Detroit Files for Bankruptcy: HBS Faculty Weigh In
After a long period of economic decline, the city of Detroit filed for bankruptcy protection last week. John Macomber, Robert Pozen, Eric Werker, and Benjamin Kennedy offer their views on some down-the-road scenarios.
Once the hub of American manufacturing, Detroit is in a long state of economic decline. The rubber finally hit the road last week, when the city filed for bankruptcy protection. The challenges ahead for those that call the Motor City home are daunting, from a relentlessly declining tax base to a mountain of pension costs. John Macomber, Robert Pozen, and Eric Werker—offer their views on some down-the-road scenarios.
Beyond a Bailout
By: Senior Lecturer John Macomber
Detroit has failed. Why did this happen, might there be more big city failures on the horizon, and what should be done?
Harvard economist Edward Glaeser argues in The Triumph of the City that "our greatest invention [i.e.,cities] makes us richer, smarter, greener, healthier, and happier." That's all well and good, but the success of mankind's greatest invention is not evenly distributed. And when cities are not successful, the economic engine runs backwards, and we become poorer, less educated, suffer from worse pollution, get sicker, and are miserable. We get Detroit.
The demise of Detroit was easy to see and hard to address. Consider the causes: Decline of a major industry, diminution of public revenues, departure of high-impact businesses and high-value taxpayers, disputes over dwindling resources, and disabling levels of obligations to pensioners and other contracts.
Unfortunately, Detroit isn't alone. Stockton, California, and Jefferson County, Alabama, are other recent municipal bankruptcies. Pundits and politicians point to the burden of pension, health, and union obligations on the cost side. True, but not it's not sufficient just to cut costs. The real game is about revenues. Municipal revenues come from economic activity, and increased revenues come from increased economic activity—from the income taxes paid by residents with good jobs, from the tolls paid by drivers, from property and sales taxes. Without revenue, costs can't be covered.
Can cities with high liabilities expect to be bailed out and propped up without limits? Probably not. In the post-Katrina and Sandy world, taxpayers and politicians, afflicted with disaster fatigue, will likely have limited appetite for subsidizing struggling cities like Detroit or Rochester or St. Louis. Steven Rattner's recent New York Times op-ed "We Have to Step in and Save Detroit" notwithstanding, "we" won't be able to step in over and over again.
What, then, should business and civic leaders do about revenue? Since the fabric of cities is woven by the many entities of which they're composed, this is a question that can be broken down into a number of options and investments that bring desired returns. Here are steps that major players working together in metropolitan areas can do to save their cities:
- When it comes to the elements of soft infrastructure such as education and healthcare, it's essential to create an environment for capital, investment, and entrepreneurship that encourages businesses to start, locate, or invest in a city. As HBS professor Michael Porter has explained in The Competitive Advantage of Nations, political units—whether nations or cities - are in competition with each other and can control their destiny using the analytical tools of business competition. Clusters like the Research Triangle in North Carolina think very hard about focus in order to create a virtuous cycle of complementary successful ventures. The results have been extraordinary. A generation ago, it would have seemed farfetched to predict that Raleigh-Durham would one day be more vibrant than Detroit, then the mecca of American manufacturing.
- Business, civil society, and municipal leaders also have options in their tool kit regarding land use. This is one of the most powerful—and most controversially applied—techniques in the box. If business and civic leaders are worried about going the way of Detroit and concerned that there is not an unlimited bailout on the horizon, they have to make choices about what land uses to protect and amplify and what to let languish. Perhaps this is heartless in the short run, but this approach improves the chances of thriving in the long run. Remember Chicago's difficult decision recently to close a number of schools, given that there were too many facilities for too few students. The goal is for the remaining students to thrive with more resources per capita, with a focus on developing human beings, not maintaining out-of-date buildings. Although Illinois has serious financial issues, Chicagoland has far more vitality, economic activity, and interaction between downtown and the suburbs than Detroit.
- In terms of basic infrastructure, (water, bridges, and roads, for example), cities and states have often proved unable to fund adequate maintenance and new construction. On the other hand, well-managed public-private partnerships, where the private sector funds, builds, and operates key public infrastructure, can shift the capital requirement from municipalities to the private sector. When there are adequate revenues to cover financing costs (and when proper oversight makes sure the "rules" are followed), cities can gain a competitive edge since businesses and citizens can benefit from services without their city having to put up the investment capital. The Carlsbad Desalination Project in San Diego County, for instance, is a privately financed project that will provide enough desalinated seawater to provide drinking water for 300,000 San Diegans. The propriety of having private companies provide a public good like water may be controversial, but the economics are not.
- As for transit infrastructure, American cities like New York, Los Angeles, and Denver have worked with private partners to emphasize public transportation and start to de-emphasize single-driver cars. Despite obvious obstacles (e.g., you live in a suburb or own a store that can be accessed only by car), if the city collectively wants to "win," then infrastructure like this helps more people get to work faster, helps businesses be more productive, makes scarce resources such as fuel and clean air go further, and attracts jobs and workers.
Such a focus on geography, employment, and infrastructure has worked to spur growth, jobs, and opportunities in the likes of London, Barcelona, Beijing, and Singapore. It's not easy, and it's not fun. But the alternative is even worse - a twisting, slow decline that squanders value. At first blush, the natural inclination for many may be to bail out Detroit, but business and civic leaders need to take control of their own destinies by making focused, business-like investments. This approach can help keep dozens of other American cities from becoming the next Detroit.
Helping with Healthcare
By Senior Lecturer Robert Pozen
When Detroit reported $18 billion in liabilities as part of its bankruptcy calculations last week, most people were prepared for the $3.5 billion in unfunded pension liabilities. Many people were surprised, however, to see the much larger amount of $6.4 billion in other post-employment benefits ( OPEB )—primarily obligations to pay healthcare premiums for retired public employees.
Detroit is not unique. The unfunded healthcare obligations of most cities are larger than their unfunded pension obligations. To avoid fiscal disasters like this one, other cities should slow down the growth of their unfunded retiree healthcare liabilities.
Last January, the Pew Charitable Trust did a study of both pension and OPEB shortfalls in the 30 largest cities in the United States. The unfunded pension deficits for these cities amounted to $99 billion, while the unfunded retiree healthcare benefits totaled $118 billion.
Why are OPEB deficits higher than pension deficits for most cities? In part, the answer is that OPEB liabilities were for many decades never reported on municipal balance sheets. Without such reporting, it seemed that cities' healthcare promises did not have serious financial consequences.
That came to an end in 2006, when the Government Accounting Standards Board (GASB) required local governments to publicly report their OPEB liabilities. But GASB did not require cities to fund their OPEB shortfalls. As a result, even the worst funded city pension funds are 50% or 60% funded, while almost all cities have minimal advance funding of their healthcare obligations. Instead, these obligations are almost always financed on a pay-as-you-go basis.
On the other hand, from a legal perspective, it is usually much easier for a city to change its healthcare obligations than its pension promises. Indeed, pension obligations that are already accrued for city employees are legally protected by many state constitutions. The key constraint in changing health care obligations, however, is usually political, especially pressure from public employee unions.
If healthcare benefits can be legally reduced, subject to political constraints, what are the most fruitful strategies for cities to pursue? The following seem politically palatable, though their actual impact on a city's finances would depend on how these strategies were implemented:
- Many cities have reduced retiree healthcare promises for new municipal employees. Unfortunately, it will take years for these reductions to have a material impact on a city's unfunded liabilities. In fact, many cities are downsizing employment, rather than hiring new workers.
- Cities could require all public employee retirees to join Medicare when they turn 65. While many cities are imposing this requirement, some continue to pay a substantial portion of Medicare premiums for their retirees. Moreover, other cities finance better benefits for their retirees than those provided by Medicare.
- Cities could require public retirees before age 65 to obtain healthcare through the new state connectors under the Affordable Healthcare Act. Although the federal government offers a range of subsidies for healthcare policies obtained through these connectors, cities would still have to decide who should pay the remaining premiums on these policies.
More dramatically, cities could reduce their retiree healthcare costs by adopting three other strategies, although each would probably trigger a political battle:
- Cities could change their healthcare policies for retired workers by increasing deductibles and co-payments. They could also cut back on the scope of care provided -- for example, by making retirees pay the full cost of dental work and eyeglasses.
- They could increase the number of working years for their employees to become eligible for retiree healthcare. In some cities, public employees are eligible after only 10 or 15 years of full-time work; this period could be extended to 20 or 25 years.
- Finally, cities could begin to fund their healthcare obligations in advance, as they do for their pension obligations. This funding could come partly from general municipal revenues and partly from public employees. Such advance funding would significantly reduce their reported healthcare liabilities and thereby decrease the interest rates on their municipal bonds.
Health care obligations to retired employees are the hidden bombshells of municipal finance. Any changes in such obligations will be politically controversial. Be that as it may, if cities don't begin to reduce these obligations and fund them in advance, there's trouble ahead. They will soon pay higher interest rates on their municipal bonds and ultimately may face a financial crisis like the current one in Detroit. That's not what the doctor ordered.
The Long View
By Associate Professor Eric Werker and Benjamin Kennedy (MBA 2009), Senior Program Officer, The Kresge Foundation
Just what does it mean for a city to go bankrupt?
Bankruptcies are so commonly associated with firms and individuals that we tend to use the same mental models to evaluate Detroit's bankruptcy filing as we do a firm like Circuit City. The Associated Press declared that "Motown Goes Bust," and most commentary described the bankruptcy as yet another nail in the coffin of a city in decline. On the surface, the Motor City does look like Circuit City. Both entities have failed to compete, with management mistakes, in a sector doomed by trends beyond their control. And Circuit City's dark and empty big box stores, like Detroit's boarded-up houses and overgrown factories, remind us of the failings and offer a sense of finality.
That's a neat and tidy narrative to attach to America's largest municipal bankruptcy, but it may be wrong. To be sure, this is an extraordinary moment in the annals of American municipal finance, with serious near-term implications for municipal bond markets and other underfunded pension systems. Detroit's Chapter 9 bankruptcy case will be precedent setting in a variety of ways. But the real story here may not be what happens in the near-term at all. This is where cities differ from firms.
Cities almost never die. A bankrupt firm's assets can be sliced up and repackaged and sold off to partially repay the firm's creditors, and once that process is complete, the entity becomes dissolved. But cities—with some incredible exceptions that prove the rule, like Atlantis or Pompeii—cannot just be dissolved. Places recover from all sorts of catastrophes including natural disasters and wars. Along the spectrum of catastrophic events, a fiscal crisis is not the worst of these; in fact, a fiscal crisis is often an essential ingredient of recovery. Detroit has a precedent in Pittsburgh and a variety of other cities and jurisdictions that have seen their trajectory fundamentally shift in the wake of precipitous economic and fiscal decline.
Long before the American automobile industry was in crisis, American steel producers began to lose out to foreign competition. In the Pittsburgh region, which is to steel what Detroit is to the automobile, primary metals employment dropped by three quarters in the 1980s. Some 150,000 jobs disappeared, devastating the region's population of 2.2 million. But Pittsburgh had a second act (or third, counting the city's reversal from untenable air and water pollution levels in the 1940s).
Pittsburgh's recovery offers a potential model for Detroit. It went on to become a technology hub, anchored in the computer science and robotics coming out of Carnegie Mellon University. It also became a medical hub, driven by the brisk expansion of the University of Pittsburgh Medical Center. The education centers of Carnegie Mellon and Pitt attracted students from all over the world, and the city helped to retain them through its new economy sectors and affordable home prices.
Philanthropy, seeded by the steel fortunes, played a major role in funding education, culture, and historical preservation projects. City and state government, combined with self-organized private-sector players, played their part by funding technology as well as sticks-and-bricks real estate projects and brownfield redevelopments. In spite of this, Pittsburgh almost went bankrupt. It fell under state receivership in 2004 due to rising pension obligations, and the state of Pennsylvania has had oversight of Pittsburgh's fiscal policy since then. It still has trouble with pension obligations, but by 2009 it was rated America's most livable city by the Economist Intelligence Unit.
Countries, like cities, have gone through their own bankruptcies on the path to recovery. Liberia, a small country in West Africa where one of us advises, did the sovereign equivalent of bankruptcy as part of its post-civil war reconstruction. When Liberia emerged from a decade-and-a-half of war, fiscal obligations were several times higher than income. Its new leaders were able to restructure the country's commercial debt (to three cents on the dollar) and negotiate most of its official debt to be forgiven.
Liberia is not yet in the clear, but it is politically stable, its economy is rapidly growing, and its citizens are returning to lives enhanced by a more egalitarian power structure. Without the fiscal fresh start, investments in infrastructure and human capital would be impossible. Scores of other countries have also undergone debt relief, and it's probably not a coincidence that eight of the twenty fastest-growing countries in the world recently underwent this process.
Every place's recovery has its own unique features, since places, as congregations of people, have an organic quality. Ultimately, places, even if fiscally bankrupt, have assets that cannot be stripped, and these are the assets that must power their recovery. People are enormously resilient, and the permanence of place only serves to stoke this common trait.
So what does this mean for how we think about Detroit? It means we should be taking the long view. Detroit doesn't have to turn things around in a year or even five years. And it doesn't have to reclaim the place it once held among America's largest urban economies. It simply needs to be a better Detroit for current and future residents.
The good news is that Detroit's private-sector leadership already seems to understand what it will take to build back the city over the next several decades. Much of what we see if we look beyond the fiscal calamity in Detroit resembles the essential characteristics of the Pittsburgh recovery. Philanthropic and corporate leadership are working collectively to strengthen the core of the city through physical redevelopment. Medical and educational institutions are doubling down on their commitment to the city. Dynamic entrepreneurs and artists are giving life to a new narrative for the future. Long-time residents are staying in the city, stabilizing neighborhoods house by house. Seen in this context, Detroit's bankruptcy is more prologue than epilogue.
This isn't just good news for Detroit. It's good news for every place around the world that might otherwise be written off because of its fiscal straits.
The economist John Maynard Keynes was right about the ultimate mortality of human beings ("In the long run, we are all dead," he once said.), but when it comes to places, it may be precisely the opposite.