Lessons from the MotorCity – why Detroit’s bankruptcy should stiffen European economic policy-heads
By Sean Garman
Detroit’s bankruptcy in July this year should have served as a warning sign for governments across Europe at what happens when a declining economic base, refusal to reform public services and unfunded promises combine into a perfect storm.
Detroit City racked up c. $18bn in debt and other liabilities and currently operates with a budget deficit of $380mn with a population under three quarters of a million. It has no way of paying off its debt. This situation should not be a surprise to anyone: the decline of Detroit and the automotive industry that once powered the city has been well documented over the past two decades as the City population declined from a peak of 1.8 million to 700,000. What this does tell us is that problems tend to compound as politicians refuse to address deep-root problems in a vain attempt to be re-elected.
I know that many of you would be sceptical that there could be lessons for European governments from Detroit. A City is not a sovereign state, and it is true that we can raise taxes more effectively than Detroit can, but there are lessons to be learned. German Chancellor Angela Merkel neatly summed up the problem when she pointed out that “Europe today constitutes little more than 7% of the world’s population and generates 25% of global GDP, but it needs to finance 50% of all global social spending, so it is obvious that it will have to work very hard to maintain its prosperity and its style of life”. This is what Detroit failed conspicuously to do: the automotive industry was dying from a combination of international competition and incompetent management, but it did not adapt public services or attract inward investment from other sources to maintain and expand on existing promises.
While economic innovation is vital to help pay for many promises made long ago, the spending side of the equation remains untouched. The rising cost of pensions is one area that has to be tackled. Detroit is a great case where politicians allowed ever more generous pension plans to be enacted despite the obvious economic and fiscal problems to fund them. These were problems for someone else to deal with – unfortunately that time has come. The net result is that about half of the City’s long-term liabilities (c. $18bn) are made up of unfunded retirement benefits!
The raising of pension entitlements to buy support was a great favourite of Gordon Brown. A fact which should give us cause for reflection.
Reform is being discussed seriously in some corners.
In a recent Wharton School article on reforming the European Welfare State, Antonio Cabrales, a professor at the Carlos III University of Madrid stated that with pensions there must be a movement towards a “combination of extending the number of working years, increasing taxes and reducing retirement benefits”. Yet when we peer over the Spanish border towards France we saw Socialist President François Hollande cut the retirement age to 60 from 62 years old! This is not sustainable and will end in tears.
Detroit is an extreme example of almost-comical political incompetence. Yet if we think of their decline we can see some of the problems confronting Europe: demographic changes, short-term promises designed to win votes and a declining economic base to pay for it all. I do not think we’ll see a wave of sovereign bankruptcies throughout Europe (with the notable exception that Greece did in all but name default on their loans) but the slow and steady erosion of economic strength is masking deeper flaws that need to be resolved. Detroit serves as a reminder what decay does to an economy and a society. Let us not repeat their errors.