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On Monday, the Government Accountability Office (GAO) defended the current method for budgeting for federal lending programs, known as “credit reform.” By endorsing the status quo, GAO puts itself at odds with the Congressional Budget Office (CBO), which has championed a “fair value” alternative. The details are wonky but the stakes are big. Over a decade, federal lending support for mortgages, student loans, and the Export-Import Bank could appear $300 billion more costly under fair-value budgeting than under credit reform.

CBO is right to question the way we budget for these programs. But GAO is right that CBO’s version of fair value is the wrong solution. Instead, we need a new approach that captures the strengths of both ideas, while avoiding their flaws. I laid out that alternative in a recent report.

One reason we need a new approach is that credit reform violates fundamental principles of good budgeting, for reasons that have nothing to do with the fair value debate.

The problem

Credit reform uses present values to measure the budget impact of federal loans, recording any expected gains or losses the moment a loan is made. But the rest of the budget operates on a cash basis, recording the budget effects of tax and spending policies as they happen over time. These two approaches do not mix well together. By using present values, credit reform can make federal lending appear to mint money out of thin air. It also credits the budget today for earnings it won’t see until well beyond the official budget window.

Consider a simple example: the government lends $1,000 to a business for four years expecting a 4 percent annual return, or $40-a-year for a total of $160. To finance the loan, the government issues $1,000 in Treasury bonds that pay 1.5 percent interest. At $15 per year, interest costs total $60. Thus, the government would net $100.

 

New New Table

How should we budget for those expected gains? One possibility would be to track cash flows, as we do for other government activities. The government lends $1,000 in year one, nets $25 in each of the four following years, and gets repaid $1,000 in year five. Its overall gain would be $100, just as it should be.

That gets the cash flows right, but the timing is ill-suited to budgeting. The upfront cost can make the loan look costly even though it actually brings in money. If Congress focused on a three-year budget window, for example, the loan would look like it costs $950 even though it actually earns $100 over its full life.

A poor solution

We can avoid that problem by eliminating the confusing lumpiness of the cash flows. Credit reform does so by calculating the net present value of the return on the loan, discounted using the government’s borrowing rate. That calculation (the second row in the table) shows an instant gain of $96 when the loan is made. (The $96 is slightly less than the $100 because of pesky technical details.)

Credit reform thus eliminates the lumpiness but at a big cost: it misleadingly claims the returns to lending happen instantly. In reality, those returns accumulate gradually over the life of the loan. In its zeal to get rid of the lumpiness bathwater, credit reform mistakenly throws out the timing baby. As a result, lending programs can look like a magic money machine.

Unlike tax increases or spending cuts, lending programs get instant credit for returns they won’t see for years, sometimes far beyond the official budget window. To take an extreme case, a 100-year loan on the above terms would score as almost $1,300 in immediate budget gains under credit reform, all before the government collects a dime in interest.

To the best of my knowledge, no other person, business, or organization budgets or accounts for loans this way (please share any counterexamples; Enron doesn’t count). Instead, they either accept the lumpiness of the cash flows or use an approach that avoids the lumpiness while reflecting the real timing of returns.

A better answer

It isn’t hard: Instead of tracking all the cash flows, we can report just the net returns on the loan. When the loan is first made, there aren’t any. In our example, the $1,000 loan exactly offsets $1,000 in borrowing to finance it. The reverse happens in year five when the loan gets paid off. In between, the government nets $25 each year: $40 in interest payments less $15 in annual financing costs.

Tracking net returns is a highly intuitive way to report the budget effects of making the loan. It would match the way we budget for tax and spending programs, and would respect the budget window.

The government can and sometimes does make money from its lending programs, but not instantly. The budget community should disavow the credit reform approach and recognize that earnings accumulate gradually over time. CBO, GAO, and budget wonks should join hands to fix this problem regardless of where they sit in the fair value debate.

Note: For more on the technical details, including how to deal with loan guarantees, how the fair value debate reappears in deciding how to measure net returns, and a second challenge in budgeting for lending programs, see my report and policy brief.

 

 

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Lending programs create special challenges for federal budgeting. So special, in fact, that the Congressional Budget Office estimates their budget effects two different ways. According to official budget rules, taxpayers will earn more than $200 billion over the next decade from new student loans, mortgage guarantees, and the Export-Import Bank. According to an alternative that CBO favors, taxpayers will lose more than $100 billion.

Those competing estimates pose a $300 billion question: Which budgeting approach is best?

As I document in a new report and policy brief, the answer is neither one. Each approach tells only part of the story. Congress would be better served by a new approach that fairly reflects all the fiscal effects of lending.

Compared with what?

If lending programs perform as CBO expects, they will bring in new money that the government can use to reduce the deficit, increase spending, or cut taxes. In that sense, taxpayers may come out more than $200 billion ahead.

But these programs do not fully compensate taxpayers for their financial risk. If the government took the same risk by making loans and guarantees at fair market rates—perhaps by investing in publicly traded bonds—taxpayers would make much more. Taxpayers are subsidizing the students, homeowners, and companies that borrow through these programs. In that sense, taxpayers come out more than $100 billion behind.

The same issue can arise in personal life. Suppose your aunt asks for a $10,000 loan to start a business. You’ve got exactly that much in a government bond fund earning 2.5 percent, and she offers to pay 5 percent. She’s got a good head for business, so the risk of default is very low; realistically you expect a 4 percent annual return.

The loan sounds like a winner, right? Her 4 percent beats the bond fund’s 2.5 percent, if you can handle the risk. But there’s one other thing: your brother-in-law, equally good at business, would like a similar loan, and he’s willing to pay 6 percent, with an expected net of 5 percent.

Now the loan to your aunt sounds like a loser. Your brother-in-law’s 5 percent beats her 4 percent. You might still prefer to lend to her, but you would come out behind in financial terms.

The competing CBO estimates reflect this dichotomy. One approach compares the financial returns of lending with doing nothing (the $200 billion gain in CBO’s case, 4 percent versus 2.5 percent in yours). The other compares the returns with taking similar risks and being fully compensated (the $100 billion loss in CBO’s case, 4 percent versus 5 percent in yours).

Both comparisons provide useful information. If you want to predict the government’s future fiscal condition, you should compare the financial returns of lending with doing nothing. If you want to measure the subsidies given to borrowers, you should compare returns with the fair market alternative.

When you discuss your aunt’s proposal with your spouse, you would be wise to mention not only the potential financial gain (“4 percent is better than 2.5 percent”) but the subsidy to your aunt (“4 percent is less than the 5 percent your brother would pay”). Only then can you have an open discussion of your family’s financial priorities.

Today’s approaches

The same information is necessary for an open discussion of federal budgeting. But official budget rules, created by the Federal Credit Reform Act of 1990 (FCRA), require CBO to use just the first approach in its budget analyses. Official estimates thus measure the fiscal effects of lending, not the subsidies provided to borrowers. CBO rightly believes, however, that policy deliberations are incomplete without measuring the subsidies, which CBO calculates separately using an approach known as fair value.

Policy analysts have vigorously debated the pros and cons of FCRA and fair value for years. Neither side has scored a decisive win for a simple reason: both approaches are incomplete. Fair value measures subsidies well, but tells us nothing about fiscal effects; this is its missing-money problem. FCRA measures lifetime fiscal effects well, but tells us nothing about subsidies.

By recording expected fiscal gains the moment a loan is made, moreover, FCRA makes lending appear to be a magic money machine. Lending may pay off over time, but the gains do not happen the moment the loan’s ink is dry. Like any lender, the government must be patient to earn those returns. It must hold the loan, perhaps for many years, and bear the associated financial risk.

A better approach

For those reasons, I believe we should replace both approaches with a more accurate budgeting method, which I call expected returns. As the report and brief describe, the expected-returns approach forecasts the fiscal effects of a loan by projecting the government’s expected returns year by year, rather than collapsing them into a single value at the time the loan is made, as both FCRA and fair value do.

Expected returns accurately tracks the fiscal effects of lending over time, thus avoiding both fair value’s missing-money problem and FCRA’s magic-money-machine problem. It also provides a natural framework for reporting the fiscal effects of lending and the subsidies to borrowers. Expected returns would give policymakers and the public a more accurate assessment of federal lending than either of the approaches we use now.

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