August 11, 2013, 11:44 pm
The Wrong Lesson From Detroit’s Bankruptcy


When I was growing up in Gary, Ind., nearly a quarter of American workers were employed in the manufacturing sector. There were plenty of jobs at the time that paid well enough for a single breadwinner, working one job, to fulfill the American dream for his family of four. He could earn a living on the sweat of his brow, afford to send his children to college and even see them rise to the professional class.

Cities like Detroit and Gary thrived on that industry, not just in terms of the wealth that it produced but also in terms of strong communities, healthy tax bases and good infrastructure. From the stable foundation of Gary’s excellent public schools, influenced by the ideas of the progressive reformer John Dewey, I went on to Amherst College and then to M.I.T. for graduate school.

Today, fewer than 8 percent of American workers are employed in manufacturing, and many Rust Belt cities are skeletons. The distressing facts about Detroit are by now almost a cliché: 40 percent of streetlights were not working this spring, tens of thousands of buildings are abandoned, schools have closed and the population declined 25 percent in the last decade alone. The violent crime rate last year was the highest of any big city. In 1950, when Detroit’s population was 1.85 million, there were 296,000 manufacturing jobs in the city; as of 2011, with a population of just over 700,000, there were fewer than 27,000.

So much is packed into the dramatic event of Detroit’s fall — the largest municipal bankruptcy in American history — that it’s worth taking a pause to see what it says about our changing economy and society, and what it portends for our future.

Failures of national and local policy are by now well known: underinvestment in infrastructure and public services, geographic isolation that has marginalized poor and African-American communities in the Rust Belt, intergenerational poverty that has stymied equality of opportunity and the privileging of moneyed interests (like those of corporate executives and financial services companies) over those of workers.

At one level, one might shrug: companies die every day; new ones are born. That is part of the dynamics of capitalism. So, too, for cities. Maybe Detroit and cities like it are just in the wrong location for the goods and services that 21st-century America demands.

But such a diagnosis would be wrong, and it’s extremely important to recognize that Detroit’s demise is not simply an inevitable outcome of the market.

For one, the description is incomplete: Detroit’s most serious problems are confined to the city limits. Elsewhere in the metropolitan area, there is ample economic activity. In suburbs like Bloomfield Hills, Mich., the median household income is more than $125,000. A 45-minute drive from Detroit is Ann Arbor, home of the University of Michigan, one of the world’s pre-eminent hubs of research and knowledge production.

Detroit’s travails arise in part from a distinctive aspect of America’s divided economy and society. As the sociologists Sean F. Reardon and Kendra Bischoff have pointed out, our country is becoming vastly more economically segregated, which can be even more pernicious than being racially segregated. Detroit is the example par excellence of the seclusion of affluent (and mostly white) elites in suburban enclaves. There is a rationale for battening down the hatches: the rich thus ensure that they don’t have to pay any share of the local public goods and services of their less well-off neighbors, and that their children don’t have to mix with those of lower socioeconomic status.

The trend toward self-reinforcing inequality is especially apparent in education, an ever shrinking ladder for upward mobility. Schools in poorer districts get worse, parents with means move out to richer districts, and the divisions between the haves and the have-notsnot only in this generation, but also in the nextgrow ever larger.

Residential segregation along economic lines amplifies inequality for adults, too. The poor have to somehow manage to get from their neighborhoods to part-time, low-paying and increasingly scarce jobs at distant work sites. Combine this urban sprawl with inadequate public transportation systems and you have a blueprint for transforming working-class communities into depopulated ghettos.

Adding to the problems that would inevitably arise from such poorly designed urban agglomerations is the fact that the Detroit metropolitan area is divided into separate political jurisdictions. The poor are thus not only geographically isolated, but politically ghettoized as well. The result is a separate, poorer inner city with a dearth of resources, made even worse because the industrial plants that had provided the core of the tax base are shut down.

The decision to file for Chapter 9 municipal bankruptcy protection was made by Kevyn D. Orr, the nonelected emergency manager appointed by Gov. Rick Snyder, a Republican, to run the city’s finances. The incumbent mayor, Dave Bing, a Democrat, has decided not to seek a second term, which is hardly surprising given that he and other local officials have been left on the sidelines as their city’s future — and the accumulated debts owed its creditors — is being hashed out in court.

As historians like Thomas J. Sugrue have demonstrated, the disintegration of Detroit precedes the conflicts over social-welfare programs and race relations (including riots in 1967) and reaches back into the postwar decades, a time when the roots of deindustrialization, racial discrimination and geographic isolation were planted. We’ve reaped what we’ve sown.

Lacking regional political unity, there is no overall structure to improve the infrastructure and public services between poorer inner cities and affluent suburbs. So the poor fall back on what means they have, which is not good enough. Cars inevitably break down and buses are late, making workers appear to be “unreliable.” But what is really unreliable is the iniquitous design of the city. No wonder America is becoming the advanced industrial country with the least equality of opportunity.

The same skewed priorities that have gutted Detroit at the local level are echoed in a void at the level of national policy. Every country, every society, has regions and industries whose stars are rising, and others that are in decline. Silicon Valley has, for some time, been America’s rising star — just as the upper Midwest was a hundred years ago. With technological change and globalization, though, the Midwest’s comparative advantage as a global manufacturing hub has ebbed, for reasons too well known to list here. Markets, however, often don’t do a good job of self-rejuvenation.

Rather than deal purposefully with this changing economic landscape with useful policies encouraging the growth of other industries, our government spent decades papering over the growing weaknesses by allowing the financial sector to run amok, creating “growthbased on bubbles. We didn’t just let the market run its course. We made an active choice to embrace short-term profits and large-scale inefficiency.

There may be something inevitable about the structural changes that have made American manufacturing less central to our economy, but there is nothing inevitable about the waste, pain and human despair in cities that have accompanied that change. There are policy alternatives that can soften such transitions in ways that preserve wealth and promote equality. Just four hours from Detroit, Pittsburgh, too, grappled with white flight. But it more rapidly shifted its economy from one dependent on steel and coal to one that emphasizes education, health care and legal and financial services. Manchester, the center of Britain’s textile industry for more than a century, has been transformed into a center of education, culture and music.

America does have an urban renewal program, but it is aimed more at restoring buildings and gentrification than at maintaining and restoring communities, and even at that, it is languishing. American workers were soldfreetrade policies on the promise that the winners could compensate the losers. The losers are still waiting.

Of course, the Great Recession and the policies that created it have made this, like so many other things, much worse. The mortgage bankers marched into large sections of some of our cities and found them good subjects for their predatory and discriminatory lending. Once the bubble burst, those cities were abandoned by all but the debt collectors and foreclosure sheriffs. Rather than saving our communities, our politicians focused more on saving the bankers, their shareholders and their bondholders.

The situation may be grim, but all is not lost for Detroit and other cities facing similar problems. The question facing Detroit now is how to manage bankruptcy.

But here, too, we must be wary of the influence of the “wisdom” of wealthy interests. In recent years, our financial wizards” at private bankswhose skill is supposed to be managing risksold Detroit some fancy financial products (derivatives) that have worsened its financial plight by hundreds of millions of dollars.

In a conventional bankruptcy, derivatives would get priority as creditors before current and retired municipal workers. Fortunately, the rules governing Chapter 9 of the bankruptcy code put greater emphasis on the public good. When a public body goes into bankruptcy, there is always some ambiguity about its assets and liabilities. Its obligations include an unwrittensocial contract,” including social services for its residents. Its ability to increase revenues is limited: higher taxes can accelerate a death spiral, driving out more businesses and homeowners.

The banks, not surprisingly, would like other priorities. With nearly $300 million of outstanding derivatives at stake, they may connive to be first in line for repayment. The Chapter 9 proceeding provides the opportunity to place the banks where they ought to be — at the back of the queue. It was bad enough that these nontransparent financial instruments were used to confuse and deceive investors. It would add insult to injury to reward the banks’ behavior. The priority in the bankruptcy proceedings must be restoring Detroit to vitality as a city, not just getting it out of the red.

The basic principle of Chapter 11 of our bankruptcy code (focusing on corporations) is that bankruptcy should provide a fresh start: doing so is vital to preserving jobs and our economy. But when cities go bankrupt, it’s even more important to preserve our communities.

Banks and bondholders will argue that pension payments for city workers are an undue burden, and should be limited or canceled to reduce the banks’ losses. But the high priority that workers are typically given in municipal bankruptcies is entirely justified. After all, they have performed their services on the understanding that they would be paid, and pensions are nothing but “deferred compensation.” Workers are not engaged in the complicated business of risk assessment, as investors are. And unlike investors, they can’t really diversify their portfolios to manage their risk. So it should be unconscionable to tell workers that, sorry, we aren’t paying you what we promised for work you’ve already done. Especially because their pensions, unlike those of corporate chieftains, are far from generous. Most of the retired city employees receiving checks get about $1,600 a month.

This means that much of the burden of bankruptcy will have to fall on those who lent Detroit money, and those who insured those lenders. This is as it should be. They got a return, reflecting their subjective estimate of the risk that they faced. Of course, they would like to get high returns, and somehow not bear the risk. But this is not the way markets work, or should work.

Ensuring that bankruptcy proceeds in a way that is good for Detroit will require vigilance, and is only the first step in recovery. In the longer term, we will need to change the way we run our metropolitan areas. We need to provide better public transportation, an education system that promotes a modicum of equality of opportunity, and a system of metropolitan governance” that works not just for the 1 percent, nor even for the top 20 percent, but for all citizens.

And on the national level, we need policiesinvestment in education, training and infrastructure — that smooth America’s transition away from a dependency on manufacturing for Jobs. If we don’t, post-Great Recession bankruptcies like those in Jefferson County, Ala., Vallejo, Calif., Central Falls., R.I., and now Detroit will become far too common.

Detroit’s bankruptcy is a reminder of how divided our society has become and how much has to be done to heal the wounds. And it provides an important warning to those living in today’s boomtowns: it could happen to you.

Copyright 2013 The New York Times Company

Illiberal Democracy in Latin America

Andrés Velasco

12 August 2013

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SANTIAGOIn an influential 1997 essay, Fareed Zakaria coined the termilliberal democracy” to describe those countries that hold elections (of varying fairness) to choose their leaders, yet restrict civil liberties and political freedom. At the time, such practices were common mostly in Asia and Africa, with a sizeable concentration of illiberal democracies among the ex-Soviet states.

Zakaria described illiberal democracy as a “growth industry,” and he was right: in the past 15 years, it has come with full force to Latin America.
This might seem surprising, because most countries south of the Río Bravo (known to North Americans as the Rio Grande) moved from right-wing dictatorship to democracy in the 1980’s and 1990’s. Some of these democracies were initially imperfect, to be sure, but optimists hoped that it was only a matter of time until all elections would be fair and restrictions on civil liberties fully lifted.
That was not to be. On the contrary, the quality of democracy has deteriorated sharply in several countries in the region.

Venezuela’s late president, Hugo Chávez, was the chief exponent of this trend. According to the democracy watchdog Freedom House, in the 2012 election, “the opposition candidate, Henrique Capriles, was able to hold rallies and engage in traditional forms of campaigning.” But “Chávez benefited from massive use of state resources that enabled him to dominate media time by a margin of 25-to-1, distribute household goods to constituents, and convince many voters that the state could punish them for casting a ballot for the opposition.”
Much the samealong with accusations of widespread vote-counting irregularities – could be said about the recent election held after Chávez died, which installed his handpicked successor, Nicolás Maduro.
Press freedom is also on the decline. In another report, Freedom House notes that the number of Latin American countries classified as “not free” when it comes to the media has risen to its highest level since 1989. The report highlights deterioration in Paraguay (where a “parliamentary coupremoved an elected president) and Ecuador, where President Rafael Correa’s government withdrewofficial advertising from privately-owned media that are critical of the government” and “placed limitations on media coverage of electoral campaigns.” He has also engaged in “legal and regulatory harassment, and physical intimidation of journalists.”
Argentina is another country where journalists are on the defensive. A 2009 law that aimed to diversify media ownership has been used to put pressure on media outlets that are critical of President Cristina Fernández de Kirchner. Fernández’s supporters in Congress recently attempted to limit the judiciary’s independence and pack the upper echelons of the court system, but the country’s Supreme Court struck down their law as unconstitutional.
Illiberal democratic policies and practices are present almost everywhere in Latin America: a distortive electoral system in Chile, persistent violence in Mexico and Colombia, and endemic corruption among lawmakers in Brazil all limit citizens’ ability to express their views effectively and shape policy.
But the left-wing populists influenced by Chávez – who ruled Venezuela for 14 years – have perfected a particularly illiberal practice: bending constitutional rules to allow themselves to be reelected again and again. In Bolivia, President Evo Morales’s new 2009 constitution banned reelection to a third consecutive term, but now the Constitutional Court has allowed him to run, arguing that the Bolivian state has beenrefounded.” Morales’s previous terms, according to this reasoning, occurred in a different state and thus do not count toward current term limits.
In Ecuador, Correa used the same trick right from the start: his 2008 constitution explicitly stated that the time Correa had served as President under the previous constitution did not bar him from seeking reelection, enabling him to remain in office until 2017.
Similarly, in Nicaragua – like Ecuador, also in Venezuela’s sphere of influence – the Supreme Court decided that President Daniel Ortega can run again, even though many legal scholars believe otherwise. In Argentina, Fernández and her late husband Néstor Kirchner have held power for 12 years combined, and it remains unclear whether she will attempt to amend the constitution in order to seek yet another term in 2015.
The phenomenon of quasi-constitutional reelection has become so widespread in Latin America that Georgetown University professor Héctor Schamis has dubbed it “the new authoritarianism” in the region.
Other elected leaders in Latin America have been curiously tolerant of these anti-democratic practices. Speeches at regional summits can go on for hours, but hardly a word is uttered about democracy’s decay. Capriles, who claims that victory in the post-Chávez election was stolen from him, was recently in Chile, but President Sebastián Piñera agreed to meet with him only at a private dinner, not at an official meeting in La Moneda Palace. Former Chilean President Michelle Bachelet, the front-runner in the country’s upcoming presidential election in November, did not meet with Capriles at all, citing “agenda problems.”
Augusto Pinochet, Chile’s former dictator, ruled for 16 years in the name of “authoritarian democracy,” and then attempted to leave behind what he called a “protected democracy.” Today’s would-be strongmen speak of “popular” or “Bolivariandemocracy. Times have changed, but one thing remains the same: true democracy needs no qualifiers.
Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University's School of International and Public Affairs. He has consulted for the International Monetary Fund, the World Bank, and the Inter-American Development Bank, as well as for several Latin American governments.

Markets Insight

August 12, 2013 9:36 am
Confidence is key to bull case for stocks
Investors need not be too concerned about slower earnings growth
The US stock market appears to be facing a more hostile environment. Record high profit margins and sluggish sales trends suggest slower future earnings growth; bond yields are finally rising; and the Federal Reserve may soon take away the liquidity punch bowl.
The stock market may pause for a few months to digest these changes. But while many investors have turned cautious, the bull market has probably not ended. This is because the primary force driving the stock market is not earnings performance, low yields or quantitative easing; rather, it is a slow but steady revival in confidence, a trend that is just beginning.
In this scenario, investors need not be overly concerned about slower earnings growth. While earnings are obviously important, stock prices have frequently diverged from earnings trends. In fact, for the third time in the postwar era, stock prices and earnings are repeating a remarkably similar three-stage cycle.

First, earnings surge while the stock market remains essentially flat (the earnings production cycle). Second, earnings performance flattens while the stock market surges (the valuation cycle). Finally, both stock prices and earnings move in tandem (the traditional cycle). It appears the contemporary bull market has just entered the second phase, making earnings growth less important.

Earnings nearly tripled between 1945 and 1951, and again between 1970 and 1982, and they have more than doubled since 2000. In all three episodes, however, the stock market remained essentially unchanged.

In both the 1950s and the 1980s, the earnings cycle was followed by an explosive stock market run despite almost flat earnings performance. Between 1952 and 1962 the market rose about 3.5 times, while from 1982 to about 1994 it surged almost fourfold.

In the contemporary era, since autumn 2012, despite earnings growth slowing to low single-digit rates, the price-earnings multiple has risen from about 13 times to about 16 times. If this means the stock market just entered its thirdvaluation cycle” of the postwar era, is slower earnings growth really that worrying?

One concern is that the recent rise in US bond yields will abort the stock market bull run. But rising bond yields reflect improving economic confidence, rather than increasing inflation expectations or concerns about the creditworthiness of the US government. A rise in bond yields predicated on a growing belief the “world will not soon end hardly seems bad for the stock market. Indeed, since 1967, when bond yields have risen in tandem with consumer confidence, the stock market has advanced at almost 12 per cent a year.
Another worry is that Fedtapering will end the stock market party. The Fed’s exit strategy may well create some indigestion, but we expect the “Great Fed Myth” – that the economic recovery and the stock market are simply sugar highs delivered by the Fed – to be debunked during the rest of this year.
The surprise entering 2014 may be that, despite a 10-year Treasury yield close to 3 per cent and far less bond purchasing by the Fed, both the stock market and the economy remain relatively steady. Indeed, if the economic recovery persists and is finally perceived as standing on its own, stopping QE could actually prove beneficial by lifting private sector confidence.

Since 1900, there have been three major bull markets, in the 1920s, 1950s-60s and the 1980s-90s. Both the first and the third of these were driven by a persistent decline in interest rates, an option not feasible today. However, the 1950s-60s bull market was characterised by a simultaneous rise in both stock prices and bond yields, driven by rising confidence.

As it was after the Great Depression and the second world war, confidence has been shattered since 2000 by numerous events. Now, if confidence is slowly rebuilt, perhaps the next several years will echo the 1950s. A numeric example highlights the possibility.

Conservatively, S&P 500 earnings per share should be close to $107 by year-end. If the recovery lasts five more years and earnings grow modestly at a 4 per cent annualised pace, they will rise to about $130. The current price-earnings multiple is about 16 times. If confidence measures eventually reach previous recovery levels, the stock market PE multiple should advance to about 20 (as it did in the 1960s). This implies a 2,600 target for the S&P 500, or with dividends, an annualised five-year return in excess of 10 per cent.

Certainly earnings, bond yields and Fed actions will create some turbulence along the way. But beware of becoming too myopically focused on these mainstream issues lest you miss what could be the second confidence-driven bull market of the postwar era.

James W. Paulsen is chief investment strategist at Wells Capital Management, a business of Wells Fargo Asset Management

Copyright The Financial Times Limited 2013.


August 11, 2013, 6:26 p.m. ET

Competing Visions for the Future of Housing Finance

A House reform would get government out of mortgages. The Senate reform is phony.


With the House Financial Services Committee's recent vote for legislation that would gradually eliminate the government-sponsored mortgage lenders Fannie Mae FNMA -1.33% and Freddie Mac, FMCC -1.45% it's possible to envision a national debate about the future of housing finance. President Obama finally joined that debate on Aug. 6, when he suggested to an audience in Phoenix that Fannie and Freddie should be replaced with a greater role for private lending. Unfortunately, the president's plan, which retains a role for the government as ultimate guarantor of the housing-finance system, is faux reform.

The bill that the House will consider proposes a housing-finance market that is predominantly operated by the private sector. The Senate bill is likely to be a proposal that keeps the government in control.
Associated Press
The choice of two visions is important—and all too rare in housing finance. In the past, the usual Washington consensus that the government must control housing finance emerged from Congress. Voters have never been given the opportunity to consider whether a government role makes sense, or why housingunlike every other sector of the economyneeds government backing. Because of the House bill, the decision will not be locked up by the Government Mortgage Complex—the realtors, home builders and community activists—before people have had an opportunity to weigh in with their elected representatives.
The government's record in housing is not enviable. The 2008 financial crisis was triggered by an unprecedented 30% loss in home values when an enormous housing-bubble collapsed. Before the crisis began, at least half of all mortgages in the U.S.—28 million loans—were subprime or otherwise risky, and their failure in substantial numbers is what drove prices down. Of the 28 million risky loans, 74% were on the books of government agencies, principally Fannie and Freddie. This shows that the demand for those mortgages originated with the government's housing policies.

The terrible events of 2008 are only the most recent government fiasco in housing. There was the collapse of the government-insured savings and loans in the 1980s (costing taxpayers at least $150 billion in bailouts), the insolvency of Fannie and Freddie (more than $180 billion in bailouts) and, coming soon, a bailout of the Federal Housing Administration. With this record, it's amazing that anyone is seriously thinking about giving the government another chance.

That's why the House bill—called the Protect American Taxpayers and Homeowners (PATH) Act—is a real reform. The House bill winds down Fannie and Freddie over five years. It charters a new FHA as an independent, nonprofit corporation that will assist low-income first-time home buyers. It sets up a utility to regularize and organize a private securitization system, and eliminates many of the obstacles in the Dodd-Frank financial-reform law to the return of a private market in mortgages.

The chief House sponsors, Jeb Hensarling (R., Texas), chairman of the House Financial Services Committee, and Scott Garrett (R., N.J.) believe that a private housing-finance system will be more stable than the government programs of the past, and will pose no threat to taxpayers. As important, it won't encourage loans to borrowers with weak credit histories, which would only ensure that they lose their homes when the next government-induced housing bubble deflates.

Even former Rep. Barney Frank, once the most stalwart defender of Fannie and Freddie, finally realized that the intended beneficiaries of government housing policies are actually its greatest victims. He said in 2010, "I hope by next year we'll have abolished Fannie and Freddie. It was a mistake to push lower-income people into housing they couldn't afford and couldn't really handle once they had it."

The Senate rival to the House bill is likely to be a proposal by Sens. Bob Corker (R., Tenn.) and Mark Warner (D., Va.) that would create a new government agency, like the FDIC, to guarantee mortgage-backed securities. Its sponsors promise that private risk-sharing will eliminate the chances of a taxpayer bailout. But any proposal that keeps the government in charge of housing finance will be subject to the same infirmity: Congress will always want to extend the program's benefits to more constituents, especially to those whobecause of weak credit histories and uncertain financial resources—are unable to qualify for conventional mortgages.

It will then turn outmuch to everyone's surprise—that compensating for the inherent risks of a subprime mortgage will make it too costly for those whom Congress wants to help. So the answer will be for the government to subsidize these mortgages, probably by lowering its own insurance rates.

That's the movie taxpayers have seen before, when Fannie and Freddie were required to reduce their underwriting standards in order to make mortgage credit available to potential home buyers who were said to be "underserved."

It's no secret why the Senate bill keeps the government in the game. It's easy to pass a phony reform that makes Congress look good and gives the Realtors, home builders and community activists what they want. Instead of the usual cave-in to the Government Mortgage Complex, the House bill will give the American people a rare opportunity to consider an alternative future for housing finance.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

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