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November 01, 2009 at 02:00 AM
When reservation at this well-known midtown Mexican place, I had no idea it doubled as a back entrance to the Ed Sullivan Theater, the home of the Late Show with David Letterman. Nor could I have foreseen that it would be the night Barack Obama chose to go on the program. So it was a bit of a surprise to arrive at our lunch rendezvous only to see the entire block cordoned off by sand-filled sanitation trucks and guarded by hundreds of New York City police officers.
As we settled down to our meal, a hand-picked audience kept filing through the restaurant and disappearing in the back, like members of some secret society. My only regret was that the president, taping that night’s show only a few feet away, couldn’t listen in on our conversation and hear what Nicole Gelinas had to say about the current economic recovery and the way it is setting the stage for the next financial debacle that is likely to be worse.
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Who: Nicole Gelinas, Searle Freedom Trust Fellow, the Manhattan InstituteWhere: Cafe Iguana, 240 West 54th Street, New York, September 21, 2009
On the Menu: Avocado fries, goat cheese wrap and a recipe for future financial disaster.
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Misguided Expectations
Even though the focus of our discussion is municipal finance, the main subject of Gelinas’ research, she begins with the two troubled Detroit automakers, GM and Chrysler.
“In both cases, the government didn’t allow the normal course of bankruptcy to take effect but instead protected the interests of the trade unions, even though they were not senior debt holders,” she says.
Earlier this year, GM went in and out of bankruptcy under the tutelage of the government, as a result of which bondholders owed some $27 billion by GM were taken to the cleaners, potentially losing as much as 80 percent of their investment. Bondholders at Chrysler, following a Washington-brokered sugar-daddy marriage with Italy’s Fiat, got around 33 cents on the dollar.
“The government stepped in to protect its constituents,” explains Gelinas. “This sends a clear warning to holders of municipal debt. It is very likely that if issuers, especially city and local governments, don’t have enough money for debt service and for politically expedient spending, political considerations will come first.”
But she also identifies this as a problem for municipal unions. They shouldn’t demand too many concessions in their contracts because in the end they may not get all they bargain for.
The constitutional protection for local government pensions has not been established, and medical benefits are even more likely not to be paid in full if the municipality can’t afford them.
Gelinas divides local governments into two categories. One is cities and municipalities, which can go bankrupt and, as courts recently ruled, can claim protection from creditors under Chapter 9 of the bankruptcy code. States, on the other hand, are sovereign entities and can’t declare bankruptcy.
“This area has not yet been explored. Lawyers and investors are wondering what will be the status of California’s recently issued IOU, which the state used in lieu of money to pay its creditors.”
According to Gelinas, playing politics over sound business considerations is what got local government finances in trouble in the first place. Governments have been spending heavily on social services, notably on Medicaid and education, while neglecting such common sense areas as infrastructure, where much more investment is needed. This creates a vicious cycle.
Investing into politically expedient black holes requires higher taxes and does nothing to attract new businesses and new jobs, which is required to expand the tax base. Neglected infrastructure boosts operating budgets, just as businesses flee to other parts of the country where infrastructure is better and where taxes are lower (and some even opt for going abroad). As governments go deeper and deeper into debt, debt service begins to loom large on their budgets.
