Detroit Could Be Better Off After Bankruptcy

Detroit Could Be Better Off After Bankruptcy
July 26, 2013

(This item originally appeared in on July 26, 2013.)

The Detroit municipal government’s entrance into Chapter 9 bankruptcy might work out for the better, or it might not. Nevertheless, whatever happens, it is a necessary step to a better outcome.

On the most obvious level, Detroit’s city government no longer needs to pay creditors and pensions, at least for a while. That means more money available to pay for basic city services. It should keep things going for a while.

In the longer term, one basic problem with municipal finances is that employee wages and pension promises are much too high. On top of that, there are probably way more employees than is needed (even as there are less services than is needed).

A basic principle of creditor seniority is that bank debt is senior to bondholders, and employees are senior to banks. In other words, employee obligations like unpaid wages are paid first, before lenders. (The exact details may differ in every situation. Detroit’s retiree health care benefits are junior, for example.)

For governments, and also for private corporations with similar issues, I think employees (and unions) are willing to work out a better arrangement. However, first the bondholders need to take big losses. It is not acceptable for employees’ commitments to be slashed just so that bondholders can get paid in full. Everyone suffers together, and the bondholders (as junior creditors) should suffer more than employees.

Although bondholders like to think they are beyond reproach, compared to the ridiculous deals that government employee unions have been able to get, actually a lot of bond debt was also taken on for corrupt purposes — for example, the infamous sewer system of Jefferson County, Alabama, which got an initial cost estimate of $250 million.

I once knew some engineers from Mitsubishi Heavy Industries, who were contracted to build a sewage treatment plant in Singapore. They do this all the time. Building sewage treatment plants is not like landing on the moon. Engineers have done this over and over and over again. They know how much it costs, within a modest range of error.

The sewer system ended up costing $3 billion. Where did the extra $2,750 million go? Probably into the pockets of cronies, one way or the other. Straight up graft. Banks managed to wheedle another $2 billion out of the county, for a total of $5 billion.

In other words, a lot of municipal debt could be considered what is known in international law as “odious debt” — debt contracted by a corrupt government basically for thievery. Here’s Wikipedia:

“In international law, odious debt, also known as illegitimate debt, is a legal theory that holds that the national debt incurred by a regime for purposes that do not serve the best interests of the nation, should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts of the regime that incurred them and not debts of the state. In some respects, the concept is analogous to the invalidity of contracts signed under coercion.”

The only way to clean this up is to go into bankruptcy, where everything becomes negotiable.

Ideally, a bankruptcy filing not only allows governments to escape the consequences of past mistakes, but also provides the political impetus to renew government operations on many levels — reorganizing offices, headcount, services and so forth in a rational and effective manner. Governments do this from time to time. China, for example, has had sophisticated governments for thousands of years. They go through cycles of corruption and decay, and also of rebirth and renewal.

It is not only a one-way slide into disintegration. Believe it or not, sometimes governments get smaller. Typically, the “renewal” phase follows some disaster.

Detroit has other issues, regarding how to downscale a city gracefully. Sometimes people just don’t want to live there anymore, not because it is unpleasant (although it is), but because a city has lost its economic purpose. In simpler terms, there are no jobs, due to broader factors such as the migration of manufacturing elsewhere, or the fact that agriculture needs far fewer people than it used to in the past.

It might not work out so well. Many things can happen. I hope that municipal governments will enter the process with a positive vision for the future, a sense that longstanding problems can finally be fixed. Even corrupt governments have people who care about the well-being of the city as a whole, and these people can finally have some influence.