Investment Contrarians

Why Detroit’s Bankruptcy Should Concern You

By for Investment Contrarians |

Detroit’s BankruptcyWell, it’s official—as of last Thursday, the city of Detroit is bankrupt.

Detroit is a sad example of a city that was continually running a large budget deficit. But it grew into such a huge amount of government debt that the only way out was to file for bankruptcy and give investors pennies on the dollar.

While some might not feel sorry for large investors, don’t forget that many pension funds will lose a significant amount of money as the city restructures its government debt. Early reports of the proposed restructuring indicate that retired municipal city workers will get less than 10% of what they are owed.

That just shows once again that you cannot run a budget deficit, spending more than you make, indefinitely. At some point, the government debt grows so large that the cost to maintain it ultimately brings the whole scheme down.

Even over the short term, since 2008, the city of Detroit has had a budget deficit in excess of $100 million each year on average. As the government debt continued to grow, there were no structural changes put in place to increase revenues and cut spending, and Detroit’s politicians simply kept borrowing more and more money, hoping things would turn around. Clearly, things didn’t turn out the way they’d hoped.

But is Detroit alone in continuing to run a budget deficit and build a government debt to insurmountable heights? No.

Just a few days ago, ratings agency Moody’s Investors Service downgraded Chicago’s general obligation and sales tax debt, in addition to further downgrades for Chicago’s water and sewer senior bonds. (Source: “Moody’s downgrades Chicago to A3 from Aa3,” Moody’s Investors Service web site, July 17, 2013.)

A large part of the reason for the downgrade in government debt has been the level of pension liabilities in addition to budget pressures associated with running a city and debt service payments.

Running a budget deficit over time creates a large government debt load; at some point the debt service payments take up a proportionately larger amount of revenue. The money that could’ve been spent on important expenditures like education instead goes to servicing government debt.

In the cases of Chicago and Detroit, the government debt we are talking about is only in the billions. However, the real worry is that the U.S. federal government debt load is now approximately $17.0 trillion. While the budget deficit has come down substantially over the past year, we’re still spending hundreds of billions of dollars more than the government takes in.

Will the U.S. simply file for bankruptcy and restructure its government debt?

That would be a historic event that would coincide with the complete loss of faith in the U.S. dollar. Because there are such massive ramifications, the U.S. will try everything it can to not go down that road.

While that makes logical sense, there doesn’t seem to be any real worry by politicians.

Looking out over the next five to 10 years, I see America continuing to run a budget deficit, which just keeps adding to the government debt load. This is on top of unfunded liabilities, which total trillions of dollars as well.

I am an optimist, as I think most Americans are. However, when I think that our future lies in the hands of the decision-making politicians in Washington, I believe the short-term attraction of running a budget deficit to get re-elected will be too strong to resist. Until we see the potential for budget surpluses so we can begin reducing our government debt load, the long-term future of America remains cloudy.

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  • ElbonianGA

    Detroit's situation is hopefully a one-off, largely due to city leaders who stuck their heads in the sand for way too many years. The tax base collapsed because people were leaving the city in droves, meaning few wanted to buy property within the city limits and many wanted to sell. Eventually, an area the size of Manhattan was totally abandoned. Detroit needed to focus on building up a local economy. But it allowed its economy to be exported to the suburbs, leaving only the poorest and richest residents still inside the city limits. The poor don't pay much in the way of taxes and the rich can't afford to pay enough to support the entire city, so the city was forced into bankruptcy. This "hollowing out of the middle class" is actually going on in the USA as a whole. its just not so obvious. Which explains exactly why my son wants to graduate from Georgia Tech and move to Sweden…..

  • Joe Shmozler

    I think you forget that we have a community organizer in charge. It's not like we elected a Rodeo Clown. Much worse I'm afraid.