Debt is Not a Funding Source

In the past week I was subjected to three instances where public officials – one elected and two professional staff – indicated that debt was a major funding source for a project they were advocating for.

And they said it in such a matter-of-fact way it suggested they considered debt an equal – perhaps superior – form of funding, at least on par with the raising of taxes or the imposition of fees.

Debt. Bonding. The borrowing of money to spend today but repay in the future... My inner Nassim Taleb is screaming.

On page 47 of Taleb’s latest book Skin in the Game is a table labeled “Asymmetries in Society.” It describes “No Skin in the Game” as a situation where one party secures an upside and transfers downside to the others. “Skin in the Game” is where one takes his or her own risk and keeps the downside. “Soul in the Game” is where one takes the downside on behalf of others or for universal values.

Here’s one entry in the table:

I’m not suggesting – and neither is Nassim – that public officials who recommend the use of debt are immoral, but they have a very different set of incentives and risks than those accountable for paying that money back.

This shouldn’t make us distrust public officials, but it should give everyone – especially the people making the recommendation – a vigilant sense of skepticism. One powerful realization from psychology is that we humans can trick ourselves into believing we are doing good, especially when that action aligns with our own self-interest (status, power, enhanced resume) and we don’t experience a symmetrical downside (loss of status, demotion, loss of employment) if things don’t work out.

For a City, what is Debt?

Like many of our current local conversations, our dialogue on debt is distorted in fundamentally damaging ways by the centralization of our national discourse. In fact, it’s almost guaranteed that we’ll get a comment on this article suggesting that debt doesn’t matter, that money is merely a human construct and that we can take on as much debt as we need so long as blah, blah, blah...

We’re also likely to get a comment that blasts the federal government for their debt prolificacy and the fragility that $21+ trillion in federal borrowing has created. These are the parts of a national conversation that are playing out on cable news, social media and other havens of less-than-enlightened discussion. I find them generally uninformed and, in terms of what this means to a municipality, irrelevant.

While the analogy comparing government to a family has some deep flaws, when we get to the level of local government — where we can’t print money, borrow unlimited amounts, bully ratings agencies and trading partners, confiscate gold, threaten others with the use of force, and so on — the comparison starts to have some validity.

That’s because, for a city, debt is something pretty simple: future spending brought forward to today. If our municipal government takes on debt today, it is agreeing to allocate future revenue to retiring that debt.

This is the opposite of savings, which represents a delay in spending today to allow for increased spending in the future. For many reasons – not all of them wrong – cities are generally terrible at saving.

So, much like a family, when a local government borrows money to spend today, there is usually an underlying assumption that the future family/government will be in a stronger financial position as a result of the spending. Thus, that future family/government will have an easy time paying back that money.

This is where that vigilant sense of skepticism comes in.

Debt as Investment

When I suggest that debt is not a funding source, what I’m pointing out is that the funding source is actually the revenue stream that is going to be tapped to retire the debt.

If I take out a college loan, I’m going to identify my future earnings as the funding source that will pay for my education, not the debt. The debt is merely the way I transfer – at an interest penalty – my future earnings to today’s spending.

If I’m going to school to be an engineer and I can confidently project not only the successful completion of my schooling but a future job with significant earnings, I can feel confident about taking on that debt. If I’m going to school to be a percussionist and have reasons to doubt my future earnings potential, that debt is going to be a much greater risk. (Side note: That simple math is one of the primary reasons I’m an engineer today and not a drummer.)

If a city is going to take on debt to maintain a street, the question is just as simple: What is the revenue stream that is going to pay to retire that debt?

If the revenue comes from new growth, then the recommendation to borrow money needs to be accompanied with identification of how much new growth is needed, and where and how it is going to happen.

I’d also want to know, is the new growth contingent on the maintenance of the street – making that project an investment like a college degree – or is that new growth coming from something else? If the former, then I’d like an assessment of the risk of that growth not coming to fruition.

If the latter, I’d have the same question on risk, but I’d also want to know whether maintaining this street today is the best use of that future cash flow. This is where vigilance suggests that Today Me is inclined to value today’s spending far more than Future Me. I need to give intentional respect to Future Me.

When taking on debt, bureaucrats and public officials need to be vigilant in discounting their own spending priorities today and elevating those (largely unknown) priorities of future residents. This doesn’t make borrowing money impossible, but it raises the bar considerably.

Cash Flow vs. Insolvency

What if debt isn’t an investment, but necessity because of slow cash flow? After all, for big ticket items, few families and businesses save up money to pay cash. Why would we expect a local government to do so?

This is a good point, but it comes with a high bar as well. If your city is going to take on debt for cash flow purposes, you have an obligation to make sure you’re not merely confusing your insolvency with a short-term cash crunch. Those two situations feel very similar for parties without skin in the game.

I wrote about confusing cash flow problems with insolvency and how to discern the difference four years ago in a post titled "Investing Cheap Money." It’s still relevant, including this:

You have to be pretty intentional, organized and disciplined if you want to discern your true financial status.

Most cities don’t. They want to believe they have a cash flow problem because it is convenient, because insolvency is too difficult to fathom.

Difficult, but not impossible. If I were being asked to take on debt and there were no investment/growth component to that spending, I would demand to know whether we were solvent, whether we could sustain our own systems with our own tax base or whether I was being asked to obligate future citizens to pay for today’s spending — stuff they very likely won’t value then in the same way that I do now.

Skin in the Game

I’ve consistently argued that cities need to be given a larger toolbox. State and federal governments need to get out of the business of managing cities. We need to stop telling them how much they can tax, how they can tax, what they must spend money on and a whole array of micromanagement that has crept into how we do business. This is because, going back to the "Asymmetries in Society" table in Skin in the Game:

Cities have soul in the game. We live with our mistakes. We experience the downside. For us, it’s real.

The only exception is debt. Public officials and bureaucrats can blow up a city with debt. They can cancel the future of a community in a way that is nearly indiscernible to the public until it’s too late. In fact, it’s often done for the very purpose of making today’s stresses – cash flow stresses – indiscernible to the public. Debt is way too seductive for those without skin in the game.

I have a simple solution: Cities should not be allowed to finance anything for periods longer than 25 years (or, put another way: the generation assuming the debt should pay it back). Cities should be limited to 5% of their locally produced revenue for annual debt service. I would allow that to increase to 10% — where I’d set a hard cap — if a majority of voters, through public referendum, approved it.

Such a provision would make life more stressful for today’s local officials, but tomorrow’s officials would find themselves in cities that were far stronger. Making that tradeoff is what it means to have soul in the game. Soul in the game is fundamental to building a Strong Town.

(Top photo from Michigan Municipal League)

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