Big Government

The Great Unraveling began this week, near Detroit (they moved the meeting to head off protestors), kicked off by Kevyn Orr:

Detroit will immediately stop payments on about $2 billion in debt, the city’s emergency manager announced Friday, an effort to conserve cash. The manager, Kevyn Orr, also said Detroit will need to cut pay and pension and health benefits for city workers.
 
Debt holders are likely to get only pennies on the dollar.
 
“Financial mismanagement, a shrinking population, a dwindling tax base and other factors over the past 45 years have brought Detroit to the brink of financial and operational ruin,” said Orr.

This article then goes on to name what happend to Detroit, caused by mismanagement and fleeing of their most productive resources, noted above:

“The city has effectively exhausted its ability to borrow,” he writes in the report, adding that the city “is clearly insolvent.”

INSOLVENT is the key word to understanding what happened in Detroit, and what I believe will soon happen across cities in dire situations across the USA. Insolvent (in practical terms) means that 1) you don’t have enough cash revenue coming in to pay your current bills such as salaries on current staff, pension contributions, payments to vendors, etc… 2) you have already accrued substantial borrowings to date that need to be either paid off (not a chance of that) or re-financed through even more debt (the route that has been taken to date) 3) there is no practical chance that you can find enough revenues to get current on your bills and make a substantial, good-faith “dent” in the backlog of debt that you’ve piled up over the years.

Over many years cities, states, counties and other non-profit entities have piled on debt to avoid raising current taxes and to placate their staff’s demand for higher pay and current benefits. They also promised benefits in the future such as pensions, medical insurance, and the like which don’t exist anymore for many / most citizens employed in the private sector. They failed to pay in advance (pre-fund) those obligations, as well. Meanwhile, many of these cities, plagued by dis-functional government, crime, rising taxes, and a low quality of life, saw an exodus of their most productive citizens, those upon whom the “real” burden of servicing these current obligations and long term debt really lie.

Unlike the United States as a whole, which can capture its citizens’ revenues anywhere within its borders and around the world (there are relatively few that give up US citizenship), cities, states and counties can drive out their productive staff and then the increasing burden of paying for mounting debts will fall on a shrinking (financial) base. Detroit can’t burden those that have escaped; not only has their population fallen, their highest-income citizens fled long ago and have no plans to return (why would they come back to pay the bills of a city that they would no longer recognize?).

Amazingly, the municipal debt market, which has funded these insolvent cities all these years at relatively low interest rates (given the facts that many of these entities are insolvent in practical terms), hasn’t taken an enormous hit yet. While plans are not finalized, Detroit is in essence offering pennies (less than 10 cents) on the dollars for their unsecured bond-holders (they do have some debt tied to utility revenues and other revenue sources which has its own economics). The municipal debt market probably doesn’t really believe, nor do I really truly believe, that the whole worm-infested edifice is about to come down now. In the past there have always been last minute bailouts, subsidies, “insurance” on bonds (with the tiniest of real-world cushions), etc… to prevent the collapse that economic sense says has been coming for years.

Another thing to note in Orr’s statement is that he plans to not only 1) stiff the creditors 2) INVEST in the city to increase the level of policing, infrastructure, etc… Cities and states are run by politicians. The odds that a city would shut schools while paying off creditors should strike anyone with a bit of political sense as incredible. Creditors don’t vote – if it came down to it, why would you put them ahead of your own political survival, especially when your opponent in the next election would just do the same thing, anyways?

The heart of the matter is that all of this Ponzi scheme depends on everyone “pretending” that the problem isn’t there and that somehow, someway, these minor moves of short term cash and budget tricks can put the wolf off forever. But the wolf is here now, and anyone who lends new debt money to these sorts of entities might as well just throw their money into a disposal and expect to get a few pennies out the other side.

Not to sound too “black helicopter” but the super-smart money might be betting that the federal government will bail out the states and cities and make all the creditors whole, to keep the illusion running a bit further. This definitely strikes me as plausible, irrespective of all the supposed Constitutional guards that prevent this from happening. A huge percentage of the funding for states, cities, and counties comes from the US government anyways – perhaps at some point we stop pretending that we will let them fail on their own (and destroy the political “minor leagues” that end up in Washington, in the end) and just backstop everyone’s debts on the US dollar.

Kevyn Orr is calling everyone’s bluff. Maybe this will be the second great accomplishment of our current presidency, stopping the “pretending” that there is any fiscal accountability with real consequences anywhere in the USA. The first accomplishment was the stone acknowledgment that Social Security /Medicare is just a “pay as you go” system of taxes when he cut the tax rate to supposedly spur job creation at a time when the actuarial numbers actually called for higher contributions.

Cross posted at LITGM