Monday, August 15, 2011

The Lesson of Debt Spirals -- A Cedar Falls Update

The story of Cedar Falls debts and obligations keeps getting more interesting and involved. Although the city's recent bankruptcy filing is certainly a sad story, it's an instructive one, too. (We addressed the small Rhode Island town's financial dilemma previously on July 13 and August 6. Please refer to these postings as needed for a memory refresh.)

The Cedar Falls saga is typical of far too many governments making promises in the past and which promises now can't be kept. The effects of such past debt spirals abound throughout the world.

Today we'll update the Cedar Falls bankruptcy filing from the respective points of view of its pensioners and bondholders. Faltering Rhode Island City Tests Vows To Pensioners essentially paints a grim picture with no easy way out for anyone involved. Its resolution by the courts is certain to be followed closely by employees and retirees of schools, cities and states, as well as public employee unions and taxpayers throughout America.

In past years, the small Rhode Island community of 19,000 committed to unusually large pensions to its retirees such as police officers and firefighters (the state did its part to make a bad situation worse, but we'll leave that story aside for now), but the promised payments weren't properly funded. Not even close. Now the city is out of money. Let's look closely at the broader ramifications of this sad situation.

In addition to not sufficiently taxing its citizens or requiring contributions from employees to fund the pension promises it now can't keep, city officials did something else. To fund city operations, they also borrowed lots of money from bondholders. As a result, and on behalf of city taxpayers, the community agreed to repay those loans with interest.

Bondholders are people, too. They quite often are individuals who use personal savings to purchase municipal bonds. They are also often members of pension funds that invest by loaning money to cities. All of these "outside" investors are people who are very much deserving of being repaid.

On behalf of their constituents, neighbors and fellow taxpayers, the Cedar Falls city officials who made the pension benefit promises are quite likely the same people who borrowed the money from the bondholders. Be that as it may, there's not enough money to keep their many promises. Thus, the pensioners, taxpayers and bondholders are entangled in a mess affecting all concerned.

In simple terms, since there is not enough money to make the promised payments to the various legitimate claimants, something has to give. And that's precisely the question for the bankruptcy court to decide. Who is going to give, and how much?

This precise question of "who's gonna give what?" will be the same question faced by many taxpayers and government entities (local, state, national, global) in the months and years ahead. So let's look beyond Cedar Falls to see what this may mean for the rest of us.

The city undoubtedly used some of the funds borrowed from bondholders to pay at least some pension payments to city retirees. It also used those proceeds for city operations as well. And it chose to borrow the money rather than increasing taxes or reducing city spending. Those were the city's choices at the time, albeit obviously bad ones.

In so doing, city officials acted on behalf of all the taxpayers, so the taxpayers now have choices to make among the various bad alternatives. Had they not chosen the bankruptcy route, Cedar Falls either would have had to somehow pay more taxes to make the required payments to both pensioners and bondholders, gut city operations or pay the pensioners dramatically less than promised (due to Rhode Island law favoring bondholders over pensioners).

Since they chose bankruptcy, bankruptcy rules apply. The federal laws state that pensioners and bondholders are treated the same. If that's the way it turns out, both pensioners and bondholders will get less than promised. The Rhode Island law states that bondholders would be paid in full to the detriment of the pensioners. If that's the way it turns out, bondholders will be repaid and the cities of Rhode Island will be able to borrow in the future at market interest rates. That said, preferring bondholders over pensioners doesn't appeal to the pensioners.

Regardless of what's deemed to be fair by the pensioners and perhaps others (normative economics), the fact is that in the future bondholders won't loan cities money at low rates, if at all, if they aren't going to be repaid.

And to the extent that repayment is even questionable, bond buyers will charge much higher interest payments than otherwise. Besides, the city wouldn't be able to redeem the principal at its date of maturity. Thus, what lender would loan the city the money in the form of a "rollover" loan upon the expiration of the first loan? Probably nobody.

Cedar Falls will need much financial support these next several years and decades. It won't seem fair to the pensioners, but there really is no other answer than to fail to pay in their entirety the promised pensions. Unless, of course, taxpayers want to increase their taxes sufficiently to do so. In that case, there will likely be many people moving from Cedar Falls, thus making it an even smaller and poorer community in the future.

Now let's briefly look at the bigger city, state, national and global story of debt spirals and their effects.

To see what happens when bond holders become worried about getting paid on schedule and in accordance with the loan terms, The Making of a Debt Spiral is worth reviewing. The author of the book "This Time Is Different" describes what causes debt spirals and their impacts on countries, states, cities and people. It's much like a run on the bank, to use simple language.

With respect to additional government borrowing, that newly increased debt leads to rising borrowing costs, which then leads to either even more borrowing, spending cuts or tax increases. These choices then lead to slowing economic growth and its debilitating consequences. The cycle then repeats itself until the spiral is broken by default or otherwise.

The effects of borrowing are too little understood by most people and most government officials, too. Let's become knowledgeable and then pass on that knowledge to the government.

Thanks. Bob.

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