Detroit – Just the beginning?

A city is driven into bankruptcy by the same problems that plague the United States as a whole but will the outcome be any different?

We have become all too accustomed to firms going bust recently amid the economic doom and gloom but a city going bankrupt seems a little strange.  But that is what happened to Detroit last month as years of decline culminated in the city admitting that it was no longer able to pay its bills.  Having thrived along with the auto industry, Detroit was always doomed to struggle as American car makers lost out to foreign rivals but its problems are not that different from those facing the country as a whole – overgenerous spending commitments from politicians focusing on the short term.  Can the politicians in Washington do any better in dodging a budgeting accident?

Detroit’s demise has come after it lost the industrial base that was the foundation of the city – the manufacturing industry around Detroit was decimated as overseas firms took a large chunk of the US auto market.  The population of Detroit was close to two million in 1950 but has since plunged to around a third of its peak as the deteriorating job market prompted people to move elsewhere to find work.  The exodus created a downward spiral with a growing number of boarded up houses and deteriorating public services as tax payers fled to more prosperous locations. 

The sharp decline still left Detroit with a large number of bills to pay, and along with having to maintain the infrastructure of a shrinking city, there was also the pensions for its public sector workers.  Its debts are estimated at $18.2 billion but around half of this money is owed to its present and past workers in the form of promises of retirement pay-outs.  It is common for government workers to be paid pensions which are a percentage of their salary (referred to as defined benefit plans) which is different to the private sector where workers must pay into their own pension pot from which pensions are paid out (referred to as defined contribution plans). 

Promises made by politicians have come back to haunt their successors – offering up bigger pensions rather than higher wages as a means to placate government workers with lower pay rates.  Pledges made when times are good are difficult to uphold when things turn bad especially since officials fail to put away sufficient funds to cover future pension payments.  The fixed sums offered to public sector employees after retirement have become more of a burden with people living longer and investments yielding a lower return after the global financial crisis (which means that the initial level of funding of pension pots is higher).  It is like a massive scheme of offering up IOUs with big pay-outs in a few decades but not bothering to put away much money to settle up in the future.

Detroit was not the first city to go bankrupt (Stockton, Mammoth Lakes and San Bernardino in California did in 2012) and it will not be the last (even some of the largest firms in the United States such as General Motors and most of the airline companies have been laid low by lavish pension schemes), but more crucial are the similar problems faced by the federal government in the United States.  The US government has committed to paying pensions and medical bills for the old and poor which will gradually ramp up the pressure on the government budget as the baby boomer generation heads into retirement and the number of workers per pensioner falls (i.e. costs will rise as revenues fall but more slowly than in the case of Detroit).  Social spending on these and other entitlements accounted for 56% of government spending or almost 14% of GDP in 2012 and increasing spending is threating to overwhelm the government spending plans.

The approach of a fiscal disaster comes at a bad time - the US government is already struggling to sort out a considerable budget deficit equal to 7.0% of GDP in 2012.  The timing is made even worse when considering that the dominant global position of the United States is under fire due to the rise of new powers such as China (for more on this, see A New Inconvenient Truth).  Instead, politicians would rather squabble than deal with the raft of problems facing the country with numerous other areas such as taxation and immigration also crying out for reform.  Even sensible adjustments to policy, such as increasing the retirement age to account for people living longer, get vilified with both the Democratic and Republican parties at each other’s throats.  Elections do little to resolve the issues with politicians happy to just target their own supporters (refer to Election with no winners for more detail).  The country as a whole is being driven toward the same destination as Detroit and politicians would rather play a game of chicken amongst themselves than steer clear of trouble – watch out for accidents in the road ahead.

Winning the election was the easy part…

In a presidential election which was more notably for the money spent (an estimated US$6 billion) than any notion of what each candidate would do in power, Barack Obama managed to pull off a relatively easy (but not emphatic) victory.  But now Obama faces a bigger challenge - the fiscal cliff.  The fiscal cliff refers to painful measures which will be implemented if Democrats and Republicans are unable to come up with a solution on how to deal with high government spending and low taxes.  But the political stalemate looks set to continue in the United States following an election which was supposed to help provide impetus for new policies but may instead result in further gridlock.

Improving the government finances was increasingly becoming a concern in the United States due to a large budget deficit of 7.8% of GDP in 2011 and rising government debt topping 100% of GDP in the same year.  Investors are still happy to buy government bonds as the United States is seen to have a more viable economy whereas similar levels of debt would cause panic among investors in Europe.  Yet, it is unclear how much longer investors will tolerate rising debt.  Politicians realise the necessity for action but are ideologically opposed to how to go about it – the Democrats want to see spending cuts accompanied with higher taxes on the wealthy whereas Republicans flatly refuse to even consider higher taxes. 

The origin of the fiscal cliff is an attempt by the two parties to force themselves into a compromise by upping the stakes.   Politicians passed the Budget Control Act of 2011 whereby, if an agreement on how to cut the deficit was not reached by the end of 2012, a range of deficit-reducing policies which are painful for both Democrats and Republicans (and the economy) would automatically kick in from the start of 2013.  Politicians have been too consumed with electioneering up until now for a deal to be struck and only have a short time left to figure out a compromise before US$600 billion of spending cuts and tax rises come into effect - the consequences of which is expected to push the United States economy into recession in 2013.

Just the possibility of recession as a result of these measures is already having an adverse effect on the economy.  The uncertainty created by the lack of a deal means that businesses are holding off from making new investments and hiring extra workers at a time when the economy should be on a path to recovery.  The election should have been a great chance for each party to convince the voters that they had a plausible solution but the outcome has only seen minor changes to the political landscape and the status quo has been maintained so that continued gridlock is a real possibility. 

Life would have been difficult for whoever won the election.  With the Republicans controlling the House of Representatives and the Democrats holding sway over the Senate, agreement between both parties is needed to pass any new laws.  But neither Obama nor Romney put themselves in a strong position due to the bulk of the campaigning being negative rather than providing any ideas on new policy direction (see An election with no winners).  As such, despite winning, Obama does not have much of a mandate - an entitlement to implement policies due to the perceived backing of a substantive majority of voters following an election.  The going will be made tougher with Obama having failed to exhibit much leadership in his first term as president.  Yet, Obama has come out of the blocks strongly with a bold statement that any new measures must include higher taxes for the rich.  On the other hand, Republicans are still not convinced that Obama has much support from voters and are likely to stand firm for now with regard to their demands for no tax hikes.

This sets the scene for last minute dramas and for uncertainty to continue to plague the economy.  The extent to which politicians can be trusted to make pragmatic decisions is unclear and Your Neighbourhood Economist is unsure of what will ensue.  Even Greek voters showed a considerable degree of pragmatism in backing pro-bailout parties in elections in June 2012 (Back from vacation in Greece).  Yet, like the situation in Greece, any possible solutions regarding the fiscal cliff are likely to be drawn out with stopgap measures likely before the end of the year (if at all) and more long-term policies discussed in 2013.  The prolonged uncertainty and political sideshows could have not come at a worse time but it is even more frightening to think that the worst may not be over. 

An Election with No Winners

Any crisis should be seen as a boon by politicians.  Problems become evident during times of turmoil and voters are more open to the prospects of sweeping change.  This gives opportunities for leaders to implement a raft of new policies and stamp their mark on the pages of history.  Yet, the opposite seems to be true with regard to the current presidential election in the United States.  The candidates have provided few details of what changes they would implement and how to better position the United States to face a rising number of challenges which stem from both internal problems and external threats.  The election has instead concentrated on the flaws of the candidates themselves rather than the ideas they espouse.  The United States looks likely to be bogged down for at least another four years until the next presidential election which may offer up a chance for decisive leadership.

The presidential election comes at a time when the country is in desperate need of leadership.  Obama has failed to deliver on his promises from the election four years ago.  It has been ironic than a presidential candidate that has given rise to so much hope among disparaged Americans has been so underwhelming even by normal standards to which presidents aspire.  In an election which should have been easy for any politician to beat Obama, Romney ended up the Republican candidate by default as other challengers each had their moment in the spotlight but all were deemed to be flawed.  But as the default candidate, Romney has struggled to even animate Republicans.  As such, the United States has been left without a genuine choice and campaigning has focused on the negatives of each candidates’ character due to a lack of new ideas. 

In an uninspiring election, Obama may be the lesser of two evils.  Obama has done a reasonable job of fixing the way in which the United States is seen by other countries in the world.  The Democrats as a party are also less entrapped by ideologues on the left and have been more pragmatic at a time when action is necessary.  On the other hand, the Republican Party has fallen under the sway of the Tea Party movement which has a virile hatred of government and taxes based primarily on ideological grounds.  The stubbornness of Republicans has stopped progress being made on dealing with the government budget deficit.  The party refuses to consider any tax increases to be implemented alongside cuts to government spending when this mix of more taxes and less spending is seen as optimal policy by many.  Instead, Republicans choose to squabble while Rome burns which may see the fall of another “empire”. 

There are signs that the United States may be heading into a period of gradual decline which its leaders refuse to confront.  Along with the rise of China and other emerging economies which is destined to reshape the global economy, the United States is also being challenged internally by problems such as a lack of investment in infrastructure and education, growing inequality and falling social mobility, and unsustainable levels of pensions and health care.  Obama has done little to solve these problems.  But there is a fear that a Republican president could make the problems worse.  Ballooning government debt in the United States during the Regan and Bush junior administrations has already shown Republicans to act more on ideology and less on economic realities.  Your Neighbourhood Economist would (if possible) vote for Obama - better the devil you know - but would rather fast forward four years in the hope for real leadership.

“It’s the economy, stupid” – or is it?

The phrase “it’s the economy, stupid” encapsulates the strategy used by Bill Clinton in his election battle with George Bush senior in 1992.  The blame for the recession at the time was attributed Bush senior and this helped Clinton to victory.  Twenty years later, Mitt Romney may have thought that a similar message would aid him in his bid to become president.  The four years that Barack Obama has been in power has coincided with the harshest economic downturn in living memory and a surprisingly weak recovery such that GDP has only edged up 0.7% between 2009 and 2011.  But the outlook for the economy has brightened a tad recently following the release of upbeat data on GDP and jobs in the United States.  Anecdotal evidence would suggest that this would be a boost to Obama but this may not hold true in an election where the candidates have sidestepped the big issues.

Economists like to point out that the state of the economy is a good guide to the plight of an incumbent in a presidential election.  Voters everywhere tend to hold politicians accountable for economic growth even though there is little that politicians can do to in this regard.  Obama was unlucky to have been voted in while the global financial crisis was still wreaking havoc.  The record of Obama’s management of the economy is hard to asses given the unique circumstances – Obama has been criticised for the assistance given to the finance sector and for the bailing out of firms such as the car maker GM but no one can know whether these actions actually staved off more wide spread disaster.

But it is economic welfare of the voters and their beliefs on how the future will pan out which is the crucial factor.  And in this regard, Obama has been getting small bits of good news among all of the doom and gloom.  In GDP figures for the third quarter (July to September) of 2012 released in late October, the economy was shown to have grown by 2.0% which is slightly faster than was expected.  Job data published one week later also exceeded expectations with 171,000 jobs being created in the US economy in October and unemployment below 8%.  Neither bit of news permits much optimism about the end of tough times and businesses will have to hire significantly more workers to make a significant dent in the unemployment rate (for more, see US Jobs Data).  But the signs of improvement may be enough to some to have hope.

But it is still unclear whether the slightly brighter outlook will be much of a boost to Obama.  Your Neighbourhood Economist would argue that news on the economy will only sway those who were undecided but these voters have been side-lined by campaigning which has vilified the personalities of the candidates rather than proposed solutions to the problems plaguing the United States.  So the election results are more likely to depend on how many Democrats and Republican can be bothered to vote for their respective candidates as both Obama and Romney have been underwhelming and failed to inspire a following from anyone else but their core supports.  Not the best way to decide who will be leading the country for the next four years and something that is likely to result in further disappointment (but more on that coming soon).