Cities and States Going Bust

A few thoughts about why Cities and States go bust, what might prevent it, and why the problem will remain.

The problem

Politicians gain from buying votes with promises of current and future payoffs financed with deferred payment arrangements.  The politicians are long gone when the chickens come home to roost.  The same is true for many of the voters that benefit from the promises.  There is little political incentive to maintain fiscal integrity over time.

Cities and States (CSs) can suffer downward financial spirals because they are not required to fully fund promises when they are made.  The result is promises of greater future payments than the CSs will be able to provide. As the cash drain from the increasing disparity between promises and financial wherewithal increases, taxes are raised, the infrastructure is allowed to decay, and services decline.  Other CSs become more attractive, and there is an exodus of firms and relatively affluent taxpayers (whose taxes support the CSs) that leads to an increasingly rapid downward spiral.

     Example: Underfunding pension funds

CSs can “underfund” pension funds, e.g., by deferring contributions until promised payments are to be made.  It becomes possible to make promises that will require future contributions beyond the CSs’ ability to pay, without material current consequences.

The answer to pension underfunding or deferring pension contributions is to disallow them.  For example, long term viability is assured if a pension fund is invested in a riskless portfolio that provides cash flows over time that match promised future payments.  This could be achieved with either an annuity or a cash matched riskless bond portfolio.  Each year’s contribution would be the amount necessary to buy an additional annuity or cash matched bond portfolio that funds the additional promises.

     Example: Funding infrastructure with long term debt

Suppose a CS wants to create a vast new infrastructure, including roads, bridges, rail systems, airports, etc.  Funding these projects with long term bonds reduces the immediate cash outflow to the interest.  If the project is large enough, the interest may consume a substantial portion of the CS’s financial resources, leaving insufficient funds to maintain the infrastructure or pay off the bonds when they come due.  Any attempt to maintain the infrastructure requires higher taxes and/or reduced services.  When the bonds come due, the CS will be unable to pay them off and will have to roll them over.  Given the CS’s financial and physical decay, any new bonds will have to be sold at bargain prices, i.e., at a much higher interest rate.

History shows that attempts to control CSs’ debt financing with either legal limits or financial responsibility don’t work.  The only answer to excessive long term debt is to disallow long term debt in the CSs’ Documents (e.g., Constitution, Charter).

Recovery

CSs that suffer financial collapse cannot recover on their own.  To be competitive with other CSs requires about the same taxes, infrastructure, and services.  Failed CSs cannot restore infrastructure and services on their own because (1) Their resources remain insufficient, (2) there is no incentive for outsiders to provide new resources, and (3) there is no incentive for firms or affluent people to move back into the CSs, which could provide more taxes, because they would shoulder the same burden they left to avoid.  That leaves only two recovery choices, bankruptcy and/or bailout.

     Bankruptcy

If bankruptcy does not forgive the failed CSs’ financial obligations, such as promised pension payments and long term debt, then the failed CSs remain without the financial wherewithal necessary for a recovery.

Even if bankruptcy does forgive the failed CSs’ financial obligations, the CSs’ financial resources remain well below those available prior to the downward spiral.  There continues to be insufficient funds to provide competitive taxes, infrastructure, and services.  Consequently, the firms and affluent people that left the failed CSs have no incentive to return.  Recovery remains problematic.

Bankruptcy that does forgive the failed CSs financial obligations is unlikely for political reasons, since the people that will be hurt include influential voting blocks, such as union workers.

In any case, bankruptcy does not guarantee that the ruling politicians will have learned a useful lesson concerning responsible fiscal management.  More likely, they will have learned that irresponsible behavior pays – because they will be gone by the time a financial collapse occurs.

     Bailout

Bailout is more likely to be politically feasible, but encourages the same unproductive fiscal behavior in the future and is unfair to those responsible citizens who must pay for it.

Privatization

Privatization of infrastructure and services on a pay as you go basis prevents CSs’ financial collapse.

     Example

A CS contracts for a new bridge.  The firm requires the cost of the bridge to be paid as it is incurred.  The bridge may not get finished, but the CS will not suffer financial collapse.