COLUMN-Why the federal government should help bail out Detroit

Mon Jun 2, 2014 4:14pm EDT

(Allison Schrager is a writer and economist. The opinions expressed are her own.)

By Allison Schrager

June 2 (Reuters) - Starting last month, and continuing through July, Detroit's 170,000 creditors will vote on the terms of the "Grand Bargain" that will end the city's bankruptcy.

Different groups are contributing to the deal: the state of Michigan, the city of Detroit, as well as philanthropic organizations including the Knight and Ford foundations. They'll either contribute money or reduce salaries of city employees, in order to restore Detroit's solvency and ability to pay its retirees.

So far, absent in the bargain is support from the federal government. On April 24 Treasury Secretary Jack Lew visited Detroit, raising hopes that a $100 million bailout from the government would materialize. The money would come under the category of "blight eradication," a pre-existing federal program designated for urban renewal. The federal government is careful to avoid setting a precedent of bailing out state or municipal pensions because it doesn't want to take on a massive liability and, in doing so, encourage local governments to make more unsustainable promises.

This is a mistake. The federal government should use Detroit as an opportunity to take a more active role in state and municipal pensions. Unless the American economy experiences unprecedented growth, future federal bailouts of state and municipal retirement benefits are inevitable. The more likely scenario of low or normal growth will make these retirement benefits a burden to all taxpayers, regardless of where they live. At some point the federal government will inevitably be stuck with the tab, either from increased political pressure or from states gaming existing federal programs.

The sooner the federal government acts, the lower the cost to taxpayers because the financial hole will only get bigger. In both the mortgage and European debt crises, the world saw how much damage an unacknowledged, but expected government guarantee can cause. Debts became unmanageable and creditors looked to the central government for bailouts. The lack of clarity caused uncertainty and wreaked havoc on financial markets. Rather than staying on the sidelines or engaging in backdoor bailouts, this time the federal government should take a more active role in shoring up state pension finances.

The problem is dire. Retiree benefits - both pensions and healthcare - will become increasingly expensive to provide, and strain state and local governments nationwide. According to a task force chaired by Richard Ravitch and Paul Volcker, in the future many states and municipalities will probably have to choose between services for other taxpayers (like schools, roads and safety), paying benefits, or significantly raising taxes. Even if pension assets earn their expected 8 percent return each year, says economist Josh Rauh, by 2025 20 states will run out of money, and there will be even more financial strain at the local level.

The federal government may claim, as it is in Detroit, that it is not on the hook for local retirement benefits. But it is, for both political and financial reasons.

When more state and local governments run into trouble, the federal government will feel political pressure to step in with financial support. Large benefit cuts expose state employees to hardship when they are most vulnerable and no longer able to work. The prospect of unionized state workers impoverished in retirement is politically untenable.

Existing federal programs, like Social Security and Medicare, already use federal tax dollars to support eligible state workers. The city of Chicago is phasing out its healthcare coverage by moving its non-Medicare retirees on to the new healthcare exchanges, created as part of the Affordable Care Act. Depending on the size of their pension benefit, many retirees will qualify for federal subsidies to buy insurance. By moving retirees on to the exchanges, Chicago expects to save $18 million this year, including the savings of discontinuing Medicare subsidies. The move shifts much of the city's healthcare costs to the federal government.

The federal government can avoid this type of large, unexpected cost by getting more involved in state pensions now. In the private sector, the Pension Benefit Guaranty Corporation - a quasi-U.S. government agency that is technically independent - insures corporate pensions, paying employers a large fraction of their promised benefit if their company goes bankrupt. In exchange for that guarantee, corporations are subject to more stringent accounting standards and insurance premiums. There is no such insurance for state and local pensions, but there should be, because it would force states and municipalities to pay for that implicit federal guarantee.

A less radical alternative involves tax subsidies. The government could start to enforce more sensible accounting standards and offer states and municipalities the option of issuing tax-advantaged bonds, where the proceeds would fully finance pension and healthcare liabilities.

With either of these options, the federal government would fulfill its obligation to state and local workers - and give Detroit and other struggling American cities the help they deserve. (Allison Schrager)

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