Thursday, 8 August 2013

Detroit – Just the beginning?

A city is driven into bankruptcy by the same problems that plague the United States as a whole but will the outcome be any different?

We have become all too accustomed to firms going bust recently amid the economic doom and gloom but a city going bankrupt seems a little strange.  But that is what happened to Detroit last month as years of decline culminated in the city admitting that it was no longer able to pay its bills.  Having thrived along with the auto industry, Detroit was always doomed to struggle as American car makers lost out to foreign rivals but its problems are not that different from those facing the country as a whole – overgenerous spending commitments from politicians focusing on the short term.  Can the politicians in Washington do any better in dodging a budgeting accident?

Detroit’s demise has come after it lost the industrial base that was the foundation of the city – the manufacturing industry around Detroit was decimated as overseas firms took a large chunk of the US auto market.  The population of Detroit was close to two million in 1950 but has since plunged to around a third of its peak as the deteriorating job market prompted people to move elsewhere to find work.  The exodus created a downward spiral with a growing number of boarded up houses and deteriorating public services as tax payers fled to more prosperous locations. 

The sharp decline still left Detroit with a large number of bills to pay, and along with having to maintain the infrastructure of a shrinking city, there was also the pensions for its public sector workers.  Its debts are estimated at $18.2 billion but around half of this money is owed to its present and past workers in the form of promises of retirement pay-outs.  It is common for government workers to be paid pensions which are a percentage of their salary (referred to as defined benefit plans) which is different to the private sector where workers must pay into their own pension pot from which pensions are paid out (referred to as defined contribution plans). 

Promises made by politicians have come back to haunt their successors – offering up bigger pensions rather than higher wages as a means to placate government workers with lower pay rates.  Pledges made when times are good are difficult to uphold when things turn bad especially since officials fail to put away sufficient funds to cover future pension payments.  The fixed sums offered to public sector employees after retirement have become more of a burden with people living longer and investments yielding a lower return after the global financial crisis (which means that the initial level of funding of pension pots is higher).  It is like a massive scheme of offering up IOUs with big pay-outs in a few decades but not bothering to put away much money to settle up in the future.

Detroit was not the first city to go bankrupt (Stockton, Mammoth Lakes and San Bernardino in California did in 2012) and it will not be the last (even some of the largest firms in the United States such as General Motors and most of the airline companies have been laid low by lavish pension schemes), but more crucial are the similar problems faced by the federal government in the United States.  The US government has committed to paying pensions and medical bills for the old and poor which will gradually ramp up the pressure on the government budget as the baby boomer generation heads into retirement and the number of workers per pensioner falls (i.e. costs will rise as revenues fall but more slowly than in the case of Detroit).  Social spending on these and other entitlements accounted for 56% of government spending or almost 14% of GDP in 2012 and increasing spending is threating to overwhelm the government spending plans.

The approach of a fiscal disaster comes at a bad time - the US government is already struggling to sort out a considerable budget deficit equal to 7.0% of GDP in 2012.  The timing is made even worse when considering that the dominant global position of the United States is under fire due to the rise of new powers such as China (for more on this, see A New Inconvenient Truth).  Instead, politicians would rather squabble than deal with the raft of problems facing the country with numerous other areas such as taxation and immigration also crying out for reform.  Even sensible adjustments to policy, such as increasing the retirement age to account for people living longer, get vilified with both the Democratic and Republican parties at each other’s throats.  Elections do little to resolve the issues with politicians happy to just target their own supporters (refer to Election with no winners for more detail).  The country as a whole is being driven toward the same destination as Detroit and politicians would rather play a game of chicken amongst themselves than steer clear of trouble – watch out for accidents in the road ahead.

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