Detroit’s Bankruptcy Is About Unaffordable Pension Obligations The city tried to raise extra revenue with higher taxes, this way encouraging more tax payers to leave. The combination of pension costs and bonds obligations proved to be unsustainable. Detroit is not "too big to fail"

By Paolo von Schirach

July 22, 2013

WASHINGTON – The convenient narrative about the Detroit bankruptcy is that the city is the main (and quite innocent) victim of the auto sector crisis. As GM and Chrysler went under, Detroit was sunk by the gigantic downdraft created by this epic collapse. Convenient story. Except that it is mostly untrue. In fact, the auto sector (however diminished) is back, while Detroit got worse. Of course Detroit was going to feel the negative impact of the auto sector crisis. But the real truth is that Detroit is the victim of the ill effects of racial and social conflicts coupled with decades of poor administration.

The 1967 Detroit riots

Detroit’s problems started after the gigantic 1967 riots, among the worst in US history. Sparked by police action that seemed unwarranted, Detroit’s Blacks went on a rampage that lasted five long days. There was so much violence that Governor George W. Romney (Mitt  Romney’s father) called the National Guard and President Johnson sent in the US Army. A curfew was ordered. At the end, there were 43 dead, 1189 injured, 7, 200 arrests and 2,000 building destroyed.

Seeing all that destruction, Whites felt unsafe and started leaving the city, this way causing a progressive shrinking of its tax base. How did the municipality cope? Poorly. Over many years, the city administration, caught between a shrinking revenue base and mounting pension obligations, quite foolishly decided not to renegotiate pensions, going instead for more tax hikes in order make ends meet.  

Making it worse

Well, not surprisingly, higher taxes going to pay for outstanding pension obligations, as opposed to funding new city projects, encouraged even more people to leave the city, therefore making the lack of revenue problem worse, year after year. Short of cash, Detroit did what other cities did and do: it issued bonds. Investors believed that those high interest bonds would be “safe”, because it seemed unthinkable to anybody that one of America’s largest cities, even though in bad shape, would be allowed to go belly up.

High pension costs, no money to pay for them

And this is Detroit’s story: Too many costly obligations towards large number of retirees, high taxes but not enough revenue, (after having lost most of the tax base due to tax hikes), and growing debt issued for the sole purpose of paying for pensions.

The only way to rebalance the fiscal outlook would have been a combination of renegotiated (meaning lower) pension benefits and measures aimed at encouraging economic growth and thus a larger and healthier revenue base. But the city did neither. The pension agreements stayed, while taxed remained too high to encourage new business. And so, year after year, things got a bit worse.

Bankruptcy

And now, here we are: bankruptcy. This is of course a tragedy for all those who trusted the word of city administrators. And this includes retirees who will see cuts in benefits and bond holders who will not see their money back.

That said, as painful as this is, it is welcome news that Detroit is not “too big to fail“. Detroit failed because it had unwisely created massive obligations, (due to the political deals between public services unions and public officials), that it could not meet. Its attempts to raise more revenue while city services were deteriorating made matters worse. It lost its tax base, while it created an army of (now) angry bondholders.

Other cities headed the same way

The cautionary tale in all this is that Detroit is only the tip of the iceberg. Many other large US municipalities, (like Chicago), are headed exactly in the same direction: too many unfunded liabilities to retirees. Trying to make up the difference through a combination of higher taxes and more borrowing is both suicidal and not enough, as Detroit’s story demonstrated. Tax payers will vote with their feet. They will simply move somewhere else in order ta avoid paying higher taxes.

Just like Greece

Ultimately, Detroit’s problems are not that different from Greece’s problems: too much spending on over generous social programs, without a growing economy that will generate the necessary revenue. While this bankruptcy is a mess, it is a good thing that Detroit is not “too big to fail”. Numbers should mean something, and when something is unsustainable it is wise to put an end to it. In the case of Greece, for the moment numbers do not count. Greece’s future is about political calculations on the part of its EU partners willing to keep the bail out going, despite all. Indeed, notwithstanding its stubborn inability to embrace serious reforms, Greece’s EU partners decided to support this virtually bankrupt country. This would be the equivalent of Detroit, whatever its financial outlook, seeking and getting more credit. 

US Federal Government has the same problem

Long term the US Federal Government faces a similar scenario. Even though the short term fiscal picture, thanks to the impact of the dreaded “sequester” has improved somewhat, long term America is faced with growing debt. And why? Yes, you guessed it, it is mostly about social spending obligations (mostly health care to seniors) completely out of line with Federal revenue. For the time being, the world is eager to lend money to Uncle Sam, trusting America’s creditworthiness. But what if global credit markets stop believing that America will pay back? As a minimum they will demand higher interest rates, this way making the fiscal outlook a lot worse.

Of course, Detroit is much, much smaller than the entire United States. And yet, until recently all creditors were comforted by the notion that such a large city would never go into bankruptcy.