The Consequences of Detroit

The city of Detroit filed for Chapter 9 municipal bankruptcy last week. Detroit and the auto industry it represented were once a symbol of all that was right with America. Now, the stock market doesn't care about the bankruptcy of a once great city because it is no longer connected to the underlying fundamentals of the global economy.

Joe Calhoun
July 21st, 2013
Alhambra Partners

The city of Detroit filed for Chapter 9 municipal bankruptcy last week and the S&P 500 made a new high. There was a time when those two headlines could not have happened in the same week. Detroit and the auto industry it represented were once a symbol of all that was right with America and it was not a stretch to say that what was good for General Motors – and by association, Detroit – was good for America and vice versa. Obviously, those days are long gone. The stock market doesn’t care about the bankruptcy of a once great city because it is no longer connected to the underlying fundamentals of the US economy. For that matter it may not even be connected to the fundamentals of the global economy anymore.

There are lots of reasons for Detroit’s failure including corruption, mismanagement and just plain bad luck but what needs to be watched closely now is how the bankruptcy is handled, which has implications not just for Detroit but for the economy as a whole. We’ve already been sent an ominous signal through the Emergency Manager’s office which has announced that General Obligation bondholders’ claims will compete equally with all other claims. GOs are full faith and credit obligations backed by the general taxing power of the issuer and therefore have always taken precedence over other claims on a bankrupt entity. In this case, the Emergency Manager is placing those claims on equal footing with all other claims, including pensions and my guess is that is the real reason for this attempt to devalue the superior legal claims of GO holders. Unions are the power base of the Democratic party that has controlled Detroit for decades and their most prominent members are now municipal employees.

During the GM bankruptcy something similar happened when bondholders’ claims were subordinated to the needs of the auto worker’s union. At the time, it was something the Obama administration justified as necessary due to the economic crisis. If Detroit is allowed to do something similar and especially if there is federal involvement, it starts to look more like a pattern of abuse and a disrespect of the rule of law. That has consequences beyond Detroit. The US has always been seen as place superior to most of the rest of the world when it comes to such issues. If we start to be seen – and it may be too late already – as just another country where raw political power is more important than the rule of law, we will give up one of our major international competitive advantages.

Allowing such a ruling to stand also has consequences for the thousands of other municipal entities around the country. GOs have generally carried lower interest rates than revenue bonds tied to the performance of specific facilities. If GOs will now be placed on the same footing as any other general creditor, interest rates on future issues will undoubtedly be higher than otherwise. Many states, counties and cities have already had to cut budgets due to the general feebleness of the economic recovery and raising their borrowing costs would obviously not help the situation.

Detroit is also a microcosm of what is wrong with the US economy. I’m sure we will hear plenty over the coming months about how globalization and free trade are to blame – politicians always prefer their scapegoats to be foreigners – but the fact is that Detroit’s wounds and those of the rest of our economy are self inflicted. While Detroit’s problems appear to be specific to Detroit, they are really connected to the wrongheaded policies that have dominated the US economy for decades. Specifically, Detroit’s problems can be connected directly to our dysfunctional monetary system. (Yeah, I know. It seems that I blame all of our problems on the Federal Reserve but I wouldn’t do that if it weren’t true.)

How does monetary policy put Detroit in bankruptcy? Well, it didn’t happen quickly that’s for sure. Our current monetary system, if you want to call it that, is one where there are no limits placed on the national economy. We can run trade deficits (really current account deficits) in perpetuity because the Fed is always there to finance them. Or at least it seems that way until at some point the world’s lenders decide they are no longer willing to buy your bonds at an interest rate you can afford. Just ask the Greeks, Spaniards and Italians what happens then. Those countries chronic trade and current account deficits are now being reversed primarily by the fact that their imports have collapsed. If they had retained their national currencies instead of adopting the Euro, their currencies would have collapsed and corrected the problem through the exchange rate. You can’t buy the same volume of imports if your currency is in the toilet. So if Detroit is in bankruptcy due to the erosion of our manufacturing base and that is a result of our running chronic trade deficits, blame the Fed. (There are plenty of other reasons Detroit and our economy as a whole are in this mess, but certainly monetary policy has played an outsized role.)

For the last several decades, the Fed has met every minor downturn in the economy with another dose of credit. That fact along with a liberalization of trade is what has kept us running an almost continuous trade deficit since the mid 1970s. In the 1970s, before much of the liberalization of trade, the Fed’s monetary nostrums showed up as consumer inflation. As trade opened up, the Fed’s inflation took the form of trade deficits and rising asset prices. The excess credit created by the Fed fueled a rise in asset prices (yes, Tim Noah, there is such a thing as asset price inflation) which funded the purchase of imports. Absent a central bank willing to inflate, countries can finance imports only to the limit of their assets and incomes. In other words, they have to produce in order to consume. The Fed and our standing as the world’s reserve currency has allowed us for decades to skip that nasty production step.

(BTW, that’s why current account imbalances were always corrected quickly under a gold standard; you could only finance imports to the limits of your gold stash. If you ran out of gold, you had nothing with which to purchase imports. In today’s system, the Fed just prints up a few more trillion and voila, you keep importing until someone starts asking what these little green pieces of paper are really worth.)

So if you want to find a scapegoat for the demise of Detroit and the creation of the Rust Belt, there is no need to blame the Chinese or the Japanese before them or the Mexicans or any other foreign country. The blame lies in our over reliance on monetary policy in lieu of better policies for the real economy. The answer to our problems is not to erect trade barriers as that would just restrict the Fed’s inflation to the domestic economy and result in high consumer inflation. The answer is to stop our reliance on credit for “growth” and that means at all levels of the economy from personal to corporate to government. It will not be a pleasant thing to get off the dope of easy credit but if we want a truly healthy economy, it is the only way.

If we want to compete in the global economy, we need to create an economic environment that is attractive to US and foreign producers. A big part of that is the rule of law. One of the reasons we have seen some American companies bring production back to the US over the last few years is for exactly that reason. China has turned a blind eye to theft of our intellectual property – or maybe more accurately been an active participant in the theft – and companies have discovered that low wages are only one part of the cost of doing business there. If we allow Detroit to stiff General Obligation bondholders in favor of union political cronies, we risk losing whatever remains of our reputation as a country that plays by the rules.

(An aside about cronies: I don’t see union cronies as any more evil than their corporate counterparts. Powerful organizations with outsized political influence are contrary to our ideals of freedom and justice for all. One of the reasons I’ve long advocated smaller government and smart regulation is because I see it as the only way to limit the influence of these organizations. If the government is less involved in the economy these organizations have less reason to pursue influence.)

To see original article CLICK HERE

Follow Us

Share Page

Login

Get access to the latest trading information, tools to help your investing, and much more!

Login   Sign Up

Search

Weekly Charts

Current Spot Prices

Gold$1297.35
Silver$20.50
Platinum$1480.50

Special Offers

 
 
© 2012 Swiss America Trading Corp. All Rights Reserved.   |   Privacy Policy   |   Site Map   |   Contact Us   |   Mobile Version
SWISS AMERICA and Logo are trademarks of Swiss America Trading Corp.
Where did you hear about us?
Roger HedgecockRay Lucia
Pat BooneMichael Savage
Bill CunninghamOther
iHeart Radio
×