Default without capital account: the economics of municipal bankruptcy.

Author:Moberg, Lotta
Position:Report
 
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  1. INTRODUCTION

    These days, news media are full of reporting on governmental financial crises. The specter of default and bankruptcy looms across all levels of government, from small towns to large nations. Commercial corporations enter bankruptcy regularly and it is easy to understand how insolvency and bankruptcy can arise. (2) Companies borrow in the anticipation that the added revenue that capital infusion makes possible will exceed the expense of retiring the debt. In a turbulent world, however, commercial plans sometimes do not work out as their creators anticipated, and the corporation may end up unable to redeem its debt. While bankruptcy may not be the best way for the corporation to move forward in the commercial world, it is a viable option all the same. A plan can be worked out to restructure the enterprise and unprofitable parts of it can be eliminated. Creditors can be assured of a process that is orderly even if disappointingly unprofitable.

    Municipalities are in many ways like commercial enterprises. Cities have a formal similarity to hotels, with paying residents, services, transportation, and public and private spaces (McCallum, 1970; Foldvary, 1994; Wagner 2007, 2012c). Because of their similar structure, cities are often described as municipal corporations. Like their commercial cousins, municipal corporations also experience financial crises. In the United States, they have their own form of bankruptcy provision, denoted as Chapter 9, to complement Chapters 7 and 11 that pertain to bankruptcy by commercial corporations. The resemblance between municipal and commercial corporations thus allows for treating municipal bankruptcy as a special case of commercial bankruptcy. Those similarities, however, are superficial. Once one looks beneath that surface, the institutional differences between municipal and commercial corporations render dubious any facile extension of commercial bankruptcy to municipal corporations. Municipalities are but cousins to commercial corporations. With commercial corporations, there typically exists an active market for shares of ownership and there is at any moment a market value for the corporation. In contrast, there is no direct market for ownership shares of municipalities, so no market value can be established for them.

    Commercial bankruptcy is often described as a means of giving everyone in the corporate nexus a fresh start once it becomes clear that they will otherwise be unable to escape their insolvency. For municipal corporations, however, insolvency is often, though not invariably, a product of intentional political conduct. As we will see, municipal bankruptcy therefore leaves unaddressed the institutional sources of fiscal crisis. Municipal bankruptcy offers not so much a fresh start as it creates a fresh source of taxation by imposing a special tax on municipal creditors.

    While economic action always follows a universal logic of seeking gain and avoiding loss, the substantive force of that logic plays out differently under different institutional arrangements. In the section that follows, we explore how institutional differences between commercial and municipal corporations affect the nature of their capital accounts and their tendency to incur debt. We explain in Section 3 that municipal insolvency therefore does not carry the same meaning as commercial insolvency. In Section 4, we show that insolvency among municipal corporations is actually an inherent feature of the fiscal commons on which they operate. Democratic governments differ significantly from commercial enterprises in that they have systematic tendencies to push costs off to some future date rather than facing them now. Section 5 points to the weakness of the link between any concept of insolvency for governments and their propensity to go bankrupt. We thus argue in Section 6 that this means that bankruptcy for municipalities is an inherently illusive concept. We conclude by explaining why municipal bankruptcy can become meaningful only by significant institutional changes in how governments operate.

  2. MUNICIPAL CORPORATIONS AND THEIR IMPLICIT CAPITAL ACCOUNTS

    While municipalities, like commercial corporations, can become insolvent, bankruptcy has a very different meaning between them due to significant differences in their capital accounts. All corporations have capital accounts in the de facto sense of the term, along with a list of assets and liabilities. For commercial corporations, the capital account is real, as illustrated by the existence of a market for ownership shares. For municipal corporations, the capital account is only implicit. Municipalities operate with assets and liabilities, and so must possess capital accounts that achieve balance between the two sides. There is, however, no direct market for ownership shares, which means the capital account is only implicit or imputed and not actual. This difference between actual and implicit capital accounts ramifies throughout a wide range of issues regarding the operation of municipal corporations.

    The capital accounts of commercial corporations reveal their net worth. They are created by funds supplied by people who choose voluntarily to become shareholders and owners. This leads to a setting where corporate shareholders tend to agree about the distinction between good and bad corporate performance. With an open market in ownership of corporate shares, there exists at any moment a market value for the corporation that is governed by the willingness of people to buy corporate stock. A significant share of the compensation of corporate executives is also tied in various ways to the changes in market value of corporate stock. Corporate executives will therefore have strong incentives to maximize corporate value, as has been explored both theoretically (Meckling and Jensen, 1976; Fama, 1980; Fama and Jensen, 1983) and empirically (Manne, 1965). In commercial corporations, the interests of shareholders and managers are not in conflict with one another because they share a common interest in efficient corporate operation (De Angelo 1981; Makowski, 1983).

    Given the kaleidic nature of economic reality (Shackle, 1972; Shackle, 1974; Wagner, 2012a), it is nevertheless unavoidable that firm executives sometimes make decisions that turn out so badly that they lead to corporate insolvency. A corporation that incurs debt to finance a new construction project will do so under the belief that the project will increase the net worth of the corporation. If the project somehow does not generate sufficient revenue to cover the project's cost, this loss depresses the market value of the corporation. If no quick remedy is found for this situation, the corporation may end up insolvent and declare bankruptcy.

    Municipal corporations can face similar situations, only their capital accounts are implicit and not explicit, and this makes all the difference. With municipal corporations, there are no explicit ownership shares that can be bought and sold, so municipal corporations, unlike commercial corporations, do not have market value. Without market value, it is impossible to tie executive compensation to changes in an enterprise's market value. Therefore, where a commercial corporation might abandon a project that turns out to be unprofitable, a municipal corporation can increase taxes to cover the losses. One rarely if ever sees municipal executives abandoning a project because it has been proven not to be worthwhile. This difference in modes of operation is due at base to the differences in capital accounts. For commercial corporations, the stock market continually yields information about corporate performance. While such information contains variable amounts of noise that prevents the fundamental value from being perceived with full accuracy, no similar information can even be collected about municipal performance.

    Unlike a corporation's shareholders and executives, therefore, the interests of residents and public managers often mesh only incompletely. In both cases, an organization is managing many people's money. In a municipal corporation however, the officials deciding how to spend the money are not guided by the incentive to maximize the value of their investments on behalf of their residents. Elections are not a substitute in this regard. They represent what economists would recognize as cheap talk, because a vote is not accompanied by a purchase of a stock whose value is rising or falling. Voters, in contrast to commercial investors, do not place their own skin in the game (Wagner and Yazigi, 2013).

    A municipality might sponsor a major construction project that includes a tunnel under a river and an elevated roadway through the center of town. The project is sold to the citizenry under the claim that construction will require $100 million, which is secured by selling bonds. Like many such public projects, the original budget projection might prove to be too low. The project is half-finished and the money is gone. Does this experience mean that it is a bad project that should be abandoned? Perhaps it does. A commercial corporation in this kind of situation might abandon the project to secure its salvage value, recognizing that to continue the project might bankrupt the firm. Municipal executives, however, are not compensated by firm value. They have no significant capital invested in the municipality, and in any case cannot use market signals about firm value to obtain guidance from third-parties about municipal performance.

    It would therefore not be surprising to see the city's governing board approving a tax increase or borrowing to support completion of the project. Where a commercial corporation faces insolvency, a municipal corporation can increase taxes. There are of course limits on the ability of any municipality to increase taxes. A city council will not raise taxes to a level where the city becomes depopulated, though...

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