Could Detroit's tragedy have a silver lining?

July 22, 2013: 8:48 AM ET

Detroit's bankruptcy could be the wake-up call Congress needs to deal with the residual problems from insufficient growth five years after the financial crisis.

By Mohamed A. El-Erian

detroit-bankruptcy-620xaFORTUNE -- The strong and impressive recovery of the U.S. auto industry has proven insufficient to prevent the proud "Motor City" having to declare bankruptcy. The next steps involve difficult and complex legal and financial issues, some of which conflict with traditional concepts of social justice. There are also questions as to whether this largest-ever city bankruptcy in American history will have negative impacts that extend beyond a community that has already suffered through too many tragedies.

Detroit's bankruptcy has been years in the making. It is the result of repeated political and financial mismanagement, inappropriate financial engineering, and institutional failures. The auto industry's initial inability to withstand international competition eroded jobs, incomes, and tax receipts. As the city suffered, people, companies and jobs migrated to other more buoyant locations. The subsequent erosion of the tax base made it even more difficult to meet expenses associated with public services and pensions, both current and future.

Kevyn Orr, Detroit's emergency financial manager, felt that there was no alternative for the city but to declare bankruptcy. Similar to the 2009 bankruptcy of two of the big three auto makers (Chrysler and General Motors (GM)), the hope is that Detroit will reemerge with financial obligations that correspond more closely to its income and assets.

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Already, tough financial and legal issues have come to the surface, including the often-tricky interactions between seemingly-conflicting federal and state laws. And the most complicated aspects relate to burden sharing – or who, among the city's many stakeholders, suppliers and creditors should take a hit, and in which relative and absolute sizes.

This pits pension recipients against creditors, and suppliers against beneficiaries of basic public services.

Should the city pay its senior bond holders while cutting the pension payments that retirees earned and get? Should bondholders who financed investments in municipal services get priority when it comes to allocating payment receipts?

As the seniority of payments implied by legal contracts can often conflict with what many would view as socially just, it has not taken long for some to suggest the need for the federal government to bailout Detroit. In addition to protecting municipal workers' pensions from deep cuts and countering some of the pressure for yet more outmigration, this could also open the door to overriding legal seniority (as occurred a few years ago with the Federal government's auto bailout).

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Yet a federal bailout is far from a simple proposition. Even if the political will existed, which is far from obvious, the spillover effects could be considerable:

  • Washington would find it very hard to ring-fence such a bailout given that there are other cities and towns that share Detroit's terrible combination of a small and contracting revenue base, large unfunded pension liabilities, and excessive indebtedness;
  • The deeper politicians venture into municipal bailouts, the larger the pressure on the Federal budget at a time when sequester-related wounds are still fresh and few wish to see another debt-ceiling debacle; and
  • The larger the number of actual and potential municipal bailouts, the greater the temptation to tamper with legal bankruptcy procedures that have two distinct objectives: to enable entities to reemerge, albeit at a considerable cost, from financial catastrophe on a more solid footing (including the possibility of restoring a growth and prosperity path that was precluded by a massive debt overhang); and to reinforce a generally predictable rule of law that plays an important role in maintaining the flow of affordable financing to a whole host of municipal activities and investments.

Whichever way you look at it, Detroit compels the administration to consider yet another difficult choice that is not of its making. But there is also a silver lining to this new cloud.

Detroit's tragedy is an extreme component of an unfortunate reality that still prevails five years after the onset of the global financial crisis: Due overwhelmingly to political polarization and dysfunction, both of which repeatedly undermine proper economic governance, America has yet to deal effectively and comprehensively with its residual problems of insufficient growth and employment engines together with pockets of excessive indebtedness.

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Perhaps Detroit's very public financial demise could serve as a catalyst to significantly elevate popular awareness of this sad and unnecessary reality.

Perhaps it could serve as a rallying point and unifying vision that have eluded Congress for too long.

Perhaps it could act as a catalyst for the tough decisions that are needed and which Congress continues to sidestep.

This is certainly the hope of many who worry about America's persistently high unemployment, its stretched social safety nets, and excessive income and wealth inequality.

Maybe, just maybe, Detroit could be a new "Sputnik moment" for American politicians and the electorate. But if this important hope remains just that -- a hope rather than an evolving reality -- Detroit's considerable human tragedy would end up also constituting yet another wasted crisis for America.

Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.

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