The Role of Finance in Detroit’s Bankruptcy and State/Local Budget Woes

This Real News Network interview with INET executive director and political insider Rob Johnson focuses on what he calls “ugly money politics” which for the most part means the role of finance in state and local elections. He points out how the trigger of Detroit’s bankruptcy was an over $300 million derivatives payment triggered by a ratings downgrade of the city. Oh, and the city manager who approved that deal took a job with the firm that profited from this toxic trade.

Johnson also points out why pensions loom so large in budget train wrecks. State and local governments, which have been under stress due to lower Federal contributions as well as weak tax revenues, often persuade themselves that they can underfund pensions and make up the shortfall by investing more in high-risk strategies to earn more returns. That also happens to provide more in fees to powerful financial players. The potential for corruption is obvious. We wrote earlier this week about how the North Carolina Treasurer Janet Cowell is embroiled in a corruption scandal, and is accused of oversight failures that cost taxpayers $6.8 billion. That comes from her mismanagement of state pension assets, which are bottom or near-bottome performers when measured against a peer group. And as reader TheCatSQuid pointed out:

A March 2012 article calls Janet Cowell “The Treasurer of Wall Street”, ranking #3 amont State Streasurers according to percentage of campaign funds raised from out of state. In terms of actual amounts of funds raised from out of state, she raised more than the #1 and #2 person combined.

Similarly, David Sirota of Pando pointed out yesterday how the two state governors pondering Presidential runs have taken the big-finance-friendly strategy of increasing their state’s pension fund allocations to high-risk alternative investment strategies like private equity:

In Sacramento, for instance, state officials running the nation’s largest pension fund, CalPERS, seem to be raising red flags about alternative investments. As Pensions and Investments reported, CalPERS officials “have begun cutting the system’s $5.3 billion hedge fund allocation in half” and have already been slashing its private equity allocations.

By contrast, in New York and Maryland, lawmakers are moving to dramatically increase the amount of public money given to high-fee, high-risk Wall Street firms. Not surprisingly, data from the Institute on Money in State Politics show the governors of those two particular states, Andrew Cuomo (D) and Martin O’Malley (D) just so happened to have collectively raised $3.6 million from the securities and investment industry – which is also the industry that stands to benefit from the allocation shift into these high-fee firms. Additionally, those two governors just so happen to be rumored to be considering presidential bids, which tend to be bankrolled by Wall Street.

Johnson also discusses how the reform-minded among the elite feel stymied and despondent. Even if they pool resources, they can’t stand up against some of the worst actors, like Big Oil. They are willing to pay more in taxes but are concerned that even they can’t move the consensus towards measures to make society fairer, like improving eduction and lower the cost of college, and creating more jobs, particularly in areas of obvious need like infrastructure.

PAUL JAY, SENIOR EDITOR, TRNN: Welcome back to The Real News Network. I’m Paul Jay. And welcome back to Reality Asserts Itself. We’re continuing our series of interviews with Rob Johnson, who joins us again in the studio.

Thanks for joining us.

ROB JOHNSON, EXEC. DIRECTOR, INSTITUTE FOR NEW ECONOMIC THINKING: My pleasure.

JAY: One more time, Rob is the president of the Institute for New Economic Thinking and a senior fellow and director of the Global Finance Project for the Franklin and Eleanor Roosevelt Institute in New York. And all of Rob’s bio’s down below the video player. And you really should watch all the other segments of this series, ’cause it’s mostly biographical.

So we’re talking about the power of finance and how destructive it is in terms of the well-being of most people. This takes place even at the level of cities. This isn’t just a big international/national issue. You did work recently on the bankruptcy of Detroit. What did you find?

JOHNSON: Well, in particular in Detroit there are always–I mean, there are many factors in Detroit, demographic decline in the aftermath of the ’67 riots, long periods of white flight, etc. But going back to your perspective on finance, what sends them over the waterfall are very, very large, questionable derivatives trades guaranteeing what are called certificates of obligation that lead to penalties. Now, who on behalf of the city would say if there’s an emergency manager appointed or you get a downgrade on $700 million, you should pay $300 million of a penalty? Well, they’re being told to pay more than $300 million of these penalties. This is absurd.

JAY: By who?

JOHNSON: Well, that was what was put into the contract, where a city manager–excuse me–the mayor of Detroit at that time, Kwame Kilpatrick, had a financial manager who dealt with a private sector financial firm, and they made this contract. By the way, that individual subsequently left as city manager and joined the firm on the other side of the trade and is now embroiled in controversy in Michigan, because he and the CEO of that private sector firm are involved in a romantic relationship together. But this is–so if you want to do another house of cards type segment,–

JAY: Yeah, really.

JOHNSON: –you can do that. But there’s just a lot of financial shenanigans.

JAY: I mean, one of the things you were writing about was how they deal with pension fund investments and that the amount of risk they were–. And why did a city like Detroit–and I’m sure it wasn’t the only one–why take such risk with people’s pension money?

JOHNSON: Yeah, the emergency manager, Kevyn Orr, in his filing for the bankruptcy plan, goes into great detail in the text about all kinds of alternative investments, which–he claims there is no discernible way to find a value for these investments. I think some of them are what you might call ways in which people are enriched who make campaign contributions to people aspiring to elected position. I think the quality of monitoring and transparency is very, very weak. As a matter of fact, Orr cites in this document that one of the members involved with the city Council has been investigated by the FBI and is now being charged with being partner to a fraud. So there’s a lot of shenanigans that are going on.

JAY: So we’re talking about municipal workers’ pension funds.

JOHNSON: Municipal workers’ pension funds or, alternatively, the obligation, the defined-benefit obligation to those people that’s the responsibility of the taxpayers. And what you see is that whether you view it from the eyes of the beneficiary or the eyes of the people who have to make good to the beneficiary, these are public goods that concentrated parochial interests playing an inside game are taking advantage of.

JAY: So there’s the sort of fraud and that kind of component. But if I understand a recent piece you wrote about this, that the underlying issue here is the cities are concerned about how they’re going to pay these pension obligations in the future, so instead of taxing the wealthy and making sure that if they’re needed there’s some kind of reserve there, they do high-risk investments on the pension funds, and then if they lose a bet, then they’re just in trouble.

JOHNSON: They’re in deeper trouble, but still in trouble.

What you’ve seen since the crisis of 2008 is federal cutbacks to state and local governments, which causes the states to, how you say, tighten their belts and cut off the cities or diminish transfers to the city. You then see diminished income tax revenue, sales tax revenue, and property tax revenue associated with the slump. So you go into a budget crisis and you tend to, quote, underprovision for the pension. The annual required contribution is not made. As the funded assets fall in relation to the value of obligations, the tendency is to throw the Hail Mary pass, reach out to higher-yield investments. But that despair is what makes what you might call the temptation to resort to things that turn out to be frauds or, how you say, too good to be true more and more prevalent, which tends deepen the losses.

JAY: For cities right across the country, this is issue of how to deal with finance, how to raise money for schools, and so on, I know Baltimore was one of the cities that was involved in a class-action suit against the banks involved in the LIBOR scandal, where the banks have now had to admit that they were committing a fraud and how they were setting interest rates, and these interest rates were affecting all the bond markets and loans that the cities were getting. I mean, the cities are up to here in dealing with the finance sector.

JOHNSON: Yes.

JAY: But aren’t they up to here in borrowing and dealing with the finance sector because either they or the states simply won’t tax enough? I mean, there is the money there.

JOHNSON: Well, there’s two dimensions to it. The unsavory activities are not prosecuted, in part because the financiers are making political donations to the legislature, the governors, the pension fiduciaries who were up–some pension fiduciaries are elected. Those people are in need of campaign funds. So the idea of enforcing rules against bad behavior from well-heeled financial firms is not likely to take place. So there’s also the fear in any given region, say, in Maryland, that if you don’t create subsidies and tax incentives for firms, they’ll locate somewhere else and you’ll lose your tax base. Then there’s the fear among high-income people–excuse me–there is a fear among government officials that high-income people, if you raise the tax, might migrate to some other place, they might move from, say, Maryland to Virginia.

JAY: Even though there’s studies that show that’s not so true.

JOHNSON: The evidence is overwhelming that when you raise income tax modestly, people do not move. But is that reality really important when your elected officials depend upon the upper-income people for their campaign donations? They may not move, but they may not give you the donation. So the mythology that they might move is actually useful in resisting social pressure to raise the revenue.

What bothers me a great deal: Detroit declared bankruptcy, but they’re not raising the water rates from Detroit water and sewage that serve about three and a half million people in the metropolitan area. I mean, the city’s only 700,000 people. Detroit is not raising taxes, Detroit is not asking for state transfers, they’re not raising revenue, and they’re choosing to restructure the pensions of already retired people and end the health care component of their retiree benefits. They’re saying they need to do this in the name of future prosperity. But if there were a little revenue raising in the mix, too, it might be considered a more legitimate what you might call balance of the distribution of burden of adjustment.

So I don’t really like what I see in the Detroit case. And as I look at municipalities around the country, very few places are raising revenue. Chicago is not even declaring bankruptcy, and they’re cutting the corporate income tax at the same time as they’re looking for restructuring on the pension funds. This is ugly money politics political economy. It’s not like a corporate bankruptcy. In a corporate bankruptcy, there’s not enough money, so you’ve got to restructure things. Here you’re choosing not to invoke your taxing power and raise money and restructuring people. You’re defaulting, essentially.
JAY: You know a lot of wealthy people. You know a lot of influential people in the American and international elite. Most of them are absolutely adamant that they don’t want to pay higher taxes. They would like to pay, I guess, next to no taxes, and many of them are. Do they not get how–even within this system, how destructive that is?

JOHNSON: I guess I would differ with–

JAY: Or do they just don’t care?

JOHNSON: –I would differ a little bit with what you said. I know a lot of wealthy people, you’re right. I don’t think all of them–

JAY: No, I didn’t say all.

JOHNSON: –are averse. As a matter fact, I think many of them feel the incoherence of our society and feel that in a coherent system they would be willing to pay more taxes. What their concern is is the government is so dysfunctional that they might pay more taxes, and it wouldn’t go to socially wholesome outlets that helped reestablish that coherence. So there’s a lot of despondency even amongst the wealthy that systemically we’re way off course.

JAY: But do they want–you know, if you want to have a change in government, you have to have a real democratization of the politics. And I think–I personally think you also have to–out of a real democratization of the politics, you will get a tremendous pressure to democratize the economics,–

JOHNSON: Yes. That’s right.

JAY: –you’ll have–you know, about who owns stuff and how income is distributed.
JOHNSON: That’s right. Yeah. The so-called job creators don’t necessarily create jobs, they just make money, in the eyes of a large portion of the population. I think the–there are a lot of wealthy people, though, who are very, very concerned at this juncture that things are not going well and, how do I say, social dysfunction can only be warded off with gated communities and private transportation for so long.

I think people are very concerned that the rungs in the ladder–. You know, some people are not so concerned about equality of outcomes; they focus on equality of opportunity. When you’re jacking up the tuitions in all the state universities because of these municipal problems in part caused by financial malfeasance, that’s taking rungs out of the ladder. When it costs $150,000 or more to go to a private university, you’re not creating a ladder of opportunity for the able who don’t start out with a full financial deck because of what you might call being lucky as to who their parents were. I think that the United States’ social mobility is diminishing a great deal, and there are a lot of people in all walks of life very concerned about this.

JAY: But if you look at the elite as a whole, I mean, if a preponderance of the elite wanted to fix it–,

JOHNSON: [crosstalk] not changing.

JAY: –it would get fixed.

JOHNSON: Yes. Well, I would say this. Some of what you call “elite” doesn’t operate as private individuals. They operate through the lobbying entities of their corporation. And they are first and foremost focusing on the survival and the thriving of the corporation vis-à-vis the rules of the game more than they’re out thinking about themselves. But the collection of all of this political activity is producing something that doesn’t cohere.
JAY: I mean, in terms of day-to-day living, how their children are going to do, they do have gated communities. You know, this doesn’t–even, like, you would think for a year or two it looked like the climate change crisis was actually starting to penetrate, and then that went away.

JOHNSON: Well, I was going to bring that up. I think there are a lot of wealthy people that want their children and grandchildren to be able to breathe, but they don’t know how to bring about that change, ’cause they’re facing concentrated fossil fuel industry as individuals, and they don’t think they can overpower big oil companies that use their cash flow for lobbying and public relations and so forth. There are very few elite individuals, even aggregated together, that bring together the kind of cash flow and revenue to be able to take on that formidable an adversary. So I think there’s a lot of despondency even among the wealthy. But the wealthy can ride out the storm, of course, much better than the rest of society, and that may anesthetize some of their willingness to what you might call roll up their sleeves and get into the fight.

JAY: So for people not in the elite and, it would seem to me–which is obviously most people–and if the solution ain’t going to come from the elite, ’cause the sections or individuals in the elite that are concerned about all this, they seem very unable to change the course of things,–

JOHNSON: Yes.

JAY: –what should ordinary people do?

JOHNSON: Ordinary people need to participate actively in politics in a way that takes money out of politics. You have to remove the currency of the wealthy and the powerful in order to restore the responsiveness of the system to individuals and voters.

Second thing we do need for a healthy democracy is a very, very vibrant education system so people know what not to be attracted to on television, so people know how to go and research a subject and understand what good public policy is. Part of what’s harming America is the deterioration of what a large portion of the population receives as education, and that’s very, very unfortunate to the fabric of democracy.

JAY: Alright. One more sort of warning note, I guess. And if nothing significant changes, what does this place look like in five or ten or 15 years?

JOHNSON: You know, the danger is that as dysfunction increases and the people subject to that dysfunction are a very, very large proportion of the population, you start to either experience social disruption or you experience what you might call authoritarian crackdown on that social disruption.

And at one level or another, it would be nice to see a political reform, what you might call a civilized tacking in a new direction, rather than a physical confrontation. But sometimes you have to have a crisis to make change. And it’s not clear that the elite stewardship, whether it be corporate or individual, is sufficiently constructive right now and able to bring this, how would I say, onto a new, more healthy path without some crisis as a precipitating factor. It might be environmental, it might be social.

Often, as Bismarck used to say, when you can’t solve your own problems, you go to war. I wouldn’t rule that out, given the strength and the vitality of the military-industrial complex in this country. But the last two or three wars we’ve been involved in haven’t really shown the American people much that they, how would you say, took solace from. I think warfare’s changed quite a lot.

And we’re at a juncture now where I think what we really need is a healthy revitalization of politics, first and foremost getting money out of politics.

JAY: Alright. Thanks for joining us.

JOHNSON: My pleasure.

JAY: And thank you for joining us on Reality Asserts Itself on The Real News Network.