The Soprano State Gets Downgraded

The Soprano State Gets Downgraded
By Steven Malanga

It sounds like a storyline out of some mob movie. Executives at a big employer with ties to powerful unions use the firm's pension funds for financial gimmicks, channeling money meant for the fund into other activities and then lying to investors about the health of the enterprise.

But it's not an episode of The Sopranos. It's merely a description of the financial gimmicks used by politicians in New Jersey over the last decade, the only state ever cited for fraud in its financial disclosure statements by the Securities and Exchange Commission.

Maybe it was all the attention fixed on the volatile market last week, or on Gov. Rick Perry's entrance into the presidential primaries. But neither the financial nor the political world paid much heed last week when Fitch Ratings downgraded New Jersey's debt. Although Fitch noted in its analysis that the state has made progress under Gov. Chris Christie toward achieving a more stable budget, the downgrade was a reminder of something that the governor himself has said when questioned about running for president, namely that fixing the once-prosperous New Jersey is not a simple task of balancing a budget or two. Governments that dig themselves the kind of holes that successive New Jersey governments have dug using an array of fiscal gimmicks can't simply pass a few nominal reforms and then declare victory.

Pension liabilities played a prominent role in the downgrade because New Jersey has essentially used its employee retirement system as a way to run deficits, even though its constitution requires balancing the state's books. What New Jersey has done is a more extreme version of the game other states and municipalities play, too. They simply don't consider their annual required pension contributions to be a part of the budget and therefore not really ‘required,' so they skip all or part of these payments, or they encourage their actuaries to use fuzzy accounting that magically reduces the size of these contributions.

In New Jersey's case, politicians made promises they couldn't afford to keep in the form of enhanced pension benefits during a statewide election year in 2001, and then they went a decade contributing virtually nothing to the pension system. The state's annual pension bill should be about $3 billion, but money has been flying out of the New Jersey pension funds in the form of retiree payments for years, with little coming in.

The math is ugly: last year, a study by George Mason University's Mercatus Center estimated the funds were paying out nearly $6 billion a year in benefits, but they've been taking in only about $1.5 billion in employee contributions. With a stock market that's gone nowhere in a decade, New Jersey's own actuaries have estimated that without reform the funds could start running out of money as early as 2014, while Northwestern University finance professor Joshua Rauh pegged 2019 as the date the funds could go bust.

Even worse, New Jersey for years tried to disguise these financial shenanigans. In offering statements for its debt, state officials declared the pension funds were in fine shape even as they were leaking cash rapidly. Among the maneuvers they perpetrated on investors was valuing the pension funds as if it were 1999, before the dot.com bubble crashed, and thus inflating their assets. Even the SEC, with little purview over state debt, couldn't let New Jersey's evasions slide.

New Jersey took a step toward long-term pension solvency earlier this year with reform that requires employees to ante up more for their retirement, but that will bring in just a few hundred million dollars annually. As part of that deal, the state also committed to making its own required contributions, but it gives itself seven years to get back to paying the full annual amount, $5 billion by 2018. State revenues will have to grow by some $700 million annually just to meet this ‘new' pension obligation, unless the state commits to funneling money in its already tight budget from somewhere else into pensions. Even then New Jersey must figure out how to make up for the money it didn't contribute for years. Pols can always cross their fingers and hope a booming stock market does the trick.

But boom is not something the Garden State has seen a lot of lately. Even before the nation's economic bubble burst New Jersey was struggling through a lost decade of job growth. Once a magnet for jobs fleeing New York, New Jersey itself has become toxic to businesses. The state ranks 44th among the states in job creation measures, including migration of jobs from elsewhere and growth of jobs at existing firms, according to the National Establishment Time Series database. And in a recent analysis of investment in manufacturing facilities nationwide over the last few years, New Jersey ranked next to last, ahead of only Connecticut, in per capita share of spending on new or expanded industrial facilities, according to a study by the California Manufacturers and Technology Association.

There's no mystery behind these numbers. Just ask business executives what they think about the state. In a recent survey by CEO Magazine, executives ranked New Jersey one of the least likely places where they would expand or start a new business. As the state has scrambled for more revenues it has grown ever more assertive and business-unfriendly. Financial executives polled by CFO Magazine have rated the state's finance department as one of the three most unpredictable and least fair among the states.

Gov. Christie acknowledged that the Fitch downgrade was expected because it followed ratings cuts by the other agencies. But those downgrades happened before the state finalized its latest budget and finished pension reform. The Fitch move was a recognition that after a few budgets that hold the line on taxing and spending and some reforms, New Jersey is still facing a long road to stability.

Perhaps that's why the governor pitching for votes in Iowa last week was Perry, not Christie. The two governors have faced vastly different political environments, for sure. Although Perry has pursued some significant reforms, such as tort reform that vastly improved the state's civil litigation environment, his biggest accomplishment has been holding the line against an expansion of government in a state where the legislature's default mode is not higher taxes and more regulation. Christie, by contrast, faces a business environment already among the worst in the country, the highest total tax burden among the states, and a legislature dominated by the other party, where change comes incrementally.

And on top of that, as the governor well knows, New Jersey has long had among the most corrupt political cultures in the states. A former New Jersey Congressman, Hugh Addonizio, once explained it all. Asked why he left Washington to go back and run for mayor of New Jersey's biggest city, Newark, he said: "You can make a million bucks in Newark." That was taxpayer money he was talking about.

New Jersey has been shaken down for so long by its own political culture that the money has finally run out.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute