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What Detroit’s Bankruptcy Has Taught Us

Sep 11 , 2013
  • Ding Yifan

    Deputy Director, China Development Research Center

The city of Detroit, once celebrated as the center of the automotive industry in the United States and the world for that matter, was home to the largest American car-makers for decades since the Ford Motor Company was founded there in 1903. In recent years, however, “Motor City’s” fortunes have been declining fast and saw it reduced to “America’s saddest city” with $14 billion in debt and eventually the largest city in US history to apply for bankruptcy protection from the federal government. It would be the largest city in US history to have gone legally bankrupt if a federal judge grants its plea for Chapter 11.

Ding Yifan

During its heydays in the 1950s Detroit was the fifth largest city in America with nearly 2 million residents. It holds a number of “America’s firsts”, including the Model-T car and the first assembly line Ford invented and built as well as the first cement roads and urban depressed highway system.

In the 1960s “Motor City” began going downhill. As automotive industries in Europe, Japan and later in South Korea started flourishing it did not take very long for American automakers in Detroit to feel the squeeze. In order to cut production cost car giants such as Ford and Chrysler, along with hundreds of car parts manufacturers, moved out. Rising unemployment fueled racial conflicts and drove more and more people away, leaving local economy in tatters. When the financial crisis triggered by a Wall Street meltdown broke out in 2008 the US auto industry was hit very hard. The three leading carmakers — General Motors, Chrysler and Ford — laid off a total of 140,000 employees; and Chrysler and Ford declared bankruptcy in 2009. As home base to the top three carmakers in America Detroit inevitably took the brunt of the hit, as more workers lost their jobs and were no longer able to pay mortgage. Private homes were repossessed by the thousand while property prices, which peaked in 2007, plummeted to record lows in years.

Detroit’s debt crisis is believed to be directly caused by a “financial trap” the city government unwittingly fell into. Back in 2005 Detroit was already in financial dire strait and could hardly pay its public servants’ salaries. The city government had no choice but to borrow from some banks. To avoid rising loan interest rates adding to the debt crisis the government took some financial experts’ advice and bought some insurance policies tied to interest rate fluctuations. Those are also known as financial derivatives and a kind of “bet” on interest rate hikes. Unfortunately the Federal Reserve Board has kept interest rate low since the “sub-prime crisis” broke out in 2007. Because the derivatives that the Detroit city government bought were “bets” on interest rate hikes, they actually inflated its debts instead of cushioning the impact from interest hikes. The firms that sold the city government those derivatives, on the other hand, hit pay dirt thanks to the government’s debt crisis.

From the glorious “Motor City” to a tow on the verge of bankruptcy Detroit’s decline demonstrates what happens when laws of economic and social development are broken. It is a very important lesson that China should learn to accomplish its economic restructuring without repeating Detroit’s mistakes: manage local government debts better and balanced economic and social development.

One of the laws of economic and social development that Detroit did not follow is that a city should have a long-term plan for industrial restructuring lest its economy hits structural snags. It should not be complacent about its existing competitive edge or neglect self-improvement, because that will lead to financial bankruptcy. There is a good example contrary to Detroit’s, also in the great lakes area not far from Motown — Chicago. The “Windy City” was one of the centers of iron-and-steel, machinery and metal processing industries that thrived in the 1950s-60s. Since the 1990s it has been developing the IT and high-end services industries and is now the second largest financial center behind New York City as well as one of the best to live in. Detroit was very prosperous when the car industry was at its peak but began losing its competitive edge when its competitors in Europe, Japan and South Korea grew stronger. It has fallen by the wayside because it did not readjust its industrial structure and develop its own IT-powered service industry while it still could. Some of China’s cities are also faced with challenges from economic restructuring. They will go down like Detroit did if they do not respond proactively by developing new industries and adjust productivity and become victims of their own redundancy.

Another law to follow is that local governments must keep diversified fiscal revenue sources in mind and always avoid relying on a single area so that the municipal finance won’t drop too much when that particular source of revenue is hit hard by some “force from outside.: When in financial difficulty, the last thing a government wants to do is try to “win big” by betting on some financial derivatives, hoping the windfall can somehow make up for the money lost. For example, many cities and regions in China overly rely on a certain source of revenue. When the price of energy resources went up a few years ago the coal-rich provinces and autonomous regions enjoyed rising revenue, but their fiscal income took a bad beating when prices of energy resources fell, along with the reserves of shadow banks and other non-official financial institutions under their jurisdiction, which only aggravate the woes of local economy.

Still another law to obey is that the central government should know the regional governments’ financial health and financial risks so as to effectively consolidate local finances against risks. Detroit’s request for bankruptcy protection sent US media scrambling for answers and solutions, but “Motor City” is not the only one in trouble. Washington D.C., California, Florida and a few other important states are staring at debt crises of varying severity as well. From 2003 to 2010 fiscal year state government budgets increased from $1.5 trillion to $2.2 trillion in all while their total tax revenue grew by just $400 billion to $1.4 trillion, which means regional fiscal discrepancies widened rather than narrowed. Theoretically the Federal government is not obligated to bail state governments out when they are in debt crises, but eventually it will have to pitch in to prevent widespread social unrest if the debt pandemic infects more states. Since the global financial crisis of 2008 broke out China has drastically increased social financing to stimulate domestic economic growth but also boosted regional government debts as a result. Some local governments hope to increase revenue from local property market growth, but may not have what it takes to handle the enormous risk it comes with. In many cities the local real estate market does not have adequate economic activities or matching demographical structure to be a reliable pillar industry. That is why the central government should keep taps on local debt levels regularly or otherwise and conduct proper “pressure tests” on them to ensure the sustainable development of the nationwide financial system and serve the overall interest of steady development of macro-economy and economic restructuring.

Ding Yifan, Deputy Director, Research Institute of World Development, China Development Research Center (DRC).

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