The best rescue plan for Detroit

Posted Tuesday, Jul. 23, 2013  comments  Print Reprints

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Detroit’s bankruptcy filing was unavoidable and largely sensible. But it will help that wounded city little.

Detroit’s problems are deeper than its inability to pay its debts. And municipal bankruptcy law gives the courts too little power to impose the radical reform the city desperately needs.

Detroit submitted a petition under Chapter 9 of the bankruptcy code, which contains the rarely used provisions for municipal bankruptcy.

As a result of the filing, Detroit can block lawsuits by creditors who seek to be paid before they start seizing city property like zoo animals and priceless Renoirs, and the city can make all creditors take a haircut on the loan payments they are due.

Those creditors include, most prominently, current and former city workers to whom Detroit owes pensions. And they include suppliers and bondholders — people who lent money to Detroit in return for a promise of repayment plus interest.

Municipal bankruptcy bears a superficial resemblance to corporate bankruptcy. The city or company can’t pay its debts, and a court orders the debts reduced, so that revenues (from sales, for corporations; from taxes, for cities) can service the rump portion.

But it is easy to tell whether a corporation is insolvent or not. The answer is yes if the company cannot generate enough revenue to pay its debts and the value of its assets — the amount equipment can be sold for, say — is less than that.

With a city, however, the main asset is the city’s ability to raise money from taxpayers. If taxpayers don’t trust their leaders, or know that the city’s debts may be forgiven in bankruptcy, they will be reluctant to agree to tax increases to pay those debts.

And so cities will be tempted to use bankruptcy to reduce their debts even when they can pay them, hoping that the bankruptcy court will accept the claim that taxes can go no higher. But this means creditors will often be unwilling to extend credit that the city will need when it emerges from bankruptcy.

By contrast, corporations are generally forced into bankruptcy by their inability to pay their bills. For them, bankruptcy is an ill to be avoided because it typically wipes away the shareholders’ stake — and managers have a duty to maximize shareholder value. Understanding that bankruptcy is a last resort of corporations, creditors are willing to lend to them even after they emerge from bankruptcy.

Cities may also be more attracted to bankruptcy than corporations are because, while bankruptcy judges have the power to “reorganize” a corporation — by ordering it to sell assets, or divide into two, for example, a court can’t fire the city’s leaders, or bisect the city, or sell buildings or put more money into collecting taxes or stopping corruption.

Detroit’s current inability to pay its debts as they come due is just a symptom of a larger, all-too-evident malaise — the loss of the industrial base, the shrinking of the population, and a corrupt political culture.

The first two problems strongly suggest that the city, like a bloated corporation, should be shrunk. A smaller government should have responsibility for a smaller and more densely packed urban area.

And to deal with the problem of corruption, ideally a court would replace the city’s leaders with proven and experienced managers, just as the incompetent management of a bankrupt corporation can be easily scuttled.

When Detroit emerges from Chapter 9, it will have fewer debts, but it will be the same old city: still too big and spread out, still mismanaged. Creditors will see new loans as just as insecure as the old ones and will charge a high interest rate or not lend at all.

Congress should revise Chapter 9 so that federal bankruptcy courts can fix cities the way they can fix corporations. It may be too late for Detroit. But for other cities saddled with enormous pension obligations, and likely to follow Detroit down the bankruptcy path, changing the law still can do much good.

Eric Posner is a professor at the University of Chicago Law School.

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