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As municipal bond yields surged (and their prices dropped) this month, market participants began asking themselves whether an increase in municipal bankruptcies was around the corner. To be sure, Harrisburg, Pennsylvania, recently engaged the law firm Cravath, Swaine and Moore as bankruptcy counsel (the firm is going to advise Harrisburg for free). The city of Hamtramck, Michigan, was denied permission to enter bankruptcy by the State of Michigan, despite the fact that it will run out of money on January 31, 2011. Also in Michigan, Mayor Dave Bing is trying mightily to keep the City of Detroit from entering bankruptcy, but he may just be buying time.

One key problem facing municipalities is retirement obligations. Manhattan Institute fellow Steven Malanga noted that:

  • San Francisco and Los Angeles have a combined pension debt of $33 billion
  • Chicago has $45 billion in total obligations to retirees
  • Orange, California, spends $13 million out of a budget of $88 million on pensions
  • New York City has $122 billion in unfunded pension obligations.

Another problem facing cities is collective bargaining by government employees: while city budgets have been crimped by the Great Recession, collective bargaining agreements have not allowed employee wages and benefits to deflate to compensate for the decline in tax revenue. Note that politicians of all stripes have promised public employees valuable wages and benefits—paid for by the taxpayer, of course—in search of public employee support and votes at election time.

If a city does enter bankruptcy—as Vallejo, California did in 2008—its retiree benefit obligations and collective bargaining agreements can be adjusted so that the city can escape their crushing burden.

Instead of allowing bankruptcies among the financials, Fed Chairman Ben Bernanke added liquidity to the economy. Instead of allowing bankruptcies among citizens, Dr. Bernanke has engaged in QE1 and now QE2. Ostensibly, Dr. Bernanke believes that quantitative easing will lower interest rates—though mortgages rates have actually been rising since November 3—thereby spurring borrowing and, as a result, economic activity. My fear is that instead of allowing municipalities to fail, the Fed will next engage in buying municipal debt in an attempt to lower the interest rate that local governments are forced to pay.

To be sure, in his [in]famous “helicopter” speech, Dr. Bernanke admitted that “the Fed has the authority to buy foreign government debt, as well as domestic government debt.” While some may claim that “domestic government debt” equates to “federal government debt,” Dr. Bernanke has not created such a restriction on himself. To be sure, the Federal Reserve has purchased commercial paper as well as mortgage-backed securities in huge quantities since the financial crisis began. If the Fed does indeed begin buying municipal debt, then cities, towns, and counties—perhaps able to pay lower interest rates—will shy away from bankruptcy, the only way they can permanently address their recurrent problems. In this scenario, Dr. Bernanke would be like the doctor that gives a very ill patient some morphine: the patient feels better for a while, but the underlying disease lingers, continuously causing damage that will finally claim his life.

Municipal bankruptcy—like personal and corporate bankruptcy—is a way to right wrongs of the past. Decisions on pensions and medical care for retirees made by foolish, selfish politicians at the local level have to be undone lest local taxpayers be saddled with greater taxes in the future. At some point, if bankruptcy does not occur, municipalities will simply be unable to pay what they have promised, and (a) taxes will have to go up, (b) services will have to be cut dramatically, or (c) a bailout—paid for by taxpayers at the state or federal level—will be rammed through. In a bankruptcy, though, everyone responsible “shares the pain” inflicted: taxpayers get fewer services, public employees’ benefits are cut, and bondholders take a haircut. It’s the fairest way to deal with the time bomb that is municipal finance.

Disclosure: No positions

Source: Will Bernanke Monetize Municipal Debt Next?