Modern America has produced a rather peculiar investment economy. When investors are riding the proverbial bull, the system resembles laissez-faire capitalism. Investment profits are taxed at a lower federal rate than wages. But when the bottom falls out and the bear pays Wall Street a visit, we socialize the losses. The AIG bailout may be the most obvious and odious example.
This dynamic was also visible during the Central Falls, R.I., municipal bankruptcy. Under a reorganization plan agreed to last fall, all relevant parties took a hit except bondholders.
New York Times: The plan, which is expected to become effective in mid-October, will ensure that the city repays its bondholders, largely by raising taxes and making deep cuts in pensions and other employee benefits.
This is something Detroit’s impending emergency management process must avoid, and not simply to ensure the fundamental fairness of “shared sacrifice.” Detroit’s bondholders were enablers of the city’s most reckless fiscal behavior. They shouldn’t be rewarded, particularly at the cost to Detroit city workers and residents.
Since 2005, according to the state review team, Detroit has been issuing long-term bonds to pay for regular expenses. At one point, the Bing Administration characterized this borrowing as “fiscal stabilization” bonding.
And here’s the problem with that: When a city issues a 30-year bond to pay for, let’s say, a new fire house, that city gets to use the fire house for the 30 years they’re repaying the bond, and hopefully a few years after that. When a city issues a 30-year bond to pay for this year’s fire department payroll, taxpayers will spend 30 years paying it off while firemen, you know, expect to keep getting paid next year and thereafter.
Capitalism, as Adam Smith explained it, was supposed to prevent such stupidity because rational actors would recognize “fiscal stabilization bonds” as the needlessly risky investment that they are. After all, any entity forced to issue long-term bonds to pay for short-term expenses like firefighters' salaries, probably won’t be able to repay bondholders in the long run.
The Central Falls example demonstrates why buying Detroit’s bonds was for too long considered a reasonable, if morally hazardous, course of action. Otherwise rational actors were happy to gobble up Detroit’s bonds because they believed their terrible investment would be indemnified from loss when the things reached their logical conclusion.
Emergency management likely means Detroit taxpayers, residents, pensioners, and city employees are going to feel (more) pain in the coming months and years. But the only way to ensure another municipality doesn’t follow Detroit down this rabbit hole is for the emergency management process to stick it to bondholders good and hard.
Now, this is the part of the program where we hear all manner of caterwauling about how all these bonds are held by teachers’ pension funds and the like, as if your 11th grade Spanish teacher supplanted Sherman McCoy on Wall Street. We witnessed all the handwringing about the GM bondholders who funded the production of Pontiac Azteks during the auto bankruptcy. We’ll likely hear this canard again if Detroit’s eventual EM reams the city’s bondholders while restructuring the city’s debt.
To be sure, there is nothing in the canons of economics to suggest that teachers or war orphans or hedge fund managers or managed equity firms should be protected from the consequences of their bad investments, which is the only way to describe buying a “fiscal stabilization” bond from Detroit.
Another argument for treating bondholders with kid gloves is if Detroit’s bondholders take a bath, then Wall Street will be less willing to extend credit to local communities and would only do so at a higher price. Oakland County Executive Brooks Patterson has been said repeatedly that if Detroit goes into bankruptcy court, it will effect Oakland County’s bond rating.
I’m not sure that’s the worst thing in the world. A tightening of the municipal credit market may be painful, but it also may be necessary. The city of Detroit isn’t the only local municipality facing fiscal problems. Communities with access to seemingly endless cheap credit will only consider what they are truly willing to pay, and how that revenue is raised, for local government in moments of crisis.
Parks and libraries and police and road maintenance are important public services and should be fully funded. This isn’t necessarily a call for austerity. But they need to be funded responsibly.
One of the lessons of Detroit’s finances is the bond market has made it too easy for local officials to make reckless fiscal policy for the sake of political expediency. Restructuring can’t be allowed to enable the enablers of that insanity.
