MSc: Economic Management & Policy

Detroit, Michigan Bankruptcy: Comparisons To

Greece’s Economy and Lessons in Economic

Policy and Management

Mohammed Saeedul Alam

UNIVERSITY OF STRATHCLYDE

Economics, Sir William Duncan Building

130 Rottenrow, GLASGOW G4 0GE

April 2015

The author is grateful to Mozammel Huq and Roger Perman among others at University of Strathclyde for useful comments, suggestions and excellent research assistance. The views expressed herein are those of the author and do not necessarily reflect the views of the University.

© 2015 by Mohammed S. Alam. All rights reserved. Short sections of text not to exceed two paragraphs may be quoted without explicit permission, provided that full credit including © notice is given to the source.

Detroit, Michigan Bankruptcy: Comparisons To Greece and Lessons in Economic Policy and Management.

Mohammed S. Alam

MSc: EMP Draft Submission

June 2015

ABSTRACT

The body of literature on the individual Greek sovereign debt and Detroit financial crises, and the research on the comparative lessons between these two are relatively sparse; I feel it is therefore necessary to fill this gap. My analysis of the causative factors behind both crises will give insights into what economic management and policy lessons could be implemented over the coming years; the analysis has revealed the mechanics behind each crises to be similar. Organized default or bankruptcy has largely been considered an extreme in the body of literature which is overwhelmingly in support of continuing inflation and financial bailouts. It is nevertheless an efficient way to remove toxic assets and investments in the economy in order for renewed growth.

Mohammed S. Alam

University of Strathclyde, Sir William Duncan Building

130 Rottenrow, GLASGOW G4 0GE

saeedul.alam@googlemail.com

I. Introduction

Detroit is the most populous city in the U.S. state of Michigan and

the largest city on the United States-Canada border with around 5.2

million residents. It serves as a major port on the Detroit River which

connects the Great Lakes system to Atlantic Ocean shipping channels. The

city is a hub of U.S. manufacturing and is the centre of the American

automobile industry and has a rich musical heritage celebrated by the

city's two familiar nicknames Motor City and Motown. In the 1950s it was

the fourth largest city in the U.S. with a population of over 1.8 million and

the wealthiest city on a per capita income basis; through the 1960s it

remained the nation’s wealthiest city with the highest home ownership

rates and an unemployment rate of less than 3%. According to the latest

available figures it is now the nation's poorest major city in terms of the

proportion of residents living below the U.S. official poverty line, at

42.3%.1 In July 2013, under accumulating financial duress it officially filed

for bankruptcy under the U.S. District Court's Eastern District in Detroit,

and only exited official bankruptcy after confirmation of its ‘plan of

adjustment’ by the court appointed judge in November 2014. Greece

is a developed country with a high-income economy and population of just

over 11 million (2013 census); the economy is the 43rd largest in the

world at $242 billion by nominal GDP and 37th in nominal per capita

income at $22,000 excluding the (considerable) informal economy.2 A

2014 U.S. Department of Commerce study estimated that Detroit's urban

area had a GDP of $225 billion with per capita income at $15,000.3 The

two economies are therefore relatively close in nominal size. Greece’s

debt crisis started in late 2009, as the first of four sovereign debt crises in

the eurozone - later referred to collectively as the European debt crisis.4

The purpose of this study is to investigate the causative factors of the

financial crisis in Detroit and derive policy lessons for the Greek problem

by looking at similarities in the underlying dynamics between the two

crises; Greece has been a focus in this study because it is a particularly

serious case of debt accumulation and financial mismanagement within

the E.U..

The body of literature on the individual Greek sovereign debt and

Detroit financial crises and comparative lessons between these two are

relatively sparse but nevertheless have been useful in progressing the

aims of this thesis. Duggan et al. (2014), Twait & Haveman (2011), and

Fottrell (2014) provided a host of useful figures to help determine the key

factors behind Detroit’s bankruptcy; Walsh (2014) provided some useful

actuarial insights to this effect also. Skorup (2012) argues that a gradual

implementation of progressive economic policies have been a key factor

behind Detroit’s bankruptcy - particularly widespread unionization and

government living wage mandates which have rendered the American

auto manufacturers and other industries unable to compete with

international competitors. The premise of his arguments stem from the

classical precept that the more costly it is for employers to hire or fire

their workforce the less likely they are to hire initially. The Economist (4

February 2010) provides insights into some of the economic and political

dynamics behind the Greek crisis. Iordanoglou summarizes key

developments in Greece’s public sector; the BBC (28 April 2013) describes

proposed cuts. Transparency International (7 October 2013) and Slipjer

(2013) analyse corruption in Greece’s economy and its military

expenditures since the advent of the crisis. Bandow (2013) discusses how

austerity can indeed be ultimately successful and studies the experiences

of the Baltic States of Latvia, Estonia and Lithuania. Hoppe (1992),

Rothbard (1962, 1970) and the Mises Institute (9 January 2011) provided

classical economic theories which helped my thinking. Panizza &

Borensztein (2010) discuss the potential economic costs of default for

countries like Greece and whether they have been overstated in the

literature. Athanassopoulou explores the political and socio-economic

implications of the Greek crisis in relation to neighbouring Turkey.

The rest of the paper will proceed as follows. Since Detroit is a key

part of the analysis, I begin by describing some of its key features.

Specifically, I focus on 3 broad areas: the movement and composition of

its population; concurrent issues with its emergency services; and lastly,

structural aspects of the labour market. In section III, I attempt to

delineate the sources of Detroit’s financial crisis; In IV, the role of

derivative financial deals acting as a catalyst to Detroit’s problems is

explored. Section V explores the city’s future economic outlook by looking

at industries which are experiencing resurgence, actions Detroit’s

municipal authorities have taken to reduce expenditures – and lastly,

possible funding and financial scenarios in the near future. Section VI

sheds light on the Greek financial crisis and describes its precursors; in

VII, the role of derivative financial deals in the Greek crisis is addressed,

as well as points of concern for the economy which will continue to be

problematic for the foreseeable future – which are in tandem compared to

Detroit’s economy. Section VIII describes the possible paths Greece may

take in order to tackle its crisis by looking at the practicalities of austerity

cuts and ongoing eurozone membership. Section IX explores pre-emptive

measures that could be taken in case of Greek exit from the eurozone, in

order to ensure the stability of a newly issued drachma. In section X, I

attempt to predict the future economic outlook and political

considerations for Greece, and to conclude I address the question of what

would be the best way forward for Detroit and for Greece by consideration

of both the similarities and differences in their situations.

II. Detroit’s Problems: Key Features

From the early nineteenth century up to the Great Depression, the

population of Detroit grew at a rapid pace, attributable to the expansion of

the automobile industry in the early twentieth century. The 2013 census

estimates a population of around 689,0005 which would represent a

decline by more than 60% from its peak of over 1.8 million in the 1950

census, coupled with the emigration of around 3,000 residents per annum

just this decade alone. Between 1990 and 2013 Detroit's population fell by

more than 33%, changing its ranking from the nation's 7th largest city to

18th; this is indicative of a long-running decline in the city’s economic

base. The number of retirees now exceeds the number of employed

labour force participants by a factor of two to one; this has proved to be

an unsustainable burden for active employees. A six-year snapshot

illustrates just how rapidly the demographic and economic landscape of

the city is declining; in 2007 Detroit had a population of approximately

951,000, unemployment at 14.1% and income per capita at $15,310; by

2013 its population had deflated to 714,000, unemployment rose to

18.6% and income per capita reduced to $13,956.

The size of the police force in Detroit has been cut by about 40

percent over the past decade alone, so much so that police response

times now average 58 minutes (the national average is 11 minutes). Due

to budget cutbacks, most police stations in Detroit are now closed to the

public for 16 hours a day. Despite emergency services being the largest

component of Detroit’s budget, accounting for around 51% of total

expenses, budgets have been consistently cut; by $105.5 million in 2013

alone, from $800.2 million for the year ended June 30th 2012 mainly due

to 10% cuts in employee compensation, reductions in overtime, attrition

and in-work benefits.6 Cutbacks over time have adversely impacted

service provision to such an extent that police are now unable solve more

than 90 percent of crimes committed. The violent crime rate in Detroit is

now five times higher than the national average and its murder rate 11

times higher than New York City’s. The two Michigan municipalities of

Detroit and Flint remain the top two most violent in the U.S. with a

population of 100,000 or more, based on Federal Bureau of Investigation

data; In 2012, Detroit experienced 2,123 violent crimes per 100,000

(versus 2,729 for Flint).7

“Detroit's minimum wage is more than $2 above the federal

minimum wage; any company contracting with the city must pay its

employees $11.03 an hour if they offer benefits or $13.78 an hour if they

do not”.5 Such wage mandates create unnecessary unemployment

especially for individuals with low skills as businesses become more

selective with their recruitment. Detroit is also home to the Big Three

auto-manufacturers, which are subject to contracts with powerful labour

unions that later provided the model for public employee unions. United

Automobile Workers (UAW) successfully extracted wages and benefits

estimated at $73 per hour prior to recent reforms. “This is about $25 more

per hour than what foreign-owned U.S. auto manufacturing plants pay

their non-unionized American employees.”8 Due to this disparity, foreign

car companies had significantly less production costs per car than their

American counterparts. The outcome has been a protracted loss of

worldwide market share that has weakened the main contributors to

Detroit’s economy and prosperity.

In the 1950’s, despite the U.S. being a much smaller country

population-wise, there were 296,000 manufacturing jobs in the city of

Detroit. Today, there are less than 27,000, a reduction of more than 90%.

Between December 2000 and December 2010 alone, 48% of the

manufacturing jobs in the entire state of Michigan were lost – a major

proportion of which would be suffered by Detroit, being the state’s

industrial hub and largest city. From 2001-10, there was an

unprecedented jobs decline of 18.5% in metropolitan Detroit, and large

declines in real private sector employment earnings per capita from 2001-

10 were offset with similarly large income gains in the public sector. The

chart below demonstrates the steady decline of Detroit as leading

manufacturing hub in the U.S.; around 50% of the pre-1990

manufacturing employment base was lost by 2009 at the onset of the

worldwide financial crisis and deleveraging. A substantial U.S. federal

government bailout of the major automotive manufacturers appears to

have reversed the trend of job losses for the time-being.

Combined job losses and migration have reduced the metropolitan

area’s tax base, so much so that in July 2014 Detroit officially filed for

bankruptcy with the largest deficit amongst 7 other U.S. municipal

bankruptcies since the recession began in 2008. Detroit’s insolvency is

however more significant than the others because of its relatively greater

economic and industrial importance; it is thus far the largest municipal

bankruptcy in the history of the nation. The city is currently indebted to

more than 100,000 creditors and has around $20 billion in debt and

unfunded liabilities e.g. pension funds, which translates into

approximately $25,000 of debt per capita including children and retirees.

With the latest estimate of the participating labour force at around

346,000, this would amount to approximately $58,000 of debt per

participant – which rises to $70,000 for those who are actually employed

(approximately 285,000).

III. Sources of Detroit’s Crisis

One of the reasons for Detroit’s bankruptcy stems from a revenue /

cash-flow shortfall. The economy has been in progressive decline for

several decades, with long-term net emigration taking a toll on the city’s

revenue base as both property and income tax revenues dropped.

Detroit’s municipal income is based primarily on taxes on property and

economic activity, charging for the provision of goods and services,

borrowing, and receiving funds from the Michigan state and U.S. federal

governments. Under Chapter 9 of the United States Bankruptcy Code, a

municipality is eligible to file for bankruptcy when it is unable to pay its

debts as they come due.9 For example, at the time of the bankruptcy

filing, Detroit’s revenue deficit was projected at around $198 million for

fiscal year 2014. To avoid bankruptcy in the near term the city would have

to meet this immediate annual shortfall – not necessarily its total

outstanding long-term debt. Other than a federally funded bailout

however, it remains unclear how this can be achieved without deep

austerity cuts as Detroit’s residents are already some of the most heavily

taxed in the U.S.. For example, on top of Michigan’s flat-rate state income

tax of 4.25%, several Michigan cities levy additional income tax on

residents and non-residents alike with rates ranging from 0.50% to 2.50%.

Detroit’s added income tax rate is a flat 2.50% for residents and 1.25% for

non-residents. The state of Michigan also has one the highest property tax

rates in the nation. As a percentage of home value, Michigan has the 8th

highest property tax rate in the nation at 1.62% - just marginally below

New Jersey’s which is the highest at 1.89%. In keeping with this, Detroit

consistently ranks highest amongst the most heavily populated US cities

for its property tax rates, at around 3.6%.10 It is also the only city in

Michigan that levies an additional excise tax on its utility users at a rate of

5%. Residential home foreclosures and delinquent property taxes have

now become a serious financial concern; at present there are

approximately 78,000 abandoned homes in the city, in certain areas some

that are on the market for $500 or less and about 30% of Detroit's

approximately 140 square miles now either vacant and/or derelict. It also

has one of the highest tax burdens among the 51 largest cities in the U.S.

for high income earners, according to the Office of Revenue Analysis; the

city ranked 9th for a family of three earning $100,000 a year ($12,991)

and 18th for a family earning $25,000 a year ($3,421).11 The municipal

government is at present very reliant on tax revenues from casinos in the

city which account for approximately $11.0 million dollars a month; there

are also 70 "Superfund" hazardous waste sites in Detroit that bring in

external revenue.6 In addition, the City is dealing with sustained high

unemployment (at 14.9% in September 2014 compared to the Michigan

State average of 7.2%), which hinders income tax revenue; it currently

has the highest unemployment rate of the 50 largest cities in the United

States. Imposing such relatively high taxes has led to tax avoidance by

high income earners and capital flight, and as the economic base of the

city has shrunk the municipal authority’s main sources of revenue have

been reduced and finances compromised.

Another concern is that Detroit’s government is relatively larger and

more bureaucratic than most other municipal governments in the U.S..

The ratio of residents to public sector employees – a key measure of

municipal authority productivity, is around 60:1 in Detroit, one of the

lowest in the U.S.. The greater the number of public sector employees

relative to the overall population of a city, the less capital is available in

the private sector to create jobs.

IV. Financial Deals

In recent times Detroit’s municipal government has entered into

complex financial deals that have proved to be costly for the city. The

city’s pension funds had begun underperforming in the early 2000s as

they were heavily invested in the dot-com speculative bubble of 1997–

2000, the deflation of which set the U.S. economy into recession. As a

result, the municipal authority’s requisite annual contributions to the fund

began to increase to such an extent that in 2001 the fund experienced its

first deficit in nearly six years which grew to about $95 million by 2004.

The incumbent mayor then met with financial and legal advisers in 2005

to try to engineer a solution. They devised a borrowing scheme in which

the city issued Certificates of Participation (COPs) – municipal finance

instruments similar to bonds but with fewer legal restrictions, which would

allow the city to avoid its constitutional borrowing limit and the need for

voter approval. The COPs were issued to provide funds for major capital

projects and equipment acquisitions and were backed by the full faith and

taxation power of the City. Banks including UBS, Merrill Lynch and

JPMorgan Chase & Co. also underwrote approximately $1.5 billion of COPs

to cover Detroit’s deficits, pension shortfalls and debt repayments;

liabilities thus rose to almost $15 billion including pension obligations. By

issuing COPs the city intended to reduce the deficit through converting

would be annual payments into the pension fund into one large payment,

making them appear fully funded. In retrospect however, COPs allowed

the city to only exchange one form of debt for another.

The debt issuance cost Detroit approximately $474 million including

underwriting expenses, bond insurance premiums and fees for interest-

rate swap derivatives meant to lower borrowing costs on variable-rate

debt. To illustrate its relative significance, it almost equals the City’s

entire 2013 budget for police and fire protection services.6 The largest

part of the issuance cost is $350 million owed for the swap derivatives in

which the city exchanged with investment banks UBS and Merrill Lynch

payments tied to interest rate indices. The banks would pay a variable

interest rate on the certificates while the city would pay a fixed rate. The

interest paid by the banks would therefore fluctuate based on the

movements of an average estimated rate of interest (specifically Libor,

which was later discovered in 2012 to have been artificially manipulated).

The city was essentially speculating; if the variable rates the banks were

paying were higher than the fixed rate, the city would gain (and lose

otherwise). In retrospect such derivative instruments have proven to be

ineffective and costly due to the subsequent behaviour of interest rates,

and U.S. municipal borrowers ranging from the Metropolitan Water District

of Southern California to Harvard University in Cambridge, Massachusetts

have paid substantial termination fees to banks to end interest-rate swaps

that did not protect them adequately. The original swap deals have cost

Detroit’s municipal government nearly $50 million a year, about 5 percent

of its annual budget.

In 2008 a process of global financial de-leveraging began. As part of

its Quantitative Easing program the Federal Reserve leveraged interest

rates down to historic new lows while the interest rate Detroit paid on its

COPs remained fixed; Detroit was now paying out more to the banks than

it received from them, aggravating its cashflow problem. In early 2009

Standard and Poor’s downgraded Detroit’s credit rating on about $2.4

billion of its tax-funded debt (general obligation bonds) from "BBB" and

"BBB-minus to "BB", which is only two grades above junk status and

induced greater limitations on access to capital and higher borrowing

costs. In response, UBS and Bank of America (which acquired Merrill Lynch

in 2008) terminated Detroit’s COP scheme and demanded immediate

payment of the outstanding balance of $300–400 million. The City pledged

its casino tax revenue as collateral to avoid the lump-sum payment until it

went into administration under Michigan’s state government in early

2013. It was then declared insolvent on June 30, 2013 at which point its

liabilities exceeded assets by $678.2 million and cash and investments on

hand totalling $102.2 million were insufficient to meet obligations due.

The City had also defaulted on $105.6 million of pension contributions due

on its General Retirement and Police and Fire Retirement schemes.6 The

state of Michigan is overseeing the City’s finances through an emergency

manager law which allows the Governor to declare a municipality to be in

financial crisis and remove local control of its finances from elected

officials to technocrats. This has similarities to the European problem as

both Italy's and Greece's governments underwent similar changes.

In July 2013 the City commenced a bankruptcy case under chapter 9

of the U.S. Bankruptcy Code. In his Authorization Letter, the Governor

agreed with Detroit’s emergency manager that bankruptcy offered the

only feasible way to address the City's finances and to complete a

sustainable restructuring for the benefit of the city’s approximately

700,000 remaining residents.9 The City has however, consistently failed to

maintain accurate accounts of its revenue and expenditures as required

by the federally administered US Office of Management and Budgets

which is in turn slowing down its bankruptcy adjudication process.

Detroit’s eighth amended bankruptcy plan of adjustment was

submitted to the Bankruptcy Court for consideration in December 2014.

Like its predecessors, it is being challenged by Detroit’s creditors and

further modifications may be enacted as a result of concerns raised. The

plan provides a framework to restructure the City’s long-term debt

obligations and investment initiatives in order to exit bankruptcy as

seamlessly as possible and return to fiscal stability. Under the plan,

Detroit’s unsecured creditors should expect to recover approximately

10%-13% of their capital which represents a substantial loss but is

nevertheless better than outright default. The plan also proposes the City

invest approximately $1.4 billion over 10 years in infrastructure and

capital to improve services at all levels; it therefore does not call for

austerity to be implemented in its purest form.12 Pensions obligations and

bond payments make up the majority of Detroit’s debt. The adjustment

plan makes a provision that the city will not seek to terminate any of its

pension schemes but that they will be closed to new participants, and it

will continue to fund adjusted (reduced) pension benefits to its current

and future retirees.

Detroit’s bankruptcy is both an expenditure and cash flow problem

caused by termination fees on interest-rate swap instruments as well as

steady economic decline resulting from an over-taxed shrinking middle

class. The interest-rate swaps were inappropriate for already revenue-

depleted Detroit which had been on the verge of a credit rating

downgrade below investment grade for some time and this ultimately

triggered the termination fee clauses in the swaps. The likelihood of

terminations were ex-ante known to be high and the financial institutions

involved behaved unethically in allowing these deals to go through – being

in a far better position than the municipal authorities to assess the initial

risk; they may have therefore their breached legal obligations to the city,

which is actively pursuing legal avenues through the bankruptcy court to

invalidate the swaps entirely and eliminate or reduce the associated

termination fees.

V. Future Outlook

Although the city’s current economic condition is poor, provided the debt

restructuring process is conducted efficiently the outlook for future

recovery and improvement will be positive. On December 10, 2014, the

city officially exited bankruptcy after its financial ‘plan of adjustment’ was

endorsed by the bankruptcy court judge.13 Businesses have begun

relocating employees from satellite suburbs back to Detroit due to a

lowering of taxes, and with U.S. federal government help automobile sales

have reached pre-2008 levels. Other favourable factors are that the Great

Lakes system surrounding Michigan contains 20% of all the world's fresh

water supplies, there are three top-tier universities within 90 minutes of

Detroit, and with the city being the hub of the American automobile

industry Michigan has the highest concentration of engineers in the U.S..

The above chart shows that overall industrial activity in Detroit has picked

up since 2008 to nominally supersede pre-recession levels. It would be

interesting to note however what variants of industrial and commercial

activity are resurging; the latest figures suggest farming, real estate,

manufacturing and educational services have experienced growth while

the public sector, construction, arts, entertainment and recreation sectors

have declined.

The growth in agriculture is mainly due to large swathes of

suburban Detroit falling into disrepair and being converted; increasing

home values in real estate are encouraging but likely originates from

inflows of speculative capital, which is volatile by nature. This particular

sector nevertheless remains highly dysfunctional; around 78,000

abandoned homes in the city are in disrepair as a result of long term

middle-class emigration, construction of new-builds is virtually non-

existent and property tax rates remain one of the highest among all U.S.

cities.10 Manufacturing jobs have started to return because an ongoing

series of financial bailouts from the U.S. federal government have helped

to maintain solvency of the automobile manufacturers which are the

pillars of the Detroit economy; interestingly, their collective outstanding

debt were in actuality larger than that of the City’s. Official estimates

however show that Detroit is still burdened with chronic unemployment,

even when discounting that official figures do not include those who have

voluntarily withdrawn from the labour force indefinitely due to

discouragement from having been unemployed long term. To illustrate of

the magnitude of the crisis, the number of employed Detroit residents fell

by 53% from 2000 through 2012 and half of that decline occurred in a

single year – 2008, as the recession took hold.

Detroit’s municipal authorities have implemented austerity

measures to reduce the deficit, such that between 2008-2013 operating

expenses were cut by around $419 million (38%), aided in part by the

redundancies of around 2,350 employees, cutting of the wage bill by

approximately 30%, attrition (the gradual reduction of a workforce by not

replacing personnel lost through retirement or resignation) and the

reduction of future healthcare and benefit accruals.6 Measures have been

implemented to boost revenue streams such as more rigorous tax

collection efforts and reductions in welfare benefits, and the city has

privatized its waste disposal and recycling services by outsourcing with

two private companies. Associated with the austerity process however is

uncertainty, and its long term effects on the population remain to be seen.

Detroit’s emergency manager has focused on cutting pension

benefits and reducing the city’s long-term liabilities through the

administration process. However the easiest way to restructure the City’s

debts may be to declare full bankruptcy, liquidate most if not all debts and

start anew. It would then have to rely mostly on realized revenue as

opposed to credit to fund its operations and services that have not yet

been privatized by that stage, ensuring more effectively that the

municipal authorities learn to spend within their means; Greece is

undergoing a similar consideration with domestic support accumulating

for a full exit from the euro back to a new drachma. Another possible

outcome is that the U.S. federal government will continue to defer a full

Detroit bankruptcy due its status as a major urban and industrial centre

and intervene with more bailouts as well as federally backed guarantees

on the city’s future borrowing – which would allow it to borrow freely

again, this time backed by the full faith of the U.S. Federal Reserve. Aside

from the moral hazard implications on both Detroit and other U.S.

municipalities currently in and about to undergo similar economic crises,

this would also impair the ability of other cities nationwide to issue their

bonds as they would see interest rates on their borrowing rise; their bonds

would have to compete with Detroit’s federally backed bonds which would

be deemed as less risky. There would then be pressure on the federal

government to further intervene to address these distortions in the

municipal bond market that would result from such a guarantee.

It is clear that the majority of the interest-rate swap termination

fees should be sought to be abandoned to the greatest extent as these

constitute the largest proportion of the City’s debt burden. The banking

counterparties would then be made to bear the full market consequences

of the credit risk they inappropriately assumed for underwriting such

derivatives; they are nevertheless substantially in the money as a result

of the synthetically low interest rates that have resulted from the

recession and Federal Reserve Quantitative Easing. It is conceivable that

the State of Michigan or the U.S. Federal Reserve may step in and

guarantee the swaps to postpone Detroit’s payment of the termination

fees, which one would expect would become smaller as interest rates rose

over time which they are predicted to do. If Detroit deals effectively with

this immediate crisis, the city’s elected officials – working collaboratively

with the State legislature and governor, can then turn their attention to

structural programs and tax reforms in order to help the city return to

prosperity again.

VI. The Greek Problem: Key Features

Greece became the 10th member of the European Community

(subsequently incorporated as the European Union) on 1st January 1981

leading to increased investment in industry and infrastructure and a

period of sustained growth in tourism and the service sector which raised

the country's standards of living to unprecedented levels. The country

joined the euro zone in 2001 by replacing its drachma currency with the

euro.14 The economy has deteriorated since the 2008 worldwide financial

crisis and has been a focal point of European sovereign debt problems; its

economic problems and subsequent civil unrest have reshaped its

domestic politics and heightened volatility in global financial markets.

Greece was accepted into the euro zone based on favourable outcomes

on a number of criteria e.g. inflation, budget deficits, public debt, long-

term interest rates, exchange rate etc.). An audit commissioned by the

incoming New Democracy government in 2004 revealed however, that the

budget deficit had been under-reported; like Detroit, Greece was found to

have misrepresented its public sector financial accounts especially on

borrowing.

Adoption of the euro allowed Greece’s government to begin

accumulating (now easily obtainable) debt that eventually surpassed its

GDP. Sovereign debt are bonds issued by national governments to obtain

funds from other nations and are denominated in the lenders’ currencies;

it is used when the issuing country’s domestic currency is weak and

volatile and finances economic growth. The problem with this type of debt

is an elevated risk of default which can occur simply from an unfavourable

shift in exchange rates in which the lender’s currency gains value, or

overly optimistic valuations of project yields. The only available recourse

for lender countries would then be to renegotiate loan terms as they have

no recourse to seize assets of the issuing government. Greece’s issuance

of sovereign debt was therefore a (losing) gamble on the strength of the

euro and has parallels to Detroit’s interest-rate swap agreements which

represented a similar wager but on elevated U.S. interest rates. The debt-

to-GDP ratio stands at about 177%, the highest in the E.U. and third in the

world behind only Japan and Zimbabwe.15 Euro entry meant that bond

markets no longer had to worry about high inflation or drachma

devaluation, and lower interest rates allowed the Greek government to

refinance on more favourable terms; the ratio of net interest costs to GDP

fell by 6.5 percentage points in the decade after 1995. The under-pricing

of default risk during the credit boom gave Greece relatively easy access

to longer-term borrowing, allowing the economy to grow by an average of

4% a year until 2008.16 From the period 1982 to 2009, it borrowed a total

of approximately $300 billion – equal to its entire 2011 GDP and $27,000

of debt per capita. This was supplemented with an additional $300 billion

of net transfers (subsidies) to Greece from the E.U.; it therefore accrued

the entirety of its GDP in E.U. subsidies on top of its borrowing and one of

the highest debt to GDP ratios in the world.17

VII. Financial Deals & Critical Areas of Concern

Greece became counter-party to off-balance-sheet derivative deals

with U.S. bank Goldman Sachs in the form of currency swaps in order to

artificially understate its budget deficits. Dozens of similar agreements

were concluded within the PIIGS group of countries whereby banks

provided capital in advance to governments in exchange for future

payments; liabilities could be kept off the balance-sheet and not get

registered as debt. These swaps enabled these countries to nominally

achieve E.U. deficit targets while in actuality spend beyond those limits.

This bears similarities to Detroit’s issuance in conjunction with U.S. banks

Merrill Lynch and J.P. Morgan Chase & Co. of off-balance-sheet certificates

of participation (C.O.Ps) allowing the city to borrow beyond its statutory

debt limit. Greece’s currency swap with Goldman Sachs allowed it to

borrow an extra $1 billion worth of debt.18

The chart below depicts long-term interest rates of government

bonds with maturities of close to ten years of all euro zone countries

except Estonia; a yield more than 4% higher than the lowest comparable

yield among the E.U. states (German bunds) indicates that financial

markets have serious doubts about the credit-worthiness of the state.

At the time of writing, the yield on ten-year Greek government bonds

stands at over 9.6%, about 9.2 percentage points more than that on

German bunds, the eurozone’s safest investment. As mentioned above,

such a high yield is considered an unsustainable long-term borrowing rate

for a government.

Source: www.investing.com

What we can see in the above charts is that by the end of 2009 the

Greek economy was facing its most severe crisis since the restoration of

democracy in 1974; the government revised its deficit from an estimated

6% to 15.7% of GDP.19,20 Potential lenders and bond purchasers began to

suspect that the Greece was overburdened with debt and might fail to

meet its obligations, and therefore demanded higher interest rates in

compensation; rates rose steeply and precipitated a sovereign debt crisis.

To avert a default the European Central Bank (ECB), in conjunction with

the IMF agreed a series of bailout packages. In order to secure the funding

however, Greece has been required to implement fiscal austerity

measures – which involve a combination of tax hikes and spending cuts,

to stabilize its deficit.

6 years of recession have shrunk Greece’s nominal GDP by almost

21% since 2008. The country has since been the most exposed and

troubled member amongst the other EU states with similar problems –

Portugal, Ireland Italy and Spain. By 2010 it was decided that all five of

the PIIGS states would receive E.U. funded bailouts as allowing them to

default on their sovereign debt would impede their ability to obtain loans

in the future; a £22 billion package was agreed for Greece in April 2010

which would be the first of a series contingent upon austerity cuts. Detroit

has similarly received a series of U.S. federal bailouts based on similar

conditions. Since July 2010 Greece's parliament has enacted austerity

reforms such as pension and welfare cuts, restrictions on early retirement,

raising of the national retirement age, and widespread public-sector

redundancies. In late 2011 E.U. finance ministers negotiated with private

sector creditors a write-down of Greek bonds by 50% which reduced the

nation's debt-to-GDP ratio from 150% to 120%; this has similarities to

Detroit’s bankruptcy court adjudications.

Like Detroit, the country has suffered from long-term low economic

growth, high unemployment and a bloated public sector comprising about

50% of the economy. The latter has been for the both the limiting factor

on economic recovery as public sectors are usually characterised by

institutional inertia and uncompromising collective bargaining. Greece’s

public sector was relatively modest in size until the end of the military

dictatorship in 1974 when recruitment into the sector began to accelerate

up until 1990; “Between 1974-80 Greece transitioned from a regime of

fiscal discipline to a decade of fiscal expansion and a tendency to relapse

to it. From 1952 to 1980, Greece had a small public deficit and debt. The

end of military rule in 1974 and return to democracy began to change the

balance of socio-political forces in the country such that the early eighties

PASOK-led governments began to enlist the support of entire social

groups through fiscal liberality. The big primary deficits of the eighties

started the public debt accumulation that has come to the fore in

Greece;”21 that 1974-1990 period saw the public sector double in size but

still remain lower as a proportion of the economy than corresponding

OECD or EU averages. “In the nineties efforts were made to reduce the

primary deficit but following Greece’s entry into the euro zone fiscal

discipline was again relaxed, and political incentives were to increase

public spending and not to restrain it.”21 The public sector again grew

substantially between 2000-2008, eventually surpassing 1 million

employees, constituting more than 20% of total employment and

exceeding the EU average. This coincided with effective union lobbying

which ensured relatively generous employee compensation and

comprised 25-30% of the entire government budget; at its peak the

number of Greek civil servants per capita was one of the highest in the

world - their salaries and pensions representing approximately 80% of the

national budget; this parallels Detroit’s situation. Greece’s public sector in

recent years has had to implement significant budget cuts which has

affected all areas including directorates, their associated agencies, public

bodies and local authorities. While there has been a lack of public appetite

towards mass layoffs, they are nevertheless pre-conditions on IMF and

E.U. bailout packages and after many years of growth the public sector

workforce is targeted to fall by about 150,000 by the end of 2015.22

There have been attempts at implementing structural reforms in

labour markets, particularly de-unionization. As in Detroit, such attempts

have not been particularly successful in Greece. The country also has one

of the most generous (and expensive) state pension systems amongst the

34 O.E.C.D. countries in which workers can expect 96% of their pre-

retirement earnings.16 As in Detroit, pension reforms will be needed and

will likely consist of raising of the retirement age; long term sustainability

of both pension systems however will depend on successful job creation.

Overall unemployment in Greece currently stands at about 26% and about

51% for youth. Those who have been unemployed for some time often

face multiple barriers to employment, and low business start-up rates and

R&D expenditures are now key challenges against economic recovery and

contributing factors to unemployment. The country has been suffering

from a steady law and order breakdown with regular anti-austerity strikes

and demonstrations in the major cities, a surge in far-right politics and a

marked rise in drugs and alcohol related abuse. It still has however, one of

the lowest overall crime rates in the E.U..

The property market in Greece – as in Detroit, is facing significant

challenges. The recession has created a significant excess supply of

approximately 300,000 empty homes partly attributable (as in Detroit) to

multiple increases in property taxes as part of the austerity program and

with now over a third of Greek households unable to meet such tax

obligations. Other factors are rises in interest rates, increased constraints

on lending and widespread unemployment rendering many properties

liable to be confiscated by creditors due to mortgage defaults. As a result,

property values in Greece have declined by around 36% since 2007, the

second biggest property crash in the EU since the debt crisis began.23 This

is happening in the backdrop of home ownership rates in Greece – at

nearly 87% being the highest in the EU historically; Detroit in the 1950’s

and 60’s also had the highest home ownership rates in the whole of the

U.S.. Home ownership rates are a key economic indicator of health of the

middle class; when any country or city observes a steady declining trend

in this indicator (or proportional rises in rental properties), it signals a

widening wealth gap due to inflation and future economic unrest if left

unmanaged. “Persons belonging to the middle class find that inflation in

consumer goods and the housing market prevent them from maintaining

a middle-class lifestyle, making downward mobility a threat to counteract

aspirations of upward mobility… home-ownership is often seen as an

arrival to the middle class, but recent trends are making it more difficult

to continue to own a home or purchase a home. Housing prices fell

dramatically following their 2006 bubble peak and remain well below this

level. Many middle-class homeowners were particularly hard-hit by the

crisis, as their homes were highly leveraged (e.g., purchased with a low

down payment). The use of leverage magnifies gains (or losses in this

case). They owe the full balance of the mortgage yet the value of the

home has declined, reducing their net worth significantly.”24 Deflation, for

the time being however, has become prevalent in the country and is a

concern for mainstream economists, but is nevertheless beneficial for

consumers as they are seeing prices for basic household necessities such

as energy and water reduce and become more affordable.

Historic CPI inflation Greece (yearly basis) – full term

Source: http://www.inflation.eu

Greece has some major economic challenges that urgently need

addressing: It is working to reduce budget deficits caused by inefficiencies

in the public sector – estimated at 12.7% in 2013, and has been relatively

successful, expecting to be in surplus for 2015 which should coincide with

tax cuts. Detroit is also in a similar position, expecting a budget surplus of

about $100 million in the 2015 fiscal year. Greece’s debt-to-GDP ratio still

stands at around 175% so the underlying issue of solvency remains, not

helped by compounding interest and continued overspending and

corruption in procurement processes. The sources of Greece’s problems –

like Detroit, are in excessive government funding of inappropriate projects

of questionable value, as well as corruption. Successive Greek

governments have as a policy purchased at artificially high prices 50-

100% above market determined rates; this is a form of subsidy towards

the State’s suppliers and contractors, and corruption scandals particularly

in defence and health procurement have been common.25 “High levels of

military spending in countries now at the epicentre of the euro crisis

played a significant role in causing their debt crises; Greece has been

Europe’s biggest spender in relative terms for most of the past four

decades, spending almost twice as much of its Gross Domestic Product

(GDP) on defence as the EU average.”26 Despite deep austerity cuts in the

public sphere, Greece nevertheless remains one of the highest military

spenders proportional to GDP in the E.U. and remains “…one of the few

E.U. members devoting more than 2% of its GDP to the armed forces.”26

The Greek government also has a revenue problem running parallel

to its over-spending; its inefficient and corrupt tax collection system runs

on a “4-4-2” basis in which the taxman is willing to write off 40% of a tax

liability in exchange for receipt of an equal proportion as a graft payment

– the State collecting only 20% of the levy. The less tax revenue the

government collects the slower it will clear its debt obligations; it is

therefore working to curb tax evasion. However, a tax collection system

run on this basis is also be inadvertently beneficial for the economy as it

minimizes distortions and allows more disposable income in the private

sector for investment; the tax burden on the economy needs to be as light

and non-intrusive as possible so that job creation can be accelerated. A

lack of competitiveness caused by union lobbying has raised wages and

salaries without similar increases in productivity; it should be offset with

reductions in the cost of living, and reduced taxes on both individuals and

corporations are an effective way to achieve that. Greece faces a dilemma

however, between austerity reforms which comprise of increased taxation

and spending cuts in order to qualify for E.U. bailouts necessary for it to

be able to service its debts (which are still significant despite partially

writing off privately-held bonds) – or to completely repudiate all of its debt

obligations and end the austerity programme.

VIII. Possible Future Scenarios

The way forward presents three possibilities for Greece. The least

likely to occur is for the country, with the euro still in place, to flatly reject

fiscal austerity and structural reforms and make no adjustments until

eventual bankruptcy. This is unlikely to occur due to the transfer of some

aspects of their sovereignty – particularly monetary, which occurred when

countries such as Greece joined the E.U. and adopted the euro. The

monetary authority of the euro is the European Central Bank (ECB) and it

would never allow Greece to choose the above path as it would pose a

serious threat to an already fragile euro.

Another scenario is that Greece will continue to implement austerity

measures in order to slowly pay off its debt and stay in the euro zone,

which will probably lead to a prolonged economic depression. However,

forecasts are becoming positive for Greece’s recovery under austerity and

its international creditors – the European Commission, the ECB and the

IMF, expect the economy to register 1.0% growth in 2014 before picking

up to expand 2.5% in 2015 and 3.6% in 2016.27 There are also examples

of where fiscal austerity has been successful. The three former Soviet

republics of Estonia, Latvia and Lithuania implemented sharp cuts in

government expenditure but without corresponding tax rises; the majority

of their fiscal adjustments therefore focused on expenditure cuts – which

differs from the Greek approach. Austerity initially led to significant

contractions in GDP in all three Baltic states but their growth recovered

relatively quickly within around 5 years before eventually joining the euro.

Corporate profits also improved along with labour productivity. Nominal

wage cuts restored competitiveness, reduced unemployment and

stabilized wages. Although endemic corruption is an ongoing issue,

austerity appears to have been very successful in reducing public deficits

and debt-to-GDP ratios in these countries; in 2013 the Estonian general

government deficit was 0.2% and its debt-to-GDP ratio was about 10%,

while Latvia recorded 1% and 38.1%, and Lithuania 2.2% and 39.4%

respectively as reported by Eurostat.28

Greece eventually achieved a primary budget surplus in 2013; the

primary budget balance being the government’s budget balance before

interest payments. In April 2014 it returned to the global bond markets,

successfully issuing €3 billion worth of five-year government bonds at a

yield of 4.95%.29 It also returned to growth in the same period after six

years of recession and was the eurozone’s fastest growing economy in the

third quarter. A key difference in Greece’s austerity program has been

that tax rises have been a correspondingly more significant component,

unlike the mainly expenditure-focused cuts of the Baltic states. Therefore,

for Greece’s austerity to achieve the desired result and for it to remain

with the euro the solution will be three pronged; it must renegotiate terms

of repayment with its creditors, increase the intensity of public sector

spending cuts and aggressively bring the tax burden on the economy

down so that private sector job creation can recover.

The third possible scenario for Greece would be a widescale

repudiation of lenders’ terms (which is similar to Detroit’s bankruptcy

adjudications), declared default, exit from the euro and reinstatement of

the drachma at a debased rate. A sovereign default is the failure or

refusal of a state to abide by the terms of its issued debt and comes with

a formal declaration of full repudiation or only partial repayments. 30 This

was rejected by voters in the early years of austerity reforms but the

political landscape has reverted to such an extent that a Greek euro exit

appears a distinct possibility and one that that might help ensure the

survival of the euro whilst allowing the country the flexibility to fix its

problems under its own terms. Default would all but end Greece’s ability

to issue further (external) debt but would nevertheless also ensure that

the government spent within its means for the foreseeable future, and

provide an opportunity to reallocate and restructure the economy without

austerity distortions. The country would revert back to the drachma the

strength of which would be determined by Greece’s monetary issuing

authority, the Bank of Greece. After a euro exit, the Greek government

could then be able to mitigate the real burden of its non-repudiated debt

through a debased drachma; the debt would still be honoured albeit with

currency of progressively lesser value. Granting full monetary authority

back to the Bank of Greece however, will pose too great a risk of future

inflationary policies with a view to stimulating growth. Inflation as

mentioned before has been observed to gradually widen the wealth gap in

societies and halt or reverse upward social mobility as wages fail to keep

up with price rises. The answer which appears to provide for a steady and

sustainable recovery as opposed to the current trend of boom and bust

cycles, lies in pegging the new drachma to commodities or currencies of

historically stable or rising values such as precious metals or the Chinese

yuan respectively.

If Greece had not joined the euro and retained the drachma, its debt

and expenditure problems would likely have been exposed and addressed

much sooner. Euro adoption allowed it to continue borrowing easily and

thus defer and significantly inflate its debt burden. Under a re-instated

drachma it would be very difficult for the Greek government to issue new

debt except at very high rates, or deficit spend until the economy adjusts,

reallocates and returns to consistent growth; this borrowing and spending

restriction would not be politically palatable but will likely prove to be

beneficial in the long term.

The new highly debased drachma will also have an immediate and

sharp negative impact on the economy; high levels of inflation will be

imported from abroad, alongside high unemployment and a reduction in

the size of the bureaucracy and government programs. Demand for euros

will rise sharply relative to the debased drachma such that it would likely

cause domestic bank runs for the former; a banking crisis may also ensue

as the banks would have to make write downs on debt owed to them by

the State. Some of the Greek governments overseas assets may also be

seized by foreign creditors. Nevertheless, the re-acquired monetary

sovereignty will allow the Greek state the flexibility to enact measures in

order to address these issues and redirect the economy towards growth.

IX. Pre-emptive Measures in Case of Greek Exit

The monetary sovereignty should, however, come with

countervailing checks and balances within the constitution to ensure the

stability of the newly issued drachma. A gold (or precious metals) bullion

based drachma would be a significant step towards this. It would not

require gold bullion to circulate as such, but the Bank of Greece would be

obliged to redeem it on demand. Until the advent of fiat currencies, gold

(alongside silver) had been a preferred form of money due to its qualities

of value retention, durability and divisibility. It is due to its rarity that gold

and other precious metals retain their value independent of the monetary

authority or any political and ideological agenda. Since the 1950s, annual

gold output growth has closely followed world population growth,

preserving its relevance as a stable store of wealth. Gold has consistently

demonstrated historical stability with regard to its purchasing power

because of these unique stock/flow characteristics, and if a fiat currency

like a re-instated drachma were suddenly as comparably constant in

value, prices would fall to stable, predictable levels. The latter would be a

key asset for not only a Greek economic recovery but the maintenance of

a stable or even declining wealth gap. A new drachma with a 100% gold

standard will obligate the Bank of Greece to hold sufficient reserves to be

able to convert all the circulating currency at a predetermined rate. It

should be easy to implement: a simple declaration by the Greek

government that bullion gold will (on a specified date) be considered

actual money and drachma notes the representative legal tender. Once

this standard is established, any stock of money becomes compatible with

any amount of employment and real income, "an extra-market institution

can in principle create any desired amount of involuntary

unemployment…. However, once a commodity has been established as a

universal medium of exchange and the prices of all directly serviceable

exchange goods are expressed in terms of units of this money (while the

price of the money unit is its power to purchase an array of non-money

goods), money no longer exercises any systematic influence on the

division of labour, employment, and produced income. There is never any

need for more money since any amount will perform the same maximum

extent of needed money work: that is, to provide a general medium of

exchange and a means of economic calculation by entrepreneurs.”31

Prices would adjust and stabilize relative to the Bank of Greece’s reserves

of gold bullion because "goods are useful and scarce, and any increment

in goods is a social benefit, but money is useful not directly, but only in

exchanges. When there is less money, the exchange-value of the

monetary unit rises; when there is more money, the exchange-value of

the monetary unit falls. We conclude that there is no such thing as 'too

little' or 'too much' money, that, whatever the social money stock, the

benefits of money are always utilized to the maximum extent."32 Long-

term price stability – with minor and temporary fluctuations, could

therefore be expected of a drachma gold standard. Stability relies on

credibility, therefore constitutional reforms that would obligate the Bank

of Greece to undergo regular audits of its actual physical gold reserves by

both domestic and international firms would be required.

In order to moderate economic disruption from the adjustment

process, consolidate credibility and minimize the probability for future

systemic bank runs as was experienced during earlier (weaker) attempts

to maintain gold standards, competition in the issuance of credible gold-

standard legal tender should be permitted and deregulated into the Greek

economy. Private entities such as banking institutions and pension funds

with their own gold reserves should be given the freedom to issue their

own unique certificates so that the supply of legal tender (including official

drachma) in the Greek economy most accurately reflects total gold

reserves and is not dependent solely on the Bank of Greece.

An official drachma gold standard running parallel to deregulated

private certificates of deposit markets would act as a check on Greek

governments tempted to deficit spend or use inflationary monetary

policies. Significant inflation would be rare because the money supply

would only be able to grow at the rate of the gold supply. High inflation

under a gold standard would only be seen when the supply of goods in the

economy is reduced substantially e.g. in war-time, or when a major new

gold source emerges.33 Negotiations are ongoing to potentially open up

surveyed Greek gold reserves to international mining companies which

would see the country becoming a major world producer of the metal. If a

reasonable proportion of the extracted gold could then be retained rather

than be expatriated, this would increase the value of a gold-based

drachma and further stimulate economic activity.

X. Future Outlook

It is unlikely that Greece will default on the entirety of its debt but

choose instead to continue negotiations with its creditors in order to defer

or partially reduce its obligations. It may be thought that restructuring will

have large costs for its creditors, but the evidence to support this is

scarce.34 Very often, international negotiations in which orderly debt

restructuring is agreed upon assure at least partial repayment when

repudiation of a large portion of the debt is accepted by creditors. For

example, in the Argentine financial crisis of 1998 – 2002, creditors had to

accept losses of up to 75% on outstanding debts; similar results can be

expected in a Greek controlled default arrangement, due to the severity of

its debt burden.30 The key to the realisation and success of the Greek

recovery back to economic growth in as rapid a time as possible will be

determined by the economic policies implemented by succeeding

governments. If such policies comprise a continuation along the lines of a

large bureaucracy, high taxes and regulations on businesses, unionized

labour and a freely inflatable currency by the Bank of Greece, then the

process will likely be drawn out, hyper-inflationary and painful and may

even not be realised. If however, quick and sharp cold turkey policies are

adopted which dramatically reduce the size of the State and its associated

responsibilities to simple law and order and infrastructure provision, along

with a simplification of the tax system from income, savings and profit-

based levies as they are at present to a less intrusive and distortionary

consumption-only based system (with exclusions for primary essential

goods such as most foods, housing, education and primary cars), the

resultant fluidity and adaptability of the economy will speed up the

recovery process. Deregulation of both real and labour markets should be

implemented and the precious metals backed drachma will ensure stable

expectations undistorted either by deflation or inflation – both of which

are harmful. As confidence in the drachma grows so will its value as an

investment vehicle to hedge risk worldwide.

During the recovery process, acquiring external debt will be

prohibitively expensive so internal debt will be one of the main sources of

extra-budgetary expenditure for the Greek government without recourse

to printing drachma; it will borrow domestically from commercial banks

and other financial institutions by issuing debt securities. Having to rely

primarily or solely on internal debt, combined with a precious metals

based drachma, will act as a a check on the Greek government’s

distortionary powers in the economy and will therefore better allow

market forces to re-allocate resources apolitically and most effectively.

This will provide the quickest way to overcome the inflationary pressures

from a euro exit. The strength of an economy is demonstrated in the

spending capacity of its economic agents and can always be sourced to

the strength of the currency with which the economic agents fund their

consumption. Whatever promotes the latter will lead to the former.

There is also a political factor to Greek economic recovery which

comprises its relations with Turkey. Simply put, open and friendly trade

relations must be resumed with urgency whichever of the above options

Greece chooses, otherwise there would be the danger of political

antagonism with a neighbouring nation-state which could impose pressure

on Greece militarily. “The history of relations between Turkey and Greece

during most of the 20th century might be best characterised as one of

hostility or perhaps even outright enmity. For both the economic, security

and political implications of the issue are profound. However in 1999 the

Turkish and Greek governments began taking initial steps to improve

bilateral relations and these efforts have continued under subsequent

governments…” and have “…resulted in the establishment of a variety of

instruments that are expected to help ameliorate relations.”35

XI. Conclusions

We have seen in this essay the similarities between the financial

crisis of Detroit Michigan – which used to be one of the world’s wealthiest

and most liveable cities and centre of the American car industry, and that

of Greece a European Union member with comparable financial problems

and similar root causes. The purpose in delineating the similarities

between these insolvency cases was to demonstrate that fundamental

lessons in economic management can be garnered from the Detroit

municipal bankruptcy and applied to an E.U. country like Greece. Detroit,

like Greece is currently part of a monetary union comprising the U.S.

dollar while Greece is part of the euro monetary union. The differences in

the possible solutions going forward in both cases therefore relates to

Detroit being an urban municipality under the broader State of Michigan

and then the federal U.S. Government, while Greece is a (mostly)

sovereign state under the European Union which oversees its currency. As

a sovereign state Greece will therefore have much greater flexibility in

how it chooses to tackle its solvency crisis, which will be determined

mainly by whether it chooses to stay with the euro or not. Detroit’s

municipal authorities have no such flexibility; they must continue with

austerity measures and debt-restructuring negotiations with the city’s

creditors to reduce as much of the debt as possible. Given then what we

know about the dynamics and similarities between the two crises, the

question arises as to what would be the best solutions to their underlying

problems. Both have been in receipt of multiple bailout packages from

their respective federal governments (Washington D.C. for Detroit and

Brussels for Greece) the funding of which originates both from citizens in

relatively more financially well-managed states in their respective

monetary unions, as well as from simple money printing by their central

banks.

In terms of solutions, the lesson that has been learned from this

analysis is that without countervailing checks and balances, audits and

de-politicization of municipal authority (or government) spending, such

authorities and governments will almost invariably display moral hazard in

their spending behaviour knowing that in the event of a solvency crisis

financial bailouts from federal authorities will be forthcoming; the

associated funding socialized among the more financially stronger cities

or countries within their respective monetary unions. The solutions in

order to minimize to the greatest degree possible similar future

occurrences of such municipal or state solvency crises must therefore rely

upon eliminating these moral hazard inducing (implicit) guarantees, in

tandem with stable currencies. Not only can the economic management

lessons from Detroit be applied to Greece but to most financial and

currency crises around the world, due to the universal relevance of

implementing non-inflationary or non-deflationary currencies and

eliminating moral hazard.

The likely evolution of the Detroit crises will see the continuation of

federal bailouts, debt restructuring negotiations and public sector cuts.

While politically more palatable, it does not address the initial moral

hazard problem which led to the crisis in the first place. Rather than

socialize Detroit’s losses, it would have been better for the city long-term

for the U.S. federal government to not intervene and allow Detroit to go

bankrupt in order to send an unequivocal message to other municipal

authorities across the country that they must get their finances in order

and balance their books. This would then allow Detroit to undergo a cold-

turkey process of structural and regulatory adjustments which would be

drastic but nevertheless for a much shorter time period than if serial

bailouts were to be continued. The same conclusion could also be reached

for the Greek crisis – the difference being that Greece would have to leave

its respective monetary union; Detroit would have to consider no such

prospect.

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