Local Financial Crises: View from the edge

Jun 10, 2019

By Rebecca Hendrick

Member, GFRC Faculty Advisory Panel, Professor, Department of Public Administration, University of Illinois at Chicago

When state and local governments face a financial crisis, typically, there’s a call for action. But the exact nature of the response is often debated by public policy makers, public interest groups, and others.  Fiscal crises occur when governments cannot pay their bills, meet payroll, make bond payments, or carry out essential services. This condition can result in credit down-grades to states, counties and cities. It can also hinder economic growth and, most important, threaten the health, safety, and welfare of the public that reside in or visit the jurisdiction.

The reasons governments reach this extreme condition are numerous and complex, and usually progress incrementally over time.  Although there might be one event that drives a government into a condition of insolvency, such as a massive loss in the value of financial assets as happened with Jefferson County in 2011, it is more likely that the government has experienced long-term deterioration in their financial condition due to gradual decline in their economic base compounded by bad financial decisions and even corruption.  This is true for many fiscal crises in local governments in the post-industrial areas of the country including Detroit (2013), Flint (2002), Cleveland (1978), Buffalo (2003), Newark (continuous), and Philadelphia (1991).

These governments stand in stark contrast with others such as Orange County (1994) and San Diego (2004), which have some of the highest residential income levels in the nation.  Although economic growth has occurred in Cleveland, Buffalo, and Philadelphia since their crises, these communities and others still face an entrenched structural imbalance between their tax bases and spending needs  according to the Economic Innovation Group report for 2016.  Compared to Orange County and San Diego, such conditions make it difficult for these governments to generate enough revenue to meet the higher service demands of their population after making all palatable service cuts and adding user fees or taxes that can be implemented without extreme political pain.

In such circumstances, many insolvent governments have no room for more cuts or tax adjustments.

Despite the differences in the causes and levels of fiscal insolvency in local governments, there are only two primary ways of dealing with fiscal crises.  Both methods are designed primarily to resolve the kinds of problems experienced by entities like Orange County and San Diego and not cities like Detroit, Flint, and East St. Louis (1991 – 2013).  These solutions are bankruptcy and state oversight/intervention.

As a solution, bankruptcy is the most aggressive in giving an external body, the court in this case, the authority to adjust and restructure a government’s debt and contracts in order to reduce their immediate financial liabilities. Bankruptcy, however, is a rare event for any government in which insolvency has been narrowly defined by the courts as the inability to generate enough cash to pay existing bills, debt service, and other obligations with available funds.

The second solution, state oversight and intervention, takes many forms with varying levels of control ceded to the state over a government’s finances and governing.   Technical assistance to governments in crisis is among the least intrusive or aggressive; appointment of an external body to take charge of operations and budgets is among the most intrusive.   According to the Pew Charitable Trusts’ report on The State Role in Local Government Financial Distress (2013), 18 states have enacted laws designating local fiscal distress, 20 states have some form of intervention, and only 11 states authorize bankruptcy by local governments without conditions (16 additional states authorize limited or conditional form of bankruptcy).  Some states, such as North Carolina, Florida, and Michigan, also rigorously monitor the fiscal health of their local governments as a form of early warning of financial distress and to intervene before a crisis occurs.

The problem with these solutions is that they will be less effective in dealing with long-term and extreme structural imbalances in the revenue bases and spending demands in many jurisdictions.  More recently, these spending demands include pension obligations.

Several of the most recent fiscal crises in Vallejo (2008) and San Bernardino (2012) were driven in large part by generous retiree benefits and rising pension obligations that could not be supported by the cities’ weakened economies.  Whatever the source of the long-term insolvency, neither bankruptcy nor intervention and oversight can solve the problem of balancing future spending and revenues that exists for local governments facing these kinds of pressures. In such cases, no amount of sound financial decision-making, efficient operations, and restructuring of current obligations will make these governments less vulnerable to another fiscal crises.  Rather these governments must grow their way to greater revenues or reduce future spending obligations.