By: Dr. Mike Walden
North Carolina Cooperative Extension
“Debt” has acquired the status of a bad four-letter word. We worry about public debt, especially the $18 trillion national debt. We also worry about our private debt, realizing, for example, that large household debt was one of the factors leading to the Great Recession.
There’s now talk about North Carolina increasing its public debt to build and refurbish roads and buildings. The total amount of new borrowing could top $2 billion.
Of course, the first question to address is whether this spending is necessary. In economic terms, the question is about the financial benefit from this spending.
Supporters say many of our state roads need repair and upgrading, and in some areas additional roads or road-widening projects are needed. The pay-off is smoother driving, better access and less congestion. These benefits save drivers both time and money and encourage business development.
Backers of borrowing also say many state buildings are in need of repair and upgrading, especially for modern technology. They say improvement of the buildings will make them safer and increase employee productivity.
For purposes of this column, I will accept these benefits and assume the economic returns from the road and building improvements are substantial enough to warrant the spending. The question then becomes how to fund the $2 billion or greater spending tab.
To begin, it is important to note the road and building projects are a specific kind of spending, called durable spending. This is spending on projects which have a long life, usually over many years. In the case of roads and buildings, the life span is multiple decades. In contrast, non-durable spending is for items that only last for a very short period of time.
The distinction between durable spending and non-durable spending has an important implication for how the spending is financed. Logically, non-durable spending should be financed out of current funds – that is, on a pay-as-you-go basis.
The tuna sandwich I bought for lunch is an example of non-durable spending. The benefit of the tuna sandwich – satisfying my hunger and giving me energy – lasts only a couple of hours. It wouldn’t make sense for me to pay for that sandwich with a loan I repay over several years!
In contrast, the home my wife and I bought 30 years ago was financed with a mortgage loan. One reason was that we didn’t have the cash to pay for the home – few home buyers do. But another reason was economic logic. By borrowing the money for the price of the home and repaying the loan in regular monthly amounts over many years, we matched the benefits we were receiving from the home to the cost of the home.
Let me expand on this point. After renting for several years, my wife and I had decided to purchase a home. We wanted the ability to control our living space, move walls if we wanted to and use paint colors we liked. If we had decided to wait until we had enough cash to purchase a home without a loan, we would have waited years – maybe decades – to begin enjoying the benefits of home ownership. Taking a mortgage loan allowed us to buy the home right away and pay for it little by little while we enjoyed it.
But what about the argument that using a mortgage loan to buy our home meant we paid much more – in dollars – over time because we had to pay interest on the loan? If we had had the cash available to purchase the home without a loan, wouldn’t that have been smarter. Isn’t it always better to use cash rather than a loan requiring interest?
Not necessarily. If we had the cash available to buy our home, then we would have given up the opportunity to invest that cash somewhere and earn interest. So the interest we would not have earned would have been the cost of using cash for the home purchase. In other words, if we had used cash, we should have charged ourselves interest to represent the interest earnings we were giving up.
So what does this discussion of the Walden’s home buying have to do with spending on roads and buildings? It has much to do with it because the decisions are exactly the same. Roads and buildings are long-lasting projects that provide benefits over several decades – some even centuries. Borrowing money today — to construct and rebuild roads and buildings — and paying for the borrowed money over time will align benefits and costs just like the Walden’s did when they bought their home.
There’s also another element to consider. If the roads and buildings were paid for completely from current tax revenues, then today’s taxpayers would bear the full cost. But future taxpayers also will benefit from those roads and buildings. If only today’s money is used, those future taxpayers get a “free ride.”
There are many reasons not to borrow. But if borrowing is done to finance long-lasting projects that produce significant benefits — projects for which all those who receive the benefits (both now and in the future) will contribute to paying the costs — then borrowing can make sense. You decide if the current proposals for funding roads and public buildings meet this standard.Share: