It didn't get much attention on the East Coast, but in late February the town of Vallejo, California, came within an eyelash of becoming the first city since Bridgeport, Connecticut, back in 1991 to declare bankruptcy. This San Francisco Bay suburb of 120,000 residents was threatening to take this radical step because it can no longer afford to pay the extravagant salary and retirement benefits of its public employees. Just a few hours before the city council was to file for bankruptcy, the unions caved in and granted wage concessions to keep the city operational.

There are several other cities in California that are contemplating the bankruptcy option thanks to multi-billion-dollar public employee pension and health care obligations that have become effectively unpayable. "Vallejo's fiscal problems aren't unique. They're just the tip of the debt iceberg here in California," says Keith Richman, a former state legislator and now president of the California Foundation for Fiscal Responsibility (CFFR). The California Public Employees' Retirement System has $26 billion of unfunded liabilities. The teachers' retirement system is $20 billion in the red--health benefits add another $48 billion to its shortfall.

Welcome to the next great financial bubble in America--a fiscal time bomb that could cause your local and state tax bills to double or even triple in years to come.

Vallejo's story of financial woe raises eyebrows because it is not a desperately poor or dilapidated city like Newark or Detroit. It is quintessential middle-class America, with an average family income of about $57,000. When the city announced it wouldn't be able to meet $6 million of unpaid bills starting in April, no one was as surprised as the residents themselves. Part of the problem is that the real estate crisis is especially pronounced in California and, as housing values fall, so do city property tax collections. The city projects a $20 million budget shortfall this year and next, which is a big bucket of red ink out of an annual budget of $80 million. City officials saw bankruptcy as the only legal option to void its unsustainable wage and retirement labor contracts and their $135 million of unfunded liabilities.

These contracts are so exorbitant that some of the richest residents of Vallejo are the police and firemen. Ten firemen earned more than $200,000 last year with overtime--a salary nearly four times higher than what the average family in Vallejo earns. Incredibly, 80 percent of the city's budget is consumed by labor and pension costs. "No city or private person wants to declare bankruptcy," says Councilwoman Stephanie Gomes, "but if you're facing insolvency, you have no choice but to seek protection."

Soaring public employee pension costs are crunching municipal budgets and causing service cuts or tax hikes across the state. In the Los Angeles County school system, health, pension, and workers compensation liabilities are so mountainous that an estimated one of every three dollars budgeted for the L.A. schools goes to teacher retirement costs. "The three Rs in the L.A. County school system are now reading, writing, and retirement," moans Richman.

There are other horror stories. The CFFR found that many cities have a 3 percent rule which allows a worker to accrue a pension benefit of 3 percent of his final salary for each year worked. So an employee who started on the job at age 22 can retire at age 52 with a lifetime pension benefit of 90 percent of the final salary. Most California towns also allow city employees to "spike" their pensions. This is a popular scam that allows workers to pad their final salary--and so their pension--by as much as 50 percent through bonuses, overtime, accrued vacation, and other add-ons. These pensions also come with an annual cost of living adjustment and lifetime health care.

"Pensions are the second biggest line item in most municipal budgets today behind law enforcement," says Steven Frates, a professor at Claremont McKenna College and an expert on California's pensions system. He adds that "the annuity value for many public employee pensions in this state is $1.5 million." Some of the highest paid state workers are walking away with lifetime annual pension and health benefits of $300,000 a year. With hundreds of thousands of public employees in California, you have the potential for catastrophic long-term financial distress.

Plenty of cities outside California are facing a similar tsunami of debt thanks to years of super-generous labor agreements. The ten largest Chicago-area cities face a combined $18.7 billion in unfunded pension liabilities, according to a new report by the Chicago Civic Federation. The city of Chicago has less than 50 percent of the money it needs to pay the benefits promised to Chicago police and firemen. Philadelphia was forced to issue a $4.5 billion bond in February to cover unfunded pension liabilities for 33,000 retirees. The total cost to states for paying for all teacher retirement health and pension obligations is now estimated at $3 trillion, and growing each year.

As California taxpayers wake up to the enormous future tax increases they and their children face to pay for expansive promises to city, county, and state workers, they're wondering, says Frates, "how did they get these sweet deals?" There lies the real scandal. For years, even decades, the only people who've cared much about public employee salaries are the public employee unions. The politicians who sit across the table and negotiate with the union bosses have little if any incentive to drive a tough bargain. The costs won't be visible until the politicians who negotiated them are long gone.

Donna Arduin, a former California budget director, explains another reason deals that border on swindles keep getting done: "The public employee unions are far and away the most powerful special interest in the state. They run the state and virtually no politician will stand up to them." She remembers being physically threatened one year when the state was broke and she tried to trim a $400 million bonus in the pensions for corrections officers: "I had to fear for my life."

Nationally, public employees now receive $39.50 an hour in wages and benefits. That's a 50 percent premium over the $26.09 average salary and benefits for private sector workers, according to 2007 Bureau of Labor Statistics data. The gap keeps widening each year. It's true that public employees are more likely to be in white-collar occupations, which receive higher pay, but it's also true that government workers receive a benefit that almost no one in the private sector gets: near 100 percent lifetime job security thanks to arrangements like teacher tenure and government no-fire rules.

In California, taxpayer watchdog groups like the Howard Jarvis Foundation are starting to fight back against the public employee unions. These groups are mobilizing to put an initiative on the ballot called "Proposition 13 for Pensions." It would simply require public employees to work until the age of 65 before they can receive retirement benefits. That's standard fare in the private sector, and the reform would save the state of California and its localities an estimated $500 billion through 2030. No surprise that the unions have pledged to spend millions of dollars to defeat the measure.

The more sensible long-term solution is for cities to immediately abolish these anachronistic guaranteed "defined benefit" pension systems and convert public employees to portable and cost-constrained 401(k)-type pensions. "In the private sector, defined benefit pension structures are rapidly becoming extinct," says financial analyst Dan Clifton of Strategas, a Wall Street advisory firm. "Pretty much only the government still offers them."

But the unions have plenty of political firepower to preserve their pension empire. This year public employee unions are expected to spend $50 to $100 million on political campaigns--as they've been doing for years. No wonder that many politicians behave like fully owned subsidiaries of the unions. So the luxurious benefits of public employees grow more unaffordable each year while the states and cities keep edging closer to the fiscal cliff. Bankruptcy may be their only recourse. Just ask the folks in Vallejo, California.

Stephen Moore is senior economics writer for the Wall Street Journal editorial page.

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