Why Cities are Flying Blind When It Comes to Their Own Debt

(Source: Pixabay/geralt.)

My grandfather, when he was alive, used to give me warnings about debt. He told me to not use credit cards, to avoid paying interest, and to never take on debt for depreciating assets. In his eyes, it was better to have no debt on a small house than a large mortgage on a big house. He lived a frugal life with my grandmother, raising six kids and a couple dozen grandkids in our small town in Central Minnesota.

But, he grew up in the Great Depression, so what does he really know about debt?

Seriously. My grandfather’s insights on debt today are way out of the modern mainstream. I’m sure there are some of you that do strict household budgeting and others of you seeking to retire early the Mr. Money Mustache way, but that is the minority. Almost everyone else in the United States is all-in on debt. 

In a chicken-and-egg kind of way, I struggle to discern whether it was our high debt levels that changed our minds on debt, or whether we changed our minds on debt and that created high debt levels. Either way, our entire society—from top to bottom—now runs on credit. This is so much so that we’ve developed elaborate explanations for why thousands of years of economic theories, philosophical insights, and moral teachings regarding debt are wrong. 

And not just wrong; ignorant, small-minded, and absurd. For nearly all of human history, the moral position on debt was to avoid it. Today, the moral position on debt is to support the expansion of credit in every part of society.

I bring this up not to make a moral statement on debt, but to point out that we are in unexplored territory, at least for any American alive today. Either this huge experiment is going to come crashing down in the manner of prior manic moments (the 1920s being the most recent example) or we’re going to transform economically into something new and profound. Perhaps both. What is normal for us is, historically speaking, far outside the norm.

While it draws the most debate and discussion, public debt is the smaller portion of the modern debt story. And, to the extent that we ponder it, we most likely focus on the federal debt, political posturing on the federal budget deficit, or debates over the federal debt ceiling. Municipal debt hides in plain sight, but it is a distant afterthought.

Few cities can tell you how much debt they have. In the accepted way in which cities maintain their books and report on expenditures, there is no line item for debt. Municipal debt is accrued and accounted for in various ways that would shock most people, especially those familiar with private sector accounting: a bit here and a bit there, with loads of fund transfers obscuring where cash comes from and where it goes.

In fact, a few years ago, when Cobb County was courting the Atlanta Braves, some of their public officials claimed they had no public debt. We went through their financial statements and showed the various ways that debt was hiding in their budget. Here’s the thing: I think those public officials believed what they were saying. They honestly thought they had no debt.

Cities use cash accounting (not accrual accounting, which is standard in the private sector). This means that when the city borrows money, it immediately shows up as revenue in the budget. The only corresponding liability is the repayment amount. So, if a city borrows a million dollars on December 31 and doesn’t pay any interest until the next year, that city will have a million dollars of cash to spend in the year they borrow it. Free and clear. 

It is very common for cities to improve their current budget by refinancing their debt. This is not the kind of refinancing where a city exchanges high interest rate debt for low interest rate debt. No, it’s more like taking debt due in the next five years and making it due over the next 15 years. With cash accounting, spreading out payments over a longer period of time helps the current budget.

Desperate cities have been known to balance their budgets by selling assets—the proceeds from which show up as cash that can be used to balance the budget—then agreeing to buy those assets back using long-term financing of some sort. Cities “borrow” from their own maintenance funds, using the cash to balance their budget and leaving an IOU in place that has no immediate budget impact. 

Some cities fund parts of their staff and operations by having a continuous cycle of revenue bonds tied to assessments. The cash is used to pay for infrastructure and staff today with the hope that, when land is sold or developed in the future, the debt can be paid off. 

I often hear people say that local politicians care only about the next election, that they will gladly sacrifice the community’s future for their own advancement today. I’ve not found that to be the case. What they do care about is getting things done. They are required to balance the budget (cities can’t print their own money). For staff eager to please (or at least go along), and for public officials wanting to project competence and get things done, it’s easier to let the tangled web of debt and fund transfers at the heart of the budget go unexplored. 

Sales Tax and Municipal Debt: A Recipe for Even Worse Dysfunction

I wrote last month about how no city should rely primarily on the sales tax for funding. The sales tax is the most opaque of all local taxes. Cities funded primarily by the sales tax find themselves in a rivalrous situation with voters, where the interests of the local government conflict with the interests of the population. Reliance on the sales tax creates all the wrong incentives for local governments to spend without any disciplined examination of the overall impact to the long-term fiscal health of the community. 

The way cities handle debt magnifies the problems of the sales tax. For states like Oklahoma, where municipal funding through sales tax and debt is the norm, the results are alarming.

For example, I’ve watched Oklahoma City over the years fund infrastructure expansion and maintenance with a series of bonds approved by referendum. This approach has the veneer of good governance, because voters must approve the debt. However, like the general sales tax, there is no financial analysis accompanying these investments. In a world of cash accounting, the only question is: Is there money in our pocket? If the answer is yes, then spend away on whatever feels right.

The latest is the Better Streets, Safer City series of referendums. Thirteen in total; something for everyone. 

There is a trick to selling large debt issuances like this. First, the city needs to fail to do proper maintenance to the point that things are noticeably in decline. Roads falling apart, sidewalks broken, parks in a dilapidated state. That kind of thing. 

Second, the city needs to bundle a bunch of projects together and sell them as a package. You want your street maintained? Great, we can do that, but we need you to also vote for a series of expansion projects. You’ll like them, too.

Third, make the decision an all-or-nothing endeavor. The only way you get competent maintenance of core infrastructure is if we can take on debt in this way. Without it, what is in decline will only get worse. Do you support a nice city or not?

What is noticeably absent to anyone with Strong Towns sensibilities is any notion of financial analysis. The entire roster of projects comes from the gut. These are projects they desire, just as with spending sales tax revenue. There is never a point in time where someone says “this bridge costs x and building it will yield this many multiples of x in new tax revenue.” As I wrote in my article on sales tax, that kind of projection is near impossible to perform because of how the sales tax is collected. Debt takes that incongruity and supercharges it.

Perversely, this approach also devalues basic maintenance. All projects funded through these large debt offerings are large. Go big or go home. So, if your sidewalk is cracked and needs a panel here or there to be replaced, the city needs to take that money from sales tax revenue, which is scarce. Or, they can simply wait until more of the sidewalk fails and the entire failure can be bundled into a large debt project. The latter is the path of least resistance. Instead of spending nickels and dimes on maintenance year after year, keeping the place nice, things have to fail so that the repairs can be aggregated into big debt-funded projects.

In a market-based system, this is called crowding out. Well-funded bad practices crowd out prudent good practices. In local government, we just call it efficiency.

Seemingly, the only limit on debt is pressure from the bond ratings agencies, but even here the bar is set extremely low. City leaders like to portray a good credit rating as a sign of good fiscal management, but it’s not. Bond ratings are for investors, not taxpayers, and so a good bond rating is merely an indication that the city can repay the debt they have assumed. Since there is no line item for debt in the city’s budget—no real accounting of the total amount of debt, including all kinds of bonds, IOUs, and interfund obligations—the analysis is mostly backward looking. 

Has the city historically paid their debt? If yes, then they are likely to continue to do so. Congratulations: here’s your AAA bond rating. (It really is that simple, although there is a veneer of analysis added to justify the agency’s fee.)

For residents, voters, taxpayers, and citizens, the ability of a municipality to make debt payments isn’t nearly as important as their ability to maintain services. There is no ratings agency for that, however. The closest approximation is to look at the budget number for debt service and compare that to the locally produced revenue. This gives a rough picture of a community’s ability to pay their own debt. It’s not perfect because “debt service” is a post-manipulation number that doesn’t represent even all the present year debt obligations (it’s an underestimate).

In Oklahoma City, here’s the trend using data from their most current budget report. This is what crowding out looks like. 

That crowding has already resulted in higher taxes and a reduction in services. Without a shift, those outcomes will only worsen. This is not the result of ill intention. It’s a result of flying blind, which is what general accounting practices direct local governments to do in a system funded by sales tax and large debt issuances.

The thing about flying blind, though, is that most of the time it feels a lot like flying.

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