When Should Local Governments Take on Debt?

The Strong Towns Knowledge Base is a crowd-sourced repository of your questions and answers about how to build a strong town. We on the Strong Towns staff chip in when we can, but we can’t get to everything—which is why we encourage all of our members and readers to head on over and add not only questions, but comments with any additional advice, useful links, or wisdom you have to offer!

Here’s what’s new in the Knowledge Base this week: Once again, we’ve taken a few of the best answers from past Ask Strong Towns webcasts, posted the video clip and a brief transcript for easy access to some of the condensed wisdom we’ve got to share with you all. Our featured answer this week is to the question, “When should local governments take on debt?”

When Should Local Governments Take On Debt?

When cities issue municipal bonds, they are taking on debt. There are many reasons why they might do this, and some of them are entirely legitimate. But it's important to understand the pitfalls of public debt.

Identifying Whether You Have a Cash-Flow Problem or an Insolvency Problem

It makes sense to issue bonds for cash flow reasons. In other words, let's say City X has a big surge in road maintenance needs in one particular year. A city is not going to tax its residents much more to cover that surge, and then lower their taxes the next year. Instead, it's going to issue bonds to pay that off, and cash-flow that expense over a period of time.

There's nothing wrong with that provided you are actually confident that you have a cash flow problem and not an insolvency problem. But often, cities get to a point where they have more road maintenance to do than they have money to take care of it, and so they go and borrow the money to meet their obligations. If you're doing this, you will eventually run out of borrowing capacity, and then you'll have neither cash nor the ability to borrow more cash. That's an insolvency problem.

To tell the difference, you need a very detailed capital improvements plan—you should know how much your infrastructure costs, how much your tax base is, and how much, proportionately, goes to maintaining that infrastructure. A cash flow gap is usually something that can be paid off in three to five years. If you're bonding road maintenance over 15 years over 20 years, you're doing it wrong—you're flirting with insolvency, because a lot about your financial situation and your needs can change in 15 to 20 years.

Debt as a Moral Issue

This gets into the moral dimensions of debt. Debt has been morally loaded all the way back to antiquity. What public debt is really doing is transferring future consumption to the present. You're getting something today at the cost of your future ability to consume, to produce, and to have flexibility. Public debt is imposing a cost on the future citizens of your city.

The ironic thing about such debt is that we often clothe it in the idea that we're making an investment today for the future, as if it's some type of sacrifice for us to take on a bunch of debt that future residents will have to pay. Instead, we should look at it the exact opposite way. If we're making an investment today and we're using debt to pay for it, I think two things have to be applicable:

First, you have to pay it off in a short period of time. It can easily become immoral to force debt on a future generation for things that they may or may not want. If you are a local government and you are borrowing money, can you pay it off 10 to 15 years max? Even if it something is a huge undertaking—like building a bridge designed to last 200 years—figure out how to do that so that you can pay off the debt in the short run.

Second, you actually have to have an analysis of how much that payoff is. Know how that money will be collected and recouped and used to pay off that debt, and then monitor that year after year after year.

It's not good enough to rely on projections that can be wildly inaccurate. Cities often say, "We're anticipating five million dollars of property value appreciation" and don't revisit after the fact to see whether that appreciation actually occurred. If you don't have a reliable source of revenue to repay the debt, what you will end up doing is shifting resources from other places. You're going to wind up not fixing a road or a pipe or maintaining an obligation. You're going to wind up shortchanging the maintenance on your parks or your public buildings or something else.

If we're going to take on debt, we have to be incredibly disciplined about it in a way that we're just not prepared to do today.

More on Strong Towns and Public Debt

Articles that deal with the distinction between a cash-flow problem and insolvency:

Articles that illustrate the consequences to residents of living in an insolvent city:

(Cover image by CreditRepairExpert via Flickr — Creative Commons license)