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With the recession hammering local governments, a growing number are eyeing bankruptcy as an option. Municipal bankruptcy rose out of the Great Depression when the sinking economy took with it many state and local governments. Unable to pay their debts, local governments lobbied for federal legislation allowing them to file for bankruptcy. The result was Chapter 9 bankruptcy, and in the past 70 years, nearly 600 local entities have filed under Chapter 9. That may seem like a lot, but it’s far lower than the roughly 24,000 of annual business bankruptcy filings in recent years. Not every state allows this option, but currently, more than half of U.S. states do.
The highest profile current case is that of Vallejo, California. Its effort to file for Chapter 9 bankruptcy, started in 2008, set off a storm of protests from public employee unions across California. The main purpose of Chapter 9 bankruptcy is to shield local governments from their creditors that include not only those holding the jurisdiction’s municipal bonds and those with contracts for city services, but also public employees, both current and retired. Bankruptcy would allow Vallejo to renegotiate its wage and pension agreements with employees. Hence the concern of public employee unions who very much fear this will set a precedent. The unions have succeeded in getting the state legislature to introduce legislation that would allow the state to limit local government bankruptcies, including the ability of local governments to alter employee contracts when in bankruptcy. The legislation sailed through the state Assembly, but has been bogged down in the state Senate. Vallejo is not the only local government considering bankruptcy and if it, or any other fiscally broke city, succeeds, that action will not be in the best interest of residents. The odds of a local government filing for bankruptcy and then “going out of business,” so to speak, are very slim, although, Miami came very close to doing so in 1996. Generally, a city in bankruptcy continues to operate just as do many businesses in bankruptcy. Police are still on patrol, firefighters still respond, the water and sewer systems still work, but bills, particularly those for past debt, can go unpaid. A city in bankruptcy is hardly an attractive place either to residents or public employees. Those with the resources to move elsewhere do so, leaving behind the ones least able to pay the taxes needed to get the city out of its mess. A bankrupt city is also one with little attraction to businesses that could help spur future economic growth. And then there are future investors. Having taken the bankruptcy option, a city is unlikely to find buyers for future bonds it seeks to float for roads, sewer and water systems, or even city buildings and parks. In Vallejo’s case, a number of public finance experts believe that wages and pensions costs played a large role – one reason why the city is seeking to alter its employee contracts through bankruptcy filing. The economics are simple – when expenditures greatly exceed income, you’re in trouble. The solution is difficult because the underlying cause of bankruptcy is politics. Multiple groups within municipalities – not just public employee unions – place demands on politicians who opt for the easy route of keeping everyone happy by handing out gifts – higher wages and benefits, as well as new programs and services. These “gifts” are given on the hope – not guarantees – that the economy will grow and with it the revenues to cover the increased expenditures. The recession squashed this hope. The failure of many municipalities to face fiscal reality will doom local independence. Bankruptcy places power in the hands of courts and creditors. An alternative option for cities facing bankruptcy is a state- created municipal control board to manage city finances. This is what New York State did in the 1970s when it created the Emergency Financial Control Board to oversee New York City’s finances and created the Municipal Assistance Corporation to float bonds for the city. Bankruptcy or some form of control board are what more local governments are likely to face if they don’t find the political will to make a real commitment to fiscal balance. Cities have been driven to the brink of bankruptcy because citizens, public employees, and politicians have all failed to take a realistic look at what cities can and cannot afford.
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