Best of Blog: Investing Cheap Money
I probably spent less time talking about the economy this year than in past years. Part of that is because I've grown cranky with all of you Krugmanites who jump down my throat branding me an ignorant fool (really?) because I don't subscribe to your theory of the world (which, by the way, is the antithesis of the Strong Towns mindset). Mostly, however, I've gotten beyond frustration and am just bored with it all.
Day after day we get a constant stream of economic propaganda, none of it really applicable to world most of us inhabit. And none of it grounded in any kind of reality. I'm not like Kunstler predicting doom with specificity of day and method, but had you told me that we would be six years on with negative interest rates, the Federal Reserve would have printed trillions of dollars, a few big banks would have an even greater market share and being paying even greater bonuses and oil prices would hover around $100 a barrel for most of that period, I would have predicted massive economic upheaval. Or at least riots in the street.
The top-down interventionists can rightly claim they have kept things from falling apart. And why not.....we're in for a penny, in for a pound on this experiment. If we are willing to print, borrow and spend whatever it takes to avoid falling prices, then there is no reason prices will ever fall. Brian Pretti had an interesting article on this last week called Deflation is Winning. I don't see a humane way to unravel this mess back to a more localized -- more real -- economy. That's not the goal, anyway, at least not of those writing the rules.
I will make one prediction: when the next recession hits -- and, statistically, we're overdue, although no society has ever been on this far end of the normal distribution curve so who knows -- we'll have another round of Quantitative Easing (Federal Reserve money printing) only, this time, it will include some form of direct subsidy to families. I sense that some of the true believers in centralized economic management are appalled at how the application of their theories has (predictably, IMO) enriched a small portion of the elite and, besides keeping the lights on at Walmart, done proportionately nothing for the average American. If there is one truism of this mindset it is the belief that "unintended" negative effects of a top-down, centralized policy can always be addressed with a new and improved top-down, centralized policy.
And for the record, despite the huge positive run for the stock market, I own no stocks and no bonds. I do have a small percentage of my family's retirement savings in some index funds that include stocks, but it is less than 10% of what we have. The casino is rigged. I'm more comfortable giving up the positive daily feedback of a rising market in exchange for knowing my future is not beholden to the casino owners.
Incidentally, this piece on investing cheap money was laughed at by the local city government here in my hometown. After an email back and forth with the city staff regarding their (really bad) recommendation to borrow millions for road maintenance, I ran an editorial in the local paper claiming that city did not have a cash flow problem but an insolvency problem and outlining steps that could be taken to address this. I prepared a spreadsheet for the staff that demonstrated this based on numbers they were using. This was in the middle of my extended travel period and I couldn't do much more. The result: another struggling city with a huge debt problem borrowed yet more millions for road maintenance.
If you want to help us bring a message of change to these struggling cities, consider becoming a member of Strong Towns. Our goal of 800 members by the end of the year is just 188 away. We started out this drive by needing 324 so we've come a long ways. Help us close the gap.
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Interest rates are at historically low levels while local governments have a huge backlog of infrastructure needs to address. It seems logical that this presents an opportunity for earnest city officials. Yesterday’s post on domain dependence was a prelude to answering the question posed me last week on Facebook.
How can we best invest cheap money to sustain growth in the future and not squander this opportunity?
There are two types of transactions where cities are justified in taking on debt. The first I will call a “true investment” and the second I will call “legitimate cash flow”. This is true regardless of how cheap money is.
True Investment
In the public realm, we call a lot of things investments that really are not, a lot of things assets that are really liabilities. So when I say a “true investment” I am referring to an expenditure that has the following properties.
- The expenditure has the potential to lead to an improvement of the city’s financial position.
- That improvement is measurable in terms of dollars.
- The actual return in dollars is measured, accounted for and used to inform subsequent investments.
Note that this doesn’t preclude speculative investments, and I’ve indicated that I support a certain level of speculation. My public project portfolio for nearly every American city in 2014 would include many small projects spread out over a large area as opposed to one, two or a handful or large projects. I would also never borrow more money – in term and payment amount – than my current guaranteed cash flow could cover if the investment went bad.
I would never take on debt speculating on future growth if the repayment of that debt depended on the growth. Never. Cities are not private businesses and property owners aren’t shareholders. When local governments gamble wrong, they don't get to go through a clean bankruptcy and then start over. Local governments have a responsibility to be prudent stewards of the public purse, not gamblers at the casino, regardless of how confident they are that the slots are loose.
Should we be using cheap money to make a true investment? I wouldn’t necessarily have a problem with that, and the cheapness of the money certainly lowers the threshold for success. I would be extra careful, however, to fight the impulse to ignore the need for a return on the investment simply because the money is cheap.
Legitimate Cash Flow
Most cities borrow money for cash flow purposes. In doing so, they are generally mistaking their insolvency problem for a simple cash flow problem.
Let me give an example. Let’s say a city has four streets. Each street lasts four years before it needs to be repaired. One street was built each year and so they are on a nice four-year maintenance rotation. If the city is solvent – if there is enough wealth in the community where the tax revenue can cover the city’s long term obligations – then there should never be a need for debt. Each year, each street produces 1/4 of the tax revenue needed to fix the street and after four years every street is fixed and the process starts over.
Cities don’t generally have their maintenance obligations so nicely staggered. Often they come in bunches, an echo of the hasty timeframe in which they were originally built. Let’s say that all four streets need to be maintained in the first year. In that case, the city could tax four times the normal amount the first year and nothing the last four OR they could take on debt in the first year to cover the project and then pay it back in the next three. (Note: Obviously this is very simplified and so I’ve not bothered with calculating interest.)
That is a legitimate cash flow problem that the local government can solve with a judicious use of debt. I fully support it.
Let’s say, however, that all four streets need to be maintained in the first year but the city’s tax base is only half of the prior example. In other words, the city is not collecting enough money from each street – there is not enough wealth there to collect – to cover the cost of maintenance. As in the second scenario, the city takes on debt to cover the maintenance cost but, when we get to the end of the fourth year and need to fix the streets again, they have not been able to pay off all that debt.
Scenario 3 is a case of confusing insolvency with a cash flow problem. The local government believes they have a cash flow problem – there’s plenty of cash there, just not right now – but what they really have is an insolvency problem. They don’t have the tax base -- the wealth -- to maintain everything they’ve taken on. By using debt at this point (good interest rates or not), they are piling more obligations on top of the unfunded liabilities they already have. This is a recipe for disaster.
Here’s the scary thing: all cities that take on debt for infrastructure maintenance believe they have a cash flow problem. They believe this despite not having the actual analysis to determine whether or not this is true. My example is four streets over four years. Cities sometimes have hundreds of miles of streets with maintenance occurring over decades. 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, especially when everyone else appears to be doing the exact same thing. Could everyone be wrong? Could we all be insolvent? These two questions probably cost me a total of six years in the intellectual wilderness as I clung to the notion that what I was seeing and measuring could not possibly be true, that a wisdom greater than mine had to be at work and I just hadn’t perceived it.
While I’m not going to say that low interest rates are a bad thing (they absolutely wouldn’t be if they were real, not artificial), they have the "desired" effect when it comes to local governments: it induces them to borrow and spend more. This is my primary critique of our current monetary policy, and Federal Reserve intervention, in general: it assumes an underlying economic model that is functioning. When the economy slows or stalls, the theory says to create the liquidity needed to get it back going again. What if it is stalling because it’s broken? What if it shouldn’t go on? Short of total collapse, where is the painful financial feedback that is going to force a change?
Some would argue that this is why we need good policy. Sure, but the smartest minds at the time – from both sides of the political spectrum – believed that suburbanization was a good thing. Same with urban renewal. Same with the nationalization of automobile transport policy. What is a good policy and how can we ever have the confidence to put the overpowering weight of the U.S. government behind what we think it is? And what if it is a good policy, but only to a degree? Is local nuance even possible with such a highly centralized approach?
The Growth Ponzi scheme has three predictable phases: growth, stagnation and then decline. During the growth phase, everyone is a genius as the new revenue pours in and all the maintenance liabilities are decades away. During stagnation, the debt climbs as we fail to deal with the insolvency problem, mistaking it for simple cash flow. When we are finally forced to deal with insolvency in the decline phase, we have to do it with a crushing debt burden already in hand. Unfortunately, this fate awaits a great number of our local governments.
So, how can we best invest cheap money? With a Strong Towns approach to debt centered on true investments which pay a measurable return and legitimate cash flow in a city that understands its true balance sheet.