The Corner

Did the Free Market Kill Detroit?

It has been suggested that Detroit’s longtime problems and recent bankruptcy are the result of the free market: The Washington Post’s E. J. Dionne suggested free trade killed Detroit; MSNBC’s Melissa Harris-Perry, on the other hand, explained Detroit’s problems resulted from lack of revenue collection, which happens when government becomes so small that you can just “drown in your bathtub,” “exactly the kind of thing that many Republicans would impose on us.” In that context, here are a few things to keep in mind about Detroit.

First, when thinking of Detroit’s lack of revenue, it’s worth noting that it is insufficient relative to the city’s oversized government spending. Some of that spending goes to paying for public employees and, as it turns out, Detroit has more public employees per capita than almost any similarly sized cities (and that’s after downsizing its public work force quite de bit). In 2011, the city had only 55 residents per employee, lower than all but one peer, San Francisco:

Second, while a lot has already been said about the size of Detroit’s unfunded pension and health-care obligations, not enough is said about the accounting illusion behind the tremendous gap. My colleague Eileen Norcross explains:

Detroit’s pension benefits suffer from the same embedded accounting errors being made in all public sector plans. Expected asset returns are used to calculate the value of pension liabilities, and then determine the annual funding amount. It’s the equivalent of re-calculating your monthly mortgage bill based on how much you think your investments will earn in the coming year. And that’s a big mistake. As economists point out, the two are independent in terms of their value. Not so in public pension accounting – and that’s where all the trouble begins. 

For years, public plans have been calculating the value of government-guaranteed (read: safe-and-default-free-like-a Treasury-bond) pension benefits with reference to risky asset returns. The problem is that this leads to systemic undercontribution, even when asset returns are meeting expectations.

Pension shortfalls didn’t suddenly crop up in 2008; they were partially revealed by a dramatic market drop. I took a look at the actuarial reports for Detroit’s two pensions plans to discover just how different the shortfalls are between actuarial accounting and market-valuation pension accounting.

Using government assumptions – an 8 percent annual return on assets – to value plan liabilities, Detroit’s two main pension plans – the General Retirement System (GRS) and thePolice and Firefighters Retirement System (PFRS) – are in good condition with a total unfunded liability of $634 million. The GRS has a funded ratio of 83 percent, and the PFRS a funded ratio of 99 percent.

Using market-valuation – that is, valuing these plans as though they are guaranteed to be paid, or as safe as a government bond – reveals the plans to be in critical shape. GRS has an unfunded liability of $5 billion and a funded ratio of 37 percent. The PFRS system has an unfunded liability of $4.7 billion and a funded ratio of 44 percent. Detroit’s total pension liabilities are many times larger than is recognized.

This in-the-weeds accounting detail is the reason for decades of poor choices that have made public plans look far healthier than they actually are. The consequence: Systems are running out of money and pushing these plans to a pay-go status. 

The same accounting system is used across the country by city and state governments, so we should expect more city-government bankruptcies in the near future. In fact, Josh Rauh of the Hoover Institution notes that “unfunded state and local liabilities are around $4 trillion when the liabilities are correctly measured.” That’s significantly higher than the official $1 trillion number.

Third, Detroit has lost a lot of people over the years in part because of the city’s incredible abuse of eminent domain — not exactly the free market. Over at Volokh Conspiracy, Ilya Somin explains (via Tyler Cowen):

Detroit’s sixty year decline, culminating in its recent bankruptcy, has many causes. But one that should not be ignored is the city’s extensive use of eminent domain to transfer property to politically influential private interests. For many years, Detroit aggressively used eminent domain to promote “economic development” and “urban renewal.” The most notorious example was the 1981 Poletown case, in which some 4000 people lost their homes, and numerous businesses were forced to move in order to make way for a General Motors factory. As I explained in this article, the Poletown takings – like many other similar condemnations – ended up destroying far more development than they ever created. In his prescient dissent in Poletown, Michigan Supreme Court Justice James Ryan warned that there was no real reason to expect that the project would produce the growth promised by GM and noted that Detroit and the court had “subordinated a constitutional right to private corporate interests.”

Eminent domain abuse certainly wasn’t the only cause of Detroit’s troubles. But the city’s record is a strong argument against oft-heard claims that the use of eminent domain to transfer property to private economic interests is the key to revitalizing economically troubled cities. In addition to the immediate destruction and dislocation caused by such takings, they also tend to deter investment by undermining confidence in the security of property rights. 

There is much more at the link.

Finally, last April on EconTalk, Russ Roberts interviewed economist Ed Glaeser about urban failure, and they spent a significant amount of time talking about Detroit. It’s worth listening to the whole thing. Glaeser also had an interesting New York Times piece in 2011 on this issue.  


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