Economist Allan Meltzer once quipped that “Capitalism without failure is like religion without sin. It doesn’t work.” Americans have been witnessing this axiom on a broad scale, as government efforts to prop up industries, bail out the financial sector and protect select private businesses from failure have only caused a prolonged financial crisis. Without failure, there is no day of reckoning and no effort by the failed party to make the fundamental changes needed to avert future crises.

Ultimately, there’s only so much bailout money to go around, and private businesses that make bad decisions, offer uncompetitive products or services or are run inefficiently ultimately go belly up or restructure their debt. Americans accept that bankruptcy is a necessary part of the market system. We want to see those poor-performing businesses change or shutter their doors. New competitors will spring up and, in the end, the public is generally better served when companies can fail rather than get bailed out.

The problem in the public sector is that government never is allowed to fail. There never is a day of reckoning no matter how poorly a government agency may provide its so-called services. Because there are no real customers in the government world, there’s never any hell to pay when the public is mistreated, when resources are wasted and when incompetents enrich themselves in the name of serving the public. Often, the worst agencies are rewarded for their failure by being granted additional public dollars. There never is actual failure.

Reform Plans

For decades, I’ve been hearing about reform plans for any number of government agencies. Think of the Los Angeles Unified School District, the poster child for mis-educating students and squandering public resources. Nothing ever changes there because the system cannot fail. It is propped up by government funding.

Our federal government does many things, almost all of them poorly and wastefully, yet our government prints as much money as it needs to pay for this. There is no failure, no day of reckoning. The federal government’s debt has soared above $15 trillion, but there is no chance of capitalist-like failure for the national government.

But it’s a different story at the state and municipal level. State governments and localities cannot print money. They must, at least theoretically, balance their books. Yet many state governments such as California struggle with endless budget deficits. Unfunded liabilities to pay for pension promises for state and local public employees hit an estimated $3 trillion nationwide. Then there are the debts for the health-care promises that municipalities have made to their employees. Much of this is not honestly accounted for, so the real numbers are worse than the official ones.

De Facto Bankruptcy

As Orange County, Calif., Supervisor and former Treasurer John Moorlach has pointed out, California is in de facto bankruptcy. States are not allowed technically to go bankrupt under current federal law, but some of them – California most notably – are basically insolvent. They spend more money than they take in. California’s officials play games with the budget every year to mask that debt, but it is there no matter how artfully legislators and governors shift around funds and paper over their ongoing debt spending.

Municipalities can go bankrupt and some of them — Harrisburg,Pa., Central Falls, R.I., Vallejo, Calif. — have actually gone bankrupt or tried to do so. In the San Francisco Bay Area,Vallejo is a union-dominated city that ended up spending 80 percent of its budget on pay and benefit packages for city workers, primarily police and firefighters. In Vallejo, one police captain earned a compensation package of $300,000 and average firefighter compensation is in the $175,000 a year range. At a certain point, cities that spend that way end up insolvent and bankruptcy becomes one of the few options available.

It’s one of the only ways to impose failure on a public entity. Governments are the ultimate example of Meltzer’s maxim. They spend. They make foolhardy decisions. They make outrageous promises to the public employee unions that have so much political power in state capitols and city halls. When there’s no money left, officials play games with the numbers or — as California Gov. Jerry Brown continues to do — make their main objective raising taxes. Of course, raising taxes is only a temporary fix. Short of the threat of failure, the same politicians who created the current mess will continue to spend money in the same old ways. They only buy themselves time and tax hikes can actually reduce tax revenues, as the supply side economists have shown.

Union Critics

The main critics of the bankruptcy option are the unions. They know that bankruptcy would enable cities and possibly states to abrogate these unaffordable contracts. I saw it many times while covering local government. Unions would promise that the new pension formula — usually granted retroactively — would not cost city governments anything. But their economic projections were always overly rosy, and before long the unfunded liabilities would soar.

But the courts in California have ruled repeatedly that once an elected body grants a pension increase, there is no reducing the benefit for the 30-year life of the contract. The California Supreme Court ruled in November 2011 that not only are vested benefits such as pensions, which were granted contractually, off-limits from any tinkering, but non-contractual and non-vested benefits such as retiree health care also can carry the weight of a contract. By unanimous vote, the court found an implied contract and made it that much more difficult for localities in this state to address budgetary problems. There are fewer and fewer options.

The public-employee unions championed a bill, signed into law by Gov. Jerry Brown in October 2011, that makes municipal bankruptcy more cumbersome by forcing localities to get approval for such actions by additional committees. It’s not a ban on such bankruptcies, but it makes it harder for cities to use this option. But it’s not just the unions that are opposed to the concept of government bankruptcy.

Bond Markets

Some conservative intellectuals, concerned about the impact of bankruptcy on bond markets, have been campaigning against this idea. This debate started in January after former Florida Gov. Jeb Bush and former U.S. House Speaker Newt Gingrich made this argument in a Los Angeles Times op-ed titled, “Better Off Bankrupt”:

“The figures for next year’s budgets are staggering. California, which faces a $25.4-billion budget shortfall, will pay $100,000-plus pensions to more than 12,000 state and municipal retirees this year. A Stanford study puts the state’s unfunded pension obligations at more than half a trillion dollars.Illinois has a $15-billion budget deficit, prompting its governor and lame-duck Legislature to hike its personal income tax rate by 66 percent.New York, where 73 percent of the government workforce is unionized, is staring at a $10-billion deficit.

“There has been an organized federal bankruptcy process for municipalities since the 1930s, and a handful of cities, towns and counties – most notably California’s Orange County in 1994 – have gone through municipal bankruptcy and gotten their fiscal houses back in working order. A bankruptcy option for the states would look very similar to Chapter 9 municipal bankruptcy, with some necessary modifications.”

The Manhattan Institute’s E.J. McMahon disagreed. He argued in the Wall Street Journal that, “Such an option would certainly rattle the bond market — which bankruptcy proponents see as a good thing. Yet this ignores the potential for collateral damage and disruption. While bond spreads might get wider for the most troubled states, the enactment of a state bankruptcy law is likely to raise the cost of borrowing for all municipal issuers.”

Granted, McMahon is dealing here with the prospect of state bankruptcy, rather than the municipal bankruptcies that are the subject of this series. As such, he is right to point out that most of the state spending problems come from educational spending and Medicaid transfer payments, not pension obligations, which are local obligations. But many of his points are meant to apply to municipal bankruptcy as well. He argues that “officials committed to cutting costs already have options for putting the squeeze on their unions.”

Unused Tools

Unfortunately, while officials indeed have those tools, they generally are unwilling to use them. Expecting state and local officials, who in California and other states with the biggest problems tend to be union-supporting Democrats, to take on the unions that elected them to office is unrealistic. It’s not going to happen easily and the threat of bankruptcy at the very least could force these unions and officials to embrace the needed tough medicine.

Critics of bankruptcy like to point to the results of the Vallejo bankruptcy as an example of why municipal bankruptcy is no panacea. I wrote in March 2010 in City Journal, “Though the city eventually voted to reduce firefighter pensions for new hires and to require a larger pension contribution by firefighters, it did not touch existing pensions or pensions for police officers.Vallejo’s avoidance of the pension issue makes it less likely that other cities could declare bankruptcy and then easily dispose of their burdensome pension promises.” Since then, the city has emerged from bankruptcy and has cut benefits mostly moving forward. The city did cut back salaries and slash its retiree health-care debt, but it fell far short of ditching its enormous benefit obligations.

Bondholders’ Losses

Wrote Nicole Gelinas in City Journal:

“Bondholders should realize, then, that they are vulnerable to real losses as cities, towns, and states move to escape massive health-care obligations to their retirees. At best, they’ll suffer the Vallejo bondholders’ fate – though a three-year deferral of payment is no small matter to an investor. At worst, they’ll take bigger losses as obligations pile up. It’s easy to imagine some future mayor convincing a bankruptcy judge that it’s only fair for bondholders, along with union members, to take big cuts in a restructuring. Indeed, heavily indebted governments’ willingness to repay crippling municipal debt will depend on what’s politically expedient. Today, politicians still see the advantages of borrowing more. Ten years from now, it may be more practical for a governor to tell the public: we’ve borrowed too much, we did so because clever Wall Street investors convinced our predecessors that it was a good idea, and we shouldn’t have to pay those investors back.”

So Vallejo was not a panacea, but it did help the city and, as Gelinas points out, might set the stage for much more far-reaching results from future municipal bankruptcies. That’s what has many bankruptcy critics concerned. Granted, bond holders might have reason to fear that result, but that should give taxpayers hope that bankruptcy could provide the pressure needed to force officials to get out from under these unsustainable costs for public employees. Cities are running out of money and something has to be done.

Sure, it would be better if elected officials used other options such as those detailed by McMahon before relying on bankruptcy. But that’s wishful thinking. Officials would rather play financial games and seek new tax revenues or leave the mess for future politicians. Yes, as other critics note, municipal or state bankruptcy is just a reflection of failure. But that’s exactly what governments need — some level of failure to force them to act responsibly. As Meltzer understood, failure — or the threat of it — is the only thing that works.

Steven Greenhut is vice president of journalism at the Franklin Center for Government and Public Integrity. Write to him at steven.greenhut@franklincenterhq.org.

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