The Weight of the Past: Understanding Municipal Debt and Pension Systems wiht David Schleicher

Today we’re joined by david Schleicher. David is Professor of property and Urban Law at Yale Law School, and an expert in local government law, land use, finance, and urban growth. I found David’s book, In a Bad State: Responding to State and Local Budget Crises, a engaging and readable primer on municipal debt: what it is indeed, how it grows, and how cities can face up to it.

Municipal pension funding may not sound like the most fascinating topic, but I hope this conversation illustrates two things: First, how our pension systems work matters to all of us – whether or not we are enrolled in a municipal pension. Second, thes questions go to the heart of how our cities are run, why they fail, and how they can be improved.

In the sections on Chicago, I’m drawing on coverage from sources including the Chicago tribune, A City That Works, Illinois Policy, freind-of-statecraft Judge Glock, the WSJ, and Austin Berg, among others. Thanks to Harry Fletcher-Wood and Katerina Barton for their judicious transcript and audio edits.

To the extent that jurisdictions spend a lot on it, they’re not spending money on other things. When a pension system is indebted, you’re paying for services you received in the past. We’re paying, not only for our school system today, but for our older school system. That means we can invest less in today’s system, because we still have to pay off the money we effectively borrowed when we employed people in the ’70s and didn’t save for their pensions. It has an effect on budgets; it limits what jurisdictions can or else buy.

A pension is just a form of deferred compensation. When you work for any employer, they pay your salary and something for retirement. People who are used to a 401(k) or a 401(k) match understand that the company might help you with retirement. State and local pensions are traditionally not “defined contribution” but defined benefit. If you work for a certain am

The Murky Waters of State and City Bankruptcy

We haven’t had a state default since the 1930s, largely because states possess exceptional taxing powers. They can raise income taxes to very high rates,though that action would likely trigger economic consequences.

defining the inability to pay is complex. Consider Detroit. Legally, states cannot file for bankruptcy; cities can. Detroit did file for bankruptcy under Chapter Nine. However, at the time of filing, Detroit wasn’t immediately unable to make its next payment – it could have, potentially, by selling City Hall. The issue was its inability to meet future payments. The legal definition of bankruptcy hinges on insolvency, meaning both failing to make current payments and lacking the ability to make future ones, but the interpretation of this isn’t straightforward.

Courts, in Detroit’s case, introduced the concept of service-delivery insolvency, initially established in Stockton, California. This rule essentially stated that if services deteriorate to a critical point, debt repayment can be suspended. What constitutes “too bad” remains ambiguous. While a one-hour ambulance response time might be considered unacceptable, a three-month wait in a remote area like Michigan’s Upper Peninsula presents a different scenario.

Importantly, state constitutions don’t guarantee specific levels of service, like policing. The consequences of a state default are largely limited to difficulty borrowing in the future. Cities, however, could potentially be forced to pay, though states can authorize bankruptcy filings.

The idea of “service-delivery insolvency” is a relatively recent judicial creation, emerging in the mid-2010s. its not codified in law; rather,courts have inserted this interpretation into the definition of “insolvency” itself,a process that bypasses traditional legislative channels.

This issue presents a challenge for the courts, which are grappling with how to handle these cases. It’s less about applying a clear legal test and more about determining “When are things so bad that we’re going to allow you to use bankruptcy?”

The discussion sets the stage for exploring three potential federal responses to such crises.

1. Bailout. Throughout american history, jurisdictions on the brink of bankruptcy have received financial assistance from the federal government – or, in the case of a city, from the state government. The most well-known example of a fiscal crisis…

the Surprisingly Fragile World of Municipal Bonds

There’s a common perception that municipal bonds are incredibly safe investments, backed by the full faith and credit of the issuing government.However, history tells a different story. there have been many instances where that wasn’t true. In the Great Depression,there was a huge number of defaults of municipal bonds. Similarly, in the 1860s and 1870s, after the Civil War, municipal bonds were defaulting frequently.

While the default rate on municipal bonds is generally low – around 1% – meaningful spikes do occur. A prominent example involved Puerto Rican municipal bonds. This contributes to why these markets don’t fully develop; the perceived unlikelihood of default isn’t always accurate.

The case of Chicago offers a fascinating insight into municipal finance. In the 1970s, political scientist Ester Fuchs, in her book Mayors and Money, explored why Chicago remained fiscally sound while New York City whent bankrupt. Fuchs argued that New York’s weakened political machine lacked central control, distributing funds widely, while Chicago, under the Daley machine, had a strong incentive to avoid fiscal trouble due to the potential for political repercussions.

Ironically, Chicago’s fiscal health deteriorated under Daley’s son, a less powerful political figure who overspent in multiple areas. The most significant issue was pension debt, but Daley Jr. also resorted to selling off future parking meter revenues to balance the budget – a practice akin to taking on debt without formally classifying it as such.

Ultimately, a pension crisis requires consistent budget deficits.While generous pensions can exacerbate the problem, simply failing to adequately fund pension obligations is enough to create significant debt. Some jurisdictions, like New York State, maintain relatively well-funded pension systems through high taxes and consistent contributions.

The Deepening Pension Crisis: Connecticut, Chicago, and a generational Divide

Connecticut, once grappling with one of the nation’s most underfunded pension systems, has demonstrated fiscal responsibility since the late 2010s through budget controls and bond covenants, resulting in significant savings. Though, this improvement hasn’t translated into tax cuts or increased spending, leading to a sense of stagnation. This situation highlights a broader issue: a generational imbalance where current generations are burdened with paying off debts accumulated by previous ones.

While Connecticut’s situation is concerning, cities like Chicago face a potentially far more severe crisis. Pension systems are in better shape nationally than they were a decade ago, aided by substantial federal funding. States, even those historically prone to overspending, have prioritized pension payments – though some, like New Jersey, treated these payments as newsworthy achievements rather than basic obligations.Generally, state budgets are stabilizing, and the practice of concealing deficits is becoming less common.

Illinois and chicago stand out as particularly vulnerable. Chicago’s pension systems are alarmingly underfunded, at just 18%. The situation is further elaborate by the intricate financial relationship between the city and its school districts, currently the subject of intense debate.This complexity extends to overlapping jurisdictions – city, school district, parks district, county, transit district, and state – creating a “nesting doll” of debts that taxpayers ultimately bear.

Many taxpayers are unaware they contribute to multiple overlapping jurisdictions through property taxes. In Illinois, residents may pay taxes to as many as 13 separate entities.

Chicago employs a system of “tiers of pensions,” a consequence of legal limitations preventing changes to benefits for current workers. An Illinois Supreme Court ruling affirmed the protection of existing pension benefits, forcing the city to create new, less generous tiers when attempting to curb pension spending.

The Tricky Triad: Bailouts,Austerity,and Default in Fiscal Crises

When facing a fiscal crisis,governments are often presented with three unappealing options: austerity (cutting spending),default (failing to pay debts),and bailout (receiving financial assistance). Each carries significant drawbacks – default damages future borrowing ability, austerity harms essential services, and bailout creates moral hazard. But the most effective responses aren’t purely one or the other. Rather, a blend of all three frequently enough yields the best results.

The US has employed all three strategies at various points in its history. A prime example is the New York City fiscal crisis of 1975. President Ford initially refused a bailout,famously telling the city to “Drop Dead.” However, after a near-default and implementation of austerity measures, coupled with the creation of a new governance structure, the federal government stepped in with emergency loans through the Seasonal Financing Act.

There’s a marginal increasing cost associated with each response: a large default severely restricts future borrowing, while a small, “technical” default might be more manageable.Extensive austerity is deeply damaging, but targeted cuts are less so. And while large-scale bailouts breed moral hazard, smaller interventions are less problematic.

Therefore, a strategy incorporating elements of all three is often the most attractive. This could manifest as bankruptcy proceedings. Municipalities often engage in austerity to meet insolvency requirements, triggering the ability to impair creditors in court.Detroit’s bankruptcy illustrates this well. After initiating bankruptcy, the city received financial assistance from foundations and the state government to pay off pensions – a bailout, but after enduring hardship. This approach minimizes moral hazard, as politicians have already faced the consequences of bankruptcy and are unlikely to repeat the mistake.

A key metric for navigating these crises should be: “What can we do to incorporate a little bit of all three, rather than relying solely on one?”

Moreover, fiscal crises present opportunities to establish rules for future stability. Following the New York City crisis, a requirement was imposed on the city to use honest accounting practices, preventing similar issues from arising.

The Unique World of State and Local Pensions

Congress deliberately excluded state and local bonds from the regulations of the Employee Retirement Income Security Act (ERISA) for two key reasons: the historically low default rates of these entities and resistance from states and cities to limitations on their budgetary control. This divergence has led to a situation where defined benefit pensions, largely absent in the private sector, remain prevalent at the state and local levels, with few jurisdictions experimenting with defined contribution systems.

The performance of these pension funds varies considerably depending on the jurisdiction and fund management quality. While active management can yield gains, success isn’t guaranteed. Well-run states, like Utah, possess the capacity to take calculated risks, while others may require a more cautious approach.

A unique aspect of pension funds is their long-term investment horizon,allowing them to invest in assets with potentially higher,but less immediate,returns – mirroring the strategy of university endowments. They are major investors in alternative assets like private equity and hedge funds.

However, this control of substantial sums of money presents challenges. Negotiations often pit elegant financial professionals against civil servants lacking comparable expertise, creating opportunities for abuse. Cases involving figures like Alan Hevesi and steven Rattner illustrate this vulnerability, as do the significant roles pension funds, particularly CalPERS, play in securities fraud litigation.

some jurisdictions globally, like those in Ontario, have successfully transformed their pension funds into highly-compensated financial firms, realizing substantial gains.The key question remains: can other states replicate this success?

even when positive returns are achieved,jurisdictions often project those earnings forward when determining future savings contributions. This practice can be misleading, as it assumes consistent performance – an unrealistic expectation in the volatile world of finance.

the Hidden Driver of Housing Costs: How Zoning Shapes Land Value

The post-pandemic shift towards remote work has dramatically reshaped where people live and,consequently,how land is valued. While many anticipated a mass exodus from expensive urban centers, the reality is more nuanced. Zoning regulations, often overlooked, play a critical role in exacerbating housing shortages and driving up costs, even in areas experiencing population decline.

The Suburban and Exurban Land Boom

The rise of remote work has fueled demand for larger properties and more space, leading to increased land values in suburbs and exurbs compared to downtown areas. This isn’t simply a matter of preference; it’s a consequence of limited housing supply in desirable locations. The ability to work remotely allows people to live further from city centers, increasing demand for land in previously less-sought-after areas.

However, this shift doesn’t necessarily translate to overall housing affordability. While demand may decrease in some urban areas, it simultaneously increases in others. Improvements in commute times, facilitated by remote work, can also open up more land for development, but this potential is often stifled by restrictive zoning laws.

The Problem with Zoning: Beyond Apartments

Zoning regulations aren’t just about preventing the construction of new apartment buildings. they dictate how land can be used, often prioritizing single-family homes on large lots. This has several consequences:

• Limits Housing Density: Zoning laws frequently restrict the number of housing units per acre, artificially limiting supply.
• Increases Land values: Scarcity drives up prices. When land is restricted to single-family homes, its value increases dramatically.
• Hinders Land Use Transition: Even in areas experiencing population loss,zoning can prevent the repurposing of land for more needed housing types.

Consider Fairfield County,Connecticut,home to affluent towns like Greenwich and Westport. These areas have experienced significant increases in land value post-pandemic, driven by commuters seeking more space. However, zoning laws requiring one or two-acre lots effectively prevent the construction of more affordable housing options.This creates a paradox: high demand, high land values, and a persistent housing crisis.

“The ability for the market to allow housing to be built in the exurbs…relies on agricultural space being turned into housing.”

Zoning Challenges Even in Declining Areas

The issue isn’t limited to booming areas.Even in the Midwest, where some cities are losing population, restrictive zoning can hinder the transition of land use. Outdated regulations can prevent the conversion of underutilized commercial or industrial spaces into much-needed housing.

Key Takeaways

• Remote work has shifted housing demand towards suburbs and exurbs, increasing land values in those areas.
• Zoning regulations are a major obstacle to increasing housing supply and affordability.
• Zoning impacts land use beyond just apartment construction, affecting density and the ability to repurpose land.
• The problem exists even in areas experiencing population decline.

Looking Ahead

Addressing the housing crisis requires a serious re-evaluation of zoning laws. Initiatives like the Senate Housing Bill, which aim to address zoning problems, are a step in the right direction. Allowing for greater housing density, streamlining the permitting process, and encouraging mixed-use development are crucial steps towards creating a more affordable and equitable housing market. Without these changes, the benefits of remote work – increased flexibility and potential for geographic mobility – will remain largely inaccessible to those priced out of the market.