Why Detroit is Going Bust
In an editorial on Monday, the Wall Street Journal asked, "After Detroit, Who's Next?"
Pension recipients and bondholders are expecting the worst in coming months and years, as municipalities across the country can no longer meet their obligations. Their largest obligations are funding pensions and debt service on bonds sold to pay for annual deficits.
"The crushing debt load is ravaging state and local government budgets, and there are few options available to them for addressing this crisis — cuts in services, reductions in benefits, higher taxes, or some combination of the three."
The report debunks the theory that public pension underfunding resulted because of the housing crisis. For over 30 years, the Government Accounting Office warned Congress that poorly-funded public pensions could lead to a "fiscal disaster and possible loss of employee benefits." A funding ratio of 80% is considered satisfactory. 40% percent of state and local government pension plans were below the standard before the 2008 recession began.
The report goes on to state that the principal reasons for the current crisis are a lack of fiscal discipline, overly generous benefits, and a failure to make annual contributions to keep pensions funded at acceptable levels.
And now, Detroit, one of the largest cities in the U.S., has declared bankruptcy. The city's pension shortfall totals about $3.5 billion of its total debt of $18 billion. Governor Rick Snyder of Michigan said that he is "worried about Detroit's 21,000 municipal workers." The foregone conclusion is that pension recipients will likely have their future benefits cut.
Kevin Orr, the new Detroit emergency manager, is "seeking to subordinate the city's debt [including pension liabilities] to the welfare of [the city's] residents via bankruptcy." The implications of this strategy are far-reaching because it may set the precedent for other expected municipal bankruptcies.
Detroit has been cutting services feverishly during the past few years. 70% percent of parks have been closed since 2008, four in 10 streetlights are not operating, 40% of the police force has been cut in the past 10 years, and the corresponding police response to emergencies is five times longer than the national average.
Orr plans to cut retirement benefits, slash debt service, and reinvest $1.25 trillion in public services. Taxpayers at this point will not be subjected to higher rates.
The question everyone is asking is whether Detroit is too big to fail. Comparing a city to a bank is an obvious ploy to sensationalize the issue of failed institutions. Yet no help is expected from the state or federal governments. On Meet the Press, Snyder said, it is "primarily Detroit's responsibility to fix its own problems."
The Detroit crisis is an exaggeration of what is going on throughout the country. Few cities have lost as many residents (and taxpayers) and cut services to such an extent as Detroit, but the problems are still very serious.
The solution, unfortunately, will be to unwind the pension promises made by irresponsible city managers 20 and 30 years ago and cut debt levels. The former will result in huge cuts to pension payments thousands of people have been counting on. The latter will create huge losses for institutional and private investors.
It is ironic that General Motors suffered the same fate as its hometown. Executives made inane deals with powerful unions to avoid strikes jeopardizing future generations of workers and creditors.