By Manan Vyas
The city of Detroit filed for Chapter 9 bankruptcy on the 18th of July, 2013, thus becoming the largest city in the United States to file for bankruptcy. Detroit, once the motor capital of the world, has been in a state of decline for the past 5 decades. Once boasting a population of as much as 1.8 million, today only 700,000 residents call the city home. Interestingly, in 1960, Detroit had the highest per-capita income of any city in the United States. The violent race riots of 1967 mark the beginning of a long era of decline. Today, Detroit owes its creditors a staggering 18 billion dollars. Today, there are two principal groups of creditors that are facing off against each other: Bondholders holding general obligation bonds and retirees and active city workers that get medical and pension benefits from the city. While most of the bondholders are insured, the bond insurers are likely to take up the fight on their behalf. On the other hand, the city has 28,500 active and retired workers that get both pension and medical benefits.
Detroit today suffers from the highest crime rate of any major city in the US (less than 10% of the crimes are solved). 40% of the citys streetlights dont work, 78,000 buildings remain abandoned and police response time is almost an hour. High crime has led to declining property rates, that has subsequently resulted in reduced income from property taxes. As the city was undergoing a decline, its revenues decreased even as its expenses remained high. The resulting gap was financed through debt. Fiscal mismanagement led to a stage whereby the debt has become unmanageable and the city needs to restructure its debts. A previous plan by the city manager sought to give the bondholders only 10 cents on the dollar. A 90% haircut is unprecedented, especially for general obligation municipal bonds that are considered among the safest investment in the United States. This plan was rejected, thus forcing the city government to file for bankruptcy protection. There is likely to be a long court battle to prove whether Detroit even meets the conditions necessary to get Chapter 9 bankruptcy protection.
Moreover, the city is caught between a rock and a hard place. The Michigan State Constitution does not permit cuts to pension benefits. On the other hand, general obligation bonds are generally considered to be at the top of the credit hierarchy. Cities are authorised to increase taxes to ensure that they cough up enough money to pay off these bonds. Imposing a haircut on these bondholders might set a dangerous precedent across the nation. Bond investors will be wary of investing in municipal debt and the increase in bond interest rates may push other cities into a debt spiral. Particularly, counties and municipalities in Michigan may find it increasingly difficult to raise debt. A bankruptcy filing the size of Detroit has not been seen before, thus, a lot of precedents are likely to be set in the ensuing legal battles.
The question that is crucial the moment is this: What are the lessons that can be learnt from Detroits failure?
To answer this question, we must first examine the causes for Detroits decline. (At this stage it may be pertinent to point out that Detroit city has been ruled by Democrats since 1962).
One of the pertinent causes has been the decline in population. From 1.849 million in 1950 to 1.028 million in 1990, population decline has contributed to declining tax revenues. One of the reasons for this population decline has been the shift from the city to the suburbs. A large section of the White population moved to the suburbs (thus not contributing anymore to the taxes in Detroit city) while a large section of the black population (now accounting for 80% of the citys population) remained behind. Whites have traditionally earned more than blacks in the United States and their shift to suburbia hurt the tax revenues of the city. The riots of 1967 are said to account for an increase in a phenomenon known as white flight, as the white population shifted to the suburbs. Several other factors are also at play. Detroits broken school system, urban decay and violence, all sped up the process of population decline.
The decline in the auto industry can be attributed to a large number of factors, from free trade agreements with Mexico, to the regulations imposed by the Environmental Protection Agency, to unionisation and several other factors that would require an entirely different article.
The other symptoms of the decline would be the declining property and income taxes. Property tax rates have suffered both from lowered assessed values and lower collection rates. Projected FY2013 property tax revenues are a mere $135 million, a 9% decline from the already low FY2012 levels. Income tax for the city has declined by 30% from 2002. High unemployment and low per capita income are contributing factors. State revenue sharing has declined as well since it is calculated on the basis of population.
Clearly, the city of Detroit has done something wrong. The city managers office believes (correctly) that one of the reasons could be its high tax rates. Detroits income tax rate of 2.4% for residents, 1.2% for non-residents and 2% for businesses is the highest in Michigan. Property taxes in Detroit are the highest in Michigan, despite the abysmal public services. Even a 5% utility tax is paid by utility users. These have encouraged residents of Detroit to shift to neighbouring suburbs or to other districts of Michigan. This is a very important point. The high-income taxes rates are a product of Democratic policies instituted back in 1964. Up till 1962, Detroit did not charge any income tax. The income tax was a natural incentive for citizens to move away. Moreover, the extensive freeway network (by most accounts, Detroit has the highest concentration of freeways per square mile in the United States) made it easier for citizens to commute to the city for work. The 2% income tax on businesses played a negative role as well. Moreover, fiscal mismanagement is apparent. The city has been suffering general fund deficits for a long period. These have been funded with increasing debt roll-overs, to a point where debt obligations run into billions of dollars. Compounding the difficulties is the fact that the city is also insolvent. These causes reveal why the city is not getting the income it requires. What is even important, however, is to examine the causes for the citys high public expenditures (despite its poor public services). For this, the focus must shift to one major group: Unions.
Detroit was once known for having what were known as good middle-class jobs. These essentially allowed semi-skilled workers to earn high salaries that allowed them to lead a decent middle-class life. These were the heydays of American industry when competition from cheaper sources such as Mexico and China had not invaded the markets. As recently as 2008, the Big 3 Ford, GM and Chrysler, were paying as much $73 in total compensation per hour to auto workers, as compared to $42 in the South and Midwest of the United States. The average compensation at the Detroit Water and Sewers Department is a staggering $86,000 per year. The department has twice as many employees per gallon of water pumped as Chicago. The Detroit Federation of Teachers is the best paid in the nation (when corrected for purchasing power). From 2008 to 2011, health insurance costs for Detroit employees and retirees have jumped 62% to $186 million a year, the Detroit Free Press reported, says Forbes. Pension contributions in that period jumped 140 percent, from $50 million to $120 million. The United Auto Workers Union was particularly notorious in its role pricing Detroit out of the labour market, essentially making it less competitive. A $86 billion bailout by the Federal government has ensured that GM and Chrysler motor on but, this time, the Federal government is taking a more cautious stance. Despite what the Michigan State Constitution states about the untouchability of public pensions, there is a clear need for a long hard look at the destruction to municipal finances that the Unions have wrought. A coalition of 33 unions is currently representing the Union side in its battle against the bondholders.
In my opinion, it is clear that Detroit must pay for decades of public mismanagement. Public profligacy and union dominance have brought about a situation that somewhat mirrors the beleaguered European nation Greece. Yet, a party riding on public money must eventually come to a screeching halt. There are likely cuts on both sides: the salaries, benefits and pensions of existing and retired city officials and the bondholders, on the other side. Personally, I believe that the city officials must take a much larger cut than the bondholders.
Defaulting on the bondholders will have a ripple effect that will harm the citizens of several other cities in the United States. Moreover, this also brings to attention the fact that a state sponsored welfare model is unsustainable in the long run and must eventually unravel. From Greece to Italy to eventually the United States (whose debt burden exceeds 100% of the GDP), it is becoming clearer by the day that socialism and welfarism have no place in any economy. The laws of economics eventually catch up with every governmental body and the cuts when they come, are painful. The role of state is to provide law and order, contract enforcement, ensure competition and provide education in the most efficient and effective manner possible (I subscribe to the model of education vouchers for the same). Detroit failed to provide law and order and good education services, eventually leading to an urban decay that ate away at its tax base. In the meanwhile, stringent labour laws prevented the city from laying off workers even as a smaller population required a smaller workforce employed by the city. Declining revenues clashed with increasing expenses as the unions successfully fought to maintain and increase the benefits they received from the city.