Why Detroit's Bankruptcy Should Concern You

By Sasha Cekerevac

Well, it’s official—as of last Thursday, the city of Detroit is bankrupt.

Detroit is a sad example of a city that was continually running a large budget deficit. But it grew into such a huge amount of government debt that the only way out was to file for bankruptcy and give investors pennies on the dollar.

While some might not feel sorry for large investors, don’t forget that many pension funds will lose a significant amount of money as the city restructures its government debt. Early reports of the proposed restructuring indicate that retired municipal city workers will get less than 10% of what they are owed.

That just shows once again that you cannot run a budget deficit, spending more than you make, indefinitely. At some point, the government debt grows so large that the cost to maintain it ultimately brings the whole scheme down.

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Even over the short term, since 2008, the city of Detroit has had a budget deficit in excess of $100 million each year on average. As the government debt continued to grow, there were no structural changes put in place to increase revenues and cut spending, and Detroit’s politicians simply kept borrowing more and more money, hoping things would turn around. Clearly, things didn’t turn out they way they’d hoped.

But is Detroit alone in continuing to run a budget deficit and build a government debt to insurmountable heights? No.

Just a few days ago, ratings agency Moody’s Investors Services downgraded Chicago’s general obligation and sales tax debt, in addition to further downgrades for Chicago’s water and sewer senior bonds. (Source: “Moody’s downgrades Chicago to A3 from Aa3,” Moody’s Investors Services web site, July 17, 2013.)

A large part of the reason for the downgrade in government debt has been the level of pension liabilities in addition to budget pressures associated with running a city and debt service payments.

Running a budget deficit over time creates a large government debt load; at some point the debt service payments take up a proportionately larger amount of revenue. The money that could’ve been spent on important expenditures like education instead goes to servicing government debt.

In the cases of Chicago and Detroit, the government debt we are talking about is only in the billions. However, the real worry is that the U.S. federal government debt load is now approximately $17.0 trillion. While the budget deficit has come down substantially over the past year, we’re still spending hundreds of billions of dollars more than the government takes in.

Will the U.S. simply file bankruptcy and restructure its government debt?

That would be a historic event that would coincide with the complete loss of faith in the U.S. dollar. Because there are such massive ramifications, the U.S. will try everything it can to not go down that road.

While that makes logical sense, there doesn’t seem to be any real worry by politicians.

Looking out over the next five to 10 years, I see America continuing to run a budget deficit, which just keeps adding to the government debt load. This is on top of unfunded liabilities, which total trillions of dollars as well.

I am an optimist, as I think most Americans are. However, when I think that our future lies in the hands of the decision-making politicians in Washington, I believe the short-term attraction of running a budget deficit to get re-elected will be too strong to resist. Until we see the potential for budget surpluses so we can begin reducing our government debt load, the long-term future of America remains cloudy.

This article Why Detroit’s Bankruptcy Should Concern You was originally published at Investment Contrarians