Opinion

James Saft

Detroit and the importance of failure: James Saft

July 23, 2013

July 23 (Reuters) – Here is the real meaning of Detroit:
human institutions sometimes fail and we are far better off
acknowledging and accommodating this than fighting it.

Information from failure is a large part of the value
created by markets and by experimentation, and we ignore and
suppress that information, as we are now in the banking system
and elsewhere, only at great cost.

Detroit filed for what would be the largest municipal
bankruptcy in U.S. history on Friday, a move which will be
bitterly fought in the courts by its creditors and by municipal
workers who stand to lose promised retirement and health
benefits.

There is plenty of blame to be divided; politicians, company
management, unions, Wall Street and the voters of Detroit all
played their role. And while it is worth debating and litigating
who is at fault and who should suffer most, some underlying
facts have to be reckoned with. Detroit’s population and tax
base have shrunk while its obligations to the holders of its $9
billion in debts and a (contested) additional $9 billion to
municipal pensioners have not. That leaves the city, with a high
crime rate and a 58-minute average response time for emergency
calls to the police, critically unable to provide even basic
services.

If we were going to live in a world where all contracts were
always honored, no matter the cost, we’d still have debtors’
prisons. In Detroit’s case, if we expect the people and
businesses which make up its current tax base to continue paying
out interest and benefits in exchange for very bad services, we
are going to have to be prepared to build a wall to keep them
in.

There are plenty of things, then, to bemoan about Detroit,
but its bankruptcy is not one of them. Bankruptcy is one of the
truly great institutions of the modern financial system. And
while a municipal bankruptcy, in which federal authority in the
form of the bankruptcy judge is limited by the division of
powers under the constitution, presents problems, it allows for
the great benefits of failure to be more fairly, if imperfectly,
apportioned. This isn’t something to resist, it is something to
welcome.

First, it allows for the debts and obligations of the
bankrupt town to be whittled back to a reasonable proportion
compared to its revenues. That, by restoring some services, can
help to staunch the bleeding of people and businesses which
otherwise would flee.

LISTENING TO FAILURE

Second, the bankruptcy, let’s call it failure for short,
sends out really good and useful information, not just to
creditors and others who will lose out, but to everyone. In this
case, municipal bondholders, past, present and prospective, will
learn that lending money to a government, especially one with a
dwindling tax base, involves a goodly bit more risk than perhaps
they believed.

That will raise the cost of financing in these situations
and will encourage governments to get to grips with their woes
sooner, rather than simply floating another bond or engaging in
a speculative interest rate swap and hoping that the sweep of
history starts breaking their way again.

It is unclear what will happen to pensioners, who may be
protected under state law, but the result may well be a loss of
expected benefits. That is awful, and arguably unjust and
unfair, news for them, but is truly valuable information for the
millions of current and future pensioners in underfunded or
pay-as-you-go pension plans elsewhere.

Failure provides feedback and encourages experimentation,
which produces both more failure and also, sometimes, success.

What is happening in Detroit is quite a contrast with how
the U.S. approached the effective failure of some of its largest
financial institutions during the crisis. Rather than forcing
them into some form of bankruptcy, installing new management and
forcing creditors and investors to recognize losses, we instead
kept the industry on a variety of forms of life support.

And while these banks may be solvent and profitable today,
crucial feedback has been missed, and investors have been
encouraged to invest not with their heads but based on faith in
the government’s willingness to bail out banks and create easy
conditions for them, no matter the cost to the rest of the
economy.

That missed feedback is doubly dangerous.

We are rebuilding imbalances in the economy and seeing the
growth, once again, of things like advertisements for plastic
surgery loans for people with bad credit.

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