Detroit and Cyprus offer debt lessons for budget
Cheap money has fueled a 'buy now, pay later' bubble that governments have to deal with
In Toronto, the house would be worth a million dollars. But in poor crumbling Detroit, it is a ruin that no one wants. Detroit is not officially bankrupt yet. Neither is Cyprus. But both are considering desperate measures to patch the holes in their sinking finances.
Detroit and Cyprus both seem very far from the Canadian experience. But both cases offer lessons for Finance Minister Jim Flaherty as he prepares to release his budget this Thursday. And they offer a warning for a world living on debt.
Just a few decades ago, the idea of Detroit going bankrupt would have sounded as crazy as Canada going broke today. Detroit had a booming industrial economy. The hub of America’s biggest engine of growth, the automobile industry, Motor City had a population of nearly two million.
With standards set by the car business, city employees had good benefits and pension packages. But with the woes that have befallen the automotive sector, the city has shrunk by more than half and with it, the tax base. As taxes declined, the city made up the difference with borrowing. At first the loans were small. Then, they got bigger.
Now, Detroit has been living on debt so long it can’t cover its interest payments — not while running the city at the same time. Something had to give.
At the end of last week the state of Michigan put the city into the hands of Kevyn Orr, an unelected emergency manager and bankruptcy lawyer.
In his search for money to patch up the budget, Orr has his eye on city employees’ pensions.
Here is the polite way the emergency manager put it: "On the employee retirement side there are people like my mother that have done nothing wrong … and I have to go to them and say 'your expectations may need to change'."
Cyprus sits on precipice
Almost half a world away from Detroit, at the eastern end of the Mediterranean, Cyprus and its banks are also effectively bankrupt.
Without a cash injection from the European Union, the banks will default, the country itself will not be able to cover its debts, expected to hit 140 per cent of GDP by next year.
But as with the state of Michigan and Detroit, Europe does not want to bail out Cyprus all on its own. Instead it has asked for a forced donation, not from pensioners, but from depositors in Cypriot banks, many of them rich foreigners.
I find it interesting the different reaction between the two sets of confiscations.
Today, there has been a roar of outrage that the people rich enough to have more than 100,000 euros in cash should be forced to contribute less than 10 per cent of their money to a plan that would prevent their cash from disappearing altogether.
"The principle that there is no division between your private property and communal property which may be appropriated by the government whenever it sees fit, is an outrageous one in any system other than Communism," was how the Daily Telegraph described the plan.
But similar contributions from policy holders in bankrupt pension plans never seems to attract such a strong reaction — although that may change if Detroit protests escalate.
That is not my point today. The point is that while borrowing feels painless in the short term, at some point, someone has to pay the piper.
Governments of the world have set interest rates to zero. (Less than zero if you factor in inflation.) They print imaginary money and buy bonds from themselves to keep interest rates low. But they, like Detroit, like Cyprus, are borrowing against the future. They are creating a new bond bubble to flood the world with liquidity that eventually will have to be unwound.
Canada should be wary of playing this game. It may be wise to borrow to invest in something that will truly create new income. But just as in your household finances, borrowing to cover daily expenses will end in pain.
Because whether you are a rich Russian living in sunny Cyprus, a Detroit city worker enjoying your retirement or a Canadian taxpayer, getting a government handout seems just fine.
Right up until being forced to pay your share of the bill starts to feel as if it is "outrageous … in any system other than Communism."