Detroit Bankruptcy - Only In America?

Empty factories, deserted homes, high crime: Detroit has experienced an unprecedented decline. Could heavily indebted German cities face a similar fate? And what can Europe learn from Detroit?

The demise of Detroit, the heart of the US auto industry and once a thriving industrial center, has been a slow process. The city today is in ruins.



Last Friday (19.07.2013), Detroit officially declared bankruptcy. It was a "difficult step but the only option," said Michigan State Governor Rick Snyder. The city has a debt burden of $18 billion (14 billion euros).



It may not be the first US city bankruptcy but it is certainly one of the biggest. Nearly 640 cities declared bankruptcy between 1937 and 2012. In Germany, by comparison, not one single city has been forced to go down that path, even though numerous communities are in financial difficulty.



Similar bankruptcy scenario?



Ralph Brügelmann from the Cologne Institute for Economic Research rules out the possibility of a German city encountering a bankruptcy scenario similar to Detroit's. "We have completely different financing structures in Germany compared to the United States, where the principle applies that every city should take care of itself, raise its own taxes and, if anything goes wrong, face possible bankruptcy," Brügelmann told DW.



German cities and municipalities can raise their own taxes, such as a business tax. But they have a second and far more important source of income - federal tax money that is allocated according to the number of inhabitants per state and city. "This means that a city automatically receives revenue and doesn't have to worry about it," Brügelmann said.



Berthold Wigger, a professor at the Karlsruhe Institute of Technology, also sees no parallels between German cities and Detroit, pointing to some experts who claim German municipalities are legally immune from insolvency. "When it comes to debt, German communities are far less independent than US cities," he said. "They are also subject to local supervision to prevent them from falling into debt."



German municipalities, however, have discovered some alternatives, including municipal loans. "Revenue and expenditures vary at different periods," said Wigger. "To cover expenditure, cities and towns can secure short-term overdraft loans. There are no set rules covering such loans, as there are for loans to finance investment projects."



Finding loopholes



Such loopholes, however, cannot be used arbitrarily, according to Wigger. Before a city could go bankrupt, it would be allocated a budget commissioner whose sole mission is to put the city back on track.



Unlike German cities, US cities can issue their own municipal bonds to generate fresh capital. But they also have to bear the risk. That is what caused Detroit's bankruptcy. Since 1937, US municipalities may seek protection under Chapter 9 of the Bankruptcy Code. This possibility allows them, for instance, to renegotiate contracts and delay payments.



There's no such provision in German law. And why should there be? "We have the idea in our federal system that we support each other. The states and the federal government help financially strapped municipalities," said Wigger. "But these are negative incentives. If you know you'll get help, you won't take enough care to ensure that you don't get into such a difficult situation."



'No Greek bankruptcy'



But which system is better: the alliance between states and municipalities or the purely separate revenue system? "The answer lies somewhere in between; both have positive aspects," said Wigger. "When a municipality is largely responsible for its own revenue, it has an incentive to become an attractive business location. But, on the other hand, in Germany we are able to establish a certain level of uniformity in living conditions and avoid letting cities fall when they encounter problems."



There are no bankruptcies on a European level either. As German Finance Minister Wolfgang Schäuble has repeatedly said, "there will be no Greek bankruptcy." Since the beginning of the sovereign debt crisis, all the machinery has been set in motion to keep eurozone member states from bankruptcy. The support has included aid packages, financial injections and other financial stability mechanisms.



"In Europe, many politicians are worried that a Greek insolvency could cause a domino effect, which would result in possible Italian and Spanish bankruptcies and ultimately the collapse of the euro," said Brügelmann. In the US, he added, no one expects the Detroit bankruptcy to cause any nationwide domino effect.



Wigger also sees no parallels to Europe today though he does think comparisons can be drawn to the situation before the crisis. "We actually thought about the same approach as the US - namely, the 'no-bailout clause,' which would prevent member states from helping each other out," Wigger said. The aim was to establish fiscal discipline. But at the moment when the no-bailout clause could have been applied, it was sidestepped with such instruments as the rescue package for Greece and the European stability mechanism.