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Initial Thoughts on the Detroit Bankruptcy

Over the past four months I have been working on a report that reviews both the economics and law surrounding state bankruptcy. I intend to summarize some of my findings once the report comes out. What I have learned suggests several important points about Detroit’s recent filing for bankruptcy.

First, Detroit’s case is likely to reaffirm the precedent that pension benefits can be cut in bankruptcy, even for existing retirees. This had already been established by Central Falls, RI where pensions were cut by up to 50 percent (although the state agreed to make up half of the cut for the first five years) . The cuts in Michigan are also likely to be deep. This is despite the fact that the state constitution protects pensions. Federal bankruptcy law governs. Unions, which have been assuring their members for decades that the pensions will never be touched, regardless of the level of underfunding, are likely to face a growing level of concern among their members. We may see unions placing relatively more emphasis on pension funding and less on wages in future negotiations.

Second, unions are benefiting from a curious turnaround in the calculation of Detroit’s liabilities. For years Detroit followed the standards set by the Governmental Accounting Standards Board and discounted future pension benefits by the assumed rate of return on pension assets, currently 8 percent. Most economists believe these obligations should be discounted at a much lower rate. Unions have strongly resisted doing this because it increases the estimated underfunding. In calculating Detroit’s liabilities, the Emergency Manager lowered the discount rate to 7 percent. This apparently had the effect of giving the pension plan an additional $3.5 billion in unsecured claims, thus ensuring that workers get a larger share of the total recovery. Had he used a risk-free rate as most economists advocate, retirees would have had an even larger claim. It seems that using a lower discount rate actually benefits unions as a city or state approaches insolvency.

Third, any final plan to emerge from bankruptcy is likely to include significant asset sales, possibly including the estimated $2 billion worth of art owned by the city. The law is not clear on whether Detroit’s creditors can force the city to sell these assets against its wishes. But the fact that they account for approximately ten percent of the losses that bondholders and pensioners are being asked to take and that many retirees will press for their sale in exchange for smaller cuts may influence the city’s position.

Fourth, it is interesting that retiree health benefits have been included in the list of claims against the city. Unions and governments have long argued that retirees do not have a legal right to these benefits. Since they can be withdrawn at any time, cities should not have to prefund them. But if this is true, then they should also not be listed as an unsecured asset in a bankruptcy proceeding. The fact that they have been indicates that governments should begin to set aside money to pay for future claims. This will add a new strain to city budgets.

Fifth, I expect this filing to move relatively quickly. Although a state judge issued an injunction ordering the city to withdraw its petition, federal law governs. If higher state courts do not remove the injunction, federal courts will. I do not think creditors will succeed in challenging the petition, since the city is clearly insolvent and has tried to negotiate a deal. The real test is how quickly the Emergency Manager can put together a plan for emerging from bankruptcy. I expect him to act quickly and to present a plan that is fair to all creditors, given the financial circumstances. If he does this, there are not many grounds for the court to refuse approving it, even if a majority of creditors object. This area of the law is still undefined, however.

Last, there should be no bailout. Steven Rattner, has recently argued to the contrary. His reasoning seems to hinge on the assertion that “the 700,000 remaining residents of the Motor City are no more responsible for Detroit’s problems than were the victims of Hurricane Sandy for theirs, and eventually Congress decided to help them.” This is false. The victims of Hurricane Sandy were hit by a natural disaster whose damage was largely beyond their control. Detroit’s failures are largely the result of decades of mismanagement and corruption by both elected leaders and union officials. If the residents of Detroit are not responsible for the quality of its elected officials, who is? And if city workers are not responsible for the positions taken by union leaders, who is? Democracy only works if people accept responsibility for the leaders they elect. Bailing out Detroit would dramatically reduce the pressure on other cities and states to reform their finances. The bailout of Wall Street is still preventing regulators from dealing with banks that are too big to fail. And the government’s interference in the auto bankruptcies set bad precedents that we may still someday regret, despite the strong rebound of the companies involved.

Finally, debt reform of one type or another was inevitable. The money simply is not there. The first rule of getting out of a downward spiral is to hit bottom as quickly as possible. Only then does the future become brighter than the past. Although bankruptcy can eliminate Detroit’s debt overhang, its real future will depend on a willingness to create an environment that is welcoming to all people and businesses. That has been a relatively foreign concept.

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Belated thoughts on the Fourth of July

Early this month I spent a week in Minnesota visiting family and seeing medical specialists. While there my wife and I contacted a couple who run a website devoted to Dravet’s Syndrome. They spontaneously invited us to come to their house in Afton, Minnesota to talk. They also encouraged us to stay for the town’s Fourth of July parade and then boat with them on the St. Croix (we did not have time to do the second). The day has stuck with me for several reasons.

Here is a normal husband and wife who happened to have a son with a serious illness. Rather than passively accept the advice of doctors and hope for the best, they began an national organization and sponsored a website, dravet.org, that provides detailed information about the disease. They put themselves in touch with the best doctors and researchers in the world. And they wrapped themselves in a community of other families with the same diagnosis. Some of the parents in their organization know more about the disease and current research than the average neurologist and they are willing to meet on call with any other family and share what they know. People and organizations like this belie the common statement that patients cannot be trusted to choose among providers and treatments. These parents are currently fighting the government for access to drugs that have been effective in other countries.

The parade was another experience. It was not very long and almost all the floats were from local businesses or organizations. Very hoaky. And yet, when you look deeper it is not too hard to see the real strength of America. On float after float you saw small businessmen who had risked their own capital to start a barbershop, dance studio, or restaurant and were now celebrating with the community that supported them. You saw people clapping and waving, usually not at the specific float or person, but at the idea of a life lived in freedom and comfort. These are not people who aspire to leadership or fame. If offered it, most would probably decline because it takes too much away from what is important: time with family, fishing, watching the ball game on TV. These are not people who need to be led by the nose. They are the strength of our country. The source of everything that makes us prosperous and great. They do not need a government that erodes their civil rights for their own protection, that spies on them, or that hides what it is doing in secrecy. They do not need to be protected from themselves.

The more I think about that day, the more convinced I am that Americans deserve much better from those who currently have money and power. They deserve parties that are willing to put forth sensible plans to deal with today’s problems. They need a President that will lead, not dictate. They need executives who refrain from using government to protect themselves from competition. They need business and political leaders with a strong sense of morality and the common decency to go away when they are caught in scandals. And most of all they need politicians and executives who realize that they are the beneficiaries, not the source, of the power that makes this country great.

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Obama: “Nobody is listening to your telephone calls”

“All that is necessary for evil to triumph is for good men to do nothing”

Edmund Burke

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Well, Now What?

The reluctant admission that Syria has probably used chemical weapons on its own people puts the Obama Administration in a real bind. Its most probable response is to reinterpret the meaning of “use.”

For over a year the Administration has dithered, seemingly unaware of the enormous strategic importance that the fall of the Assad regime would have for American policy. When, against all expectations and hope, a substantial portion of the Syrian people rose up against one of the Middle East’s most brutal regimes, the President seemed hardly to notice. Rather than realize that the regime’s fall would immediately give hope to strong popular dissent in Iran and isolate Hezbollah from its main source of financial and military support, Obama seemed more concerned about the inconvenience of upsetting the status quo. While the Administration eventually decided that Assad should go, it has done almost nothing to help bring this about, its inaction sending a strong signal to both allies and adversaries about American determination.

In one area, however, the President has been bold. Several times Obama has warned Assad not to use chemical weapons, declaring that doing so would be crossing a red line. If words have any meaning, then the implication can only be that serious American action would follow. Since any actions that we would take in response to the use of chemical weapons are actions that we should be taking anyway given the strategic importance of replacing Assad, it is unclear why the President drew this line. Perhaps he naively thought Assad would never cross it. Perhaps he did not even think that far, but was merely responding to an opportunity to provide leadership on the cheap. In any case, the line has apparently been crossed.

What to do now? Given the President’s reluctance on Syria, it is hard to believe that he will suddenly see the merits of risking American life and treasure in exchange for an opportunity to fundamentally shift the balance of power in the Middle East. More likely there will be some sort of redefinition of the line. Something along the lines that a small use of chemical weapons does not justify a disproportionate response. And in a perverse way this makes sense. After all if, we allow Assad to carpet bomb his people with impunity, then why object to a little sarin?

The Administration has never had a real policy for the Middle East. Given the tremendous promise, as well as risk, posed by the political and economic turmoil that the region is undergoing, this exposes both the country and our allies to unnecessary risk. It also makes clear to everyone that America is neither a reliable ally nor one capable of recognizing and acting on its true interests.

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How Do We End Too-Big-To Fail?

On Tuesday of this week the Peterson Institute held a panel event devoted to the problem of financial institutions that are too big to fail.  The panel consisted of Sheila Bair, Jon Huntsman, Simon Johnson, and Senator Sherrod Brown.  The more I listened to the panel the more convinced I became that they were really missing the point, and in missing the point came to the wrong solution. Efforts to shrink financial institutions to a size where political leaders no longer feel compelled to bail them out are unlikely to be successful. A much better solution would be to amend the bankruptcy laws so that politicians have more confidence in their ability to handle large bankruptcies.

The common wisdom regarding too-big-to-fail institutions is that they are so important to the general economy that the failure of any one large bank would threaten the financial system and therefore the economy. As a result, regulators will always have to rescue the company’s creditors. However, this in turn will create moral hazard because both the financial institution and its creditors will feel free to engage in riskier behavior than they otherwise would. The solution proposed by all of the panelists is to penalize bigness.

I have no opinion on bigness. In the early 1990s officials in the first Bush Administration worried that large Japanese banks were eclipsing American ones and that the American banking industry was too fragmented. On the other hand, the trend in other industries has been away from large conglomerates because they were seldom able to achieve the efficiencies promised by their proponents. Absent regulatory intervention, I would expect many of today’s largest financial institutions to gradually sell off parts of their business as they face greater pressure from shareholders and the full costs of Dodd-Frank regulation became clear.

But I am fairly certain that government efforts to break up the banks are a poor solution. First, they assume that proponents of this strategy can obtain the political capital to accomplish it.  This seems highly unlikely given that stronger language did not make it into the Dodd-Frank legislation and the difficulty regulators are having implementing the Volcker rule.  Second, even if they had the statutory and Constitutional powers to force downsizing, I doubt regulators possess the detailed knowledge of markets and institutions to do in wisely. Especially in finance, the market is too complex and evolves too quickly.  Most of all, however, bigness is not really the issue.

During the panel discussion, Sen. Brown mentioned his support of the auto bailout in which the government intervened in the bankruptcy of General Motors and Chrysler. The bailout was financed by a highly strained interpretation of the authority given to the Administration under the Troubled Asset Relief Program (TARP) and accounted for most of the taxpayer losses under it. The central arguments for government intervention were the same for GM and Chrysler as they were for the financial institutions: that the consequences of bankruptcy to the broader economy were too great to let these companies go through the normal bankruptcy process. In this case the number of jobs lost and the interconnectedness of the supplier network were often mentioned.  Similar arguments might someday be made if other companies such as Boeing get in trouble. And yet no one is talking about breaking these companies up. So I question whether bigness is the real issue.

The real problem is that, when push comes to shove, political leaders often face tremendous pressure to mitigate the fallout from large firms. The current emphasis is on financial institutions because they started the crisis. But similar concerns surround any large company that has a large number of employees, counter parties, suppliers, and customers. Political pressure is part of the problem, but so is a genuine uncertainty about the ability of normal bankruptcy laws to handle large and complex organizations, especially in the absence of a clear buyer with bridge financing. If this is the problem, then the solution is to improve the bankruptcy laws.  Dodd-Frank addressed this problem by requiring companies to prepare living wills and giving the FDIC enhanced powers to liquidate an insolvent financial institution but these solutions are unlikely to work in practice. The plans are unlikely to be sufficiently detailed to help in a crisis and there are serious problems with giving politically appointed regulators the broad powers needed to handle such a crisis successfully.

A better solution would be to deal with the problem directly by amending the bankruptcy code to give the bankruptcy judge and the trustee the necessary powers, many of which are now given to FDIC under Title II of Dodd-Frank. The Pew Financial Reform Project Task Force, which I worked with at the Pew Charitable Trusts did make such a proposal. The Task Force called for the designation of a special bankruptcy court to handle all financial bankruptcies. This designation would reduce the uncertainty about which court would oversee a filing and allow the selection of the judge and trustee most skilled in financial matters. Reliance on bankruptcy would remove political considerations from any liquidation and provide greater certainty to both creditors and potential investors. If one proceeds from the premise that politicians usually do not want to bail out failed institutions (not always true) then giving bankruptcy courts the specific powers needed to enable them to handle large financial institutions would make the most sense.

A few scholars including John Taylor have been working on such a proposal but Congress seems to have no interest in acting on it. Luckily the public is so strongly against the TARP legislation that another bailout is unlikely.

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Predictions following the State of the Union

I was twittering away during the President’s State of the Union speech last week.  In the course of it I made several predictions.  Although it is easy to get carried away during the event, I think the predictions hold up pretty well.  In the interests of posterity I have copied them down here with a brief explanation of each.

1. Despite what he said, this President will never agree to cuts in Social Security and Medicare. Although the president made about as an explicit commitment as possible, I still do not think he has any intention of actually agreeing to cuts. If Obama were serious about entitlement cuts he could have struck a deal with Republicans during his first term.  Instead he raises hopes but repeatedly moves the goal posts anytime there is a hint of compromise from Republicans.  I think his statements were mainly an attempt to convince voters that he is not the one standing in the way of a deal.

2. Tax reform will not be an Obama priority. That means it will not get done. In the best of circumstances comprehensive tax reform would be an exhaustive undertaking. Because it entails great complexity, high stakes, and inevitable disagreement, it cannot be done without strong presidential leadership. There is no sign that Obama is willing to spend significant capital on this issue.

3. The President’s budget will not contain many details on how to pay for the many initiatives he proposed in his speech.  To be fair, he can make others pay the cost of some of them such as the higher minimum wage and pre-K education. But many inevitably will require federal spending. The budget will not indicate how this should be done.  Nor will it indicate which entitlement cuts the President supports.

4.Within 5 years of leaving Afghanistan, the Taliban and Al Queada will have a significant presence in the country. The President has bragged about withdrawing troops from both Iraq and Afghanistan.  He does not talk about the chaos that is likely to grow in both countries once U.S. forces are gone. The Karzai government perhaps does not deserve any further American support, but there is little indication that it can maintain national unity in the absence of significant outside involvement. There is no reason to think that it will be able to maintain national unity in the face of continued opposition from the Taliban based in Pakistan. Iraq is already splintering. Whether this has security implications for America remains to be seen.

5. The President will not make a serious effort to conclude a major trade agreement.  There seems to be little chance of reviving Doha anyway.  But despite the current talk of trade agreements involving Asia and Europe, nothing will get done.  The President did not show any interest in trade negotiations during his first term, although he did finally support free trade agreements that had been negotiated by Bush. Nor has he requested trade promotion authority even though he would likely get it. The Democratic party remains opposed to bringing down trade barriers, even when economic studies show that doing so would boost growth. Even if Obama feels differently, he will not exert energy over the tough concessions that are inevitably required to complete a major deal of this kind.

Lets see how well these predictions stand up over the next four years.

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Is the Fed’s Monetary Stimulus Helping?

On Monday Janet L. Yellen, currently Vice Chairman of the Federal Reserve gave a speech laying out the case for the Fed’s current policies. Ms. Yellen is commonly viewed as one of the strongest supporters for taking action to reduce the current unemployment rate. She is also one of the likely successors to Chairman Bernanke when his term expires. Her views are important.

Ms. Yellen did a compelling job of laying out the costs of the recent recession to workers and homeowners. But is should not really come as a surprise that many people suffered over the last few years. The real issue is whether the Fed’s current policy of trying to lower interest rates by purchasing assets is good for the country. On this important question she had surprisingly little to say. She did cite a prior speech by Ben Bernanke which in turn cites studies showing that the unprecedented purchases have lowered interest rates, but this again should hardly be surprising. When the Fed is buying roughly $80 billion in new assets every month you would expect that. The real questions are whether its policies are jeopardizing our long-term future for a little extra growth now.

The answer to that question depends on a couple of things. One is the impact that government policy can have at this particular time. Ms. Yellen includes a couple of graphs that show that fiscal policy and job growth have been disappointing during the current recovery, but the slides comparing both to past recessions only start at the beginning of each recession.  It would have been interesting to see what the comparisons looked like in the year or two prior to each recession. The Fed seems to believe that the Great Recession was pretty much like its predecessors and therefore the recovery and room for fiscal stimulus should also have been roughly the same. An alternative view is that this time was different. If unemployment was artificially low before the recession, then it should not be a surprise that it has fallen more sharply and recovered more slowly than in the past. If government deficits were larger, then the scope for fiscal stimulus at reasonable deficit levels is also constrained. Finally, if much of the activity and wealth creation prior to 2007 was artificial and never backed by true economic value, then we would not expect the declines in GDP and household wealth to recover their old values. But Ms. Yellen never addresses these issues.

The Fed’s strategy is to lower real interest rates.  This will have three effects. First, it should make it cheaper for consumers and businesses to borrow. Second, by boosting asset values it should make them richer and therefore more inclined to spend. Third, it lowers the income of savers and pension funds. If our long-term problem is a surplus in spending and low savings rates or, to put it another way, too much consumption and not enough investment, then it is not clear that the Fed’s policy is wise. Similarly, if the rise in asset values is temporary and artificial, then the Fed’s wisdom is also questionable.  Again, there is no discussion of this.  The Fed’s assumption seems to be that we simply need to jump start the economy and then it will take off on its own momentum. But other researchers, notably Carmen Reinhart and Ken Rogoff, have argued that, because this was a financial recession the recovery will be longer and less responsive to stimulus.

A second criteria for judging Fed policy is whether it harms the future. It is certainly hard to argue that inflation is a problem. Not only is current inflation low, there are few signs that people expect higher inflation in the future. But the real test will come when the economy begins to grow rapidly and the Fed has to raise interest rates and unwind its position.  Just as buying assets lowered interest rates, not buying them will raise them. The recent history of the Fed is that it has been slow to raise rates when economic growth resumes. In its defense, any rate increases are always met with political opposition because they slow growth from what it might otherwise have been. In such a circumstance, inflation expectations may rise. In fact, Ms. Yellen’s speech invites such a conclusion when she makes it clear that a rise in inflation expectations would not necessarily cause the Fed to pull back if unemployment was still high. It is clear that future stores of wealth such as private savings, pension plans, and college endowments will all be lower because of the current policies.

The lack of serious public discussions of these problems gives one the impression that the Fed is winging it: pursuing unprecedented increases in its balance sheet largely because it feels pressure to do something and worrying about the consequences later. Such strategies often turn out poorly.

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