July 15, 2012

Municipal bankruptcies on the rise

We are beginning to see on the horizon an approaching wave that may wash over us all.

Three municipal governments in California recently sought bankruptcy protection. San Bernardino is following Stockton and Mammoth Lake in its effort to settle with creditors and restructure contracts and liabilities in a way that proves more sustainable.

An incorporated municipality is much like a private-sector corporation seeking bankruptcy protection. A court will help broker an arrangement in which creditors take their share of liquidated assets if there cannot be found a way to reorganize. Courts prefer, though, to help broker a reorganization that allows a viable entity to go on in a more sustainable manner. This typically means breaking contracts, settling debt for pennies on the dollar and reaffirming that corporations must not spend and commit beyond their means going forward.

Municipalities are different from private-sector bankruptcies in a couple of important aspects, though. First, they have the ability to increase revenues, to a point, simply by increasing the tax rate. However, once the tax rate becomes excessive, they discover residents flee to lower-cost communities rather quickly. Residential flight depresses property values, which forces the tax rate up even more, and creates a viscous cycle that rarely ends well.

Municipalities are also different in that their predominant factor of production is us. Government is labor intensive, and the labor often lives in the municipality. In some sense, government is like a worker co-op. The voters are shareholders, but many are also employees. When beleaguered mayors go to a town meeting to announce that their city cannot pay its bills and must contemplate layoffs or wage reductions, those voters who are also employees like to remind the room that the mayor works for them and cannot lay them off.

The difference between a municipality and a worker cooperative is that only a minority of the voters work for the municipality. However, these voters have a much bigger stake in the decisions of government because they are taxpayers, like all of us, but their economic future is also tied to government spending. They may have one vote, but they wear two hats.

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