Commentary

What Are the Most Likely Outcomes of State and Municipal Financial Crises?

Across the U.S., investigators are scrambling to find out how much debt states and municipalities have taken on. The general answer is: far more debt than has been previously disclosed, often debt beyond legal limits and without required approvals. The debt is in the trillions.

There are sure to be some epic showdowns between (1) interest groups determined to collect everything politicians promised them and (2) taxpayers determined not to pay for other people’s problems — especially since many of the problems involve other people’s pension and health care benefits plans that are much richer than their own.

The interest groups include institutions holding some $3.5 billion of municipal bonds and labor unions representing most of America’s 19 million state and local government employees. What can we expect to happen?

1. Probably there will be more strikes disrupting public services including public schools.  Some of these strikes are likely to be prolonged and perhaps violent.

When politicians take serious steps to curb runaway spending, there’s sure to be defiant push‑back.

The 2012 Chicago teachers’ union strike made clear the determination of union bosses to gain the most costly contracts, regardless of the ability of the city to pay. Chicago public school teachers have made more money than teachers elsewhere — between $71,000 and $76,000, not counting pension and health care benefits — for working America’s shortest school days. That might be fine if results were stellar, but only about 20 percent of Chicago’s 8th graders are proficient readers, and only 60 percent of students graduate from high school. Chicago teachers went on strike the day after they were offered a 16 percent pay raise over four years, while millions of Americans were struggling to find full-time jobs.

Union tactics don’t seem to have changed since New York City’s financial crisis of the 1970s. In 1975, Mayor Abraham D. Beame proposed that municipal unions accept a 6 percent pay cut, and tens of thousands of outraged union members responded with noisy protests in lower Manhattan. Beame proposed limited layoffs, and the result was a deluge of walk-outs and sick-outs.

The New York Times reported that “Laid-off police officers rushed onto the Brooklyn Bridge, their still employed brethren reluctant to make arrests. Sanitation workers went on a wildcat strike, leaving garbage piled up in the South Bronx and on the Upper East Side alike. Perhaps the most creative acts of resistance occurred in November, when the city shut Engine Company 212, a fire company in Williamsburg, Brooklyn. Tipped off to the imminent closure by an air-raid siren, residents occupied the fire station, refusing to leave or to let the fire engine be driven away. They slept and ate there, and held meetings every Tuesday night that were open to the community and attracted large numbers of activists.”

During struggles to stop runaway spending, it will be abundantly clear that the unions are pursuing their own self-interest, not the interest the public they are supposedly serving amidst state and local financial crises.

2. When states try to force financial reforms on insolvent municipalities, local officials are likely to resist — slowing down and complicating a reform process.

Local officials don’t want state officials taking over their turf. “It looks like the Germans occupying Paris,” remarked a Rhode Island lawyer representing local officials amidst a state takeover. In addition, local officials are driven by labor union members who don’t want their generous pension and health benefits plans cut back.

In Detroit, resistance has racial overtones, since 80 percent of Detroit’s population is black, and for 39 years Detroit’s mayors have been black Democrats, whereas the state government is currently in the hands of white Republicans.

One thing for sure, those mayors generally didn’t do any favors for ordinary folks who more than anything needed a prosperous economy and safe streets. Instead there was racial hustling and massive corruption.

The most notorious hustler was Kwame Malik Kirpatrick who, at 31 in 2001, became the youngest mayor of Detroit. He went wild with his city-issued credit card, running up more than $200,000 of bills for all sorts of personal items like strippers performing at the mayor’s official residence. He went on to spend time in the slammer for perjury, obstruction of justice, mail fraud, wire fraud and racketeering. Clearly, a bailout can’t help a desperate city recover when voters repeatedly elect politicians like this.

3. Creditors — especially bondholders and government employees — count on government’s taxing power to pay everything a state or municipality might owe. But the taxing power often backfires.

If there’s a shortfall, the answer is always to raise taxes as much as necessary until creditors are fully paid.

But the higher taxes go, the stronger the incentives people have to change their behavior in ways that will reduce their tax liabilities.

For example, higher property taxes will generate upward pressure on rents. More people will start looking for cheaper places to live and work.

Increasing numbers of people will come to the conclusion that it makes sense to move out of a high-tax jurisdiction and go where it’s less expensive to live, start a business, grow a business and, ultimately, retire.

Consequently, the taxing power can lead to an exodus of employers, an exodus of people and an exodus of capital. So the taxing power can contribute to a declining population and economy, reducing tax revenues and making it more difficult for a state and/or municipality to pay its bills.

This is what happened to Detroit which lost a quarter of its population between 2000 and 2010. Many high-tax states and municipalities are similarly suffering from net outflows of people.

4. Cities will try restricting the ability of people and employers to move away.

One way of making it harder for people to move away is to order steep hikes in property transfer taxes, so that it’s more expensive to sell property. At the very least, this is a deliberate nuisance that tells investors they’re not welcome.

Cities could make it more difficult for employers by requiring advance notice — like 180 days — before a business could shut down a facility.  This would subject employers to possible intimidation and violence.

Employers might be obligated to continue paying for terminated employees’ pension and health care benefits as well as providing big severance payments and paying the cost of job retraining. If employers are believed to have violated such laws, they might be subject to individual or class action lawsuits as well as civil penalties for each day of violation.

5. In the name of “regionalization” and “revenue sharing,” city dwellers probably will try to tax suburbanites. Doing this will require help from politically-connected friends in state capitals and in Washington, who could give an urban jurisdiction some power over a suburban jurisdiction.

This idea seems to have been kicked around for decades, and apparently Detroit’s bankruptcy has revived interest in it. For example, recently the New York Times published a feature about it.

While city dwellers want suburban money, they won’t want suburbanites telling them what to do with the money.

There are a number of ways of doing regionalization. For example, establish or expand regional taxing authorities to support hospitals, utilities, rapid transit systems and/or other entities.

A variation of regional taxing authorities would be regional school authorities, combining suburban school districts with crime-ridden inner city school districts. Like forced busing, that would probably provoke another exodus.

Some municipalities might try to revive commuter taxes like New York City had for three decades until 1999. Commuter taxes require the approval of state legislators. Over time, more and more suburbanites worked in the suburbs, and they didn’t see the point of paying taxes to a jurisdiction they neither lived nor worked in. That was the end of New York City’s commuter taxes.

In Michigan, three counties voted for a property tax levy to help support the Detroit Institute of Arts, but it might be difficult to come up with something else that would be mutually beneficial for city and suburbs. If it isn’t mutually beneficial, it will be forced and deeply resented. Probably the result would be another exodus to more distant destinations.

6. More states and municipalities will be charged with securities fraud. 

The first state charged was New Jersey in August 2010. The Securities & Exchange Commission accused it of misleading investors into believing that New Jersey government employee pension funds were properly-funded when New Jersey sold $26 billion of bonds between 2001 and 2007. While the state was supposed to have contributed $67 billion for the pension funds, it had contributed only $21 billion — a $46 billion shortfall.

New Jersey officials did more than fail to disclose unfunded pension liabilities that could impair its ability to make bond payments. Officials claimed there was a special reserve fund to cover pension liabilities, but the fund turned out to be an accounting illusion. It led investors to pay more for the bonds than they were actually worth.

Despite the substantial amount of money involved, the SEC settled the case quickly. New Jersey officials denied any wrongdoing and vowed not to do it again. No New Jersey officials seem to have been reported paying fines, losing their jobs or going to prison. By contrast, the Sarbanes-Oxley law (2002) holds private corporate executives to a much higher standard — personal responsibility for other people’s actions — even though far smaller amounts of money are involved, compared with the tens of billions in a state government employee pension fund.

To be sure, the SEC cannot force states to honor pension fund commitments. The SEC can’t even force states to accurately disclose its pension fund liabilities. The SEC’s power is limited to requiring adequate disclosures that affect bond offerings.

All such disclosure can do is make a point, perhaps embarrassing irresponsible state officials and generating some public pressure to fulfill obligations for the pension health care benefit plans.

In this, the SEC has been a laggard, not a pioneer. Three years before the SEC announced its charges against New Jersey, the New York Times reported serious discrepancies in New Jersey’s accounting for government employee pension funds. “The discrepancies raise questions about how much money is really in the pension funds,” the article noted. But better late than never.

In March 2013, the SEC accused Illinois of securities fraud when it issued $2.2 billion of bonds between 2005 and 2009. Here again, there was more than a failure to disclose liabilities that could impair the ability of a state to make bond payments. For some 15 years, Illinois issued annual reports that claimed it was making scheduled contributions for government employee pension funds, when actually there were ever larger shortfalls, and the pension funds didn’t have enough money for current and future obligations. Top officials didn’t admit any wrongdoing, but they agreed to “cease and desist” from doing it again.

The SEC charged Pennsylvania’s capital city, Harrisburg, with securities fraud in May 2013. For years, local politicians had gone on spending binges for money-losing projects like a sports arena, a Civil War museum and a big incinerator that didn’t work. Between 2009 and 2011, officials suppressed worsening news so that investors would overpay for bonds. When the cover-up could no longer be sustained, Officials neither denied nor admitted the charges. The SEC’s settlement omitted the names of responsible officials, and it didn’t mention penalties.

Despite the SEC’s outrageous policy of giving dishonest officials an easy-pass, more people are coming to recognize that cities as well as states are running out of money. There are financial crises developing across the country. California, Connecticut, Illinois, New Jersey and New York and Washington rank among the most financially-troubled states. Big cities struggling include Camden, Chicago, Los Angeles, New York, Providence and San Diego. Many smaller cities are in financial trouble, too.

There have been financial gimmicks aplenty for misleading municipal bond investors. For example, the New York Report (2012), from the State Budget Crisis Task Force, acknowledged that “Common practices are to transfer ‘excess’ revenues from other state funds and public authorities, refinance outstanding bonds without creating new assets while realigning debt service payments to achieve front-loaded savings, roll or delay payments to suppliers, contractors and localities from one fiscal year to the next, and delay payment of tax refunds into the following fiscal year.”

7. Pressure will be intensifying for a political resolution of state and municipal financial crises.

Bankruptcy proceedings tend to involve significant concessions from both bondholders and labor unions.

David A. Skeel Jr., of the University of Pennsylvania Law School, explained, “Much as admiralty law’s ‘general average’ principle requires that every constituency share in the cost of measures taken in response to a crisis during a voyage, bankruptcy requires that the sacrifice be borne by everyone, rather than one or two disfavored constituencies…The principle of equal treatment of creditors is deeply entrenched.”

It’s quite possible that in a bankruptcy proceeding, labor union pension and health care plans would be protected only to the degree that they’re funded. Since these plans are major factors in state and municipal financial crises precisely because they’re substantially unfunded, unions could emerge from bankruptcy proceedings as big losers. That’s why they want politicians to step in and make sweetheart deals.

If General Motors had gone through bankruptcy proceedings in 2009, probably both bondholders and labor unions would have ended up with an equal share of the reorganized company. But labor unions had spent hundreds of millions of dollars helping Barack Obama win the 2008 presidential election. Unions demanded their payoff. Obama appointed Wall Street wheeler-dealer and Democratic fundraiser Steven Rattner to become “Car Czar,” protecting the unions’ interests. He seems to have been the one who decided that investors with $27 billion of General Motors bonds should receive only a 10 percent share of the restructured company, while the United Auto Workers Union, with $20 billion of claims, should receive a rich 39 percent of the company. The federal government ended up with a 50 percent share of the company, but since it wasn’t an active owner, the unions gained control.

Now unions are demanding that Obama bail out Detroit. Most Democrats seem to favor such a bailout.  Steven Rattner wrote New York Times piece insisting that “We have to step in and save Detroit.”

But Detroit’s problems didn’t develop because of a lack of money. Back in 1960, Detroit had the highest per capita income in the U.S. Detroit’s problems are primarily consequences of bad policies. They certainly weren’t unique to Detroit, but together they made a devastating cocktail:

  • Detroit has had the highest income taxes in its state, and people figured out they could give themselves a tax cut by just moving out of the city.
  • Welfare benefits for single teenage mothers created perverse incentives not to get married, thereby increasing the odds that single teenage mothers would stay poor and that they would have difficulty controlling their children, especially teenage boys — thereby contributing to higher crime rates.
  • Minimum wage laws made it illegal for employers to hire unskilled, inexperienced people unless they were given the pay of people who had marketable skills and experience. This policy has had the effect of denying unskilled, inexperienced people opportunities to gain on-the-job experience and become more valuable — thereby perpetuating poverty.
  • Costly unionized government school monopolies (with a market share over 90 percent) have failed to help inner city children master fundamental skills needed to rise out of poverty and prosper.
  • Skyrocketing taxes and crime rates made Detroit an unattractive place to do business, and increasing numbers of employers moved out.
  • After the 1967 race riots, mayors increasingly catered to black constituencies with anti-white rhetoric that convinced more and more whites to leave the city. The city’s population, now around 714,000, is less than it was in 1920 (993,698).

These policies are still the prevailing orthodoxy, and no amount of bailout money will revive Detroit as long as they’re in effect. In these circumstances, it would be easy to pour tens or even hundreds of billions into Detroit and have nothing to show for it except colossal corruption.

Perhaps that’s a major reason why Obama’s Treasury Secretary John Lew claimed there would be no bailout. He might also have been aware of polls showing that most Americans don’t want more bailouts.

But Lew left the administration some wiggle room. He was quoted as saying, “We stand with Detroit and have been working with them, the technical advice, working with the kinds of normal programs the federal government has, to see if there’s anything we can do to help.” Well, the federal government has hundreds, maybe thousands of “normal” spending programs that could pour a lot of money into Detroit, even if nobody in the administration dares to call it a “bailout.” Perhaps the first of the payments will be $100 million to demolish some abandoned buildings — Detroit has approximately 78,000 of those.

What about a payoff for the unions, Obama’s top priority? He might be bold and order a federal guarantee of Detroit’s $9.4 billion of unfunded liabilities — $3 billion for pensions and $6.4 billion for health care benefits.

Such guarantees have been a popular way of appeasing powerful interest groups, because guarantees don’t cost anything when they’re issued. Costs usually occur after a politician has left office, and they’re somebody else’s problem.

In Detroit’s case, Obama might belittle the numbers as chump change, suggesting that money for Detroit shouldn’t be compared with the notorious Wall Street bailouts.

Of course, Chicago, New York, Los Angeles and dozens of other improvident cities and states would line up outside the Oval Office for their guarantees. Suddenly, the policy of guaranteeing unfunded pension and health care liabilities would involve huge numbers. The States Project, conducted by Harvard’s Institute of Politics, the University of Pennsylvania’s Fels Institute and the American Education Foundation, reported that “State and local governments are carrying over $7 trillion in debt. Over half of that debt is not reported in the official financial statements produced by state and local governments.”

With a single executive order, though, Obama could pull off the biggest ever giveaway for labor unions and energize them to go all-out for him in the 2014 election campaigns.

Obama could leave whatever cash flow there is in Detroit for bondholders and current city employees to fight over.

In 2012, the Detroit Water and Sewerage Department generated revenue of approximately $403 million, more than enough to cover the $356 million of interest due on bonds. But debt service and payments to retirees consume more than half of Detroit’s annual budget. There isn’t much financial maneuvering room.

If it turns out municipal bondholders take a huge hit, while unions are guaranteed their generous pension and health care benefits, this could send a shockwave through municipal bond markets, shattering the illusion that municipal bonds are secure investments for retirees, widows, orphans or anyone else.

The doubling of municipal bond markets since 2005 might come to be seen as a bubble like the housing bubble, something reckless that prudent investors should avoid. The flow of municipal bond revenue could slow down, and for many municipalities it could stop altogether. If after making municipal bond investors absorb a disproportionate share of Detroit’s municipal bond losses, politicians might be reminded that what goes around comes around. Without municipal bond revenue, they would have to make really serious spending cuts, the likes of which they have never seen. Maybe they would wake up sober.

Jim Powell, a senior fellow at the Cato Institute, is the author of FDR’s Folly,Wilson’s WarBully BoyThe Triumph of Liberty and other books.