Today, Detroit became the biggest US city to ever file for bankruptcy. Hearing bankruptcy in the same sentence as a city almost automatically leads one to think: what is that city thinking? A city should never file for bankruptcy - bankruptcy would cause too much damage to a city by scaring off bond investors and other creditors. However, this line of thinking is too absolute. In the case of Detroit, bankruptcy was likely the right move.
Detroit is a city fighting an immense amount of stigma. Jokes abound about Detroit’s poor financial situation and high level of crime. The city cannot afford to not aggressively combat this stigma. Stigma creates a vicious, painful cycle for cities - it scares away business investment and potential residents, leaving no tax base and more problems to be addressed. Stigma has a material, lasting effect. As someone that has spent a significant amount of time working in Newark, NJ, I’ve seen this first-hand. The riots in Newark in the late 1960’s have plagued Newark for over 50 years. A poor reputation for crime and poverty are many of our cities’ biggest obstacles.
Although combating stigma is hugely important for cities like Detroit, it is difficult to take the steps necessary to do so when the city must pass its revenues to creditors. Provide seed money to local entrepreneurs? Implement wireless internet services in a downtown park? Start an after-school program for impoverished youth? Can’t do it - we gotta pay the bondholders. Hence, the idea is simple: file bankruptcy, address city needs. Sound crazy?
As suggested above, filing bankruptcy creates a different kind of stigma: creditors view a city that has filed for bankruptcy as a risky investment and charge the city more to borrow money. Many would assert that this stigma should be a city’s main concern - it will prevent cities from getting REAL money, the level of funds needed for infrastructure and other large scale projects.
But, after filing bankruptcy, Detroit will still be able to find investors. There are always investors willing to make a very risky bet (see subprime lending fiasco). Furthermore, in the case of Detroit, whether the city filed bankruptcy or not, it was already a risky investment - the marginal cost of the bankruptcy to the city in terms of increased interest rates may not be much. At least bankruptcy gives the city a chance to begin addressing the issues that have made it a risky investment.
While there are always investors willing to buy a bond, our cities have shown us there are far fewer individuals willing to move to or start businesses in a stigmatized city. Filing bankruptcy and taking immediate steps to attack this self-perpetuating, long-lasting stigma, is likely the right approach for Detroit.