Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Accounting Hides True Costs
Transcript
- Lucas: Let’s talk about the most expensive thing you don’t see on a government balance sheet. It isn’t the defense budget, and it isn’t social security. It’s the gap between what governments owe and what they admit they owe. Today we’re looking at off-balance-sheet liabilities, specifically how special purpose entities are used to hide debt from voters and credit rating agencies. Luna: It feels like a loophole that’s been there since the beginning, doesn’t it? But the scale has changed dramatically over the last decade. Lucas: Exactly. And the mechanism is surprisingly simple once you know where to look. A city or state creates a separate legal entity, often called a special purpose vehicle or SPV. They transfer an asset or a liability into that entity. Because the parent government no longer technically owns it on paper, it doesn’t appear in their official consolidated financial statements. Luna: So they can borrow billions without increasing their reported debt to gdp ratio, which makes them look fiscally healthier than they actually are. Lucas: Precisely. And the kicker is that the government usually guarantees the debt anyway. So if the SPV defaults, the taxpayer picks up the tab. But because the debt sits outside the main ledger, it doesn’t trigger the same borrowing limits or political backlash. It’s accounting magic, but with very real consequences. Luna: I remember reading about Detroit’s bankruptcy, and while pensions were huge, there were also these weird utility financing deals that complicated everything. Lucas: That’s a perfect example. Detroit used various financing structures to defer payments on its water system and other utilities. These weren’t direct bonds, so they didn’t show up as traditional debt. But when the city collapsed, those obligations became immediate problems for residents who suddenly couldn’t pay their bills without facing service cutoffs. The debt was still there, just dressed up differently. Luna: It sounds like the definition of moral hazard. You get the benefit of lower reported debt today, but the risk stays in the system. Lucas: Right. And it’s not just cities. States do it too. California, for instance, has used lease-purchase agreements for decades to buy equipment and build facilities. Technically, it’s a lease, not a loan. So it doesn’t count against their constitutional debt limits. But the monthly payments are mandatory, effectively functioning like bond interest. Luna: So you’re borrowing money, but calling it rent. That’s a clever way to bypass voter-approved debt caps. Lucas: It is clever until the payments come due. And here’s the thing: many of these leases have escalation clauses. The cost goes up every year, sometimes faster than inflation. So the burden on future budgets grows exponentially, even though the initial purchase price looked manageable. Luna: This brings me to something I’ve been thinking about regarding your earlier point about incentives. Who actually benefits from hiding this debt? Lucas: Good question. Politicians benefit in the short term because they can claim they delivered new infrastructure without raising taxes or issuing visible bonds. Credit rating agencies benefit because they get paid by the issuers, and aggressive accounting keeps ratings stable, which keeps borrowing costs low. Everyone wins, except maybe the person holding the bag ten years later. Luna: So it’s a collective action problem. Individual actors optimize for themselves, but the system becomes fragile. Lucas: Spot on. And the fragility is real. When the Great Recession hit, many municipalities found that their off-balance-sheet liabilities were far larger than anyone realized. Some had to declare bankruptcy precisely because these hidden obligations came due all at once, catching treasurers completely off guard. Luna: It makes you wonder if there’s any way to truly clean up the books. Or if the pressure to hide debt is just too strong. Lucas: There are reforms, but they’re slow. The Governmental Accounting Standards Board, or GASB, has issued new rules requiring more disclosure of certain types of leases and obligations. But compliance is patchy, and enforcement is weak. Plus, the definitions are complex enough that creative accountants can always find a way around them. Luna: It feels like we need a fundamental shift in how we define 'liability' for the public sector. Lucas: Agreed. Currently, the focus is on legal ownership. If the government doesn’t legally own it, it’s not on the books. But economically, if the government is on the hook for it, it should be treated as debt. The distinction is arbitrary, but the consequences are not. Luna: I’m curious, though. Do investors really care about this? Or do they just assume the government will bail out these entities anyway? Lucas: Smart investors do care. Bond analysts dig into footnotes and look for related-party transactions. They check if the government has provided implicit guarantees. But retail investors, the average person buying municipal bonds, rarely does. They see a low yield and assume safety. They miss the structural risks entirely. Luna: That’s a dangerous asymmetry. The experts know, but the everyday holder doesn’t. Lucas: Exactly. And it leads to mispricing. Debt that carries high hidden risk trades at similar rates to safer debt, distorting capital allocation. Money flows into inefficient projects because the true cost isn’t reflected in the interest rate. Luna: So it’s not just a transparency issue; it’s an efficiency issue for the whole economy. Lucas: Right. Resources are wasted on projects that shouldn’t be built, funded by debt that shouldn’t exist. It’s a drag on growth, even if you can’t see it in the headline numbers. Luna: Before we go deeper into the solutions, I want to pause here. If walking through the economy with us has made something click, consider supporting the show directly. We deliberately don't run ads on these. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. It helps keep the research rigorous and the conversation ad-free. Lucas: Yeah, that’s right. Your support is what allows us to dig into these details without selling out to advertisers who want soundbites instead of substance. Thanks for listening. Luna: Back to the debt traps. You mentioned mispricing capital. Can you give us a concrete example of how that plays out in a real project? Lucas: Sure. Let’s look at a hypothetical stadium deal. A city wants to build a new arena for a professional team. Instead of issuing general obligation bonds, which would require a voter referendum, they set up an industrial development bond through an SPV. The team operates the stadium, but the city issues the tax-exempt bonds to finance construction. Luna: So the city gets the prestige of a new landmark, and the team gets cheap financing, but the taxpayers are on the hook if the team fails. Lucas: Exactly. And often, the revenue projections are wildly optimistic. Ticket sales, concessions, parking fees—they all fall short. Then the city has to step in and cover the shortfall using general fund revenues. That’s money that could have gone to schools or roads, diverted to subsidize a sports franchise. Luna: It’s essentially a wealth transfer from the public to private owners, masked as economic development. Lucas: That’s the best way to describe it. And because the debt is off-balance-sheet, the city doesn’t have to justify the expense in the same way. It’s buried in the footnotes, easy to ignore during election season. Luna: Do you think public awareness is growing? Or are people just tired of hearing about government waste? Lucas: Awareness is growing, but slowly. Investigations by local journalists are starting to shine a light on these structures. But it’s hard to compete with flashy announcements of ribbon-cuttings. Nobody puts up a banner saying 'New Hidden Liability Opened Here.' Luna: So the solution might be better journalism, or maybe even algorithmic monitoring of financial filings. Lucas: Both. Technology could help. Imagine a tool that scans thousands of municipal filings and flags unusual SPV activity automatically. It would make it much harder for governments to hide the ball. But until then, we have to stay vigilant. Luna: It reminds me of how corporate scandals used to unfold. Enron, WorldCom. The public eventually demanded stricter rules. Will we see the same for public finance? Lucas: I hope so. The Sarbanes-Oxley Act cleaned up corporate accounting after Enron. We need a similar shock for municipal finance. Maybe a major default caused by hidden liabilities will finally force Congress to act. Luna: Here’s hoping it doesn’t take a crisis to fix a known problem. What’s one thing listeners can do right now to protect themselves? Lucas: If you hold municipal bonds, read the prospectus. Look for the section on 'other financing sources' or 'related party transactions.' If it looks vague, ask questions. Demand clarity. Transparency is the only defense we have. Luna: Simple advice, but powerful. Knowledge is power, especially when the game is rigged. Lucas: Always. And remember, the next time you hear about a 'cost-free' government initiative, ask yourself: who’s paying for it, and where is the bill going to land? Luna: That’s a question worth carrying into your next conversation. Thanks for breaking this down, Lucas. Lucas: My pleasure. Let’s keep digging.