America’s bankrupt cities

An emergency manager has taken over control of Detroit from elected officials to deal with its crippling debt. What does this bode for the rest of the US? James McKeigue reports.

What's happened?

In the short term, the emergency manager, Kevyn Orr, will have to find a way to avert a $100m cash shortfall that's due to hit the state by the end of June. Longer term, he will try to find a way for the city to reduce or repay its $14bn in liabilities. If he fails, Detroit faces the largest municipal default in American history.

What went wrong?

Social factors have also played a part. A violent race riot in 1967 encouraged a white flight' that saw many of Detroit's wealthier citizens leave for the surrounding counties. As a result, Detroit's population is now 700,000, down from a peak of two million in the 1950s. The loss of tax-paying jobs and its richer citizens hit Detroit's revenues. So in recent years, local authorities have been providing costly police, schooling, health and fire services for a sprawling, emptying city.

Meanwhile, pension and healthcare commitments made in the good times are getting harder to fulfil. As a result, Detroit hasn't balanced a budget since 2004. As more public-sector workers hit retirement, and more citizens leave 25% of the population has deserted since 2000 the problem is getting worse. Last year, Detroit had to borrow almost $1bn.

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How will this mess be fixed?

He will have the power to override elected officials, rewrite labour contracts with unions, privatise services and sell assets. He also plans to end the corruption that has bedevilled Detroit's finances just this month a former mayor was convicted for bribery. But Orr's job won't be easy. Some cost-cutting solutions, such as cutting public-worker pensions, could provoke unrest.

Are there other options?

Such a move would not be unprecedented indebted Indianapolis tried something similar in 1970. However, redrawing the map to encompass new taxpayers and voters would be controversial. Instead, Detroit could simply embrace bankruptcy.

Many of its citizens say they would prefer to be presided over by a bankruptcy judge than a Republican-appointed manager. However, John Pottow, a bankruptcy law professor at the University of Michigan, warns that the lack of precedent "throws everything into uncertainty". The other option would be a federal-government bail-out.

Indeed, it's one that many members of Detroit's City Council seem to have been holding out for. Yet, as former Federal Reserve chairman Paul Volcker notes in the Financial Times, "the federal government doesn't want to think or talk about that". Just about the last thing Barack Obama wants to do now is encourage a new wave of bail-outs.

But isn't Detroit a one-off?

Last year, US states ended the year with a combined deficit of $91bn. The most indebted state, both in absolute and proportional terms, is California, whose $26.5bn 2012 deficit was 28% of that year's total budget.

The good news is that so far there has not been the wave of defaults that some predicted. With a few exceptions (see below), the overall municipal bankruptcy rate is still in line with its average since 1980.

That may be because record low US Treasury yields, combined with investors' demand for income, have allowed struggling local governments to issue debt, known as muni bonds, and keep borrowing. Many of these issuers will be praying that the Fed doesn't change tack anytime soon.

What Detroit could learn from New York

It may yet provide a model for Detroit. But so might New York. In 1975, the city was on the verge of bankruptcy. Its finances were so badly mismanaged that officials didn't know how many employees it had on its books or the size of its pension obligation. A bi-partisan team took control and enforced cuts. Public-transport fares were doubled, 60,000 public-sector staff were laid off and the university began charging. Combined with a cheap Federal loan, the measures worked.

James McKeigue

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.