"Coming Attractions?"

Sydney M. Williams

Thought of the Day

“Coming Attractions?”

July 14, 2011

An article in Tuesday’s New York Times provided a preview of what could be in store for millions of Americans who work in state and local government – not because of dastardly acts by greedy bankers, but due to the stranglehold of union leaders and incompetence of elected officials. “A Small City’s Depleted Pension Fund Rattles Rhode Island” tells the story of Central Falls, RI, a poor industrial city of 20,000 north of Providence, in which $80 million of retirement benefits have been promised to 214 public employees, an amount far greater than the taxpayers can afford. Average household income in the city is $33,500; the amount due works out to about $16,000 per household. According to the articles authors, “If the city were contributing the recommended amount to the plan each year, it would take 57 percent of local property taxes.” Having lived in a number of small towns, I can say that typically school systems in smaller cities and towns consume between 70 and 80 percent of a town’s revenues, leaving Central Falls few options.

What is happening in Central Falls risks, unfortunately, becoming ubiquitous. Employee unions and elected officials for years have enjoyed a symbiotic relationship, which served both parties very well – the victims being the taxpayers of the city and duped union members. In a column entitled “How Unions are Stifling America” in Wednesday’s USA Today, Julia Vitullo-Martin writes that labor has become increasingly unproductive. It is “organized labor’s legacy of work rules, jurisdictional disputes and unproductive practices that cause costs to soar.” It has been their benefits, pension and healthcare plans that are today submerging towns, cities, counties and states around the country with obligations that cannot be honored.

Seventeen years ago, on December 6, 1994, Orange County, California became the largest municipality in U.S. history to file for bankruptcy. But that was a far different situation than what faces our nation today. In that case, a rogue official, County Treasurer Bob Citron borrowed funds to invest in a host of derivatives, inverse floaters and high yielding long term bonds. He leveraged the portfolio two to one, investing the dollars in exotic securities whose yields were inversely related to interest rates. His losses exceeded a billion and a half dollars.

Other cities have flirted with bankruptcy, most famously New York in 1975. President Ford had essentially told the city to “drop dead.” The federal government would not bail them out. Mr. Ford equated providing money to the profligate city would be like “giving $100.00 to your daughter to support her heroin habit.” Felix Rohatyn established a Municipal Acceptance Corporation which allowed the city to borrow with the state’s backing. The city was saved from bankruptcy, but it would be six years before New York City could borrow on its own behalf.

Today’s problem is far more insidious. Of Rhode Island’s thirty-nine cities and towns, thirty-six of them manage their local pension funds and of those twenty-three have been designated at risk, including Providence. Rhode Island is not alone. New York, New Jersey, Illinois and California are well known for the pressing demands of their retirement programs. Minnesota is embattled and Wisconsin’s situation has been well publicized. In cases like New Jersey, New York, Wisconsin and Ohio, governors are taking tough actions, while being vilified by unions, political parties and much of the liberal press. Connecticut has chosen to raise taxes, virtually assuring that economic growth in that state will continue to be anemic.

Economic growth in the U.S. during the 2000s was based on leverage. Consumer debt increased about 66% during the decade, while GDP rose about 45%. Residential mortgage debt doubled from about $6 trillion to $12 trillion. Federal debt, as a percent of GDP, rose from 56% to just almost 100%. Future obligations (pension and healthcare promises) rose, as union bosses demanded more generous benefits, and actuaries based their investment assumptions on the unrealistically high returns that had occurred during the 1980s and 1990s. Following the housing collapse, consumers had no choice but to deleverage, which they have been doing for the past four or five years. However, deleveraging translates into slower economic growth. Slower economic growth means lower tax revenues. Lower tax revenues mean higher deficits. Higher deficits mean fewer options available to government to counteract the recession. Unfortunately, government borrowing has done very little in terms of economic growth or jobs; in large part, this is because government has failed to instill confidence into the private sector.

In a sense, states are experiencing the perfect storm. A slow economy has deprived states of their usual revenues. Demographics have increased the number of retirees per working person. Investment returns have been mediocre for a decade, impacting pension assets. Healthcare costs have risen at double the rate of inflation, negatively impacting retirement costs. While the influence of unions waned in manufacturing industries, they have waxed in the public sector. Promises made are proving too expensive too be honored.

Watching Central Falls stumble toward bankruptcy is like seeing a preview of coming attractions, but in slow motion. Yesterday, it was widely publicized that Moody’s placed the U.S. on watch for possible downgrade. However, at the same time they placed 7000 municipalities on review. The factors that have led to possible bankruptcy in Rhode Island reflect the dichotomy between those who would have us become a welfare state and those who would not. Polls indicate that people overwhelmingly believe that the deficits must be addressed, but that taxes should not be raised. However, those same polls suggest that people do not want to give up their entitlements. We can’t have it both ways. Forty or so years ago, Western Europe embarked on a path toward socialism. In today’s Wall Street Journal, Daniel Henninger quotes Robert Lucas, University of Chicago Professor and 1995 Nobel Laureate that a 20% to 40% income gap has emerged between the U.S. and Europe, a gap which reflects a lowered European work effort. Other economists, Professor Lucas notes, “have cited a 30% loss in GDP per person in Western Europe since the 1970’s.”

We are at a crossroads; our politics are riven between those who would have us take one road and those who would have us follow a different route. Over the past several years we have been inching towards a welfare state. And the President accelerated that trend with his passage of the healthcare bill, another entitlement, and with his demonization of business. The differences are being played out in the press, in the halls of Congress and within the West Wing of the White House. Both sides seem adamant; the President represents one side; John Boehner, the other. Tax increases are necessary if we are moving towards socialism. Tax reform and less government spending is critical if we are to remain a capitalist state. An aging population may desire more of a welfare state, but such a situation would distinctly limit the opportunities for our children and grandchildren. In the meantime, cities like Central Falls, Rhode Island are caught in the web.