The big story of the week in the US has undoubtedly been the bankruptcy of the city of Detroit. I should stress that I have next to no insight into Detroit’s fiscal situation. However, the bankruptcy is nonetheless a reminder of the risks moral hazard.

Conservative commentators has been fast to pick up on a comment from President Obama who back in October last year made the following statement:

“We refused to throw in the towel and do nothing. We refused to let Detroit go bankrupt. We bet on American workers and American ingenuity, and three years later, that bet is paying off in a big way”

This quote is of course taken completely out of context. Obama was not talking about the municipality of Detroit, but about the Detroit auto industry. So claiming that Obama in some way had promised to save Detroit from bankruptcy is not really fair. However, the quote nonetheless raises a highly relevant question of local public finances and moral hazard, which is highly relevant for not only US municipalities, but also have wider global implications as I will argue below.

The moral hazard of local government

While Obama’s comments regarding Detroit was not explicitly about the municipality they nonetheless are a pretty good illustration of the general perception about the US federal government’s willingness to bailout major US cities and US states for that matter.

By saying that he was happy to have bailed out the auto industry Obama most likely also signaled that he would be equally happy bailing out the city of Detroit. Furthermore, the fact that Detroit has been run by Democrats for decades probably also adds to investors’ expectations for some kind of Federal bailout of Detroit.

However, as I said I don’t have a lot of insight to the finances of Detroit and what I really want to discuss is the general problem of moral hazard in local government.

The key problem is that central government – in the case of the US state and federal government – will be tempted to bailout major municipalities that gets into financial distress. In US history this of course has happened numerous times. Just imagine what would happen if the mayor of a major city comes out and says “We are bankrupt so from now on there will be no public services. The police force has been sent home”. If that happened it would put tremendous political pressure on state and federal government to “solve” the problem.

And this is really the problem in terms of local government funding. Investors know that they to some extent can rely on state and federal government to step-in and save the municipality even if it has been grossly financially irresponsible. As a consequence the financial markets will tend to significantly mis-price the risk of a default. This is, however, not market failure, but rather government failure. At the core of the problem is that investors rationally expect local government to be bailed out by either state or federal government. It might or might not happen, but just the fact that there is a certain probability that this will happen will lead to a mis-pricing of the default risk.

This means that the funding costs of local government will be lower than it should be to reflect the true default risk. It is not very hard to see that that will at least indirectly reward irresponsible policies. The local government will likely be politically rewarded for building a new mega stadium (a well-known local finance problem in the US) or increasing teachers salaries etc. However, the cost of bankruptcy will at least party be transferred to states and federal government. This obviously encourage irresponsible policies locally.

Did moral hazard play a role in Detroit’s economic troubles? I am not sure, but I am very sure that moral hazard has had a major negative impact on the state of the US auto industry for decades and that at least indirectly have had a serious impact on the state of city of Detroit’s finances. Anyway I am sure that the bankruptcy of Detroit will inspire aspiring young public choice economists to study the impact of moral hazard of Detroit’s bankruptcy – at least I hope so.

Since it is very hard to avoid the temptation of bailing out failed municipalities it is not surprising that in most developed countries in the world the fiscal independence of local government is restricted by more or less strict rule imposed by central government (for example balance budget rules or rules limiting the ability to raise funds through lending in the financial markets). That is also to some extent the case in the US. These “constitutional” restrictions apparently has not be effective enough to avoid the Detroit’s bankruptcy and if Detroit’s troubles should lead to any policy debate in the US – then it should be how to change the constitutional/institutional set-up for major US cities to provide lawmakers with the right incentives to ensure prudent financial manage of municipal finances. And yes, this is of course is a completely parallel discussion to the discussion of moral hazard in the banking sector.

From Detroit to Egypt

The bankruptcy of Detroit should actually also lead to a debate about US foreign aid. Yes, believe it or not there a strong parallels between the moral hazard problems in US local government finances and US foreign aid.

The recent political unrest and the military coup in Egypt has made me to think about moral hazard problems of particularly US foreign aid.

There is no doubt that US foreign aid to a large extent is driven by what the US government perceives to be US foreign policy interests – particularly security interests and this has been a key motivating factor for US aid to Egypt for decades and no one would deny that the changing Egyptian governments over the years has been reward for keeping peace with Israel – a close ally of the US.

A list of the top-five recipients of US aid clearly reveals to what extent US foreign aid is driven by geo-political concerns rather than anything else: Afghanistan, Israel, Iraq, Pakistan and Egypt. Particularly the fact that Israel – not exactly a developing country and a country  – is notable.

To argue that the key concern of US foreign aid is economic and social development is pretty in fact pretty hard. Rather it is US foreign policy interests that determines what countries, which will receive foreign. And investors of course know this. Hence, who would seriously imagine that the US government would let Israel or Egypt go bankrupt (as long as these countries act accordingly with US foreign policy interests)? And this of course is reflected in market pricing of the default risk of Israel and Egypt.

So in the same way as investors would investors could be betting on the US federal government (or state governments) to bailout major US cities then in the same way investors would rationally bet on countries like Israel or Egypt being bailout if they were to get into financial troubles. As a result we should expect financial markets to under-price the risk of a government default in for example Egypt and similarly is this is likely to make the Egyptian government less fiscally responsible. Whether or not moral hazard has been the main driver of Egyptian fiscal decisions or not is hard to say, but it remains a fact that Egyptian public finances been a mess for decades.

IMF lending and moral hazard

Does all this sound far-fetched? Not at all if you look at numerous studies of what determines for example IMF lending. The US of course is the large contributor to the IMF and the US has a major say in how IMF funds are used.

Hence, for example a very interesting paper by Axel Dreher, Jan-Egbert Sturm and James Raymond Vreeland published earlier this year shows that “political important” countries face “softer conditions” for IMF loans than politically non-important countries.

I believe that it is very likely that US foreign aid motives distort the market pricing of default risk in certain particularly Emerging Markets and as a consequence increases global moral hazard problems.

So if you think moral hazard played a role in Detroit’s bankruptcy you should also consider what role moral hazard has played in recent events in Egyptian financial markets and it is hardly a coincident that the Egyptian financial markets rallied when the anti-US Muslim Brotherhood was ousted – effectively making a new IMF loan for Egypt more likely.

PS If you want to understand what is the problem with the ECB’s OMT program then you should just think about moral hazard. And while I certainly do not think that monetary easing is not moral hazard, “credit easing” done in the way the ECB is doing it certainly is. Also see my earlier post on why monetary easing is not a bailout, but ECB style credit polices are.

Update: Jim Pethokoukis has a very good piece on National Review Online on how to revive Detroit.