Should California Let Stockton Go Bankrupt?

Should California Let Stockton Go Bankrupt?
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Early last week, a federal court ruled that Stockton, California was eligible for bankruptcy. The decision represented a victory for the city, which wants to be in bankruptcy, and a loss for creditors, who argued that Stockton wasn’t broke enough to deserve federal permission to dodge its obligations. To substantiate his ruling, Judge Christopher Klein said that Stockton was in a state of “service delivery insolvency,” meaning that it’s unable “to pay for all the costs of providing services at the level and quality that are required for the health, safety and welfare of the community.”

This proves too much. By going beyond debt and deficits to raise the issue of why Stockton city government is not functioning properly, Judge Klein inadvertently weakened the case for bankruptcy and pointed the way to state takeover, a more logical solution to the city’s problems.

Municipal bankruptcy differs from corporate bankruptcy in the number of filing requirements that federal law imposes on the debtor. One of the important requirements is that of “cash flow” insolvency: the city must show that that it is unable to pay its debts as they become due. Over the objections of Stockton’s bondholders and bond insurers, Judge Klein ruled that the city met the fiscal insolvency requirement because any further spending cuts would threaten Stockton’s ability to provide basic services, particularly in the area of public safety.

How to know when a city is “service delivery insolvent”? Service delivery is just as much a question of administration as finance. Was New York City “service delivery insolvent” in 1990, when there were over 2,000 murders (31 per 100,000 pop.; Stockton in 2012 had 24 per 100,000, an all-time high)? Criminologists have demonstrated time and again that crime does not rise and fall in accord with economic cycles, although government revenues certainly do. Some poor communities are safe communities. The concepts of fiscal insolvency and service insolvency may overlap, but they’re not equivalent. If they were, every problem could be solved through increased government spending.

Judges have no training in public administration, nor independent knowledge, in a distressed city, of conditions on the ground or government operations. Indeed, Klein admitted he drew his assessment of service delivery insolvency in Stockton, and even the term itself, from an analysis by an independent consultant hired by the city.

But even if we accept that Klein’s analysis was basically sensible, and that Stockton’s crisis is extraordinary, it does not follow that bankruptcy is the solution. High crime caused by too few cops cannot be reduced to a fiscal problem. It’s a management decision to decide, as Stockton has, to employ a few highly-paid officers as opposed to many modestly-compensated ones. At present, Stockton does not intend to use Chapter 9 bankruptcy to cut pensions. City manager Robert Deis believes that “if Stockton didn't offer an industry-standard pension plan, we simply would not be able to staff an already challenged police department.” This claim that pension cuts would produce a dangerous undersupply of labor is belied by the 1,300 job applicants fielded last year by the Stockton police department (which has fewer than 350 sworn officers), and the Stockton metro area’s 14.7 percent unemployment rate. In response to Deis’ further claim that “We cannot just pluck people from the unemployment lines—the requirements to be a police officer are demanding and 99 percent of applicants do not qualify or, if hired, wash out,” Reuters’ Cate Long quipped: “99 percent of police applicants don’t qualify or wash out? Is the Stockton police force run by Navy Seals?”

Chapter 9 only offers fiscal relief through debt adjustment. It’s not designed to enact structural reform of city government. Stockton can adjust pensions and union contracts in Chapter 9, but it is not obligated to do so. Unlike in Chapter 11, the debtor remains in full control of operations. The judge does not design the debt adjustment package, and can only exercise indirect influence by issuing judgment on its fairness to all creditors.

Fortunately, there’s an alternative: state takeover, which is a better solution to fiscal distress than Chapter 9 because it targets the need for structural reform.

Consider Detroit, a city worse off than Stockton (Stockton gained population over the last decade). In late March, Michigan Governor Rick Snyder placed Detroit under the control of a state-appointed emergency financial manager. Snyder took this action for two reasons. One, Michigan’s emergency financial manager law provides state appointees with sufficient power—including the ability to modify contracts—to render Chapter 9 unnecessary. Two, Detroit faces an administrative crisis, not just a fiscal one. In the last six years, Detroit's annual revenue estimates were off by an average of 25 percent, and its spending estimates by 33 percent. Despite Detroit’s major crime problem, the state-appointed Financial Review Team that recommended the emergency financial manager found that the Detroit Police Department maintained “no reliable information” about staffing levels, not even how many officers are assigned to desk jobs vs. how many are engaged in police work. Detroit’s fiscal and economic problems raised the issue of state intervention, but its administrative dysfunction ultimately decided the matter.

Unlike Michigan, California has always had a laissez faire attitude towards fiscal distress, allowing local governments relatively free access to Chapter 9. California should reassess this non-policy, because of Chapter 9’s inability to drive structural reforms and because appointed state experts will always be better trained and better-positioned to evaluate a city’s fiscal and administrative problems than a federal judge.

Conservatives will be skeptical of any policy that looks to California’s notoriously union-friendly state government for help in scaling back outlandish compensation packages. But soft takeovers—whereby state appointees don’t possess the power to break contracts, only renegotiate them when they expire—would still be an improvement over leaving in place the same local governments originally responsible for the distress. A manager appointed by the state can be trusted to strike harder deals than elected officials, because he lacks their incentive to stay in favor with unions and other local interest groups.

By all means, let’s evaluate governments’ health based on their overall ability to provide basic services, and not merely by fiscal indicators. But when a city can be definitively said to be “service delivery insolvent,” its fate should be entrusted to state-appointed experts, not federal bankruptcy judges.

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