The former Obama administration auto czar, Steven Rattner, wrote in yesterday’s New York Times that “We Have to Step in And Save Detroit” from bankruptcy.  Detroit has $18 billion in liabilities, half of which are for municipal employee pension plans and retiree health benefits.  Mr. Rattner says that “It isn’t fair to cut pensions.  The workers didn’t cause this mess.”
Many state and local governments are indeed in terrible financial condition because of the cost of public employee pensions.  There have already been several municipal bankruptcies around the country and there will be many more.  The state of Illinois is in particularly bad financial shape, for the same reasons as Detroit, and will almost certainly have to declare bankruptcy in the near future.
The basic problem is that state and municipal governments often have so-called “defined benefit” pension plans for their employees rather than the “defined contribution”, or 401(k), retirement plans used by private business.  Defined benefit plans guarantee a certain level of pension payment, based on the employee’s salary, regardless of the investment returns of the contributions to the fund.  Defined contribution plans, on the contrary, only pay out in benefits what has actually been accumulated in investment earnings.  For a defined benefit plan the employer (i.e. the government and therefore the taxpayers) is at risk for any shortfall in funding.  For a defined contribution plan, the individual employee is at risk for underperforming investment of the fund.  The only viable solution to this massive problem is for state and local government to shift as rapidly as possible from defined benefit to defined contribution retirement plans.
For the federal government to jump in and bail out one particular struggling municipality would create a moral hazard.  Every other state and local government with the same problem, numbering in the hundreds or thousands, would want equal treatment.  The federal government can’t afford such an expense because of its own perilous financial condition.  Furthermore, federal aid would just delay the fundamental changes in fiscal policy which must be made at the state and local level.
It is a very bad idea for the federal government to bail out Detroit!