Detroit Michigan Bankruptcy and Greece; Comparative Lessons in Economic Management and Policy
1. MSc: Economic Management & Policy
Detroit, Michigan Bankruptcy: Comparisons To Greece’s
Economy and Lessons in Economic Policy and Management
Mohammed Saeedul Alam
UNIVERSITY OF STRATHCLYDE
Economics, Sir William Duncan Building
130 Rottenrow, GLASGOW G4 0GE
April 2015
3. Detroit, Michigan Bankruptcy: Comparisons To Greece and Lessons in Economic Policy
and Management.
Mohammed S. Alam
MSc: EMP Draft Submission
June 2015
ABSTRACT
The body of literature on the individual Greek sovereign debt and Detroit financial crises,
and the research on the comparative lessons between these two are relatively sparse; I
feel it is therefore necessary to fill this gap. My analysis of the causative factors behind
both crises will give insights into what economic management and policy lessons could be
implemented over the coming years; the analysis has revealed the mechanics behind each
crises to be similar. Organized default or bankruptcy has largely been considered an
extreme in the body of literature which is overwhelmingly in support of continuing
inflation and financial bailouts. It is nevertheless an efficient way to remove toxic assets
and investments in the economy in order for renewed growth.
Mohammed S. Alam
University of Strathclyde, Sir William Duncan Building
130 Rottenrow, GLASGOW G4 0GE
saeedul.alam@googlemail.com
4. I. Introduction
Detroit is the most populous city in the U.S. state of Michigan and the largest city
on the United States-Canada border with around 5.2 million residents. It serves as a major
port on the Detroit River which connects the Great Lakes system to Atlantic Ocean
shipping channels. The city is a hub of U.S. manufacturing and is the centre of the
American automobile industry and has a rich musical heritage celebrated by the city's
two familiar nicknames Motor City and Motown. In the 1950s it was the fourth largest
city in the U.S. with a population of over 1.8 million and the wealthiest city on a per
capita income basis; through the 1960s it remained the nation’s wealthiest city with the
highest home ownership rates and an unemployment rate of less than 3%. According to
the latest available figures it is now the nation's poorest major city in terms of the
proportion of residents living below the U.S. official poverty line, at 42.3%.1
In July 2013,
under accumulating financial duress it officially filed for bankruptcy under the U.S.
District Court's Eastern District in Detroit, and only exited official bankruptcy after
confirmation of its ‘plan of adjustment’ by the court appointed judge in November 2014.
Greece is a developed country with a high-income economy and population of just
over 11 million(2013 census); the economy is the 43rd largest in the world at $242 billion
by nominal GDP and 37th in nominal per capita income at $22,000 excluding the
(considerable) informal economy.2
A 2014 U.S. Department of Commerce study estimated
that Detroit's urban area had a GDP of $225 billion with per capita income at $15,000.3
The two economies are therefore relatively close in nominal size. Greece’s debt crisis
started in late 2009, as the first of four sovereign debt crises in the eurozone - later
referred to collectively as the European debt crisis.4
The purpose of this study is to
5. investigate the causative factors of the financial crisis in Detroit and derive policy lessons
for the Greek problem by looking at similarities in the underlying dynamics between the
two crises; Greece has been a focus in this study because it is a particularly serious case of
debt accumulation and financial mismanagement within the E.U..
The body of literature on the individual Greek sovereign debt and Detroit
financial crises and comparative lessons between these two are relatively sparse but
nevertheless have been useful in progressing the aims of this thesis. Duggan et al. (2014),
Twait & Haveman (2011), and Fottrell (2014) provided a host of useful figures to help
determine the key factors behind Detroit’s bankruptcy; Walsh (2014) provided some
useful actuarial insights to this effect also. Skorup (2012) argues that a gradual
implementation of progressive economic policies have been a key factor behind Detroit’s
bankruptcy - particularly widespread unionization and government living wage mandates
which have rendered the American auto manufacturers and other industries unable to
compete with international competitors. The premise of his arguments stem from the
classical precept that the more costly it is for employers to hire or fire their workforce the
less likely they are to hire initially. The Economist (4 February 2010) provides insights
into some of the economic and political dynamics behind the Greek crisis. Iordanoglou
summarizes key developments in Greece’s public sector; the BBC (28 April 2013)
describes proposed cuts. Transparency International (7 October 2013) and Slipjer (2013)
analyse corruption in Greece’s economy and its military expenditures since the advent of
the crisis. Bandow (2013) discusses how austerity can indeed be ultimately successful and
studies the experiences of the Baltic States of Latvia, Estonia and Lithuania. Hoppe (1992),
Rothbard (1962, 1970) and the Mises Institute (9 January 2011) provided classical
6. economic theories which helped my thinking. Panizza & Borensztein (2010) discuss the
potential economic costs of default for countries like Greece and whether they have been
overstated in the literature. Athanassopoulou explores the political and socio-economic
implications of the Greek crisis in relation to neighbouring Turkey.
The rest of the paper will proceed as follows. Since Detroit is a key part of the
analysis, I begin by describing some of its key features. Specifically, I focus on 3 broad
areas: the movement and composition of its population; concurrent issues with its
emergency services; and lastly, structural aspects of the labour market. In section III, I
attempt to delineate the sources of Detroit’s financial crisis; In IV, the role of derivative
financial deals acting as a catalyst to Detroit’s problems is explored. Section V explores the
city’s future economic outlook by looking at industries which are experiencing
resurgence, actions Detroit’s municipal authorities have taken to reduce expenditures –
and lastly, possible funding and financial scenarios in the near future. Section VI sheds
light on the Greek financial crisis and describes its precursors; in VII, the role of
derivative financial deals in the Greek crisis is addressed, as well as points of concern for
the economy which will continue to be problematic for the foreseeable future – which
are in tandem compared to Detroit’s economy. Section VIII describes the possible paths
Greece may take in order to tackle its crisis by looking at the practicalities of austerity
cuts and ongoing eurozone membership. Section IX explores pre-emptive measures that
could be taken in case of Greek exit from the eurozone, in order to ensure the stability of
a newly issued drachma. In section X, I attempt to predict the future economic outlook
and political considerations for Greece, and to conclude I address the question of what
7. would be the best way forward for Detroit and for Greece by consideration of both the
similarities and differences in their situations.
8. II. Detroit’s Problems: Key Features
From the early nineteenth century up to the Great Depression, the population of
Detroit grew at a rapid pace, attributable to the expansion of the automobile industry in
the early twentieth century. The 2013 census estimates a population of around 689,0005
which would represent a decline by more than 60% from its peak of over 1.8 millionin
the 1950 census, coupled with the emigration of around 3,000 residents per annum just
this decade alone. Between 1990 and 2013 Detroit's population fell by more than 33%,
changing its ranking from the nation's 7th largest city to 18th; this is indicative of a long-
running decline in the city’s economic base. The number of retirees now exceeds the
number of employed labour force participants by a factor of two to one; this has proved to
be an unsustainable burden for active employees. A six-year snapshot illustrates just how
9. rapidly the demographic and economic landscape of the city is declining; in 2007 Detroit
had a population of approximately 951,000, unemployment at 14.1% and income per
capita at $15,310; by 2013 its population had deflated to 714,000, unemployment rose to
18.6% and income per capita reduced to $13,956.
The size of the police force in Detroit has been cut by about 40 percent over the
past decade alone, so much so that police response times now average 58 minutes (the
national average is 11 minutes). Due to budget cutbacks, most police stations in Detroit
are now closed to the public for 16 hours a day. Despite emergency services being the
largest component of Detroit’s budget, accounting for around 51% of total expenses,
budgets have been consistently cut; by $105.5 million in 2013 alone, from $800.2 million
for the year ended June 30th 2012 mainly due to 10% cuts in employee compensation,
reductions in overtime, attrition and in-work benefits.6
Cutbacks over time have
adversely impacted service provision to such an extent that police are now unable solve
more than 90 percent of crimes committed. The violent crime rate in Detroit is now five
times higher than the national average and its murder rate 11 times higher than New
York City’s. The two Michigan municipalities of Detroit and Flint remain the top two
most violent in the U.S. with a population of 100,000 or more, based on Federal Bureau of
Investigation data; In 2012, Detroit experienced 2,123 violent crimes per 100,000 (versus
2,729 for Flint).7
“Detroit's minimum wage is more than $2 above the federal minimum wage; any
company contracting with the city must pay its employees $11.03 an hour if they offer
benefits or $13.78 an hour if they do not”.5
Such wage mandates create unnecessary
10. unemployment especially for individuals with low skills as businesses become more
selective with their recruitment. Detroit is also home to the Big Three auto-
manufacturers, which are subject to contracts with powerful labour unions that later
provided the model for public employee unions. United Automobile Workers (UAW)
successfully extracted wages and benefits estimated at $73 per hour prior to recent
reforms. “This is about $25 more per hour than what foreign-owned U.S. auto
manufacturing plants pay their non-unionized American employees.”8
Due to this
disparity, foreign car companies had significantly less production costs per car than their
American counterparts. The outcome has been a protracted loss of worldwide market
share that has weakened the main contributors to Detroit’s economy and prosperity.
In the 1950’s, despite the U.S. being a much smaller country population-wise,
there were 296,000 manufacturing jobs in the city of Detroit. Today, there are less than
27,000, a reduction of more than 90%. Between December 2000 and December 2010
alone, 48% of the manufacturing jobs in the entire state of Michigan were lost – a major
proportion of which would be suffered by Detroit, being the state’s industrial hub and
largest city. From 2001-10, there was an unprecedented jobs decline of 18.5% in
metropolitan Detroit, and large declines in real private sector employment earnings per
capita from 2001-10 were offset with similarly large income gains in the public sector.
The chart below demonstrates the steady decline of Detroit as leading manufacturing hub
in the U.S.; around 50% of the pre-1990 manufacturing employment base was lost by
2009 at the onset of the worldwide financial crisis and deleveraging. A substantial U.S.
federal government bailout of the major automotive manufacturers appears to have
reversed the trend of job losses for the time-being.
11. Combined job losses and migration have reduced the metropolitan area’s tax base,
so much so that in July 2014 Detroit officially filed for bankruptcy with the largest deficit
amongst 7 other U.S. municipal bankruptcies since the recession began in 2008. Detroit’s
insolvency is however more significant than the others because of its relatively greater
economic and industrial importance; it is thus far the largest municipal bankruptcy in the
history of the nation. The city is currently indebted to more than 100,000 creditors and
has around $20 billionin debt and unfunded liabilities e.g. pension funds, which
translates into approximately $25,000 of debt per capita including children and retirees.
With the latest estimate of the participating labour force at around 346,000, this would
amount to approximately $58,000 of debt per participant – which rises to $70,000 for
those who are actually employed (approximately 285,000).
12. III. Sources of Detroit’s Crisis
One of the reasons for Detroit’s bankruptcy stems from a revenue / cash-flow
shortfall. The economy has been in progressive decline for several decades, with long-
term net emigration taking a toll on the city’s revenue base as both property and income
tax revenues dropped. Detroit’s municipal income is based primarily on taxes on property
and economic activity, charging for the provision of goods and services, borrowing, and
receiving funds from the Michigan state and U.S. federal governments. Under Chapter 9
of the United States Bankruptcy Code, a municipality is eligible to file for bankruptcy
when it is unable to pay its debts as they come due.9
For example, at the time of the
bankruptcy filing, Detroit’s revenue deficit was projected at around $198 million for fiscal
year 2014. To avoid bankruptcy in the near term the city would have to meet this
immediate annual shortfall – not necessarily its total outstanding long-term debt. Other
than a federally funded bailout however, it remains unclear how this can be achieved
without deep austerity cuts as Detroit’s residents are already some of the most heavily
taxed in the U.S.. For example, on top of Michigan’s flat-rate state income tax of 4.25%,
several Michigan cities levy additional income tax on residents and non-residents alike
with rates ranging from 0.50% to 2.50%. Detroit’s added income tax rate is a flat 2.50%
for residents and 1.25% for non-residents. The state of Michigan also has one the highest
property tax rates in the nation. As a percentage of home value, Michigan has the 8th
highest property tax rate in the nation at 1.62% - just marginally below New Jersey’s
which is the highest at 1.89%. In keeping with this, Detroit consistently ranks highest
amongst the most heavily populated US cities for its property tax rates, at around 3.6%.10
It is also the only city in Michigan that levies an additional excise tax on its utility users at
13. a rate of 5%. Residential home foreclosures and delinquent property taxes have now
become a serious financial concern; at present there are approximately 78,000 abandoned
homes in the city, in certain areas some that are on the market for $500 or less and about
30% of Detroit's approximately 140 square miles now either vacant and/or derelict. It also
has one of the highest tax burdens among the 51 largest cities in the U.S. for high income
earners, according to the Office of Revenue Analysis; the city ranked 9th for a family of
three earning $100,000 a year ($12,991) and 18th for a family earning $25,000 a year
($3,421).11
The municipal government is at present very reliant on tax revenues from
casinos in the city which account for approximately $11.0 million dollars a month; there
are also 70 "Superfund" hazardous waste sites in Detroit that bring in external revenue.6
In addition, the City is dealing with sustained high unemployment (at 14.9% in
September 2014 compared to the Michigan State average of 7.2%), which hinders income
tax revenue; it currently has the highest unemployment rate of the 50 largest cities in the
United States. Imposing such relatively high taxes has led to tax avoidance by high
income earners and capital flight, and as the economic base of the city has shrunk the
municipal authority’s main sources of revenue have been reduced and finances
compromised.
Another concern is that Detroit’s government is relatively larger and more
bureaucratic than most other municipal governments in the U.S.. The ratio of residents to
public sector employees – a key measure of municipal authority productivity, is around
60:1 in Detroit, one of the lowest in the U.S.. The greater the number of public sector
employees relative to the overall population of a city, the less capital is available in the
private sector to create jobs.
14. IV. Financial Deals
In recent times Detroit’s municipal government has entered into complex financial
deals that have proved to be costly for the city. The city’s pension funds had begun
underperforming in the early 2000s as they were heavily invested in the dot-com
speculative bubble of 1997–2000, the deflation of which set the U.S. economy into
recession. As a result, the municipal authority’s requisite annual contributions to the fund
began to increase to such an extent that in 2001 the fund experienced its first deficit in
nearly six years which grew to about $95 million by 2004. The incumbent mayor then
met with financial and legal advisers in 2005 to try to engineer a solution. They devised a
borrowing scheme in which the city issued Certificates of Participation (COPs) –
municipal finance instruments similar to bonds but with fewer legal restrictions, which
would allow the city to avoid its constitutional borrowing limit and the need for voter
approval. The COPs were issued to provide funds for major capital projects and
equipment acquisitions and were backed by the full faith and taxation power of the City.
Banks including UBS, Merrill Lynch and JPMorgan Chase & Co. also underwrote
approximately $1.5 billion of COPs to cover Detroit’s deficits, pension shortfalls and debt
repayments; liabilities thus rose to almost $15 billion including pension obligations. By
issuing COPs the city intended to reduce the deficit through converting would be annual
payments into the pension fund into one large payment, making them appear fully
funded. In retrospect however, COPs allowed the city to only exchange one form of debt
for another.
15. The debt issuance cost Detroit approximately $474 millionincluding underwriting
expenses, bond insurance premiums and fees for interest-rate swap derivatives meant to
lower borrowing costs on variable-rate debt. To illustrate its relative significance, it
almost equals the City’s entire 2013 budget for police and fire protection services.6
The
largest part of the issuance cost is $350 millionowed for the swap derivatives in which
the city exchanged with investment banks UBS and Merrill Lynch payments tied to
interest rate indices. The banks would pay a variable interest rate on the certificates while
the city would pay a fixed rate. The interest paid by the banks would therefore fluctuate
based on the movements of an average estimated rate of interest (specifically Libor, which
was later discovered in 2012 to have been artificially manipulated). The city was
essentially speculating; if the variable rates the banks were paying were higher than the
fixed rate, the city would gain (and lose otherwise). In retrospect such derivative
instruments have proven to be ineffective and costly due to the subsequent behaviour of
interest rates, and U.S. municipal borrowers ranging from the Metropolitan Water
District of Southern California to Harvard University in Cambridge, Massachusetts have
paid substantial termination fees to banks to end interest-rate swaps that did not protect
them adequately. The original swap deals have cost Detroit’s municipal government
nearly $50 milliona year, about 5 percent of its annual budget.
In 2008 a process of global financial de-leveraging began. As part of its
Quantitative Easing program the Federal Reserve leveraged interest rates down to historic
new lows while the interest rate Detroit paid on its COPs remained fixed; Detroit was
now paying out more to the banks than it received from them, aggravating its cashflow
problem. In early 2009 Standard and Poor’s downgraded Detroit’s credit rating on about
16. $2.4 billion of its tax-funded debt (general obligation bonds) from "BBB" and "BBB-minus
to "BB", which is only two grades above junk status and induced greater limitations on
access to capital and higher borrowing costs. In response, UBS and Bank of America
(which acquired Merrill Lynch in 2008) terminated Detroit’s COP scheme and demanded
immediate payment of the outstanding balance of $300–400 million. The City pledged its
casino tax revenue as collateral to avoid the lump-sum payment until it went into
administration under Michigan’s state government in early 2013. It was then declared
insolvent on June 30, 2013 at which point its liabilities exceeded assets by $678.2 million
and cash and investments on hand totalling $102.2 million were insufficient to meet
obligations due. The City had also defaulted on $105.6 million of pension contributions
due on its General Retirement and Police and Fire Retirement schemes.6
The state of
Michigan is overseeing the City’s finances through an emergency manager law which
allows the Governor to declare a municipality to be in financial crisis and remove local
control of its finances from elected officials to technocrats. This has similarities to the
European problem as both Italy's and Greece's governments underwent similar changes.
In July 2013 the City commenced a bankruptcy case under chapter 9 of the U.S.
Bankruptcy Code. In his Authorization Letter, the Governor agreed with Detroit’s
emergency manager that bankruptcy offered the only feasible way to address the City's
finances and to complete a sustainable restructuring for the benefit of the city’s
approximately 700,000 remaining residents.9
The City has however, consistently failed to
maintain accurate accounts of its revenue and expenditures as required by the federally
administered US Office of Management and Budgets which is in turn slowing down its
bankruptcy adjudication process.
17. Detroit’s eighth amended bankruptcy plan of adjustment was submitted to the
Bankruptcy Court for consideration in December 2014. Like its predecessors, it is being
challenged by Detroit’s creditors and further modifications may be enacted as a result of
concerns raised. The plan provides a framework to restructure the City’s long-term debt
obligations and investment initiatives in order to exit bankruptcy as seamlessly as possible
and return to fiscal stability. Under the plan, Detroit’s unsecured creditors should expect
to recover approximately 10%-13% of their capital which represents a substantial loss but
is nevertheless better than outright default. The plan also proposes the City invest
approximately $1.4 billion over 10 years in infrastructure and capital to improve services
at all levels; it therefore does not call for austerity to be implemented in its purest form.12
Pensions obligations and bond payments make up the majority of Detroit’s debt. The
adjustment plan makes a provision that the city will not seek to terminate any of its
pension schemes but that they will be closed to new participants, and it will continue to
fund adjusted (reduced) pension benefits to its current and future retirees.
Detroit’s bankruptcy is both an expenditure and cash flow problem caused by
termination fees on interest-rate swap instruments as well as steady economic decline
resulting from an over-taxed shrinking middle class. The interest-rate swaps were
inappropriate for already revenue-depleted Detroit which had been on the verge of a
credit rating downgrade below investment grade for some time and this ultimately
triggered the termination fee clauses in the swaps. The likelihood of terminations were
ex-ante known to be high and the financial institutions involved behaved unethically in
allowing these deals to go through – being in a far better position than the municipal
authorities to assess the initial risk; they may have therefore their breached legal
18. obligations to the city, which is actively pursuing legal avenues through the bankruptcy
court to invalidate the swaps entirely and eliminate or reduce the associated termination
fees.
19. V. Future Outlook
Although the city’s current economic condition is poor, provided the debt restructuring
process is conducted efficiently the outlook for future recovery and improvement will be
positive. On December 10, 2014, the city officially exited bankruptcy after its financial
‘plan of adjustment’ was endorsed by the bankruptcy court judge.13
Businesses have begun
relocating employees from satellite suburbs back to Detroit due to a lowering of taxes, and
with U.S. federal government help automobile sales have reached pre-2008 levels. Other
favourable factors are that the Great Lakes system surrounding Michigan contains 20% of
all the world's fresh water supplies, there are three top-tier universities within 90
minutes of Detroit, and with the city being the hub of the American automobile industry
Michigan has the highest concentration of engineers in the U.S..
The above chart shows that overall industrial activity in Detroit has picked up since 2008
to nominally supersede pre-recession levels. It would be interesting to note however
20. what variants of industrial and commercial activity are resurging; the latest figures
suggest farming, real estate, manufacturing and educational services have experienced
growth while the public sector, construction, arts, entertainment and recreation sectors
have declined.
21.
22. The growth in agriculture is mainly due to large swathes of suburban Detroit
falling into disrepair and being converted; increasing home values in real estate are
encouraging but likely originates from inflows of speculative capital, which is volatile by
nature. This particular sector nevertheless remains highly dysfunctional; around 78,000
abandoned homes in the city are in disrepair as a result of long term middle-class
emigration, construction of new-builds is virtually non-existent and property tax rates
remain one of the highest among all U.S. cities.10
Manufacturing jobs have started to
return because an ongoing series of financial bailouts from the U.S. federal government
have helped to maintain solvency of the automobile manufacturers which are the pillars
of the Detroit economy; interestingly, their collective outstanding debt were in actuality
larger than that of the City’s. Official estimates however show that Detroit is still
burdened with chronic unemployment, even when discounting that official figures do
not include those who have voluntarily withdrawn from the labour force indefinitely due
to discouragement from having been unemployed long term. To illustrate of the
magnitude of the crisis, the number of employed Detroit residents fell by 53% from 2000
through 2012 and half of that decline occurred in a single year – 2008, as the recession
took hold.
23. Detroit’s municipal authorities have implemented austerity measures to reduce the
deficit, such that between 2008-2013 operating expenses were cut by around $419 million
(38%), aided in part by the redundancies of around 2,350 employees, cutting of the wage
bill by approximately 30%, attrition (the gradual reduction of a workforce by not
replacing personnel lost through retirement or resignation) and the reduction of future
healthcare and benefit accruals.6
Measures have been implemented to boost revenue
streams such as more rigorous tax collection efforts and reductions in welfare benefits,
and the city has privatized its waste disposal and recycling services by outsourcing with
two private companies. Associated with the austerity process however is uncertainty, and
its long term effects on the population remain to be seen.
Detroit’s emergency manager has focused on cutting pension benefits and
reducing the city’s long-term liabilities through the administration process. However the
easiest way to restructure the City’s debts may be to declare full bankruptcy, liquidate
most if not all debts and start anew. It would then have to rely mostly on realized
revenue as opposed to credit to fund its operations and services that have not yet been
privatized by that stage, ensuring more effectively that the municipal authorities learn to
spend within their means; Greece is undergoing a similar consideration with domestic
support accumulating for a full exit from the euro back to a new drachma. Another
possible outcome is that the U.S. federal government will continue to defer a full Detroit
bankruptcy due its status as a major urban and industrial centre and intervene with more
bailouts as well as federally backed guarantees on the city’s future borrowing – which
would allow it to borrow freely again, this time backed by the full faith of the U.S.
Federal Reserve. Aside from the moral hazard implications on both Detroit and other U.S.
24. municipalities currently in and about to undergo similar economic crises, this would also
impair the ability of other cities nationwide to issue their bonds as they would see
interest rates on their borrowing rise; their bonds would have to compete with Detroit’s
federally backed bonds which would be deemed as less risky. There would then be
pressure on the federal government to further intervene to address these distortions in
the municipal bond market that would result from such a guarantee.
It is clear that the majority of the interest-rate swap termination fees should be
sought to be abandoned to the greatest extent as these constitute the largest proportion of
the City’s debt burden. The banking counterparties would then be made to bear the full
market consequences of the credit risk they inappropriately assumed for underwriting
such derivatives; they are nevertheless substantially in the money as a result of the
synthetically low interest rates that have resulted from the recession and Federal Reserve
Quantitative Easing. It is conceivable that the State of Michigan or the U.S. Federal
Reserve may step in and guarantee the swaps to postpone Detroit’s payment of the
termination fees, which one would expect would become smaller as interest rates rose
over time which they are predicted to do. If Detroit deals effectively with this immediate
crisis, the city’s elected officials – working collaboratively with the State legislature and
governor, can then turn their attention to structural programs and tax reforms in order to
help the city return to prosperity again.
25. VI. The Greek Problem: Key Features
Greece became the 10th member of the European Community (subsequently
incorporated as the European Union) on 1st January 1981 leading to increased investment
in industry and infrastructure and a period of sustained growth in tourism and the service
sector which raised the country's standards of living to unprecedented levels. The country
joined the euro zone in 2001 by replacing its drachma currency with the euro.14
The
economy has deteriorated since the 2008 worldwide financial crisis and has been a focal
point of European sovereign debt problems; its economic problems and subsequent civil
unrest have reshaped its domestic politics and heightened volatility in global financial
markets. Greece was accepted into the euro zone based on favourable outcomes on a
number of criteria e.g. inflation, budget deficits, public debt, long-term interest rates,
exchange rate etc.). An audit commissioned by the incoming New Democracy
government in 2004 revealed however, that the budget deficit had been under-reported;
like Detroit, Greece was found to have misrepresented its public sector financial accounts
especially on borrowing.
Adoption of the euro allowed Greece’s government to begin accumulating (now
easily obtainable) debt that eventually surpassed its GDP. Sovereign debt are bonds issued
by national governments to obtain funds from other nations and are denominated in the
lenders’ currencies; it is used when the issuing country’s domestic currency is weak and
volatile and finances economic growth. The problem with this type of debt is an elevated
risk of default which can occur simply from an unfavourable shift in exchange rates in
which the lender’s currency gains value, or overly optimistic valuations of project yields.
26. The only available recourse for lender countries would then be to renegotiate loan terms
as they have no recourse to seize assets of the issuing government. Greece’s issuance of
sovereign debt was therefore a (losing) gamble on the strength of the euro and has
parallels to Detroit’s interest-rate swap agreements which represented a similar wager but
on elevated U.S. interest rates. The debt-to-GDP ratio stands at about 177%, the highest
in the E.U. and third in the world behind only Japan and Zimbabwe.15
Euro entry meant
that bond markets no longer had to worry about high inflation or drachma devaluation,
and lower interest rates allowed the Greek government to refinance on more favourable
terms; the ratio of net interest costs to GDP fell by 6.5 percentage points in the decade
after 1995. The under-pricing of default risk during the credit boom gave Greece
relatively easy access to longer-term borrowing, allowing the economy to grow by an
average of 4% a year until 2008.16
From the period 1982 to 2009, it borrowed a total of
approximately $300 billion – equal to its entire 2011 GDP and $27,000 of debt per capita.
This was supplemented with an additional $300 billion of net transfers (subsidies) to
Greece from the E.U.; it therefore accrued the entirety of its GDP in E.U. subsidies on top
of its borrowing and one of the highest debt to GDP ratios in the world.17
27. VII. Financial Deals & Critical Areas of Concern
Greece became counter-party to off-balance-sheet derivative deals with U.S. bank
Goldman Sachs in the form of currency swaps in order to artificially understate its budget
deficits. Dozens of similar agreements were concluded within the PIIGS group of
countries whereby banks provided capital in advance to governments in exchange for
future payments; liabilities could be kept off the balance-sheet and not get registered as
debt. These swaps enabled these countries to nominally achieve E.U. deficit targets while
in actuality spend beyond those limits. This bears similarities to Detroit’s issuance in
conjunction with U.S. banks Merrill Lynch and J.P. Morgan Chase & Co. of off-balance-
sheet certificates of participation (C.O.Ps) allowing the city to borrow beyond its
28. statutory debt limit. Greece’s currency swap with Goldman Sachs allowed it to borrow an
extra $1 billion worth of debt.18
The chart below depicts long-term interest rates of government bonds with
maturities of close to ten years of all euro zone countries except Estonia; a yield more
than 4% higher than the lowest comparable yield among the E.U. states (German bunds)
indicates that financial markets have serious doubts about the credit-worthiness of the
state.
At the time of writing, the yield on ten-year Greek government bonds stands at over
9.6%, about 9.2 percentage points more than that on German bunds, the eurozone’s safest
29. investment. As mentioned above, such a high yield is considered an unsustainable long-
term borrowing rate for a government.
Source: www.investing.com
What we can see in the above charts is that by the end of 2009 the Greek economy
was facing its most severe crisis since the restoration of democracy in 1974; the
government revised its deficit from an estimated 6% to 15.7% of GDP.19,20
Potential
lenders and bond purchasers began to suspect that the Greece was overburdened with
debt and might fail to meet its obligations, and therefore demanded higher interest rates
in compensation; rates rose steeply and precipitated a sovereign debt crisis. To avert a
30. default the European Central Bank (ECB), in conjunction with the IMF agreed a series of
bailout packages. In order to secure the funding however, Greece has been required to
implement fiscal austerity measures – which involve a combination of tax hikes and
spending cuts, to stabilize its deficit.
6 years of recession have shrunk Greece’s nominal GDP by almost 21% since 2008.
The country has since been the most exposed and troubled member amongst the other EU
states with similar problems – Portugal, Ireland Italy and Spain. By 2010 it was decided
that all five of the PIIGS states would receive E.U. funded bailouts as allowing them to
default on their sovereign debt would impede their ability to obtain loans in the future; a
£22 billion package was agreed for Greece in April 2010 which would be the first of a
series contingent upon austerity cuts. Detroit has similarly received a series of U.S. federal
bailouts based on similar conditions. Since July 2010 Greece's parliament has enacted
austerity reforms such as pension and welfare cuts, restrictions on early retirement,
raising of the national retirement age, and widespread public-sector redundancies. In late
2011 E.U. finance ministers negotiated with private sector creditors a write-down of
Greek bonds by 50% which reduced the nation's debt-to-GDP ratio from 150% to 120%;
this has similarities to Detroit’s bankruptcy court adjudications.
Like Detroit, the country has suffered from long-term low economic growth, high
unemployment and a bloated public sector comprising about 50% of the economy. The
latter has been for the both the limiting factor on economic recovery as public sectors are
usually characterised by institutional inertia and uncompromising collective bargaining.
Greece’s public sector was relatively modest in size until the end of the military
31. dictatorship in 1974 when recruitment into the sector began to accelerate up until 1990;
“Between 1974-80 Greece transitioned from a regime of fiscal discipline to a decade of
fiscal expansion and a tendency to relapse to it. From 1952 to 1980, Greece had a small
public deficit and debt. The end of military rule in 1974 and return to democracy began
to change the balance of socio-political forces in the country such that the early eighties
PASOK-led governments began to enlist the support of entire social groups through fiscal
liberality. The big primary deficits of the eighties started the public debt accumulation
that has come to the fore in Greece;”21
that 1974-1990 period saw the public sector double
in size but still remain lower as a proportion of the economy than corresponding OECD
or EU averages. “In the nineties efforts were made to reduce the primary deficit but
following Greece’s entry into the euro zone fiscal discipline was again relaxed, and
political incentives were to increase public spending and not to restrain it.”21
The public
sector again grew substantially between 2000-2008, eventually surpassing 1 million
employees, constituting more than 20% of total employment and exceeding the EU
average. This coincided with effective union lobbying which ensured relatively generous
employee compensation and comprised 25-30% of the entire government budget; at its
peak the number of Greek civil servants per capita was one of the highest in the world -
their salaries and pensions representing approximately 80% of the national budget; this
parallels Detroit’s situation. Greece’s public sector in recent years has had to implement
significant budget cuts which has affected all areas including directorates, their associated
agencies, public bodies and local authorities. While there has been a lack of public
appetite towards mass layoffs, they are nevertheless pre-conditions on IMF and E.U.
32. bailout packages and after many years of growth the public sector workforce is targeted to
fall by about 150,000 by the end of 2015.22
There have been attempts at implementing structural reforms in labour markets,
particularly de-unionization. As in Detroit, such attempts have not been particularly
successful in Greece. The country also has one of the most generous (and expensive) state
pension systems amongst the 34 O.E.C.D. countries in which workers can expect 96% of
their pre-retirement earnings.16
As in Detroit, pension reforms will be needed and will
likely consist of raising of the retirement age; long term sustainability of both pension
systems however will depend on successful job creation. Overall unemployment in
Greece currently stands at about 26% and about 51% for youth. Those who have been
unemployed for some time often face multiple barriers to employment, and low business
start-up rates and R&D expenditures are now key challenges against economic recovery
and contributing factors to unemployment. The country has been suffering from a steady
law and order breakdown with regular anti-austerity strikes and demonstrations in the
major cities, a surge in far-right politics and a marked rise in drugs and alcohol related
abuse. It still has however, one of the lowest overall crime rates in the E.U..
The property market in Greece – as in Detroit, is facing significant challenges. The
recession has created a significant excess supply of approximately 300,000 empty homes
partly attributable (as in Detroit) to multiple increases in property taxes as part of the
austerity program and with now over a third of Greek households unable to meet such
tax obligations. Other factors are rises in interest rates, increased constraints on lending
and widespread unemployment rendering many properties liable to be confiscated by
33. creditors due to mortgage defaults. As a result, property values in Greece have declined
by around 36% since 2007, the second biggest property crash in the EU since the debt
crisis began.23
This is happening in the backdrop of home ownership rates in Greece – at
nearly 87% being the highest in the EU historically; Detroit in the 1950’s and 60’s also
had the highest home ownership rates in the whole of the U.S.. Home ownership rates
are a key economic indicator of health of the middle class; when any country or city
observes a steady declining trend in this indicator (or proportional rises in rental
properties), it signals a widening wealth gap due to inflation and future economic unrest
if left unmanaged. “Persons belonging to the middle class find that inflation in consumer
goods and the housing market prevent them from maintaining a middle-class lifestyle,
making downward mobility a threat to counteract aspirations of upward mobility…
home-ownership is often seen as an arrival to the middle class, but recent trends are
making it more difficult to continue to own a home or purchase a home. Housing prices
fell dramatically following their 2006 bubble peak and remain well below this level.
Many middle-class homeowners were particularly hard-hit by the crisis, as their homes
were highly leveraged (e.g., purchased with a low down payment). The use of leverage
magnifies gains (or losses in this case). They owe the full balance of the mortgage yet the
value of the home has declined, reducing their net worth significantly.”24
Deflation, for
the time being however, has become prevalent in the country and is a concern for
mainstream economists, but is nevertheless beneficial for consumers as they are seeing
prices for basic household necessities such as energy and water reduce and become more
affordable.
34. Historic CPI inflation Greece (yearly basis) – full term
Source: http://www.inflation.eu
Greece has some major economic challenges that urgently need addressing: It is
working to reduce budget deficits caused by inefficiencies in the public sector – estimated
at 12.7% in 2013, and has been relatively successful, expecting to be in surplus for 2015
which should coincide with tax cuts. Detroit is also in a similar position, expecting a
budget surplus of about $100 million in the 2015 fiscal year. Greece’s debt-to-GDP ratio
still stands at around 175% so the underlying issue of solvency remains, not helped by
compounding interest and continued overspending and corruption in procurement
processes. The sources of Greece’s problems – like Detroit, are in excessive government
funding of inappropriate projects of questionable value, as well as corruption. Successive
Greek governments have as a policy purchased at artificially high prices 50-100% above
market determined rates; this is a form of subsidy towards the State’s suppliers and
contractors, and corruption scandals particularly in defence and health procurement have
been common.25
“High levels of military spending in countries now at the epicentre of the
euro crisis played a significant role in causing their debt crises; Greece has been Europe’s
biggest spender in relative terms for most of the past four decades, spending almost twice
as much of its Gross Domestic Product (GDP) on defence as the EU average.”26
Despite
35. deep austerity cuts in the public sphere, Greece nevertheless remains one of the highest
military spenders proportional to GDP in the E.U. and remains “…one of the few E.U.
members devoting more than 2% of its GDP to the armed forces.”26
The Greek government also has a revenue problem running parallel to its over-
spending; its inefficient and corrupt tax collection system runs on a “4-4-2” basis in which
the taxman is willing to write off 40% of a tax liability in exchange for receipt of an equal
proportion as a graft payment – the State collecting only 20% of the levy. The less tax
revenue the government collects the slower it will clear its debt obligations; it is therefore
working to curb tax evasion. However, a tax collection system run on this basis is also be
inadvertently beneficial for the economy as it minimizes distortions and allows more
disposable income in the private sector for investment; the tax burden on the economy
needs to be as light and non-intrusive as possible so that job creation can be accelerated.
A lack of competitiveness caused by union lobbying has raised wages and salaries without
similar increases in productivity; it should be offset with reductions in the cost of living,
and reduced taxes on both individuals and corporations are an effective way to achieve
that. Greece faces a dilemma however, between austerity reforms which comprise of
increased taxation and spending cuts in order to qualify for E.U. bailouts necessary for it
to be able to service its debts (which are still significant despite partially writing off
privately-held bonds) – or to completely repudiate all of its debt obligations and end the
austerity programme.
36. VIII. Possible Future Scenarios
The way forward presents three possibilities for Greece. The least likely to occur is
for the country, with the euro still in place, to flatly reject fiscal austerity and structural
reforms and make no adjustments until eventual bankruptcy. This is unlikely to occur
due to the transfer of some aspects of their sovereignty – particularly monetary, which
occurred when countries such as Greece joined the E.U. and adopted the euro. The
monetary authority of the euro is the European Central Bank (ECB) and it would never
allow Greece to choose the above path as it would pose a serious threat to an already
fragile euro.
Another scenario is that Greece will continue to implement austerity measures in
order to slowly pay off its debt and stay in the euro zone, which will probably lead to a
prolonged economic depression. However, forecasts are becoming positive for Greece’s
recovery under austerity and its international creditors – the European Commission, the
ECB and the IMF, expect the economy to register 1.0% growth in 2014 before picking up
to expand 2.5% in 2015 and 3.6% in 2016.27
There are also examples of where fiscal
austerity has been successful. The three former Soviet republics of Estonia, Latvia and
Lithuania implemented sharp cuts in government expenditure but without corresponding
tax rises; the majority of their fiscal adjustments therefore focused on expenditure cuts –
which differs from the Greek approach. Austerity initially led to significant contractions
in GDP in all three Baltic states but their growth recovered relatively quickly within
around 5 years before eventually joining the euro. Corporate profits also improved along
with labour productivity. Nominal wage cuts restored competitiveness, reduced
37. unemployment and stabilized wages. Although endemic corruption is an ongoing issue,
austerity appears to have been very successful in reducing public deficits and debt-to-
GDP ratios in these countries; in 2013 the Estonian general government deficit was 0.2%
and its debt-to-GDP ratio was about 10%, while Latvia recorded 1% and 38.1%, and
Lithuania 2.2% and 39.4% respectively as reported by Eurostat.28
Greece eventually achieved a primary budget surplus in 2013; the primary budget
balance being the government’s budget balance before interest payments. In April 2014 it
returned to the global bond markets, successfully issuing €3 billion worth of five-year
government bonds at a yield of 4.95%.29
It also returned to growth in the same period
after six years of recession and was the eurozone’s fastest growing economy in the third
quarter. A key difference in Greece’s austerity program has been that tax rises have been
a correspondingly more significant component, unlike the mainly expenditure-focused
cuts of the Baltic states. Therefore, for Greece’s austerity to achieve the desired result and
for it to remain with the euro the solution will be three pronged; it must renegotiate
terms of repayment with its creditors, increase the intensity of public sector spending cuts
and aggressively bring the tax burden on the economy down so that private sector job
creation can recover.
The third possible scenario for Greece would be a widescale repudiation of
lenders’ terms (which is similar to Detroit’s bankruptcy adjudications), declared default,
exit from the euro and reinstatement of the drachma at a debased rate. A sovereign
default is the failure or refusal of a state to abide by the terms of its issued debt and comes
with a formal declaration of full repudiation or only partial repayments. 30
This was
38. rejected by voters in the early years of austerity reforms but the political landscape has
reverted to such an extent that a Greek euro exit appears a distinct possibility and one
that that might help ensure the survival of the euro whilst allowing the country the
flexibility to fix its problems under its own terms. Default would all but end Greece’s
ability to issue further (external) debt but would nevertheless also ensure that the
government spent within its means for the foreseeable future, and provide an opportunity
to reallocate and restructure the economy without austerity distortions. The country
would revert back to the drachma the strength of which would be determined by
Greece’s monetary issuing authority, the Bank of Greece. After a euro exit, the Greek
government could then be able to mitigate the real burden of its non-repudiated debt
through a debased drachma; the debt would still be honoured albeit with currency of
progressively lesser value. Granting full monetary authority back to the Bank of Greece
however, will pose too great a risk of future inflationary policies with a view to
stimulating growth. Inflation as mentioned before has been observed to gradually widen
the wealth gap in societies and halt or reverse upward social mobility as wages fail to keep
up with price rises. The answer which appears to provide for a steady and sustainable
recovery as opposed to the current trend of boom and bust cycles, lies in pegging the new
drachma to commodities or currencies of historically stable or rising values such as
precious metals or the Chinese yuan respectively.
If Greece had not joined the euro and retained the drachma, its debt and
expenditure problems would likely have been exposed and addressed much sooner. Euro
adoption allowed it to continue borrowing easily and thus defer and significantly inflate
39. its debt burden. Under a re-instated drachma it would be very difficult for the Greek
government to issue new debt except at very high rates, or deficit spend until the
economy adjusts, reallocates and returns to consistent growth; this borrowing and
spending restriction would not be politically palatable but will likely prove to be
beneficial in the long term.
The new highly debased drachma will also have an immediate and sharp negative
impact on the economy; high levels of inflation will be imported from abroad, alongside
high unemployment and a reduction in the size of the bureaucracy and government
programs. Demand for euros will rise sharply relative to the debased drachma such that it
would likely cause domestic bank runs for the former; a banking crisis may also ensue as
the banks would have to make write downs on debt owed to them by the State. Some of
the Greek governments overseas assets may also be seized by foreign creditors.
Nevertheless, the re-acquired monetary sovereignty will allow the Greek state the
flexibility to enact measures in order to address these issues and redirect the economy
towards growth.
40. IX. Pre-emptive Measures in Case of Greek Exit
The monetary sovereignty should, however, come with countervailing checks and
balances within the constitution to ensure the stability of the newly issued drachma. A
gold (or precious metals) bullion based drachma would be a significant step towards this.
It would not require gold bullion to circulate as such, but the Bank of Greece would be
obliged to redeem it on demand. Until the advent of fiat currencies, gold (alongside silver)
had been a preferred form of money due to its qualities of value retention, durability and
divisibility. It is due to its rarity that gold and other precious metals retain their value
independent of the monetary authority or any political and ideological agenda. Since the
1950s, annual gold output growth has closely followed world population growth,
preserving its relevance as a stable store of wealth. Gold has consistently demonstrated
historical stability with regard to its purchasing power because of these unique stock/flow
characteristics, and if a fiat currency like a re-instated drachma were suddenly as
comparably constant in value, prices would fall to stable, predictable levels. The latter
would be a key asset for not only a Greek economic recovery but the maintenance of a
stable or even declining wealth gap. A new drachma with a 100% gold standard will
obligate the Bank of Greece to hold sufficient reserves to be able to convert all the
circulating currency at a predetermined rate. It should be easy to implement: a simple
declaration by the Greek government that bullion gold will (on a specified date) be
considered actual money and drachma notes the representative legal tender. Once this
standard is established, any stock of money becomes compatible with any amount of
employment and real income, "an extra-market institution can in principle create any
41. desired amount of involuntary unemployment…. However, once a commodity has been
established as a universal medium of exchange and the prices of all directly serviceable
exchange goods are expressed in terms of units of this money (while the price of the
money unit is its power to purchase an array of non-money goods), money no longer
exercises any systematic influence on the division of labour, employment, and produced
income. There is never any need for more money since any amount will perform the
same maximum extent of needed money work: that is, to provide a general medium of
exchange and a means of economic calculation by entrepreneurs.”31
Prices would adjust
and stabilize relative to the Bank of Greece’s reserves of gold bullion because "goods are
useful and scarce, and any increment in goods is a social benefit, but money is useful not
directly, but only in exchanges. When there is less money, the exchange-value of the
monetary unit rises; when there is more money, the exchange-value of the monetary unit
falls. We conclude that there is no such thing as 'too little' or 'too much' money, that,
whatever the social money stock, the benefits of money are always utilized to the
maximum extent."32
Long-term price stability – with minor and temporary fluctuations,
could therefore be expected of a drachma gold standard. Stability relies on credibility,
therefore constitutional reforms that would obligate the Bank of Greece to undergo
regular audits of its actual physical gold reserves by both domestic and international firms
would be required.
In order to moderate economic disruption from the adjustment process,
consolidate credibility and minimize the probability for future systemic bank runs as was
experienced during earlier (weaker) attempts to maintain gold standards, competition in
42. the issuance of credible gold-standard legal tender should be permitted and deregulated
into the Greek economy. Private entities such as banking institutions and pension funds
with their own gold reserves should be given the freedom to issue their own unique
certificates so that the supply of legal tender (including official drachma) in the Greek
economy most accurately reflects total gold reserves and is not dependent solely on the
Bank of Greece.
An official drachma gold standard running parallel to deregulated private
certificates of deposit markets would act as a check on Greek governments tempted to
deficit spend or use inflationary monetary policies. Significant inflation would be rare
because the money supply would only be able to grow at the rate of the gold supply. High
inflation under a gold standard would only be seen when the supply of goods in the
economy is reduced substantially e.g. in war-time, or when a major new gold source
emerges.33
Negotiations are ongoing to potentially open up surveyed Greek gold reserves
to international mining companies which would see the country becoming a major world
producer of the metal. If a reasonable proportion of the extracted gold could then be
retained rather than be expatriated, this would increase the value of a gold-based
drachma and further stimulate economic activity.
43. X. Future Outlook
It is unlikely that Greece will default on the entirety of its debt but choose instead
to continue negotiations with its creditors in order to defer or partially reduce its
obligations. It may be thought that restructuring will have large costs for its creditors, but
the evidence to support this is scarce.34
Very often, international negotiations in which
orderly debt restructuring is agreed upon assure at least partial repayment when
repudiation of a large portion of the debt is accepted by creditors. For example, in the
Argentine financial crisis of 1998 – 2002, creditors had to accept losses of up to 75% on
outstanding debts; similar results can be expected in a Greek controlled default
arrangement, due to the severity of its debt burden.30
The key to the realisation and
success of the Greek recovery back to economic growth in as rapid a time as possible will
be determined by the economic policies implemented by succeeding governments. If such
policies comprise a continuation along the lines of a large bureaucracy, high taxes and
regulations on businesses, unionized labour and a freely inflatable currency by the Bank
of Greece, then the process will likely be drawn out, hyper-inflationary and painful and
may even not be realised. If however, quick and sharp cold turkey policies are adopted
which dramatically reduce the size of the State and its associated responsibilities to simple
law and order and infrastructure provision, along with a simplification of the tax system
from income, savings and profit-based levies as they are at present to a less intrusive and
distortionary consumption-only based system (with exclusions for primary essential
goods such as most foods, housing, education and primary cars), the resultant fluidity and
adaptability of the economy will speed up the recovery process. Deregulation of both real
and labour markets should be implemented and the precious metals backed drachma will
44. ensure stable expectations undistorted either by deflation or inflation – both of which are
harmful. As confidence in the drachma grows so will its value as an investment vehicle to
hedge risk worldwide.
During the recovery process, acquiring external debt will be prohibitively
expensive so internal debt will be one of the main sources of extra-budgetary expenditure
for the Greek government without recourse to printing drachma; it will borrow
domestically from commercial banks and other financial institutions by issuing debt
securities. Having to rely primarily or solely on internal debt, combined with a precious
metals based drachma, will act as a a check on the Greek government’s distortionary
powers in the economy and will therefore better allow market forces to re-allocate
resources apolitically and most effectively. This will provide the quickest way to
overcome the inflationary pressures from a euro exit. The strength of an economy is
demonstrated in the spending capacity of its economic agents and can always be sourced
to the strength of the currency with which the economic agents fund their consumption.
Whatever promotes the latter will lead to the former.
There is also a political factor to Greek economic recovery which comprises its
relations with Turkey. Simply put, open and friendly trade relations must be resumed
with urgency whichever of the above options Greece chooses, otherwise there would be
the danger of political antagonism with a neighbouring nation-state which could impose
pressure on Greece militarily. “The history of relations between Turkey and Greece
during most of the 20th century might be best characterised as one of hostility or perhaps
even outright enmity. For both the economic, security and political implications of the
45. issue are profound. However in 1999 the Turkish and Greek governments began taking
initial steps to improve bilateral relations and these efforts have continued under
subsequent governments…” and have “…resulted in the establishment of a variety of
instruments that are expected to help ameliorate relations.”35
46. XI. Conclusions
We have seen in this essay the similarities between the financial crisis of Detroit
Michigan – which used to be one of the world’s wealthiest and most liveable cities and
centre of the American car industry, and that of Greece a European Union member with
comparable financial problems and similar root causes. The purpose in delineating the
similarities between these insolvency cases was to demonstrate that fundamental lessons
in economic management can be garnered from the Detroit municipal bankruptcy and
applied to an E.U. country like Greece. Detroit, like Greece is currently part of a
monetary union comprising the U.S. dollar while Greece is part of the euro monetary
union. The differences in the possible solutions going forward in both cases therefore
relates to Detroit being an urban municipality under the broader State of Michigan and
then the federal U.S. Government, while Greece is a (mostly) sovereign state under the
European Union which oversees its currency. As a sovereign state Greece will therefore
have much greater flexibility in how it chooses to tackle its solvency crisis, which will be
determined mainly by whether it chooses to stay with the euro or not. Detroit’s
municipal authorities have no such flexibility; they must continue with austerity
measures and debt-restructuring negotiations with the city’s creditors to reduce as much
of the debt as possible. Given then what we know about the dynamics and similarities
between the two crises, the question arises as to what would be the best solutions to their
underlying problems. Both have been in receipt of multiple bailout packages from their
respective federal governments (Washington D.C. for Detroit and Brussels for Greece) the
funding of which originates both from citizens in relatively more financially well-
47. managed states in their respective monetary unions, as well as from simple money
printing by their central banks.
In terms of solutions, the lesson that has been learned from this analysis is that
without countervailing checks and balances, audits and de-politicization of municipal
authority (or government) spending, such authorities and governments will almost
invariably display moral hazard in their spending behaviour knowing that in the event of
a solvency crisis financial bailouts from federal authorities will be forthcoming; the
associated funding socialized among the more financially stronger cities or countries
within their respective monetary unions. The solutions in order to minimize to the
greatest degree possible similar future occurrences of such municipal or state solvency
crises must therefore rely upon eliminating these moral hazard inducing (implicit)
guarantees, in tandem with stable currencies. Not only can the economic management
lessons from Detroit be applied to Greece but to most financial and currency crises
around the world, due to the universal relevance of implementing non-inflationary or
non-deflationary currencies and eliminating moral hazard.
The likely evolution of the Detroit crises will see the continuation of federal
bailouts, debt restructuring negotiations and public sector cuts. While politically more
palatable, it does not address the initial moral hazard problem which led to the crisis in
the first place. Rather than socialize Detroit’s losses, it would have been better for the city
long-term for the U.S. federal government to not intervene and allow Detroit to go
bankrupt in order to send an unequivocal message to other municipal authorities across
the country that they must get their finances in order and balance their books. This
48. would then allow Detroit to undergo a cold-turkey process of structural and regulatory
adjustments which would be drastic but nevertheless for a much shorter time period than
if serial bailouts were to be continued. The same conclusion could also be reached for the
Greek crisis – the difference being that Greece would have to leave its respective
monetary union; Detroit would have to consider no such prospect.
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