Endgames

The downside of debt financing

by Tom Bender

IN CONTEXT #44, Summer 1996
© November 1990 by Tom Bender, © 1996 by Context Institute

Alternate courses of action with apparently equivalent financial, environmental, and social results may actually leave us in entirely different end positions.

Endgame analysis suggests that we give primary consideration to the different endgame positions we can end up in from alternate actions as well as to the financial and other returns gained in the course of the actions. With it, we can discover profoundly different results lurking in unconsidered alternatives.

Endgame thinking really shines when we look at debt financing. Here it clearly shows us that something which may seem to be of value done once, can become a disaster when repeated. It shows us as well that debt financing, (a true economic cocaine), also makes it extremely hard to avoid slipping from the "once good" into the "continuing disaster" category. Let's look a bit closer.

We're told that time-payment, pay-as-you-go, or credit buying, has benefits that justify the cost. We are able to have use of what we're buying while we pay for it instead of having to wait until we've saved the money for its purchase. Some truth there.... maybe. But lets look down the road a bit, at the end of that game, or better yet a few games later.

After fifteen years, we've bought and financed five cars, let's say, and given ourselves the same rationale each time. But if we compare a "financed" end situation to a "cash" scenario, where we'd gone without, or driven a junker, or shared while we saved to buy just the first one, we'd see very significant differences!

After the first purchase, we're not going without a vehicle in either scenario. Debt financing ends up with possible use benefit during the first vehicle's life, but with five vehicles interest payments. Pay-as-you-go ends up with possible partial inconvenience during the first vehicle's life, but with interest payments gained on savings for 12 years instead of financing charges paid out for fifteen years!

ENDGAME: We only benefit from credit or debt financing the first time we use it. On subsequent purchases financing is a major expense (often doubling the total cost of purchases) that we're trapped into with no real benefit, because payments on the original debt prevent us from saving for subsequent purchases.

We can also see that if we adopt a pay-as-you-go pattern generally, the savings generated quickly allow us to immediately pay cash for purchases rather than having to wait until we've saved up the cost. This eliminates even the original justification and value of debt financing.

These alternatives represent MAJOR differences in cumulative costs. When we apply endgame thinking to our personal expenditure patterns as a whole, including car and home payments, credit card purchases, etc. we see we're talking a cost difference amounting to maybe ten years of net income. And this translates into perhaps fifteen years of our total pretax income! A pretty heavy price for sloppy thinking.

In the public realm, debt-financing (such as bonded capital improvements), results in our paying DOUBLE what those improvements would otherwise cost. Debt financing in the public realm is one of perhaps a half-dozen baseline reasons our public expenditures have become unaffordable.

A city needs a new $10 million sewage treatment plant and votes in a 30 year bond issue to pay for it. No one mentions that the actual total cost to pay off the bonds is probably $20 million, not $10 million. A few years later the city needs a new school, then a new hospital, then street improvements, then a new landfill or water treatment plant. Because of the $10 million finance charges on the first debt, it can't revenue-finance the subsequent needs, and has to bond-finance them, and successive ones also.

The reality is that capital investments are a consistent ongoing process of every city, county, state or national government. The government that plans ahead sees roughly what improvements will be needed, and when. Then they get those needs queued up so that each can be financed in turn out of current revenues. Improvements are obtained at half the cost and with freedom of action that the debt-financing entity has lost.

Many higher education systems, for example, now have an ongoing budget item for construction. Campus A gets a new physics building this year, campus B gets a new gym next year, and Campus C gets some new dormitories two years later, all financed out of current revenues.

Proponents of public debt-financing point to low interest costs, and talk about inflation resulting in "lower cost of repayment dollars".

Interest rates on loans, however, already include a projection for anticipated inflation in addition to interest rates for the lender .The length of most public capital improvement bonds is also long enough that interest represents a higher proportion of repayment costs than on personal loans, and means that more "old loans" are having to be pay for each year instead of paying cash for current expenditures.

Looked at in aggregate, by examining the financial records of almost any public body over a forty or fifty year period, we can clearly see:

• Consistent patterns and levels of continuing capital expenditures, virtually all debt-financed after the first occurrence of debt-financing.
• Repayment demands each year of twenty to thirty years of old debts, not just current ones.
• Total debt service on old debts each year running about as high as current expenditures (excluding their commitments to future debt costs).

Endgame thinking involves figuring out what kind of a position we want to be in some years hence, when actions we are committing ourselves to today have made their effect. It helps us choose alternative actions according to what situation they will leave us with in addition to their initial cost. Should we permit manufacturers to use foreign made components in everything from cars to computers? This may permit some marginal financial savings (or merely profit centralization). It may also, however, destroy our manufacturing capability to support a major war in the future, which could be disastrous from a national "defense" perspective. But then again, if everyone was in a similar situation, it might be good for all!

Compare, for example, what we see when we look at the endgame results of natural gas vs. home insulation as an energy resource. Both may cost the same over a twenty year period and have only minor environmental effects.

Yet at the end of the twenty years, expenditure on the fuel alternative ends with no fuel, no insulation, and a furnace needing replacement, while the home insulation alternative leaves us with a conservation resource in place ready to continue "supplying energy" for twenty to a hundred more years, plus still having the original fuel reserves for our benefit.

ENDGAME: An irreplaceable resource was needlessly consumed or saved, energy use for subsequent fifty years avoided or still needed. The financial cost may have been the same, but the endgame position is totally different.

Endgame positions can also be strongly affected by the sequence in which choices are made . Compare two households, each anticipating purchasing several expensive vacations plus a house over the next ten years. The household which purchases the vacations before the house ends up with memories, and a house. The household which purchases the house before the vacations ends up with memories, a house, plus perhaps $50-$60,000 in avoided rental payments!

ENDGAME: Expenditures on durables before consumables reap enduring benefits.

Take this game one step further. Player A bought their house before vacations, but bought a house with an expected use life of 50 years. Player B does the same, but spends 20% more for a house which will last 400 years. Fifty years later they both retire and sell their houses. Player A gets out just before the roof falls in. Player B gets 90% of the entire investment back.

ENDGAME: Durability pays. And pays. And pays.

And what happens with Player C, who built a durable house, paid cash, and built for energy efficiency? They set up an additional stream of events which could result on a 75% savings in housing expenditures for themselves and their descendents! (See "The Hidden Cost of Housing",Tom Bender. RAIN MAGAZINE, Mar/Apr 1984. Reprinted in UTNE READER, Summer 1984; SUN TIMES, Nov/Dec 1984; ALTERNATIVE PRESS ANNUAL, 1984.)

Endgame thinking can reveal how carefully we sometimes avoid looking at the overall costs of our actions. Ask yourself what you paid for your house or car. Did you include the total financing cost in your answer? Few people do. Do you even know, in dollars, how much the total financing is going to cost you?

Next time you vote, take a look at bond issue explanations on the ballot. Odds are that they give just the net proceeds of the bond issue, instead of telling you the total amount you are going to have to pay to provide the net proceeds plus pay financing costs plus tax avoidance makeup for taxfree bonds.

You can make another check on your financial reality avoidance if you have recently sold a house or some property. Ask yourself if you made a profit on the sale. Then check if you made that conclusion by just comparing the purchase and resale price. Examine what difference there is when you deduct realtor's commissions, taxes, and financing charges while you owned it, and compare the result to what you would have made in interest on the money if you had put in the bank or invested it elsewhere.

At its very least, endgame strategy offers opportunity for major financial resource redirection from illusory benefits of debt financing into support of expenditures which can give us lasting benefit as a society.

Endgame strategy also suggests a range of actions which can help ensure us the freedom to choose affordable ways of purchasing:
* Require ballot information on the total cost of bond issues to encourage us to support revenue-financed alternatives.

* Enact state statutes which require or encourage revenue financing for public capital improvements.

* Enact legislation to protect state and local government entities from being forced into debt financing to pay for federally mandated projects.

* Eliminate tax-deductability of corporate and personal debt service.

* Develop alternative auto financing institutions based on "saving" rather than repeated "borrowing".

Our new economic competitors are used to thinking in terms of hundred and thousand year time increments and strategies which ensure their best endgame situation over such time periods. It is time we began to do as well.