EconoMonitor

Thoughts From Across the Atlantic

Detroit and the Federal Government: Can the U.S. Learn from Europe’s Mistakes?

Detroit Bankruptcy

Bankruptcy by Detroit is the largest municipal bankruptcy in U.S. history. It is a shock for residents of Detroit and their creditors, and it could have important consequences for the fiscal policy of the entire country, depending on how the federal government reacts to it.  The municipal bankruptcy problem is bigger than Detroit, as Harrisburg, PA, Jefferson County AL, San Bernardino, CA, and Stockton, CA have already declared bankruptcy. The municipal debt problem is related to current promises to pay current and future pensions and medical care. Most government pensions are the defined benefits type, in which the government invests now to pay future liabilities. The problem arises because governments invest too little to meet future obligations. Joshua Rauh has estimated that state and local government pensions are underfunded by $4 trillion (Cochrane). Whether these debt problems are resolved locally depends on fiscal relationships between state/local governments and the federal government that date back to the American Revolution. Recent developments in the Eurozone, where initially agreed rules were violated to restore short- run stability, have some relevance to the U.S. municipal debt problem. They resulted in considerable uncertainty about the nature of future fiscal relationship among the member states. It will be interesting to see whether the U.S. can learn from this European experience.

History of U.S. and European Bailout Policy

Following the Revolutionary War, the new Federal government agreed to repay the debts of state governments that were incurred during the War, but they did not commit to paying future debts of states. Subsequently, the Federal government refused bailout requests by states related to bonds issued to finance what turned out to be unprofitable canal building. The no bailout policy has continued to the present in the United States, and a similar rule was adopted as an important foundation principle for the European Monetary Union. The recent bailouts of several countries, although some of the most recent ones included elements of private sector involvement, violated the initial no-bailout principle of the Eurozone, and they converted a problem that was initially confined to a few countries into a much broader, even if less acute problem, for the union. They also destroyed the credibility of Eurozone institutions, which will take a long time to restore.

Fiscal Differences between the U.S. and the EU

There is, however, a major difference between the EZ/EU and the U.S. The central budget expenditure of the European Union still amounts to just about 1% of its GDP and largely consists of cohesion policy payments to relatively poorer member states and payments to farmers under the common agricultural policy. There is no common social policy in the EU. Thus, when the debt crisis hit, the EU lacked a central fiscal capacity that could provide a temporary cushion to the residents of a member state that would be unable to meet its liabilities. As such a fiscal capacity could not be created in the short run, bailouts were apparently chosen as a distant next-best alternative to maintain social and political stability and avoid the risk of some countries leaving the Eurozone. In the U.S., however, there are federal programs (such as Social Security, Medicare, unemployment compensation) in place to provide a cushion to residents of a municipality subject to an unfavorable shock. In the case of Detroit, the AFL-CIO and former Obama administration “auto czar”, Steven Rattner, have already called for a federal bailout. A bailout of the municipality of Detroit could, however, not be justified using the arguments that were used to justify the bailouts of several EZ states – a bankruptcy of Detroit does not pose the risk of a major social upheaval and political instability. Neither does it jeopardize the integrity of the “dollar zone”.

Official Debt and Contingent Debt

Official U.S. debt consists of bonds issued by the federal government, and the ratio of this debt to GDP is now the largest in peacetime history. There is a body of empirical evidence indicating that debt ratios in excess of a threshold are associated with slower economic growth. For example, research at the Bank for International Settlements led by chief economist Steven Ceccetti have found that excessive government debt has inhibited economic growth. The current level of official government debt is extraordinarily high, but the federal debt problem would be much bigger if one included the debt of Detroit, other cities, and other contingent debt. A new study by James Hamilton that includes a broader set of contingent debts (Social Security, Medicare, guarantees on housing and student loans, etc.) estimates the total federal debt in 2012 to be six times the official debt. Thus, an accurate measure of the true Federal debt depends on how the government responds to requests for aid. We have seen that when governments take on new debt obligations in emergencies, official debt/GDP ratios can increase rapidly. For example, the Irish government had a debt ratio of 25% in 2007, but after it made the mistake of extending a blanket guarantee to all bank depositors and subsequently had to bail out its whole banking sector, the debt ratio rose above 117% in 2012.

Dealing with Detroit’s Problem

If a Federal bailout of Detroit is not a prudent response, what can be done about Detroit’s debt problem? Since the movement of production and employment to other regions is part of Detroit’s problem, labor migration is important, and population data indicate that many workers and their families have already relocated. The city’s population has dropped from 2 million to 700,000. However, labor mobility in the EU is lower than in the U.S., not least because of language barriers. For those left behind, local authorities are in the best position to evaluate difficult trade-offs involving reducing current services, reducing benefits to current and future pensioners, raising taxes on current residents, etc. There is no justification for bailing out bondholders, who should have known that municipal bonds are not a riskless asset. However, there is a case for providing better information to potential bondholders that would allow them to better evaluate risks. Marketers of state and municipal bonds have used accounting gimmicks to make bonds appear safer than they really are. For example, the Securities and Exchange Commission has already accused New Jersey and Illinois of fraudulently understating the value of state liabilities to promote sales of their states’ bonds. Changing state and local pensions from defined benefits to defined contributions is a fundamental reform that has been adopted by some states and nearly all private firms. With defined contributions, pension funds avoid future obligations by making current payments into approved investment funds of workers.

Conclusion

A debt crisis in the Eurozone occurred when the debt problems of some countries were allowed to grow into a debt crisis for the entire European Monetary Union. The no bailout policy of the Maastricht Treaty was abandoned, and European leaders continue to search for substitute principles about when one country is liable for another country’s debt. Can the U.S. learn from the European experience and continue with the historical U.S. policy of no Federal bailouts for cities and states? The Federal response to the Detroit bankruptcy will be an important precedent for policies toward other troubled cities and states. It will also have implications for policies toward a broader set of contingent liabilities that could substantially increase Federal government debt relative to the size of the economy. A  Federal bailout of Detroit and other cities and states would convert an already large Federal debt problem into a much larger and unmanageable debt problem.

References

Cochrane, John. “The Value of Public Sector Pensions”. The Grumpy Economist. July 23, 2013.

Hamilton, James D. 2013. “Off-Balance-Sheet Federal Liabilities”. NBER Working Paper 19253, July 2013

8 Responses to “Detroit and the Federal Government: Can the U.S. Learn from Europe’s Mistakes?”

TomAugust 1st, 2013 at 5:31 pm

The federal government needs to find some way of effectively bailing out the pensions of Detroit police and firemen. They're not eligible for social security, so any hit to their benefits will be felt sharply and will worsen an already desperate recruitment situation.

ThomasGrennesAugust 1st, 2013 at 8:22 pm

This specific pension problem is broader than Detroit. It is now being faced by many municipalities, including some with financial problems that have not yet declared bankruptcy. The bankruptcy process itself allows judges to take into account the claims of
pensioners. All the trade-offs are unpleasant, including paying pensions of retired police
and firefighters vs. paying currently active police and firefighters. Is the Federal government in a position to take on additional financial obligations? It already has large unfunded obligations for Social Security, etc. Don't Social Security recipients have a stronger claim
on the Federal government than employees of the City of Detroit?

EdDolanAugust 2nd, 2013 at 2:46 pm

Let's hope you are right, and that the US takes a no-bailout approach to its cities. If so, the attention will shift to China, which faces a similar problem. There, local governments have issued a lot of debt to finance infrastructure and other investments that do not produce the cash flows needed to service the debt. The central government in China is facing a big decision point: Will it allow local governments to go the way of Detroit, or will it bail them out? Let's hope the US does the right thing and China then follows our example.

ThomasGrennesAugust 2nd, 2013 at 3:41 pm

Agreee. The problem is emerging in China. If the national government accepts responsibility for local debt (bailouts) and does not restrict local borrowing, they will have a large national debt problem that will not be reflected in the current national debt/GDP ratio. The IMF has already warned China of this problem. If the national government restricts local borrowing, it would be moving in the direction of greater fiscal union, as the EU is. The final possibility is no bailouts of local governments, which is the traditional U.S. policy.

George WoodAugust 6th, 2013 at 10:09 pm

Cities are political subdivisions of their respective states. All of their powers are derived from a delegation of the state's "police power". Consequently, it is only for the specific city, and if the state's citizens agree, the state government, to address any funding problems. After all, the state should have had statutes and procedures in place to protect against this underfunding of pensions, corruption, and unaffordable union contracts.

In NC, the State Treasurer's Office also runs the Local Government Employees Retirement System. Each local government is REQUIRED to make the actuarially required annual contribution to the pension system. Not surprisingly, NC has one the best funded local government pension systems in the USA. My point is: please explain the "fairness" of those US citizens having to pay higher taxes to bail out the corruption, mismanagement, and poor economic and financial policies of Detroit and the State of Michigan.

DiranMAugust 17th, 2013 at 4:30 am

The only pension rights that concern the US Federal government is social security. If the Detroid union pensions go bust, this a matter between Municipal union members and their leaders. The leaders and their policies should be scrutinized carefully. If there is mismanagement, then those responsible should be punished. The Federal Government has no place backstopping these contracts. Otherwise, the moral hazard would be unlimited with everyone liable for the tab.

Fortunately the US is a sovereign country with its own currency. For hapless Eurozone members on borrowed Germanic currency, their social security systems face bankruptcy risk just as Detroit Union pension schemes and are subject to haircuts, etc. This together with bankrupty risk of the domestic banking system is one of the very negative consequences of using a borrowed currency that is not your own.

pallgrantDecember 22nd, 2013 at 1:29 pm

Well, now Detoit is in Bankruptcy. I am from Ann Arbor and it's really shame to see Detroit suffer. Bailout is not the best way to go about ti, but so many people affected by this. Well, it's been like that for decades. Hope government will find solution for Detroit.

Let's hope for the better

Leave a Response

Most Read | Featured | Popular

Recent Posts Recent CommentsArchives Categories Meta

Blogger Spotlight

Dan Steinbock

Dr Dan Steinbock is a recognized expert of the multipolar world. He focuses on international business, international relations, investment and risk among the major advanced economies (G7) and large emerging economies (BRICS and beyond). In addition to his advisory activities (www.differencegroup.net), he is affiliated with major US universities as well as international think-tanks, such as India China and America Institute (USA), Shanghai Institutes for International Studies (China) and EU Center (Singapore).

Economics Blog Aggregator

Our favorite economics blogs aggregated.