DETROIT AFTERSHOCKS WILL BE STAGGERING / THE FINANCIAL TIMES COMMENT & ANALYSIS

July 23, 2013 7:33 pm

Detroit aftershocks will be staggering

By Meredith Whitney

Leaders across the country cannot continue as they have, says Meredith Whitney

 

©Bloomberg

 

As jarring as the reality may be to accept, Detroit’s decision last week to declare bankruptcy should not be regarded as a one-off in the US municipal market – which is what the bond-peddlers are now telling their clients. The aftershocks of the largest municipal bankruptcy in US history will be staggering, and Detroit will set important precedents.

 

Municipal bankruptcies have historically been rare for a number of reasons – including the states’ determination to preserve their credit ratings, their access to cheap funding and the stigma of bankruptcy. But, these days, things are very different in the world of municipal finance.

At the root of the problem is the incentive system that elected officials used to face. For decades, across the US, local leaders ran up tabs for future taxpayers; they promised pensions and other benefits for public employees that have strong legal protection. That has been a great source of patronage for elected officials: they can promise all sorts of future perks to loyal supporters (state and local workers) with very little accountability on the delivery of those promises.

Today, we are left with the legacies of this waste. The bill for promises past is now so large for some cities and towns that it is crowding out money for the most basic of services – in the case of Detroit, it could not even afford to run its traffic lights. Across many American cities, cuts to basic social services have already been so deep that they have made the communities unpleasant places.

This is, in part, because of a strange legal position. Over the past decade, US states’ finances have run deficits in more years than they have not. But, of the 50 states, 49 are constitutionally required to balance their budgets; quick cuts to social services were largely used to bridge the gaps. This meant delays in infrastructure projects, delays in basic maintenance of roads, bridges, and schools, cuts to school and higher education.

 

This type of cut is allowed by state constitutions. But, under the same laws, cuts to pension and benefit costs or debt service payments are often not permitted.

In other words, education and public safety tend not to be safeguarded by constitutions but pensions and repayments on municipal bonds are. So, over the past several years, basic social services have steadily eroded, and in most cases home values have declined, crime rates have soared and education has suffered.

Rotten public services take a toll on home values and business investment alike. After all, what makes one neighbourhood worth more than another is the perceived value advantage of its schools, safety, public parks and libraries. Cuts in services happen even when taxes go up; the combination acts to drive out businesses and other taxpayers from the area. This sets off the negative feedback loop from hell.

So leaders across the country cannot continue as they have. They must choose sides because there is simply not enough money to go around. Will they side with taxpayers, unions or the municipal bondholders? If they back residents, money will be directed to underfunded public services at the expense of pensions and bondholders. If they side with the unions, social services will continue to be cut and the risk to bondholders will increase considerably. If they side with bondholders, social services and pensions are at risk.

Up to this point, it has taken either an incredibly daring elected official to stand up for taxpayers or, in the case of Detroit, an appointed official (read “unelected”) whose mandate has been the “emergency management” of the city. After decades of near-third-world conditions in the richest country in the world, the city finally stood up and said enough was enough. Officials could raise taxes further and cut social services deeper but leaders are finding these once “go-to” measures to be counterproductive. They are destructive to the very sustainability of the city.

Since the credit crisis, taxpayers have paid most dearly in terms of reduced social services while paying the same or often higher tax bills. Increasingly, unions are being asked to make concessions on pensions and benefits. And – now – bondholders, who up until last week thought they would be protected in almost any scenario, are being forced to make a contribution to the fiscal problem. Elected officials, for the first time in a very long time, are siding with residents. This is a new precedent that boils down to the straightforward reality of the survival and sustainability of a town or city.

There are five more towns like Detroit in Michigan alone. There are many more municipalities across the country in similar positions. Detroit’s decisión last week paves the way for other elected or non-elected officials to make decisions to save their cities and towns, decisions that probably involve politically unpopular actions that may secure their long-term viability.


The writer is author of ‘Fate of the States’
 

Copyright The Financial Times Limited 2013.