Detroit

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I was born and reared in the state of Michigan, and its affairs remain very interesting to me. I regard Detroit’s bankruptcy as the virtually inevitable result of events I’ve been witnessing throughout my life.

First there was the triumph of modern labor-management relations, which kept the price of labor sky-high, as long as junky cars could be unloaded on a market largely free of good-quality foreign goods. With the help of union-friendly politicians, labor disputes were settled amicably, usually with an enormous increase in benefits for labor. When there actually was a strike or layoff, which happened so rarely that it was regarded as a kind of natural disaster, challenging the existence of God, Michiganians were treated to constant interviews with baffled assembly-line workers, who informed the 10 o’clock news that if this thing continued for even a day longer, they couldn’t meet the mortgage on the house at the lake, and they might even have to sell the boat. It was hard, really hard, to meet the payments on three cars. As for savings, who could keep money in the bank, considering all these expenses?

Such were the rewards of unskilled labor. So why should anyone learn any skills? Then came the nervous collapse of both labor and management, once genuine competition took hold.

But something else had happened, simultaneous with the monopoly of the Big Three automakers and their inseparable companion, the United Auto Workers. This was the triumph of Great Society liberalism and the new class of managers and planners who purveyed it. Many of the big chiefs came from auto company management. Remember Robert McNamara? He’s a sample. These people demonstrated that they could be failures in civic planning as well as business planning. After the 1967 race riots in Detroit, they backed every sorry, money-losing civic improvement project they could think of, applying social engineering to the city’s problems. You can guess how well that worked.

Tax money that is used to do anything more than protect your rights is going to be devoted to building things that will violate your rights by taking yet more taxes.

The logical product of the Great Society was the flight from Detroit of everyone, white or black, who could possibly escape and buy a home in the suburbs. The city’s population went from 1,850,000 (1950) to 701,000 (2010). The escapees left behind them an inner city that was poor in productive workers but rich in people who voted for a living. The natural product of that was a chronically corrupt political class, keeping itself elected by class warfare and racial resentment.

Now the city of Detroit is so poor that it is letting large areas of formerly choice real estate go back to the fields and forests. It is arranging not to keep the streets open, not to keep the power running in whole sections of the city. The people I feel for most are the African-American families who have hung on, kept their modest houses and modest jobs, survived the violence and criminality of their neighbors, and now find that their own jealously guarded homes are to be abandoned by the city they struggled to keep in operation. Looking down Woodward Avenue, once the Champs Élysées of the Midwest, I see block after block of emptiness — or worse: wonderful early 20th-century housing, places to live that would be worth a fortune to almost anyone, anywhere else, but that are now hopelessly derelict.

I suppose that most people understand these things, in general. But one factor that should be emphasized, and almost never is, except in a way that contrasts with the truth, is the influence of that mundane but vicious thing, the tax. It is oft lamented that Detroit’s taxes can’t keep up with its expenditures. The problem is that the taxes existed at all.

Right now, Detroit’s municipal income tax is 2.4% for residents and 1.2% for nonresidents who work in Detroit (if that be not a contradiction in terms). Before 1999 these taxes stood at 3.0 and 1.5, respectively, and were authorized by a special provision in the state tax law allowing cities with populations of more than 600,000 (of which Michigan has only one) to exceed the statewide cap of 1.0 and 0.5%. In 1999, Detroit began slowly and minutely reducing tax rates in accordance with a deal, politically extorted from the state, that gave the city a whopping special subsidy from the revenues of Michigan as a whole.

I say “special,” not just because Detroit was getting a deal that, say, Muskegon didn’t get, but because Michigan had already, for many years, been subsidizing major Detroit projects and institutions — something that did not prevent Detroit politicians from erecting giant signs in front of them, bearing their own names.

Anyhow, in 2011, which is about the time when the probability of a Detroit bankruptcy became common talk in Michigan, the Detroit income tax represented about $230 million out of the city’s $1.2 billion general fund revenue. This means that the average man, woman, or child connected with this impoverished town was somehow generating over $1,700 in revenue for the city alone, about $330 of it from income taxes. Overlapping with the income tax, of course, are many other taxes, including property taxes, which generate several hundreds of millions of dollars and would generate more if the owners of half the land parcels in the city were still paying their property taxes, which they aren’t.

Then there’s the income that the city gets from government-licensed gambling and, ah yes, the income it gets from corporate taxes. In 2012, the city council doubled the corporate income tax rate, taking it from 1 to 2%. The excuse was a threatened 10% pay cut for municipal workers. “I can't in good conscience,” said one council member, “ask city employees to give back 10% and not ask the corporate community to share in the sacrifice by raising their taxes." Oh. OK. I see the logic.

Meanwhile, the state of Michigan has been cooperating with Detroit in attempting to create a new stadium for the Red Wings hockey team, a stadium that, its advocates insist, will generate “as much as $1 billion in economic development over 30 years.” It won’t, of course. People will just keep driving into Detroit to see the games, then driving out again. But over the same 30-year period, the taxpayers of Michigan will have to pay $444 million for bonds to subsidize this scam. Let’s see . . . if there were a billion dollars of economic development (over 30 years, of course), and it were highly profitable (which it won’t be), it might possibly earn, say, 10% on investment, which means an average profit of maybe $22 million a year (it can’t all happen at once), from which the taxpayers of the state of Michigan would receive, in taxes from the grateful beneficiaries of their subsidy, something less than $1 million a year.

So that’s the way — not bread and circuses, but welfare and hockey. Isn’t there an old saying about castles being erected on the ruins of cottages?

The more Detroit taxed, and the more Michigan taxed and subsidized, the worse things got. And continue to get. But why oh why? Because, as Isabel Paterson explained long ago in The God of the Machine, tax money that is used to do anything more than protect your rights is going to be devoted to building things that will violate your rights by taking yet more taxes. The things it builds may simply be dead weight, from an economic point of view, and will therefore have to be supported by continued taxation. Or, more likely, they will be institutions devoted to extracting yet more money from the productive members of society.

The illness of Detroit has been blamed on “white flight,” as if whiteness were some magic elixir.

These may be institutions such as the welfare industry. These may be institutions such as Detroit race politics, which long defended and empowered every crook in the city government, so long as he or she was an African-American, and is currently demanding that Detroit’s debts be “canceled,” thus neatly averting the consequences of bankruptcy. Or these institutions may be government-“stimulated” businesses, erected by subsidies and continually devoted to extending them.

But two things are certain. The beneficiaries will not “give back.” And they will never, never be the productively working black, white, or Asian population of anywhere. These are the people who are tricked into voting for the money-extraction industry, told that more taxes are needed to support the schools or the police or the fire department or something, or defeating the hated Republican Party, and then, mysteriously, find that every increase in taxes is turned into more guns aimed against them.

The illness of Detroit has been blamed on “white flight,” as if whiteness were some magic elixir. If you had any thoughts along those lines, the social history of Detroit will show you that it isn’t. The illness has also been blamed on mysterious “changes” in the auto industry. That’s not the cause either. Business and labor that aren’t on the take from subsidies — subsidies in the form of bailouts, friendly legislation, and noncompetitive labor laws, all of which the Detroit auto industry got, and fattened on, and sickened on — can “change” without doing grave damage to their communities. And the illness has been blamed on “massive corruption,” as if corruption could be massive without the profits it derives from laws and taxes.

Enough. Just look at who’s taking money from whom.




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The Shape of Things to Come

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On August 1, the City of San Bernardino, California, filed for protection under Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 is designed for municipalities and other local governments; the federal government can’t declare bankruptcy. At least that’s what most bankruptcy experts claim.

City officials gave media outlets the same explanations that CEOs of bankrupt companies often do: the mayor explained that the City would continue to meet its payroll and pay essential bills. He said that the main reason the City was seeking bankruptcy protection was to prevent lawsuits from being filed by a couple of angry creditors.

Asked to explain the cause of the crisis, San Bernardino officials passed the buck. They said that, because of budget shortfalls at the federal and state level, California Gov. Jerry Brown and the state legislature had made changes to vehicle tax money and redevelopment agencies that stripped local governments of hundreds of millions in state funding.

One of the most destructive qualities of statism is its tendency to turn good intentions into disastrous results.

This was true. But not everyone accepted the official explanations as the whole truth. Some conspiracy-minded sorts hinted darkly about criminal wrongdoing in City offices. Others looked through San Bernardino’s filing and pointed to one of its largest creditors: the City owed the California Public Employee Retirement System (CalPERS) some $143 million in unfunded pension obligations.

For its part, CalPERS claimed that San Bernardino was using a misleading “actuarial” calculation of its obligation and actually owed something closer to $320 million.

Now, that was a fiscal emergency.

San Bernardino also drew media attention because it was the third California city in as many months to file for bankruptcy protection. In June, Stockton had sought bankruptcy protection because it couldn’t come to agreement with its employee unions on a plan to close the $26-million gap in its general fund; in July, the ski-resort town of Mammoth Lakes had filed bankruptcy (its story was slightly different, though; the Mammoth Lakes meltdown was triggered by a court judgment the town couldn't pay).

Welcome to the late stages of American statism. Government and quasi-governmental agencies battling in bankruptcy court. Political rhetoric piling high. Bureaucrats talking evasively about where tens or hundreds of millions of dollars have gone.

* * *

On July 26, San Bernardino’s Interim City Manager, Andrea Miller, and Director of Finance, Jason Simpson, delivered to the mayor and city council a report called the Budgetary Analysis and Recommendations for Budget Stabilization. The report lays out the City’s problems and various possible solutions — including several that might have avoided bankruptcy. It’s a dense and important document, a harbinger of trouble ahead for spendthrift municipalities and states.

At the start, the report notes:

The City of San Bernardino has been affected by the serious economic recession as have other cities and has taken steps over the last several years to reduce costs. Nevertheless, costs continue to outpace revenue due to increased operational expenses and significant rapid declines in property tax revenues as a result of a drop in property values and decline in sales tax revenue. Deficits of major proportions are projected in all five years of the forecast created as part of this project. To ensure basic operational service levels are maintained and anticipated cash flow requirements are met, steps will be needed immediately to reduce costs. . . . If these measures do not achieve immediate and substantial cost savings, then the City will have to explore other alternatives to deal with its fiscal crisis.

They didn’t. And, less than a week later, the city council decided to declare bankruptcy.

A quick side note: I’ve read Miller and Simpson’s report numerous times in the preparation of this piece; and, each time I read through it, I’m more impressed. It’s an honest assessment of how a municipal government (or, by extension, any government) can stumble into insolvency, despite the best intentions of several generations of leadership — including leadership that fancied itself reform-minded. Indeed, one of the most destructive qualities of statism is its tendency to turn good intentions into disastrous results. That tendency is on full display in the San Bernardino story.

While the report does take off on some tangents of bureaucratic jargon, most of its 49 pages are a fairly common-sense narrative of what happened. And what needs to be done to get the City back on an even financial footing.

This is how the report describes San Bernardino’s financial circumstances:

Reserves in the General Fund were exhausted years ago, reserves in the internal service funds were also depleted and the City has encumbered itself with various debt obligations and labor agreements putting additional and unnecessary risk on the General Fund.

The City has declared numerous fiscal emergencies based on fiscal circumstances and has negotiated and imposed concessions of $10 million per year and has reduced the workforce by 20% over the past 4 years. Yet, the City is still facing the possibility of insolvency due to a variety of issues including accounting errors, deficit spending, lack of revenue growth, and increases in pension and debt costs. . . .

Over the past several years, the City has utilized General Fund reserves, asset sales and one time revenues to maintain City services. To address the projected deficits in previous fiscal years, the City has reduced positions, negotiated compensation reductions, and implemented new revenue measures. Unfortunately, the decline in taxable sales and property values over the last several years has resulted in revenue losses of $10 to $16 million annually.

In other words, it had used the usual one-time, off-budget legerdemain and accounting gimmicks that spendthrift governments — and spendthrift people — instinctively employ when they expect some future windfall to make everything okay. In San Bernardino’s case, the one-time tricks had been played . . . and there was no windfall coming.

According to the report, for the 2012–13 fiscal year, the City’s expenditures would exceed revenues by $45 million. And that annual shortfall would only increase over time.

The report lays out some of the most critical financial weaknesses facing the City:

  • Because the City has used reserve funds to balance previous budgets, there are no reserves in place to balance current and future budgets.
  • Budget choices made in previous years have left the City with high capital lease balances for equipment — and no effective way to refinance or otherwise resolve those expenses.
  • Because of the loss of federal and state redevelopment funds, the City has insufficient economic development programs in place to project stronger tax revenues in the future.
  • Since the City has a current deficit in its General Fund, it does not have sufficient unrestricted cash available to pay its ongoing obligations.
  • The City has an unemployment rate above state and county averages.
  • The City has an unusually high ratio of public safety costs to overall General Fund revenues.
  • The City’s expenses were over budget in FY 2011–12 and would be massively more so in 2012–13 and following.
  • The City’s failure to complete its FY 2010–11 budget audit on time delayed necessary budget reductions, further depleting cash.
  • The starting General Fund balance has been erroneously stated for each the previous two fiscal years.

In mid-July, the San Bernardino County sheriff’s office announced that it was involved in a multi-agency criminal investigation of the City government. The sheriff’s announcement didn’t indicate whether the investigation was related directly to the City’s bankruptcy filing. It referred to “allegations of criminal activity within departments of the San Bernardino city government” and confirmed that it would focus on those General Fund balances, which had been “erroneously stated.”

And, then, the hardest truth: “It is atypical practice for cities to have adopted [sensible] budget policies” like these. That may be the biggest problem that the United States faces today.

But the City’s financial problems aren’t (or aren’t entirely) the result of malfeasance. Many of its problems are structural. San Bernardino’s population is approximately 211,000; that number has been increasing rapidly since the 1970s. Because the City is a bedroom community and has never had a substantial commercial or industrial base, its population growth has outpaced growth of tax revenues needed to provide essential services.

According to the report, the largest employers in the City — in roughly descending order — are local government agencies, California State University San Bernardino, the San Manuel Band of Mission Indians, and San Bernardino Community Hospital. The common thread? There’re all either government agencies or government-dependent entities, relying directly or indirectly on public money for the majority of the revenues.

* * *

An important strategy for avoiding structural budget deficits is to adopt a budget philosophy that can serve as a meaningful framework for maintaining financial discipline.

This may sound elementary: Reporting on a government entity’s finances clearly and for public discussion is a way for the fiduciary responsibilities of elected officials and executive managers to be understood by the public and organization. But many government entities have become so decadent that they no longer look at financial reporting in that way.

The San Bernardino report describes some “best practices” in public-entity financial management:

  • Structurally Balanced Budget. The annual budgets for all City funds should be structurally balanced throughout the budget process. Ongoing revenue should be equal to or exceed operating expenditures in both the proposed and adopted budgets. If a structural imbalance occurs, a plan should be developed and implemented to bring the budget back into structural balance.
  • Multi-Year Financial Forecasting. To ensure that current budget decisions consider future financial implications, a five-year financial forecast should be utilized by the staff and Council. The annual General Fund proposed budget balancing plan should be presented and discussed in context of the five-year forecast. Any revisions to the proposed budget should include an analysis of the impact on the forecast out years.
  • Use of One-Time Resources. One-time resources (e.g., revenue spikes, budget savings, sale of property, and similar nonrecurring revenue) should not be used for current or new ongoing operating expenses. Examples of appropriate uses of one-time resources include rebuilding reserves, retiring debt early, making capital expenditures (without significant operating and maintenance costs), and other nonrecurring expenditures.
  • Established Reserves. San Bernardino has multiple funds, based on different revenue sources and requirements. Because there are risks (both known and unknown), it is important that reserve levels in all funds be maintained as a hedge against such risks. Without proper reserves, there can be major disruptions in services when unforeseen financial demands emerge, requiring immediate attention.
  • Debt Issuance. A municipality should not issue long-term (over one year) debt to support ongoing operating costs (other than debt service) unless such debt issuance achieves net operating cost savings and such savings are verified by appropriate independent analysis. All debt issuances shall identify the method of repayment (or have a dedicated revenue source) without an impact to operations.
  • Employee Compensation. Negotiations for employee compensation should continue to consider total compensation bargaining concepts and focus on all personnel services cost changes (e.g., step increases and the cost of benefit increases). Compensation costs should be included in the five-year financial forecast to ascertain affordability to the municipality, within context of expected revenues.

Summing up these points, the report concludes:

To resolve its structural budget deficit and prevent a recurrence in the future, the City needs to adopt a budget philosophy similar to the measures above to help elected and appointed officials maintain the financial discipline crucial to a growing community like San Bernardino.

And, then, the hardest truth: “It is atypical practice for cities to have adopted budget policies” like these.

That may be the biggest problem that the United States faces today.

* * *

For decades, the City of San Bernardino — like many of its residents — counted on rising real estate prices to subsidize the shortfalls in its day-to-day operations. For the City, these subsidies took the form of sharply increasing property tax revenues; the rising revenues allowed the City’s senior officials to grow sloppy.

Warren Buffett has a famous quote that’s relevant to this sloppiness (though it pains me some to quote such a chiseling crony capitalist): “It’s only when the tide goes outthat you discover who’s been swimming naked.” When the southern California real estate market collapsed, the tide went out. And San Bernardino was caught without its shorts.

The report takes a hard look at the City’s prospects for regaining some of the property revenues it lost to the collapsing California real estate bubble:

There are actually two bottoms for housing. The first is new home sales, housing starts and residential investment. The second is sale prices. Sometimes these can happen years apart.

Calculaterisk.com [an economics web site cited by one of the City’s property tax consultants] reports that the first housing bottom was spread over a few years from 2009 until 2011. They believe the second bottom, prices, hit in March 2012. This doesn’t mean prices will increase significantly any time soon. Usually, toward the end of a housing bust, normal prices mostly move sideways for a few more years. Real prices adjusted for inflation could even decline for another 2 or 3 years. . . .

Because we do not anticipate much growth with housing new starts or employment in the near future . . . we should assume construction-related permit activity will also be flat or possibly continue with its decline. Permit activity within most California cities has been very volatile with trends pointing to decreasing activity.

This is an interesting and useful discussion of cycles in the real estate market. But it hints at one of the many problems that come when a government agency tries to “time” a market. If San Bernardino’s consultants are right and a real estate market has a two-part bottom — and if those two parts occur years apart — predicting trends in property tax revenues at or near the bottoms is practically impossible.

In the end, all the report could conclude is: “The rate of revenue growth has not been sufficient to meet the contractual and debt obligations of the City.”

* * *

Every financial crisis — whether it involves a municipality, a company or a family — has two parts: expenses that are too high and revenues that are too low. The drop in property tax revenues was only half the reason for San Bernardino’s lurching deficit. The other half was the City’s expenses. And expenses are the thing bankrupt entities of any sort have to address first when they’re trying to emerge from their crises.

Here’s how the report describes San Bernardino’s expenses:

Roughly half of the annual deficit is attributed to unfunded liabilities in City Retiree Health, Workers’ Compensation and General Liability accounts.

The remaining half is attributed to increasing operational costs and the end of employee concessions. As early as FY 2009–10, expenditures exceeded revenues and the City had begun to utilize prior year fund balances to avoid service cuts or delays in projects. Because expenditures continue to exceed revenues, fund balances have been depleted and have reached a critical point in 2012–13 where the City will begin the year with an actual deficit and significant cash flow constraints.

Put into perspective, this projected deficit in 2012–2013 represents almost 38% of the General Fund budget for that year. The remaining fund balances cannot pay for ongoing operating costs and large sustained reductions will be required. Reducing ongoing expenses must largely come from ongoing reductions in personnel costs since these costs represent about 75% of total General Fund expenditures. Of the personnel costs in the General Fund about 78% are for public safety.

City of San Bernardino Public Safety and Fire expenditures consume the majority of the budget, some 73% of the General Fund in FY 2011–12. And personnel costs in total account for about 85% of the General Fund.

When the southern California real estate market collapsed, the tide went out. And San Bernardino was caught without its shorts.

“Public Safety” is, of course, bureaucratese for “police.” The problem that San Bernardino and other bankrupt local governments face is that the most essential service they provide citizens is police and law enforcement. Everything else — education, parks, growth management plans, performing arts centers, and sports stadiums — pales in comparison to keeping cops on the streets. And crime to a minimum.

Here’s the report’s suggestion for cutting the cost of law enforcement in the City:

To substantially reduce costs in the public safety services, the City will need to reduce staffing, or seek out contract opportunities for the City’s Police Department to provide services to adjacent communities. In recent years, several municipal police departments have provided services to others under contracts for service. In fact, its common place for public safety departments to share dispatch services.

This is an important point to consider for the future of local governments. Cities, at least smaller ones, may not be the most efficient mechanism for financing law enforcement. As the report suggests, a regional law-enforcement infrastructure may be more cost-effective. This suggestion won’t sit well with many mayors and city councils, since their authority over the local constabulary is often their strongest source of political power.

But, when a bankrupt city like San Bernardino has three-quarters or more of its financially unsustainable budget dedicated to “public safety” expenses, it has abdicated the political power that comes with being the boss of the cops.

* * *

The San Bernardino report notes that “reductions to the expenditure side of the budget are not going to produce the level of savings that will be needed to balance the budget.” And, to boost revenues, it suggests increases in or additions of the following municipal taxes:

  • Real Property Transfer Tax
  • Utility User Tax
  • Sales Tax
  • Transient Occupancy Tax
  • 911 Communications Fee
  • Fees for Recovering Paramedic Costs

With bureaucratic resentment, the report notes that “all would require voter approval.”

In the meantime, the City has to find other, more immediate, ways to raise money. In this effort, the report circles back to an idea that it’s already admitted is bad for the City’s long-term fiscal health. Even though the report warns against paying for ongoing expenses with one-time transactions, the authors can’t ignore the quick money available from privatizing real estate:

Currently the City [owns] 294 parcels with total book value of $300 million and a likely sale estimate of less than $100 million dollars. Given the City’s 18% of the property assessment, the sale of these parcels would generate roughly $18 million dollars. The City may also wish to explore selling or leasing some of the parcels at below-market rates in order to incentivize developers and other business interests to spur additional economic development and development-related revenues.

Selling assets doesn’t improve the financial prospects of a city — or a business, or an individual — in the long-term. But insolvent entities don’t have the luxury of making the long term a priority. They need to survive the near term. So, they sell things.

The report tries to inject some wisdom into the breathless discussion of raising taxes and selling off real estate. On these matters, it concludes:

. . . the pursuit of new revenue sources and/or increasing existing revenues is a strategy that can no longer be ignored. However, seeking to increase revenues that are subject to large fluctuations should not be treated as a cure-all. As was the case with revenue received during the real estate boom, some increased revenue could be short-lived.

Therein lies the problem. Governments at any level are rarely able to see past the short-term. Even — or especially — when their press releases talk about the importance of long-term vision, statist entities rarely have it. Twenty years ago, hundreds of books and thousands of articles were written about the long-term vision of Japan’s mighty Ministry of International Trade and Industry. How the mighty have fallen. MITI doesn’t exist any more.

* * *

All of this discussion is really just a warm-up act for the 800-pound gorilla at the center of San Bernardino’s problems: the expanding amount of money required to maintain the pensions owed to retired City employees. Here’s how the report describes this issue:

. . . the City is faced with increasing pension costs, as CalPERS adjusted the investment returns increasing retirement costs to all its members starting in FY 2013.

The City’s costs for employee retirement have increased from $1 million in FY 2006/07 to nearly $1.9 million in FY 2011/12. By FY 2013/14 the annual cost will be over $2.2 million. To put this into perspective, the City was spending about 9% of its General Fund budget on retirement costs in FY 2006/07. In FY 2011/12 it will need to spend 13% of the budget on those costs, and by FY 2015/16 it will require 15% of the budget for retirement obligations. [This] is basically an overhead cost over which the City has little control over in the short term.

California law grants CalPERS extraordinary powers (essentially, taxing powers) by which it can demand payments from cities, counties, schools districts, etc, if it runs short of the money needed to meet its defined-benefit pension distributions. Kind of like a cash call to members of business partnership.

This creates a great deal of moral hazard. The San Bernardino report describes this in painful detail:

To address growing public safety pension obligations, the City issued pension obligation bonds (POBs) in 2005. This is a common strategy to reduce unfunded liabilities through the issuance of fixed-rate bonds. . . . the City’s annual pension costs were reduced by $2 million after the issuance of the bonds. However, at the time of the issuance of bonds and subsequent deposit of bond proceeds into the City’s public safety account, CalPERS lost a significant amount of its pension portfolio. The market losses have negatively impacted the City beyond the losses of its deposited funds and have completely reserved all the saving realized from the issuance of POBs.

So, CalPERS’s shoddy investments negated any advantage for the City in issuing pension bonds. The City is still responsible for paying back its bonds…and CalPERS can demand additional money from the City to make up for CalPERS’s bad investments.

It’s as if you refinance your home mortgage to get a lower interest rate. But, after agreeing to the refi, the bank reneges and raises your interest rate back to where it was before and then increases the principal amount of your loan because it lost money on an investment scheme involving Greek bonds.

Twenty years ago, hundreds of books and thousands of articles were written about the long-term vision of Japan’s mighty Ministry of International Trade and Industry. Today, MITI no longer exists.

CalPERS divides the payments that it demands — which it calls “rates” but which aren’t “rates” in any insurance or actuarial sense — into two parts: employee rates and employer rates. According to the San Bernardino report:

It has been a common practice for San Bernardino and many other agencies to pay both parts of the rates. However, recently the City was able to negotiate with the employee groups for all new hires after October 2011 to pay the full employee share. . . . The City could negotiate with current employees to pay all or a portion of the employee share. Further, the City could negotiate any level of sharing with its employees and is not limited to [traditional formulas]. Some cities are planning for [their employees to pay] a greater share of PERS costs than what has commonly been referred to as the “employee share.”

This is an overlooked point. CalPERS can raise the “rates” it demands from local governments as much as it needs to; and those local governments can simply pass CalPERS’s higher demands onto their workers. Or file bankruptcy.

In the years leading up to its bankruptcy filing, San Bernardino did what conventional wisdom suggested for getting its pension obligations in order. It negotiated a “two-tier” retirement benefit program wherein newly-hired employees receive a smaller retirement benefit than more senior employees. But the effects of these new deals are still years away. According to the report:

Savings under this program will build with workforce turnover, as employees under the current system retire and are replaced by employees at the new rate. Therefore, initial cost reductions are minimal but savings to the City in the long term will be significant.

Long-term solutions for near-term problems — the opposite of what a prudent financial manager should propose. In the meantime, the City was still desperate to cut costs. Immediately.

As California’s local governments downsize their employee bases, even slightly, a shrinking number of remaining employees end up paying CalPERS “rates” to support the pension demands of a growing number of retirees. This system is not sustainable. In fact, it’s a bubble . . . if not a Ponzi scheme.

Some senior elected officials in California — including, to his credit, Gov. Jerry Brown — have started to discuss “pension reform” as a pressing issue for the state. But their talk remains rather academic; in the real world, for San Bernardino, annual pension costs have grown from $1 million in FY 2006-07 to $2.2 million in FY 2012-13. That’s a shocking increase in a sunk cost — and one that’s not affected by anything the City does today, including layoffs, restructurings, assets sales, etc.

As the report notes: “costs are increasing at rapid rates significantly beyond increases in revenue and are no longer affordable to most public agencies.”

* * *

So, downsizing local government workforces is a Gordian knot.

The layoff program used by most local governments and public agencies in California is referred to as the “Golden Handshake,” made available under the California Public Employees Retirement Law (Gov. Code, 20903). The Golden Handshake, also as known as the “CalPERS Two Years Additional Service Credit” benefit, requires a local government to provide two additional years of service credit for the calculation of pension benefits to “employees who retire during a designated window period because of imminent demotions, mandatory transfers or layoffs.” While it can provide some short-term savings, this arrangement adds to a city’s future retirement costs and limits management flexibility. For example, the Golden Handshake requires an employer to establish a “window period of at least 90 days and no more than 180 days” to solicit early retirees.

This is a kind of madness. Cities on the verge of bankruptcy don’t have six months to wait for workers to come forward for early retirement. So CalPERS’s union rules end up being largely irrelevant in the circumstances where action is needed, like the ravings against “greedy corporations” of a 30-year-old graduate student at a bottom-tier university.

As the San Bernardino report notes:

The cost-effectiveness of these programs must be examined within the context of an aging workforce. . . . the program [must] be carefully managed to ensure that the option is only offered in instances where a financial justification exists. If that is not the case, the City could be put itself in a situation where additional layoffs are needed to pay for early retirements.

That last line reads like something out of George Orwell. Or: the beatings will continue until morale improves.

Out of this Orwellian muck, the City has to keep streets open and police on them. The essential elements, to most people, of the social contract. So, for the foreseeable future, local governments like San Bernardino will be faced with firing some workers . . . or firing more. Faced with an existential threat to the notion of “city” itself. As the report concludes:

The revenue forecast shows that significantly lower costs will be required for the foreseeable future. During this period of time, it has been noted the that Council, residents and businesses in the City expect and deserve a well well-maintained street network, nice manicured parks, cultural opportunities, well-maintained neighborhoods, in addition to fundamental public safety services. The challenge to the City will be to identify what it can afford and how that relates to the type of community services it wants to provide.

Indeed.

* * *

These problems are only going to get worse in the coming years. As the federal government reaches the limits of its borrowing capacity, it will be forced to cut back on block grants and other disbursements to the states. As the states have to deal with these cuts — and structural problems of their own — they’ll cut payments to cities and counties.

And the cities and counties will go bankrupt.

Even in bankruptcy, California’s cities and counties won’t be able to correct their economic models without restructuring the pensions that they promised public employees in more prosperous (or what seemed like more prosperous) times. According to a February 2012 Stanford Institute for Economic Policy Research report, public-employee pension spending in California grew an average of 11.4% a year between 1999 and 2010. That’s twice as fast as spending growth for essential budget items like public safety, health and sanitation.

These problems aren’t limited to California. As Reuters recently noted:

CalPERS has long argued that pension contributions cannot be touched even in a bankruptcy. But firms that insure municipal bonds have strenuously objected to the idea that pension payments should come ahead of bond payments. The outcome of how CalPERS and bondholders are treated as creditors . . . and whether CalPERS receives preferential treatment . . . will have broad implications for local governments around the country.

In the weeks since its bankruptcy filing, San Bernardino has slogged along. It made payroll in August and September. Miller and Simpson are still in their jobs, trying to keep things running in some semblance of order.

The City plans to layoff more employees and shut down libraries and has reduced its annual shortfall from about $45 million to $7 or $8 million. But this still isn’t sustainable.

The multi-agency criminal investigation hasn’t produced any results. Yet. Some locals say that it has more to do with political theater (specifically, a feud between San Bernardino’s mayor and city attorney) than any prosecutable crimes.

Even in bankruptcy, California’s cities and counties won’t be able to correct their economic models without restructuring the pensions that they promised public employees.

The real battle remains between San Bernardino and CalPERS. And this is a battle that neither side seems particularly interested in joining. The City, like many bankrupt debtors, seems to believe that the longer it delays a resolution of the money it owes CalPERS, the lower the final number will be. CalPERS, on the other hand, seems to be concerned that the San Bernardino bankruptcy will expose it as another of Warren Buffett’s naked swimmers. Or, more in line with its haughty history, an emperor with no clothes.

CalPERS lawyers can cite statute and weep well-rehearsed tears over pabulum like “fairness” and “austerity” but they can’t get blood — or $320 million — from a turnip.

And the City of San Bernardino is merely the first of many turnips ahead.

p




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Governments Finally Outsourcing

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A report out on a small Michigan city points the way for other school districts to deal with their looming fiscal problems.

The city is Highland Park, which faces a major problem with its school district, consisting of three schools and 1,000 students. The system ranks near the bottom in the state academically, and it is facing a fiscal fiasco.

In fact, only a wretched 22% of the system’s third-grade students passed the state’s reading exams, and a pathetic 10% of them passed the math exams, last year. Only 10% of its high school students tested proficient on reading, and 0% — yes, precisely none of them — tested proficient in math.

This, in a district that last year spent over $16,500 per student, which is 80% more than the average per student expenditure for the state (which last year was about $9,200 per pupil)!

Moreover, despite the fact that its student population has plummeted by two-thirds in the past five years, the district’s deficit has exploded — reaching over $11 million last year.

So the Highland Park school district has taken a bold step: it is borrowing a tool commonly employed in private industry, outsourcing — the process by which one company hires a second company to handle some part of its operations. For example, a major retailer (such as Walmart or Costco) will often hire industrial janitorial firms to handle the cleaning of their stores, rather than hiring janitors within their own companies.

Outsourcing has a number of benefits, most importantly improving efficiency and increasing accountability. It improves efficiency because the company that outsources operations will be able to hire a company that specializes in that aspect of business. It improves accountability, because if the company outsourcing doesn’t see an improvement in that aspect of its business, it can terminate the service and hire another contracting firm to do the job. This puts pressure on the contracted company to do the job properly and within the price negotiated.

Highland Park is outsourcing its entire school system to the charter school company Leona Group.

The Leona Group runs 54 schools in five states. While almost half the students in them don’t score at standard levels, that is on average better than the public schools they replace. And in Michigan, 19 of 22 schools that Leona runs do meet state standards. Moreover, Leona’s contract is for five years, so if it doesn’t dramatically improve student outcomes, it can easily be replaced. That is the missing factor in district-run schools: accountability.

Charter schools have some major advantages over district-run schools. While the charters are overseen and funded by the district, they have substantial freedom when it comes to setting union contracts, curricula development, and teacher standards. And precisely because they are not controlled by teachers unions, they are usually much less costly to the taxpayer.

Indeed, Leona Group will charge the district only $7,100 per student, plus an annual management fee of $780,000 — dramatically less than what the district is currently paying.

Public school outsourcing is a growing trend. Highland Park is the second district in Michigan to outsource its schools to charter schools. Several districts in Georgia have also done the same thing. Of course New Orleans has already converted most of its schools to charters (which has already produced a dramatic increase in graduation rates) and even allows its students to use the newly issued state educational vouchers.

Other districts are now eyeing this novel idea — novel, that is, only in the world of government; it has been a staple of private industry management forever. In Michigan alone there are 48 districts in fiscal peril (with a collective $429 million in annual deficits).

Naturally, the teachers unions are fighting outsourcing fang and claw, but given the looming financial disaster, the pressure for extensive education outsourcing is increasing rapidly.

Outsourcing district-run schools to charter school companies is a tool that many districts can and should consider, especially as more and more of our cities declare bankruptcy.




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