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Detroit Hard Luck City

2:01 PM, Jul 25, 2014 • By IKE BRANNON
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The law does not always deliver what people might consider the “fairest” outcome. But setting aside the law and the various compromises made by elected officials when they crafted it in order to deliver a “fair” outcome would be a costly mistake—costly for every single city, county or state government that borrows money. Unfortunately, this is precisely what may occur in Detroit when the courts finish adjudicating the morass that is the Motor City's historic bankruptcy.

Detroit

Detroit filed for bankruptcy protection just over a year ago, saddled with $19 billion of debt—most of which is in the form of unfunded pension obligations. Its financial demise was decades in the making, the result of middle class flight combined with a gradually worsening economic climate in the region, all of which was exacerbated by a series of poor decisions made by various governments over the years. 

In order to shed its debt, bankruptcy law requires there be a repayment plan that is agreed upon by a majority of each class of creditor. Like almost anything of import in this day and age, the process has become highly politicized: Public employee unions and other Detroit denizens are fighting a public relations battle that is encouraging the under-valuation of Detroit’s assets—namely its historic fine art collection, along with real estate and infrastructure.

The city—not unlike other creditors in the same situation—would prefer to keep these assets, and the state has put together a consortium with various donors to pledge up to $800 million to creditors if the city can retain its art collection. There is significant pressure on the unsecured creditors to acquiesce to such a deal.

There is some evidence that this valuation may be low: An appraiser recently suggested the collection could be worth as much as $4.7 billion, although donor litigation and the practicalities of selling such an immense collection could make it difficult to collect that much in a timely manner. However, political exigencies may effectively preclude that option.

Detroit will certainly not be the last city to file bankruptcy, as communities around the country find themselves facing some of the same fiscal pressures—most notably escalating public pension debt—that exist in Detroit. If the city manages to hold onto valuable assets while bondholders hold the bag it would cause problems for any community that tried to borrow money in the future. Lenders would have a greater reason to believe they would be stiffed in a bankruptcy and ask for a higher interest rate, making it costlier for cities to finance roads, bridges, schools, or other public investments. Taxes would need to be raised and fewer public investments would occur as a result.

One reason that the public employees’ unions have gotten traction in their PR battle is that they can put a empathetic mien onto their campaign—that of their current workers and retirees. However, caricaturing the other side as merely wealthy Wall Street bondholders is mistaken; the people who would be hurt from giving in to the city would be the people whose money is in their municipal bonds, namely current and future retirees from the rest of the country whose money is invested in Detroit’s municipal bonds. 

There is an unavoidable tension in bankruptcy law between the debtor and creditor in a bankruptcy, and when the debtor is a city this tension is even more acute. But stiffing the creditors in the name of “fairness” is anything but fair and represents nothing but a short-term palliative that will create all kinds of illnesses for communities across the nation, whether or not they will ever find themselves contemplating bankruptcy protection in the future. And all of us will pay the cost of such perfidy, in the form of higher taxes and fewer public investments.

Ike Brannon is a Fellow at the George W. Bush Institute and President of Capital Policy Analytics, a consulting firm in Washington D.C.

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