Belmont Club

The Wages of Sin

Detroit, in going bankrupt, is threatening to pull down with it two pillars of the current economic model. The first is municipal pensions. “Pension-related costs and other post-employment benefit obligations make up about $7.5 billion of the city’s at least $15 billion long-term debt.” Some believe “a bankruptcy judge could trump the state constitution by slashing retiree pensions, ripping up contracts”.


However “the General Retirement System and the Police and Fire Retirement System of the City of Detroit filed the lawsuit yesterday in state court in Ingham County, Michigan, seeking a judgment that Governor Rick Snyder can’t authorize a bankruptcy filing that could reduce pension benefits.”

That still leaves the question of where the money is going to come from. Clearly it can’t come from Detroit. The hope is that it will come from the Federal Government. “A city official notably said the federal government should bail out Detroit, though the president has made no indication that’s a possibility.” If not the Federal Government, then some officials hope it will come from those “who can actually afford to pay taxes”. One Detroit official claimed that bankruptcy was unnecessary. All someone needed to do was go out and collect the vig.

“The whole foundation that brings him here is false,” Crittendon said. “We do not have a $15 [billion] or a $20 billion debt problem. We have less than a $2 billion short-term debt problem that we could manage if we just went out and collected revenues that are owed to the city; stop giving, you know, tax abatement to people who can actually afford to pay taxes.”

U.S. Rep. Dan Kildee (D) actually hopes help will come from the Federal Reserve. “Dear Chairman Bernanke,” Kildee wrote, “in response to your testimony before the House Financial Services Commission … I raised the issue of how widespread municipal failure, if unaddressed, could result in the next economic crisis.”


U.S. Rep. Dan Kildee wants to know what the Federal Reserve Board of Governors and Chairman Ben Bernanke are doing to address the prospect of municipal failures — including the one facing Detroit — and its potential impact on economic growth and the bond markets.

“For too long, lawmakers and regulators have stood aside as cities grapple with budget deficits, unfunded pensions and crumbling infrastructure,” Kildee, D-Flint Township, said in a letter sent to Bernanke on Wednesday.

The second pillar under threat is faith in government to pay. Kildee’s argument is simple, if circular. Unless somebody pays Detroit’s bills, the interest rate charges on all munis will go up. The New York Times had already sounded a similar alarm after Alabama’s Jefferson county went bust. The faustian bargain had been that corruption in the municipalities would be tolerated in exchange for the implicit assurance that “someone” — maybe Bernanke — would pick up the tab.

The Jefferson County bankruptcy may serve as a precedent for forcing bondholders to take losses in bankruptcy. Despite lots of legal protections, loans to municipal governments can be just like loans to people and companies: if the borrower truly can’t afford to pay what was promised, it won’t be paid….

Jefferson County’s problems involve corrupt politicians and bad luck, but they also include a longstanding reluctance to face facts about the county’s sewer system — and a bond market that failed to face the facts about the county and kept lending money long after it was prudent to do so.

The corruption involved was breathtaking. More than 20 people, including politicians, contractors and influence peddlers, have been convicted. JPMorgan escaped criminal charges, but the Securities and Exchange Commission penalized it for paying bribes through local middlemen.

That corruption was important and no doubt raised the financing costs for the county. But the basic financial decisions about the structure of the county’s debt were different only in scale from what many other municipalities did.


The Detroit bankruptcy shreds this implicit contract with the bondholders, just as it threatens to smash the assurances to the pensionholders. As Bloomberg News put it: “emergency Manager Kevyn Orr’s plan to suspend payments on $2 billion of Detroit’s debt threatens a basic tenet of the $3.7 trillion municipal market: that states and cities will raise taxes as high as needed to avoid default.”

By calling into question the safety of any security backed by a government’s general obligation to pay what it owes, Orr, 55, imperils similar debt across Michigan, the eighth-most-populous state. As local governments strive to rebound from the longest recession since the 1930s, they may confront higher borrowing costs.

Indeed another article from Bloomberg points out that “the yield penalty on Michigan’s debt has climbed 40 percent in less than two weeks as defaults by Detroit and two school districts lead investors to question the state’s commitment to protect bondholders.” This would trap some municipalities in the same bind that doomed Greece. The more they owed, the shakier they became. The shakier they became the higher the interest charges and the more they owed.

The exit from that trap is known as a “bailout”, another way of saying that somebody else has to pick up the tab for municipal mismanagement and corruption so municipal mismanagement and corruption can go on. Exporting the wages of corruption was an option during the long postwar boom because there was always a surplus somewhere to pick up the slack. The problem now facing governments in Europe and in the United States is that the Design Margin is gone. The markets no longer believe that “that states and cities will raise taxes as high as needed to avoid default”. Nor may they believe for too much longer that Bernanke will keep the presses running to achieve the same result.


That leads to the conclusion that something has to give. The only question is what. Detroit is in its own way “the canary in the coalmine”, the leading indicator of a tsunami that is still out of sight of the shore, but which is nevertheless approaching at jet speeds. The logic of the Blue Model is that the music must keep playing because it can’t stop.

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