The biggest story in the media this past year has been the federal deficit and the resulting debt ceiling controversy that bitterly divided the country, stalled the economy, and resulted in a humiliating credit downgrade of the United States. However, under the radar, local governments across United States are playing out some of the same dire fiscal scenarios. Just this past July, the city of Central Falls, Rhode Island, became the latest to declare bankruptcy, and other cities such as Joliet, Illinois, San Diego, California, Harrisburg, Pennsylvania, as well as Hamtramck and Detroit here in Michigan, are facing similar prospects. (1) And with the economy continuing as it is, local financial emergencies will likely become increasingly common in Michigan and around the country.. City financial emergencies like the one currently underway in Rhode Island are nothing new in the U.S. and it will be important to learn from cases across the country when evaluating municipal policy in Michigan. Historical causes of fiscal stress in cities always include some combination of the effects of a transitional economy, a singular shock event, or years of unsustainable and negligent budget management. But the national and state government also always has a role in these situations. Multiple state government policies can have effects on municipalities and once there is a fiscal emergency, the choice of higher level government to get involved or not, and to what degree, has profound impacts on the city’s future. Due in large part to state level policies, some local governments have been able to get out of fiscal emergencies quickly and effectively, while others are bogged down in court battles or caught in a devastating cycle of service cuts and depopulation, perhaps never to fully recover. Therefore, it is vital to learn from past and present policy decisions across the country and continually review responses to municipal fiscal stress.
The history of modern municipal fiscal policy begins with the Great Depression. After the stock market collapse, city governments across the country rapidly found themselves in a catch-22. Revenues already decimated by high tax delinquency rates were strained as citizens called for even further tax cuts, all while expenditures skyrocketed with massive demands for increased city services and public welfare. It was a quandary that would become all too familiar to cities in decades to come. Throughout the 1930s, thousands of cities and towns across the country went into default and came to rely on state aid to function.(2) The first municipal bankruptcy laws on the federal level came about during this time seeking to allow desperate cities to negotiate settlements with creditors under court oversight while continuing to provide critical services. Struggling states stepped in and provided the aid needed to save their city governments, but that aid also came with strings attached as states started to exercise some of their superintending powers over municipal finances.
While the collective financial crisis of the Great Depression laid the basis for future fiscal policy, it was the individual cases in the postwar era that highlighted the effects of state policy and developed new procedures for local financial emergencies. The 1970s, in particular, became characterized by the negative effects of post-industrialism on inner cities and the first notable case city to experience a municipal financial crisis was America’s largest city, New York, in 1975. (3)
The state and national government responses to the New York Crisis were unprecedented because of the weight the city carried in the bond market. After a mass sell-off of municipal debt put the city on the edge of a huge default, the State of New York immediately stepped in and declared a moratorium on debt obligations and created the Metropolitan Assistance Corporation (MAC) to back municipal bonds with a state guarantee. However, borrowing costs for the state subsequently shot up and by September it became apparent that the MAC bonds would not be enough. The State was forced to take over the City to avoid the default. In order to appease creditors, powerful banking and industry interests were given seats on the newly created state-level Emergency Financial Control Board (EFCB). (4) It was drastic measure and a notable test to democratic government. The EFCB was given final control over any and all financial decisions of the city: all expenditures, contracts, labor agreements, borrowing, and internal monitoring. Departments, elected officials, even the mayor were essentially stripped of their powers. (5) The EFCB could seize city assets, stop checks, and give direct orders to city officials and public employees. (6)
Over the course of the next three years under the state level EFCB, New York City’s workforce was cut by 20%, taxes and tolls were increased, mass transit fares were raised 43%, and the city ended free tuition for residents at CUNY schools. With the addition of some major bailout help from the federal government to stabilize credit markets, the radical procedure generally worked, although not without years of controversy and lasting distaste between the state and its largest city. By the early 1980s, the city returned to having a balanced budget and state control ceased. (7)
Due to the New York City crisis and fallout, the Federal Government amended Great Depression era bankruptcy laws in 1976 to make it easier for cities to declare bankruptcy under a Chapter 9 designation and receive certain new bankruptcy protections and reorganization tools. Small cities were now able to more effectively use Chapter 9 to deal with unforeseen events, or financial “shocks”. Many cities that lost devastating lawsuit cases, for example, would go on to declare Chapter 9 Bankruptcy including Bay Saint Louis, MS (1977), Wapanucka, OK (1982) and South Tuscon, AZ (1983), and, more recently, Desert Hot Springs, CA (2001) and Westfall Township, PA (2009). The cases involved multi-year court proceedings, but were mostly carried out without state involvement or major effects on community functions.(8)
For larger cities, however, a bankruptcy or default is still exceedingly dangerous. The lasting effects of a downgraded credit and a bad fiscal reputation can cause huge hardships on the citizens and workforce of the entire metropolitan area. People and business may move out fearing higher taxes, and a credit downgrade of one city can affect the rating of adjacent cities and the state. (9) Needed economic development and infrastructure projects are held back and borrowing costs skyrocket. For these situations it becomes imperative for higher government to get involved in order to mitigate the downward spiral before it becomes too late, as was the case of Cleveland which defaulted in 1978.
Cleveland found itself in a similar hole to the one New York City faced down, with tens of millions of dollars of running budget deficits and a $15 million dollar bond obligation outstanding. The situation became highly political as the mayor (young Dennis Kucinich) stood up to large banking creditors over the public ownership of a local utility company. The standoff ended in the city going into default, although the banks elected not to push the city into a bankruptcy. (10) Throughout the 1970s, the city of Cleveland had teetered on the edge of a fiscal emergency with manufacturing jobs and middle class citizens moving out to the suburbs. The city and state tried to combat these postindustrial effects by transferring various city services to the county level including mass transit, sewers, jails, ports, and health and welfare. However, multiple initiatives to raise much needed taxes failed and state policy allowed citizens to vote for even further tax cuts which proved dangerously unsustainable for the city. (11)
The State of Ohio took over its largest city in 1980 after passing through new 1979 laws allowing it to do so. The formation of the Financial Planning and Supervision Commission (FPSC) was modeled after New York’s EFCB with most of the same powers. Under FPSC control, Cleveland’s debt was restructured through bank negotiations, and, with a new mayor, taxes were increased for Clevelanders. But the FPSC remained in control of the city until all state-backed bonds were retired and Cleveland wouldn't officially come out of the default for another seven years. (12)
Further effects of the Cleveland default ended up being felt throughout Ohio as small cities and towns suddenly found themselves falling under FPSC control due to the parameters set by the new 1979 laws directed at Cleveland. Although Ohio (like Michigan) is a “Home Rule” state with a greater level local autonomy, municipalities determined by the state to be in a fiscal emergency can be placed under a FPSC, resulting in a sense of loss of self-determination for locals. All commission members are appointed directly by the governor, although they usually include some elected officials from the town. Today, the Ohio cities of Mansfield, Garfield Heights, and West Mansfield, as well as Scioto County and numerous small villages and school districts are under the control of a FPSC and the oversight of the State. (13) Cities are typically released from FPSC control once short term bonds are paid off and the city returns to a stable and balanced budget. This, however, can take as many as fifteen years. (14)
The year of 1978 marked the beginning of huge changes in overall state fiscal policy after California voters passed Proposition 13 in what became known as a ‘tax revolt’. This populist movement spread across the country aiming to make it much more difficult for state and local governments to raise taxes. The property taxes that local governments depend on were especially hated and since control was being sought at the state-level, these new initiatives became a striking infringement of state government on municipal fiscal autonomy. (15) Due to the dramatic post-prop.13 decrease in tax revenues for municipalities in California, the State quickly started providing large-scale relief assistance to local governments, on which, in many respects, they came to depend. Increasingly, state and local fiscal health would become intrinsically linked as complex revenue allocation formulas shared fiscal stress across jurisdictions. (16) Credit ratings and subsequent borrowing costs for government were negatively affected by the revenue raising constraints that were seen as decreasing fiscal flexibility in times of crisis. (17) For example, one study found that across the U.S., “States with binding revenue limits pay, on average, 17.5 basis points more on their general obligation debt than states without such limits.” and local revenue limiting adds another 4.5 basis points to state borrowing costs. (18) For California, all three major credit rating agencies downgraded the state G.O. bond rating after the passage of Prop.13. (19)
Problems for California in particular would continue as the local governments in the state sought to regain more financial autonomy. Although major local financial emergencies were relatively uncommon during the later 80s and through the 90s due to a more stabilized economy (20), arguably the most high profile bankruptcy of the century occurred in 1994 in Orange County, California. In short, the County Treasurer invested billions of dollars from cities and towns in the county into risky high yield investments in order to offset property tax loss and gain back some fiscal discretionary power for local governments. The bets paid off for a while, but when the investment pool collapsed, the county suddenly lost more than $1.6 billion. (21) The county quickly declared bankruptcy in order to stop some of the losses, but most of the damage had already been done.
Clearly the case was a financial-shock event. The county didn't receive help from the state, pulling out of bankruptcy in just 18 months by issuing new high interest bonds itself, but years of finger-pointing and lawsuits followed. (22) Many people thought that the county should not have rushed into a bankruptcy filing in panic. The bankruptcy ruined the county’s credit and hurt other local governments in the state. The case proves what can happen to even one of the most prosperous counties in the country with little or no oversight of finances. In 1994, federal bankruptcy laws were amended again in order to give state governments authority over their municipalities’ ability to file under Chapter 9. (23) But California and Alabama, along with some 9 other states, chose at the time not to place any new restrictions on a local government’s ability to file for bankruptcy. (24)
Orange County may have been a unique situation, but at the turn of the new millennium a new swing of municipal financial emergencies started occurring beginning in 1999 with the bankruptcy filing of the city of Prichard, Alabama. Rather than being caused entirely by old-style post-industrial ailments or financial “shock” events, these bankruptcies can be blamed, at least in some part, on decades of unfunded pension benefits finally coming to fruition. And with the baby boomer mass-retirement just beginning, we can expect financial emergencies of this type to be a major problem for the foreseeable future.
In the Prichard case, post-industrial effects on the city combined with unsustainable salaries and pension benefits to create a perfect storm of fiscal disasters. (25) The two decades long saga continuing today in Prichard began with a 30% raise for police and firefighters in 1994 amid a $1.4 million budget gap. Meanwhile, jobs in the industrial suburb of Mobile continued leaving and the tax base quickly eroded. By 1999, the city stopped paying its employees and declared bankruptcy with a $3.2 million budget gap. Churches in the city even started taking up collections to help city workers pay their utility bills. (26) For its part, the State of Alabama funded a study of city finances but refused to bailout or assist Prichard in any way. (27)
Years of mass layoffs of city workers and cuts to salaries were ultimately not enough to completely solve the city’s problems and in 2009, Prichard declared bankruptcy again after having just pulled out two years earlier. After a decade of court battles over pension benefits, the city took the unprecedented step of stopping pension checks for retirees entirely at the end of 2009, blatantly breaking state law. Partial pension benefits started up again just this past June after a 20 month hiatus, but severe struggles for the exhausted city continue to this day. (28)
The growing pension problem and its relation to state policy has been brought into focus even further by the recent bankruptcy of the San Francisco suburb of Vallejo, California. The suburban city appeared to be doing well during the suburban boom of the late 90s, but the housing market crashed in 2003-2004 sending the city into a rapid downward spiral. By 2008, the city found itself spending over 75% of its general fund budget on police and firefighter salaries under a unionized contract formed in better times. (29) A long series of negotiations with the city unions ultimately failed and, unable to meet obligations, the city council voted unanimously to file for bankruptcy in order to give the city more leverage to make cuts and more time to work out agreements. However, after three years, the city remains in bankruptcy today even after cutting hundreds of city workers, slashing city services down to basics, and raising some taxes and fees (although it is strictly limited from doing so by California Proposition 13). (30) Apart from taking over the schools, the State of California seemed to be continuing its “hands-off tradition” of dealing with local government emergencies. However, due to Vallejo’s continuing fiscal disaster, a bill was recently passed through the state legislature, and is currently awaiting the governor’s signature, that would put restrictions on municipalities’ ability to unilaterally file for bankruptcy.
Assembly Bill 506 (CA 2011) would create a “third party neutral evaluator process” through which local governments must seek approval before they would be able to file for bankruptcy. Basically this requirement is in response to concerns by unions that Vallejo didn't do enough to negotiate a settlement with workers and retirees before declaring bankruptcy, and so any other cities seeking to declare bankruptcy would first be required to pass through a state-level mediation commission bringing “stakeholders” into the state approval process. (31) In testifying before the legislative committee against the bill with other municipalities, Vallejo Mayor Osby Davis said, “I’m with the old school: you make a contract, you ought to stick with it, but if you don’t have the money, there’s nothing you can do. And [In Vallejo] we are still, to this day, negotiating. [. . .] We are doing everything we can to resolve this problem. I urge you not to put an unelected oversight committee, or anyone, over the finances of our cities. Leave us alone. We can handle our own financial affairs.” (32)
Some of the same bitter wrangling between municipalities and public employee unions is playing out today on the other side of the country in Central Falls, Rhode Island: the most recent case of municipal bankruptcy. Central Falls previously made national news in 2010 when it laid off the entire faculty and staff of its high school due to a dispute with the teachers’ union. Conflicts with workers and retirees have been going on for many years in Central Falls as it quarrels over a $5 million deficit with $80 million in unfunded pension and benefit obligations. (33)
The State of Rhode Island has helped out somewhat in this case, declaring a fiscal emergency in Central Falls and appointing a receiver to take control of the city’s finances. According to Rhode Island laws passed as recently as 2010 to head off Central Falls, municipalities declared to be in fiscal distress must go through a three step process at the state level before filing for bankruptcy. The process begins with a state financial overseer reviewing municipal finances, then a budget committee that reviews municipal budgets, and, if the problem continues, a state receiver is appointed to take over the city who is given broad powers over municipal activities and contracts. (34) However, even with this new state intervention, the Central Falls filed for bankruptcy this past summer after another last ditch offer to retirees, to save the city $2.5 million, was soundly rejected. Proposed solutions to the problem include, among other things, actually merging the city with an adjacent (and larger) city. (35) Meanwhile, the state receiver in control of Central Falls has started voiding contracts with city workers and setting new ones. (36) This relatively recent case still has a long way to go in court and whether or not the state provides any financial assistance remains to be seen. Central Falls and all the cities facing pension bankruptcy today face largely uncharted territory going into the future as angry retirees fight tooth and nail for the promises that they have trustily paid into over the course of their careers serving the public.
The one true commonality among all the major municipal fiscal emergencies is years of financial planning mistakes, obscurity, and corruption leading up the disaster. In most cases in history, the situation becomes highly divisive and politicized for many years and this most likely makes the costs to municipalities even worse. More proactive policy from the state and federal levels is important in suppressing and preventing future municipal emergencies. History shows us that state policies should create a culture of openness and transparency in municipal finances, while still allowing cities to retain some autonomy. Instituting regional cooperation between localities in dealing with economic problems is essential as is recognizing that any revenue raising restrictions will come with credit and borrowing concerns. In addition, governments across the country and here in Michigan should be studying the situations currently playing out in California and Rhode Island closely and figure out whether pension plans and employee salaries are sustainable. This is one area that may need much more aggressive oversight from higher government in the coming years. Finally, residents will have an important role to play as well. Citizens of a city must keep a close watch on their local government finances and recognize that small sacrifices now can preclude much larger sacrifices down the road.
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