularity, is one approach or tool available to governments to meet this demand for transparency and accountability. The purpose of popular reporting is to provide financial data in a form that is not confusing or discouraging to those unfamiliar with accounting and financial reporting. Therefore, provision of such information is important for facilitating communication pathways between government and citizens, and fulfilling the democratic goals of accountability and transparency in governance.



Optimal Fiscal and Monetary Policy with Occasionally Binding Zero Bound Constraints

The short-term nominal interest rate, which serves as the conventional policy tool for macroeconomic stabilization, is subject to the constraint that it cannot go below zero. Despite this notion, in late 2008, the Federal Reserve effectively lowered the federal funds rate to zero. The policy rate has been at the zero lower bound since then, and is expected to remain so for the near future. With the standard monetary policy tool constrained, the government has turned to alternative policy tools to stimulate the economy. One such policy tool was fiscal policy. In early 2009, Congress enacted the American Recovery and Reinvestment Act to provide fiscal stimulus to the U.S. economy in the hope that it would create jobs and promote economic recovery.


In light of this policy experience, many authors have recently examined positive and normative implications of fiscal policy when the nominal interest rate is constrained by the zero bound in the context of dynamic general equilibrium models. Some have shown that an exogenous increase in government spending leads to larger increases in consumption and output when the nominal interest rate is constrained at the zero lower bound. Others have shown that it is even optimal to increase government spending when the nominal interest rate is zero. These results support the active use of fiscal policy in the current economic environment.



Economic Impact

Don't Let Them Fool You, We Still Have Debt Problems

It's true that there has been good news on a variety of fronts regarding the budget, but it is premature to say that we've solved the long-term fiscal imbalance. Fiscal optimism stems from the Congressional Budget Office's most recent estimates, which place the deficit at 4 percent of GDP this year, falling as low as 2 percent of GDP by 2015, before rising to about 3.5 percent of GDP by 2023. These figures are way down from the deficit of 10 percent of GDP that prevailed a few years ago. Some of this reduction is due to the slowly improving economy. The rest is due to policy changes, slower health care cost growth, and various technical factors. But the fiscal problem isn't gone. There are really two different deficits out there - the short-term and the long-term.



Hey, Where Did Our Economy-Threatening Fiscal Crisis Run Off To?


According to a recent editorial published by the Brookings Institution, authored by former Representative Bill Frenzel, federal policy makers always seem to be looking for reasons to dodge the difficult choices necessary to avoid the fiscal crisis. Now they got some new excuses. First, CBO updated its fiscal outlook, predicting the Fiscal Year 2013 deficit would be $200 billion less than earlier forecast. That's delightful, but the 10-year forecast remains substantially unchanged. It also remains dismal. Next, the Trustees of Social Security and Medicare made their annual report. It again showed the Social Security Trust Fund going into the red in 2033, at which time, recipients, by law, will take a 23 percent cut in benefits. It also showed the Social Security Disability Trust fund going broke in 2016, with a similar benefit cut of 20 percent. But, Medicare looked a bit better. It does not tank until 2026, two years later than previously forecast. That small improvement was another excuse. In short, the economic albatross of deficit and debt continues to threaten our future.



Chapter 9 Municipal Bankruptcy: Municipalities Facing Financial Crisis

According to Public Budgeting & Finance, the recession has had a devastating real world impact on cities, counties and states throughout the nation. The reason is that Chapter 9 has gone from being a seldom used area of the Bankruptcy Code to a matter of current events that is discussed in the news daily and debated by unions, municipalities and Congress and state legislatures alike.

Currently, there are at least 115 cities and counties within the United States that are struggling financially. Additionally, 44 out of 50 states project budget shortfalls for the 2011-2012 fiscal year. Furthermore, U.S. cities, counties and states face a $3.6 trillion gap between their pension assets and what has been promised to retirees. Chapter 9 provides bankruptcy relief to municipalities, which include counties, cities, towns, villages, municipal utilities, school districts, and other taxing districts.

Under current U.S. bankruptcy laws, states are prevented from filing for bankruptcy. Since the 2008 financial crisis, many states are facing staggering budget deficits. The financial crisis facing the states has resulted in serious concern among members of Congress that, if there is no bankruptcy option available to the states, states will eventually seek a federal bailout.



Rescuing the Budget Process

There is no doubt that the budget process is broken. The clearest evidence is the fact that we are all counting on the Joint Select Committee (JSC) to avoid total gridlock or a replay of the near-catastrophic debt ceiling brinkmanship. There is a chance that the JSC, with the strong support of the president and the leadership in both houses and both parties, will be able to agree on actions that will stabilize the rising debt and set the federal budget on a sustainable path. However, even if the JSC succeeds, the budget process has failed. Our much-vaunted democracy should not have to abandon its normal decision processes and concentrate power in the hands of an ad hoc group to solve a budget problem. The regular budget process, of which this Committee is an essential part, should have functioned long before now to put in place both a near-term budget and a sustainable long-term plan.

Congress has to fix the budget process. But a better budget process will not make budget decisions easy or create the will to compromise and solve problems, without which a diverse democracy cannot move forward. Process can either hamper decision-making or facilitate it, but only at the margins. The current congressional budget process certainly makes it harder to make fiscally responsible budget decisions. But bad process is a symptom, not a cause of unwillingness to make the compromises necessary to solve hard problems. No process will work well unless the participants in the process want it to work.

The Founding Fathers bequeathed us a system of checks and balances that makes it extremely difficult to get decisions made unless participants work tirelessly to make it work. It requires negotiation between the legislative and executive branches and between the two houses of Congress, even when all are controlled by the same party. It requires negotiation and compromise between the political parties, especially but not exclusively when different parties are in control of one house or one branch. No budget process reform will work well until participants realize that making this complex structure function requires a patient willingness to try to understand each other and to work together to make responsible, sustainable budgets.

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Revenue Diversification in the States: The Credit Quality and Interest Cost Impacts

This paper in The Municipal Finance Journal uses data on general obligation bond sales in the United States from 1980 to 2006 to explore the impact of revenue diversification on credit ratings and, consequently, on borrowing costs. The findings indicate that a standard deviation increase in revenue diversification increases by 25 percent the probability that an issue will be rated Aaa. However, the results also indicate that increasing revenue diversification does not necessarily translate into lower borrowing costs for state governments. Although the sign of the coefficient is in the expected direction (negative), revenue diversification does not have a statistically significant impact on borrowing costs.

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Tax and Expenditure Limitations and State Credit Ratings

According to the Public Finance Review, the impact of state tax and expenditure limitations (TELs) on bond credit ratings is estimated using an incomplete (or unbalanced) panel from the United States from 1973 to 2005. Three indices of the restrictiveness of TELs are used. Both Moody's and Standard and Poor's bond credit ratings are used and the outcomes compared. The results are consistent with previous work; more restrictive revenue TELs are associated with lower credit ratings while expenditure TELs are generally associated with higher credit ratings. TELs restricting both revenues and expenditures are negatively associated with Moody' ratings, but not with those of Standard and Poor's. Contrary to previous studies, the authors find limited differences in the fiscal and economic variables that influence the ratings of the two agencies.


Assessing and Combining Financial Conditions Indexes


This paper in the Federal Reserve Board's Finance and Economics Discussion Series (FEDS)evaluates the short horizon predictive ability of financial conditions indexes for stock returns and macroeconomic variables. The evaluation revealed that reliable predictability was reported only when the sample includes the 2008 financial crisis, and arguably, this result is driven by tailoring the indexes to the crisis and by non-synchronous trading. Financial conditions indexes are based on a variety of constituent variables and aggregation methods. A simple procedure can be used for consolidating the growing number of different indexes into a single proxy for financial conditions.


Fiscal Decentralization and Trust

The Public Finance Review reports on the relationship between financial decentralization and trust, using data from U.S. states and various measures of decentralization. Findings show a one standard deviation increase in either revenue decentralization or expenditure decentralization causes the share of trusting people in a state to increase by almost 4 percentage points. A one standard deviation increase in the number of governments, however, causes trust to increase by almost 2.5 percentage points. The results are robust to endogeneity.

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Fiscal Decentralization and Governance

The literature on the economics of fiscal decentralization stresses the potential for both positive and negative effects on governance in a country. Using a data set comprising 64 developed and developing economies and several different measures of fiscal decentralization, the Public Finance Review reports that countries in which a larger share of fiscal revenues and expenditures are located at the level of subnational governments appear to be less corrupt.

Findings also reveal that the beneficial impact of fiscal decentralization on corruption is mitigated in the presence of mechanisms enforcing vertical administrative decentralization. The results indicate that fiscal decentralization appears to reduce corruption even in countries in which there is a high degree of political representation. The results are robust to alternative estimation methodologies and to specifications that control for the influence of variables that have been identified as affecting governance.


Health Care and Education

Aging and Its Impact on Municipal Credit

It is well known that the nation's population is aging at an unprecedented rate, but the impact this trend will have on municipal finances may not be fully understood. The issue of aging is framed using important areas beyond health care costs and delivery, including labor force characteristics, voter preferences, education system quality and, ultimately, economic growth. Recent demographic trends and their implications, as well as potential policy responses to these trends, also add to the discussion and interpretation of this trend.

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Long-Run Growth and Welfare Effects of Rising U.S. Public Health Expenditure

The rising public health spending has created financial pressure on the government budget. This may force the government to cut its spending on other programs, including education and productive public investment. For instance, from 1970 to 2006, in terms of their percentages to GDP, public health spending was rapidly risingfrom 7 to 16 percent and is projected to reach 29 percent of GDP in 2030. Conversely, gross public fixed investment had declined, and public education remained had been relatively constant.

Numerous studies have shown positive effects of education spending on economic growth. The positive effect of productive public spending such as infrastructure on economic growth is also well documented. Since health spending is also considered important for economic growth, the competing uses of these three growth-enhancing expenditures can adversely affect growth and welfare.


Employment Growth Slows in Ohio

According the Federal Reserve Bank of Cleveland, employment in Ohio has grown 2.7 percent since the start of the recovery (June 2009 to March 2013). Over the same period, national employment grew almost a percentage point more (3.5 percent). Elsewhere in the District, employment in West Virginia and Pennsylvania grew at rates similar to that seen in Ohio, 2.6 percent and 2.5 percent, respectively. By contrast, Kentucky saw growth above the national average at 4.1 percent. Among other states, North Dakota saw the largest employment gain-driven by a boom in energy production-followed by Utah and Texas, while New Mexico and Missouri experienced employment declines.


Underemployment, College Graduates, and the Recession

The exceptionally high unemployment rate of recent years indicates that the U.S. workforce has been persistently underutilized. With fewer individuals working than would otherwise be, or those with jobs working fewer hours than they would prefer, the economy is producing at a level far below its potential. This underemployment impacts current standards of living, but it could also have long-lasting effects on workers and the economy.


Global Economy

Minding the Gaps: Integrating Poverty Reduction Strategies and Budgets for Domestic Accountability

The Poverty Reduction Strategy (PRS) approach aims to enhance accountability by promoting the participation of domestic stakeholders in the formulation of clear and realistic development goals. Institutions for monitoring and evaluation are designed to trigger learning and improved performance. The World Bank reports on how to strengthen the links between PRSs and national budgets, with a view to improving domestic accountability. The accountability relationship has three dimensions including; ownership of the task, incentives to carry out the task effectively, and capacity to deliver results.

Additionally, links between the PRS and budget have been considered integral to the successful implementation of the PRS for some time. These links are also increasingly recognized as vital for enhanced domestic accountability. However, fractures in planning and budgeting systems pose obstacles for donors and national governments. Such obstacles include ineffective prioritization of plans and coordination between planning and budgeting units, difficulty developing incentives to formulate realistic budgets and execute them as planned; and the lack of integration of reporting mechanisms.

A well-functioning, results-oriented reporting system needs to integrate financial information on actual expenditure inputs with performance information on the outputs and outcomes that result from public spending. While the PRS goes beyond the budget, because it includes strategies and priority actions that do not require the allocation of public funds, the systems for monitoring government performance in implementing budgets could provide a solid basis for reporting on a critical part of PRS implementation.

To analyze the effectiveness of the PRS approach, the World Bank reviews a series of case studies that document the status of budget and PRS integration in a sample of nine low-income countries-Albania, Burkina Faso, Madagascar, Malawi, Mali, Mozambique, Rwanda, Tanzania, and Uganda-and the links among policies, budgets, and service delivery in four higher-income countries that are internationally considered to be successful reformers in public financial management-Australia, Chile, the Republic of Korea, and South Africa.


Public Financial Management Reforms in Post-Conflict Countries


Public financial management (PFM) is frequently a key pillar in reforms to build more capable and accountable states in post-conflict environments. It is the focus of attention of international financial institutions as well as other bilateral aid agencies, and in many cases drives the financial support provided by key donors. PFM reforms are expected to contribute to the wider state-building goals that are equivalent to the post-conflict phase, including a more transparent management of public finances, regular payment of salaries of civil servants, better service delivery, and better allocation of resources in support of reconstruction priorities.


Public finances are a central component of state-building and peace-building efforts. Governments need control over public resources for funding national priorities. States need resources for providing public services-ranging from security, to water and sanitation, to education and health-and fulfilling their fiscal commitments such as paying staff salaries. These are essential for building legitimacy and resilience, which have typically been eroded in fragile and conflict-affected situations.



How Global Fiscal and Monetary Policies and Sovereign Credit Affect the U.S. Municipal Market

Municipal analysts have long considered the impact of U.S. fiscal and monetary policy on interest rates and the economy. As we have recently seen, however, it is becoming increasingly necessary for municipal analysts to consider global fiscal and monetary policies, as well as sovereign credit, because these can have profound effects on our local economies and financial markets and, consequently, on municipal credit. Global trends should inform our thinking about what the next U.S. economic downturn might resemble. Specifically, the fiscal and monetary challenges around the world, involving the credit quality of key sovereign governments in Europe and Asia, and the potential for its contagion into the United States through exposures of money market funds to European banks, is a trend that should be observed.

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The Politics of Fiscal Austerity: Implications for the United States

As austerity becomes the new normal for advanced nations, questions are raised about whether nations can make the hard choices necessary to bring about a sustainable fiscal future. The political defeat experienced by so many European governments undertaking fiscal consolidations points to the vulnerabilities that leaders will face. Unlike many European nations today, the seemingly endless appetite for U.S. treasuries by worldwide markets gives the United States the luxury of choosing to begin deficit reduction only when the economy strengthens. However, the absence of market pressure also reduces the sense of urgency, consigning national leaders to create internal crises such as the 2012 fiscal cliff to force their own hand. While the polarized politics characterizing our party system does not bode well for concerted fiscal action, divided government carries the potential for spreading political risks and promoting more sustainable fiscal outcomes, as it has in our recent history and in other nations as well.

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The Recession and Recovery from an Industry Perspective

Real GDP grew at an annualized rate of 0.1 percent in the fourth quarter of 2012, according to the Bureau of Economic Analysis' revised estimate. Although this revision may confer the important psychological effect of keeping a streak of 14 consecutive quarters with positive growth alive, the reality is that the U.S. economy stagnated in the last quarter of last year. The overall growth rate of real GDP hides a fair amount of heterogeneity across industries.

Advancing Urban Policy: Public Finance & Budgeting was created with counsel from Benjamin Clark, Ph.D., and Kevin O'Brien; compiled by Jessica Murphy, graduate assistant; edited by Roslyn Miller, consultant.

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