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Feb022009

The Small Town Ponzi Scheme

The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going. The system is destined to collapse because the earnings, if any, are less than the payments. Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational in the economic sense if a government will likely bail out those participating in the Ponzi scheme.

 

- Wikipedia entry for Ponzi Scheme

 

With Bernard Madoff and his $50 billion ponzi scheme being in the news, I have been thinking about the concept of a Ponzi scheme. What I am going to describe to you in this post is the small-town version of the Ponzi scheme, one that governments legally do every day across the entire country.

Throughout rural America, cities and small towns popped up along railroad tracks, rivers and to a lesser extent, trails. These were not great places to live in terms of being clean and safe (a fact we should remember), but they were efficient. Besides the land given to railroads, these towns were built naturally without any government subsidy. In those terms, they were also economically sustainable. Those that were not supported by the economic activity they generated (as a center of commerce for the agricultural, forestry, trapping, fishing, etc... industries), never materialized or quickly went away.

At some point, each of these towns were served with urban infrastructure (water supply, sanitary sewer and often storm sewer of some type). Some installed their own infrastructure. Others had infrastructure installed as part of state and federal investment programs. Either way, the innocent seeds of the Ponzi scheme were planted.

As these infrastructure systems aged, they needed maintenance and, ultimately, they needed to be replaced. Replacing worn out urban infrastructure is a difficult thing to do financially. As a local government, it is one thing to convince everyone to pay for a sewer system once (especially when the alternative is a foul stench and rampant disease), but what is the benefit the second time? The first time will increase the standard of living, create jobs, promote growth, etc.... None of this is true the second time. Maintenance of such infrastructure allows a city to merely tread water - not going forward or backward. If you have ever been to a city council meeting where they are trying to get residents to agree to pay for replacing existing, but worn, infrastructure, you know that it is an unpopular calling.

Enter the solution: "invest for growth". The idea is if the city can put in new infrastructure and grow, then it can use the revenue from that growth to cover the costs of maintaining the original system. This is where the common notion that a city needs to "grow or die" comes from. Cities grow their infrastructure systems, induce new tax base and investment and in the short term the entire community is better off without overtaxing the existing residents.

This works when the new growth is not only economically sustainable, but it actually generates a "profit" for the community. After all, not only does the new development need to financially support the expansion of infrastructure for the new development AND pay for the long-term maintenance and replacement of that new infrastructure, but it needs to also pay a good portion of the replacement of the old infrastructure on the existing system.

Unfortunately, this rarely happens. What typically happens is that the infrastructure is first extended to the new development. The added tax base and revenue from the new development is then used to cover the cost of the extension AND a good portion of the replacement of the old infrastructure. Monies for ongoing maintenance are often not part of the equation. Setting money aside for future infrastructure replacement is all but unheard of. But everyone is happy. Old property owners enjoy growth in their community and have their infrastructure subsidized by the new development. Those investing in the new development benefit from the infrastructure.

It is not hard to understand now why this takes on the trappings of a classic Ponzi scheme. Now the same community not only has its original infrastructure but also now has additional infrastructure to maintain. With no money set aside for its replacement and little for proper maintenance, when the system ages the existing users will have to come up with the money for replacement or look for more users to connect and share the costs with. Because there is more infrastructure this time and thus more cost, even more new users are required.

The cycle continues until the community collapses (rare) or, as noted in the wikipedia definition for Ponzi scheme, the government bails them out (most often). The bailout comes in the form of infrastructure "investments", of which trillions today are needed just to maintain our existing systems.

What is probably the worst aspect of this is that voters applaud state and federal governments as they make this problem worse. Politicians love to stand up and take credit for a big project in a community, but rarely do those projects include an evaluation of what caused it to be needed in the first place (the notion of "grow or die" is so strong that it is rarely even questioned). And being ignorant of the underlying cause, those projects also rarely evaluate the long-term financial sustainability of the project or require communities to (a) budget for future capital replacement costs or (b) develop more efficiently to maximize the infrastructure investment.

So in the end, by subsidizing inefficient development patterns, state and federal governments (temporarily) bail communities out of the Ponzi scheme or, more aptly, put off the day of reckoning.

How can a small town avoid the Ponzi scheme cycle? There are really three simple to understand (but difficult to follow) steps. 

  1. Adjust your budget to include realistic funding for replacement of existing infrastructure systems. It will be difficult for people to tax themselves now for  replacement thirty years from now, but it is critical that it be done.
  2. Do not allow for the extension of utility systems where it can't be justified through a long-term cost/benefit analysis (must include at least one replacement cycle). In other words, don't dig the hole deeper.
  3. Look at ways to increase development where there is existing infrastructure. Make better use of those existing infrastructure investments. 

For most small towns, there is no way out of the Ponzi trap without state and/or federal government subsidy. That is reality. Most small towns have long assumed that the state and federal governments will continue to have the desire and the means to bail them out in the future. With the current financial crisis, the massive deficit spending on stimulus, the migration of Americans back to urban cities and suburbs and the pending financial obligations this country has for retirement and health care, that is no longer a safe assumption.

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Reader Comments (3)

Chuck,

I'm most interested in step #3. Would a revival of "downtown" living - people moving into towns and big cities - make better use of existing infrastructure and create more money available for maintenance and upgrade? Would this be true for towns like Brainerd, Bemidji, Hibbing and Grand Rapids as well as big cities? If so, can city councils or even state government design policies to encourage this?

Scott

February 5, 2009 | Unregistered CommenterScott Hall

Scott,

You are right on....making better use of our infrastructure is the key. Right now the zoning ordinances of most cities artificially restricts the amount of development on existing infrastructure on one hand while large government subsidies makes it economically viable (short term) to waste/devalue these huge investments. Downtown living can be encouraged in a healthy free-market system just by removing subsidy to do otherwise. The increased tax base in areas with infrastructure will help pay the cost. This is the key to sustainable small towns.

Thanks for the post. Go Twins.

-Chuck

February 6, 2009 | Unregistered CommenterCharles Marohn

In our small city, 81,500, we are doing well on points 2 and 3. We are missing the boat on item 1. My issue with doing well on items 2 and 3 is it means infrastructure needs to be redone for existing areas that are above their capacity currently. Adding more density will further tax the system in place. We have some areas that are having sewage backup now and are reluctant to welcome more density. The classic problem, Ponzi scheme, it's more attractive to spend money on the shiny things than infrastructure. So what do we do? We spend $160,000,000 on a Performing Arts Center. No matter how much we increase the density we can't do better than 1,600 people/show in the PAC. Seems we have come to the fork in the road where we have to put up (infrastructure) or shut up. Yet as we allow some of our citizens to deal with unpleasant issues we spend unspecified amounts of tax dollars paying subsidies to 'preferred' Arts businesses to entice them to relocate into our Arts and Design District.

This doesn't seem sustainable?

Thoughts?

November 1, 2013 | Unregistered CommenterRick Smith

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