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Is the mortgage crisis to blame for San Bernardino’s bankruptcy?

by Eileen Norcross on July 26, 2012

in City Life, Debt, Institutions, Pensions, Public Choice, Public Finance, Regulation, Tax and Budget

The LA Times contains a new kind of argument on why cities like Stockton and San Bernardino are in bankruptcy. To date, politicians, analysts and journalists have drawn a direct line from rising employee costs and declining revenues to municipal fiscal stress. Harold Meyerson takes another path to reach his own destination – to burnish the image of unions and  politicians. His bankruptcy diagnosis gets lost along the way.

He blames the banks. These cities went bankrupt because, “banks were peddling subprime mortgages to poorly-paid workers.” While the banks are certainly involved in the economic and fiscal train wreck he is upfront that the goal is to weave a counter-narrative, challenging the “right and center right” story of fiscal irresponsibility and overpaid public employees.

The problem with narratives (on either the right or the left) is when they cobble together related events and actors without a theoretical framework and empirical evidence. Mr. Meyerson is holding several of the puzzle pieces but then forces them together without regard to how they fit.

Some puzzle pieces he correctly identifies: a housing bubble, the role of banks, the economic fortunes of the Inland Empire, and the fiscal effects of California’s Proposition 13. What he airbrushes or ignores are the roles of Fed Policy, government lending, regulatory and land-use interventions, the short-term incentives of politicians, the hand of special interests, unions, and erroneous accounting assumptions that generated the perfect storm for a fiscal fallout in 2008.

Stockton’s troubles are plain for all to see. Steven Malanga discusses them here. The municipality’s spending spree can be traced to an overheated housing market which drove Bay Area homebuyers into Stockton in search of cheaper properties. That lead to a 20 percent population growth and a surge in property tax revenues fueling Stockton’s appetite for redevelopment. In 2003 the city borrowed for a waterfront revitalization and a 5000-seat sports arena. They bonded for pension enhancements. In total the city issued $700 million in debt.

Part of the pension deal allowed workers to retire at 50 with 90 percent of their final pay plus COLAs. To pay for this, Stockton invested some bond proceeds into CALpers on the bet it would earn more than the interest payments on that debt. They lost that bet. The housing boom – itself the creation of decades of government interventions – created the mirage of ever-increasing revenues that encouraged politicians to play fast and loose with bonds and future promises to workers.

The next claim is that defined benefit plans have been “demonized” also misses the mark. Defined benefit plans – or annuities – have been destroyed by those who champion them most loudly. Faulty government actuarial assumptions made them appear cheap to operate. That encourage politicians to offer workers (in union negotiations) increasingly generous retirement terms all while underfunding those benefits and taking risks with plan assets. This is accounting chicanery, and sadly, it was not (and still isn’t fully) recognized as such. The blame there can be pinned on the esoteric but well-documented trouble with defined benefit pension accounting. This case has been made in great technical detail by economists and practitioners.

The right salary for a public worker can really only be determined with reference to a private sector counterpart. It isn’t backed into based on area housing prices. Biggs and Richwine find public teacher salaries are on par with a private sector counterpart (in terms of SAT scores and skills). But, salary is only one component of total compensation for public sector workers. Compensation also includes (undervalued and underfunded) pension benefits and (largely unfunded) health benefits. Public sector compensation is a big and growing part of many municipal budgets. What can be said is that the cost of San Bernardino’s police and firefighters represent three-quarters of the city’s expenditures and revenues are flat.

Again, Meyerson is holding one of the right puzzle pieces: the revenue bust that followed the housing bubble. But he fails to note that it was the government-induced housing bubble and subsequent revenue boom that tempted public officials to overextend themselves. This house of cards was supported by flawed accounting and incentivized by short-term gains. This is why to make those pieces fit one needs a theory and empirics otherwise the diagnosis of San Bernardino’s and Stockton’s bankruptcy is cast aside in service of the meme. It is “politics with romance.”

What caused these two cities to tank? A host of economic and fiscal factors and scores of regulatory interventions over many decades. Some of that can be found in the accounts and CAFRs. They are no fun to comb over but they reveal choices, bargains, and tradeoffs under constraints and contain the record of the evasions and faulty assumptions of “public choosers.”

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