The Newark Budget Debacle: What Happens Next?

Written by Dan O’Flaherty no-avatar

Brendan O'Flaherty is professor of economics at Columbia University. He works in the areas of homelessness, housing, crime, race, and urban economics in general. Mr. O'Flaherty is an expert on local public finance and has worked with the Cory Booker administration to reform the finances of Newark, NJ.

Monday, 15 November 2010 00:00

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I don’t know.  Nobody knows.  A lot of people are saying or hinting that the current situation is just business as usual.  The Mayor, for instance, is saying that he has things under control and there was no need to “embrace” the more drastic steps the budget working group called for, and the Governor is saying nothing.  Such mass denial of reality is a good sign that a financial crisis is near.  The last time Newark’s finances failed, in 1934, was only a year after a large tax cut, and Standard and Poor’s upgraded New York City’s bond rating in December 1974.

When I say “I don’t know” I mean that I don’t know how the crisis will play itself out.  But I’m pretty sure there will be a crisis soon.

The reason is simple: the city government has made commitments it cannot fulfill.  You cannot maintain a workforce the size of Newark’s with Newark’s tax rates.  It’s not even close.  It was not close in 2009, and even with all the layoffs and the 16 percent tax increase in 2010, it’s still not even close.  The city managed to balance its budget for many years with one-time revenues, windfalls, nonrecurring state aid, and pension holidays.  But those days are over.  The city government’s implicit promises to taxpayers, to businesses and citizens expecting services, and to workers who have invested their careers are all going to be broken, because they can’t be kept.  So too will the Mayor’s implicit promise to the Governor that Newark can operate under the Governor’s property tax cap in its current form without added state aid.

Of course, everybody will fight—to maintain what they have, or get what they have been promised.  Workers will fight for their jobs and compensation, taxpayers will resist tax hikes, citizens and businesses will fight to maintain the services they count on, the Mayor and Council will fight to maintain their powers and perks, and the Governor will fight to maintain his tough-guy image and reductions in the state budget.  Investors too, may have to fight for repayment.  Everyone can’t win, and everyone will probably lose something. But they have to fight, because anyone who doesn’t fight is sure to lose massively.

I don’t know what’s going to happen because melees like this have no rules. If the outcome were not uncertain, there would be no need for a melee.  Municipal financial crises are contests to determine who makes the smallest sacrifices when a large gap opens up between what people in the aggregate legitimately expect from a city government and what they can actually get.  Corporate bankruptcies are usually easier—judges reconcile the irreconcilable claims according to established law.

Crises are like Tolstoy’s unhappy families—no two are alike.  Some are better and some are worse.  In this essay, I will try to figure out what makes some crises merely bad and others truly terrible, and what people who care about Newark can do to avoid a truly terrible one.  There is not a lot of science to municipal financial crises, and so I will begin with some history—the New York City fiscal crisis of 1975.  Most people alive now in Newark have never seen a real crisis, and it’s helpful to see what one looks like before we’re engulfed in our own.

After the story comes some analysis and after the analysis, a discussion of where we are now.

  1. New York City 1975

    The most famous fiscal crisis occurred in New York City in 1975, and lasted for several years.  The most famous image from that crisis is the October 30, 1975 Daily News headline: “Ford to City: Drop Dead.”  We’ll see how and why New York City reached that point.

    The story starts around 1961-62, when the city starts running small operating deficits. It keeps on doing this all through the 1960s and early 1970s.  They start adding up.  The real situation is probably worse than these numbers, because city accounting systems are very weak and the city is borrowing in all sorts of indirect ways like charging operating expenses to the capital budget and moving paydays.

    In cash terms, these deficits are financed by issuing tax anticipation notes (TANs) and revenue anticipation notes (RANs).  The city also issues bond anticipation notes (BANs).  These are all short term, and when they come due the city usually just rolls them over.  Banks and investment houses are happy to buy them and earn good commissions. Banks also hold them as capital.

    The bond rating services also like this short term debt.  In the mid-1960s, the rating is downgraded to BAA.  The city starts a campaign against the bond raters.  In 1972, Moody’s relents and raises the city’s rating to A.  Standard and Poor’s upgrades the city in December 1974, as I have mentioned.

    Why did the city run these operating deficits?  I don’t have a definitive answer.  Maybe the real question is why not.  The standard conventional urban-legend answer is that the city was under tremendous pressure from incredibly powerful unions to raise wages and also afraid of riots if they didn’t keep welfare payments extremely generous and expand higher education.  This can’t be a complete answer, even if it’s accurate, because it doesn’t explain why they didn’t raise taxes to cover higher expenditures.

    Newark is under a lot of pressure at this time too—much more pressure, really—but it doesn’t run operating deficits except in election years. It cannot sell TANs very well.

    My guess is that New York City ran operating deficits because it could.  The bond market thought it was too big to fail, and the city thought it would outgrow the debt and the deficits.  Sounds familiar.

    These deficits continue through three mayors, and real interest rates start to rise, despite the upgrading by the credit rating agencies.

    In late 1974, several major issues of short term debt bring the total outstanding to $5-6 billion—compared with an operating budget of around $11 billion.  By the end of 1974, NYC accounts for around 29% of outstanding short term notes in the US.  These include BANs—long term interest rates are high and the city is waiting for them to come down.  A big recession is underway: 1974 and 1975 are the only two consecutive years in the postwar period in which real GDP fell.  Because of the recession and automatic stabilizers, federal debt is rising quickly and so investors have an alternative safe-looking investment.

    The late 1974 note sales go poorly, and the underwriters lose money.  Banks start reducing their holdings of city securities.

    The banks also start telling Mayor Beame that he ought to do a better job managing the city. He doesn’t like it.  He tells them the city is doing fine and that they are a community of interest.  They hold so much city paper already that if the city goes down, they go down. He tells them that the way he spends money is not their problem because they have a first lien on city revenue.

    But he takes actions to put the house in order, since he’s continuing to run an operating deficit of about $1 billion. These actions, however, are feckless.  He announces layoffs of 8000 workers, but only 436 actually go out the door.  A ‘hiring freeze’ is ordered, but the city payroll to grow by 13,000 in a quarter.

    By March 1975, the city can’t sell notes to the banks.  Beame reaches into his personal savings and plunks down $50,000 for notes to demonstrate his confidence, but it doesn’t work.  Beame goes on television, lambastes the banks, says the city is in great financial shape, and announces cutbacks.  Nothing happens.

    By April, the city is out of cash. To meet payroll, it gets a 3-day bank loan.

    The banks are worried now too.  About 20% of their equity is tied up in city paper.  But they don’t know what their liability to bondholders will be if they underwrite a city issue.

    They try to force Beame to run the city their way.  He balks and the stalemate continues.

    Then the state (Governor Carey) steps in.  The state has a lot at stake too.  If the city defaults, its bonds will be suspect. If city bondholders have first lien on city revenues, then the state will have to step in to pay city workers to maintain order and perform essential services like picking up garbage, fixing water main breaks, running city hospitals, keeping city jails secure.  The state budget director estimates that the state would default about 30 days after the city.

    So in mid-April the state advances revenue sharing funds to the city—making the state more vulnerable to a city default by depleting its cash.

    Then in June Carey and the state legislature create MAC—the Municipal Assistance Corporation.  This is an entity of the state, and a majority of its members are appointed by the governor.  But the mayor is on it too.  The state legislature makes the city sales tax and the city stock transfer tax into state taxes, and funnels them to MAC.  The plan is for MAC to take this revenue and sell long-term bonds against it.  MAC will then use the long-term bond proceeds to retire the city’s short-term debt.  So MAC makes spending for current obligations into long-term debt.  Once it sells bonds, MAC can give the city the proceeds at whatever pace it chooses.

    MAC also has power to audit and to advise the city about what it should do as a condition for getting the cash.  But this power is advisory only, and its threat to withhold cash and force the city into default may not be especially credible—it’s like threatening nuclear Armageddon to get a parking space.  MAC demands that the city institute a wage freeze (inflation is still considerable despite the recession), effect further layoffs, increase subway fares, and charge tuition at CUNY.  Heretofore CUNY has been tuition-free.

    The plan is for MAC to sell $3 billion in bonds over the summer in three offerings.  But MAC can sell only $2 billion, and only at a real high rate of interest.  The market does not think MAC can prevent a city default because it cannot rein in city spending or bring other revenue to the table.

    By late June and the start of the new city fiscal year, Beame has a budget with tens of thousands of layoffs.  Unions and workers are angry.  Demonstrations and PBA leaflets warning tourists that they are likely to die.  A wildcat strike of sanitation workers lasts two days and 48,000 tons of garbage accumulate on city streets.  Harlem River drawbridges are left open. Highway workers picket vital arteries at rush hour. Firefighters stage a sick-in.

    In July, the state gives the city authority for $330 million in added taxing power.

    The MAC board forces Beame to a deadline of July 29 for a deal with the unions on retrenchment—for concessions on their contracts.  A deal emerges at the deadline.  Final deal is not quite a wage freeze—lower salaried workers still get some raises.  But it’s an agreement.  Why did the unions make these concessions?  Bankruptcy would abrogate their contracts totally.  And whom would it leave in charge of negotiating with them?

    In September, the state sets up the EFCB—Emergency Financial Control Board.  This is a state board that includes a lot of bankers.  It has much greater control over the city than MAC did.  It controls the bank accounts, can issue orders, remove city officials from office, review and reject contracts and plans and city borrowing.  And the state finds more aid.  The EFCB is essentially receivership—Beame is left with the power to smile at parades.

    At the same time, Carey gets the unions to agree to use their pension funds to buy MAC bonds. This doesn’t really gamble their members’ pensions, since those appear to be guaranteed by law, but it does gamble the leaders’ credibility, and to the extent that the state might not replenish the funds in the event of a city default, it puts the pensions at some risk.  So the unions are in deeper now too.  Carey’s plan is that between the state aid and pension fund investments, the city has enough cash to get through October.

    Next, the school year starts and the teachers go on strike.  The city government isn’t overwhelmingly upset because they’re saving money.  So after a little while the teachers accept a mediocre deal and go back to work.  But then on October 7 the EFCB rejects even the mediocre deal.  Al Shanker, the teachers’ union president, is not happy.

    On October 15, Shanker announces that the teachers’ union is pulling out of the part of the September deal about buying MAC bonds.  The teachers’ union was supposed to by $225 million of these bonds.  The city has to roll over notes on October 17, and without the teachers’ money, there is no way to do this.

    On the night of October 16, city lawyers draw up bankruptcy papers and the Mayor signs them in the morning of October 17.  The lawyers are then ready to go to bankruptcy court.  The bankruptcy press release is prepared.  Banks usually closed at 3 pm in those days, but the Mayor prevails on them to stay open until 5.  Then everybody goes to work on Shanker, including the other unions.  Around 2 in the afternoon he relents.  The city has another month.

    Then attention turns to Washington.  Ford is worried about a challenge from Reagan in 1976, the rest of the country hates NYC, there is a bad recession going on, and nobody wants to bail out NYC.  Carey, a former congressman, has been trying since spring to get federal loan guarantees.  Now all the actors in NYC start contacting bondholders and suppliers around the country to show them what they would lose from an NYC bankruptcy. Economists prepare reports on the macro impact (those of us who have seen the aftermath of Lehman would not be surprised that the macro impact would have been substantial).  States and cities start to worry about what a default would mean to the interest rates they would have to pay.

    Ford decides that the best he can do is set up an orderly expedited bankruptcy so that there won’t be too much confusion and craziness when the city defaults.  But he’s not going to bail out the bondholders and noteholders.

    That’s what he says on October 29 and that’s what leads to the famous Daily News headline.

    The Daily News headline stirs up a backlash against Ford.

    In early November, the state declares an emergency bond repayment moratorium and forbids the city from paying back bonds and notes.  (Of course, the city didn’t have the money to do this, but the city’s non-payment did not technically constitute default.)  This forces the investors to reschedule and extend the debt—their first and only concession so far.  While technically not default, this rescheduling also technically satisfies Ford’s demand for concessions by creditors.  The presidents of France and Germany, whose banks hold of lot of New York City debt, go to Ford and say, “What? How can you let New York go under?  You can’t be serious.”

    In the middle of November, Ford relents, Congress relents, and the federal government lends New York around $2 billion on pretty bad terms—1% above the cost to the government.  At that point, the worst of the crisis is over, although there are many hiccups over the next few years (including a court decision that the debt moratorium is unconstitutional).   The EFCB really runs the city for the next several years.  By 1978, the city has no short term debt, and by 1981, the city balances its budget and sells long-term debt on its own.

    In the end:

    • The city was stuck with billions in long-term debt for past operations, although growth and inflation did a lot to reduce the burden of this debt. MAC bonds have been refinanced several times and are still outstanding.
    • Lots of fee hikes were imposed for transit and CUNY. Expansion of CUNY stopped just as the rate of return to college education started to grow.
    • The state took over a major portion of the costs of CUNY and welfare.
    • Lots of service cuts and real wage cuts were imposed: about 40,000 job losses, and city employment fell by 20%.  (Newark is already approaching the 20% mark and the worst is yet to come.)  Some observers attribute the civil unrest that occurred during the 1977 power blackout to these cutbacks.
    • Banks took losses on rescheduling and extending debt.  Some of them were also forced to trade short-term debt for MAC bonds.
    • About 40% of city pension funds were invested in MAC bonds.
    • City taxes rose by about $200 million—a pretty small amount.  (Newark taxes have already risen by a larger margin.)
    • Municipal bond interest rates rose nationwide.
    • The First Deputy Mayor, the Deputy Mayor for Finance, and the Budget Director are all forced to resign.
  2. Analysis
    1. “Bankruptcy” in general

      This is really too harsh a word; “reorganization” would be better.  This is what happens when an organization’s commitments get to be more than it can fulfill--for instance, an ordinary company with too many debts, or GM last year.  For a normal corporation, this is an orderly process for sorting out all the commitments it has, marshalling its assets, and deciding who loses how much among those who have received those commitments.

      It’s not liquidation. You have an ongoing enterprise and it’s valuable to keep that enterprise going.  This is not always the case, but it happens in the interesting cases.

      There are three main dangers in bankruptcy:

      1. Moral hazard.  You don’t want people to be able to reduce their commitments arbitrarily, because then those commitments will be valueless.  So the people who initiate bankruptcy usually have to take some hurt.  In private businesses, the CEO normally gets fired.  At the very least, once someone admits to being overextended, they lose their credibility and ability to make promises.  This is why Beame kept denying that there was a problem.
      2. “Mischief” and gambling on redemption.  People’s time horizon changes.  They think more short-term and are willing to take bigger risks. The creditors want to make sure that the leader doesn’t run off with the assets, but creditors have poor information and can’t always distinguish looting from keeping the enterprise going.  Receivership is the mechanism in regular bankruptcy law to prevent looting (although sometimes receivers loot themselves).  In New York, it was first MAC and then the EFCB.
      3. Stalemate.  Everyone is better off if the enterprise returns to normal after reorganization is done, but everyone is better off if the others take the losses.  Agreement with reorganization is a public good, and so everyone wants to be a free rider.  Bankruptcy judges and formal rules prevent stalemates from occurring with normal corporations.  But even for private corporations, when they get big enough like GM, the normal rules don’t apply, and there is a danger of stalemate.  The pie evaporates as you fight over it.
    2. Interpreting NYC 1975 in these terms
    3. The denial phase is not irrational; it’s a rational response to the loss of credibility, power and perks that a crisis brings. As long as there’s some hope that some piece of good luck could save them, leaders have no reason not to try to keep the old situation going.

      Most of the crisis consists of a game of chicken, in colloquial terms—in technical terms, a prisoners’ dilemma game.  Sequential concessions are made until enough concessions are made, or no more can be made.  To recap the order of concessions in NYC:

      First, the state, in return for concessions by Beame.

      Then, the unions and more concessions from the state and Beame.

      Then, the investors and more concessions from the unions, state and Beame.

      Then, Ford.

      Each stage consists of bringing in another party who didn’t want to be involved in this at all, convincing them that they will be hurt if the city goes down, getting a few more concessions from the folks who are already in, and then getting some concessions from this party.  For instance, when Shanker agreed to buy the MAC bonds he wrote that the pressure had not come from the governor or the mayor, but from “the situation.”  “If the city goes down, you don’t have a system.”  (It would take 17 months for the EFCB to approve the 1975 teachers’ contract, and the union lost 15,000 teachers and aides—20% of its membership—during the three years of austerity, but Shanker still thought he had to buy the MAC bonds.)  The crisis ends when the combination of concessions is great enough that everyone’s expectations are once again consistent (and it can’t end as long as some party that people think will make concessions has not made concessions).

      The exception may be future taxpayers, since they have no alternative to the heavy concessions that are made for them. The crisis transforms a lot of short debt into long debt, but it also stops additions to debt.

      All in all, the NYC reallocation seems to be only about a $3-4 billion out of an $11 billion budget in a city with GDP of probably around $80-100 billion. But it was still huge for many people and needed all the drama to work itself out.  These figures are not that much different from the situation Newark finds itself in; maybe a little smaller in relative terms.

      Social security and Medicare now are an interesting analogy.  Everyone knows that major changes will have to be made to make them sustainable in the long run, and it’s easy to outline many different ways that they can become sustainable.  But someone will sustain major losses under any of these scenarios, and it may take a crisis for something to be done.

    4. How does this apply to Newark?
    5. Do these lessons apply to Newark today?  The relative size of Newark’s budget problem today, I have mentioned, is probably a bit greater than New York City’s budget problem in 1974.  Beame had an $11 billion budget, including schools, and a budget gap of around $1 billion to $2 billion, depending on how rigorously you do the accounting. Excluding schools and county, over which he has little or no financial control, Booker has a 2011 gap of around $100 million in a budget of about $680 million (including grants but excluding water, sewer, and reserve for uncollected taxes). This is after the tax increases and layoffs of 2010. And Booker has less scope for raising taxes than Beame did because of the cap law.

      On the other hand, Newark does not (yet) have the short-term debt that New York City had.  Bond anticipation notes were converted into long-term debt in June 2010, but Newark sold $75 million in tax anticipation notes in May 2010 and may have to roll these notes over soon.  Moody’s also reports that the city was planning to issue $20-30 million in bond anticipation notes in the third quarter of 2010.  The bond anticipation notes, however, are not as risky as New York City’s were because Newark can convert them into long term “qualified bonds”—bonds backed by a trustee who intercepts state aid to make sure that these bonds are paid before Newark gets the rest of the state aid.  (In this sense, Newark already has a less stringent version of MAC.)

      Since the 2011 budget will probably be late, and since (at least) until a budget is adopted, expenditures will run well ahead of revenues, short-term borrowing will probably expand rapidly at the beginning of next year. It is possible that at some point the market will turn against Newark short-term debt the way it turned against New York City debt in 1975, especially if a large government like California or Detroit defaults, but this is unlikely.  New Jersey keeps Newark on a much tighter leash than New York State kept New York City, although state aid will not be able to cover the principal on $100 million in short-term debt if it comes to that.

      The distinguishing mark of a crisis is not that investors are disappointed in their legitimate expectations, but that many groups are.  New Jersey law makes it virtually impossible for cities to issue the kind of debt that will default (unless the state defaults or the city guarantees the debt of a municipal utilities authority), but to make default unlikely the state has taken on many of the functions that the bond market normally performs. This is why the state has taken over several municipalities in the last few years—Hoboken, Atlantic City, and Trenton—and why it will take over several more next year.

      Newark is now spending roughly $100 million a year more than it is taking in.  It may be able to cover this shortfall for a while by some form of borrowing or asset sale.  The crisis occurs when the city can’t borrow any more—it doesn’t matter whether the market stops the borrowing or state law stops the borrowing.  Sooner or later, one way or another, $100 million plus of annually recurring disappointment has to be meted out.

      As an exercise in arithmetic, it is easy enough to come up with plans to handle this $100 million plus.  Some of it will come from job cuts and wage cuts.  If all of it comes from job cuts, as many as a thousand more workers will have to be let go, most of them police officers and firefighters probably.  Combined with the 2010 layoffs, this would bring the city workforce to slightly more than half of its level for most of 2010.  Wage and benefit cuts won’t make much of a difference—maybe a hundred jobs or so.

      If Newark is going to come out of the crisis with job and service cuts less vicious than these, then either revenue has to increase or a major reorganization has to occur.  So, for instance, UMDNJ could take over the health division, the county could take over the parks, the school board could take over the crossing guards, and police, firefighting, and the library could be regionalized. Reorganizations work, of course, only if some other entity can be induced to pick up a lot of the tab for existing Newark services.  That would never happen in normal times, but inducing some action like this is what the crisis is about.

      Similarly, revenue could increase if the state provides additional aid, or authorizes new taxes, or relaxes the cap rules on property levies; or if Newark voters decide to approve property tax increases. (I include the Port Authority as part of the state, since the Governor has veto power over its minutes.)

      Conventional wisdom holds that none of these things will ever happen—Newark axing half its workforce, the Newark Police Department being regionalized, Governor Christie backing down on property tax caps or on new taxes, Newark voters approving a property tax increase.  But arithmetic guarantees that at least one of these things has to happen—probably several.

      Arithmetic, however, doesn’t tell us which ones will happen or how much each party will give.  That is why there is a crisis—a game of chicken—not just an accounting exercise.

    6. Bad crises and worse crises
    7. Like a toothache, there is no good crisis.  But some crises are less damaging than others. In general, shorter crises are less damaging.

      Long crises produce three closely related toxins: unproductive borrowing, poor morale, and “mischief,” to use the appellation that Star-Ledger columnist Joan Whitlow favors.

      Consider unproductive borrowing first. Every day that Newark spends more than it takes in adds to a debt that future taxpayers will be responsible for.  That debt comes with no corresponding benefit (like a new road or a fire engine) for these future taxpayers; it is pure burden for them.  As long as it is outstanding, it condemns Newark to have a less attractive tax-and-service mix. This leads to less investment and less population, and so leads to an even less attractive tax-and-service mix. (Tax abatement policies do not change the fundamental accounting identity driving this result; only pure land value taxation would do so.)  The constitutional injunction against paying for current operations with long-term debt in small jurisdictions (that do not operate by land taxes) is a wise one. Every day that the crisis continues, Newark violates it egregiously.

      (In a town that is growing already, adding debt is less of a problem because more and more people are sharing the debt as time goes on and so the burden that any individual bears is falling.  But Newark is not growing quickly.)

      Morale is the second problem with long crises.  Almost all city workers have jobs that need to be done well.  Obviously people’s lives depend on the actions of police and firefighters, but the actions of the workers who repair traffic signals and fix the brakes on garbage trucks are also crucial.  Taxpayers rely on the basic fairness and care of the tax collector’s office, and nothing else can happen if the payroll office is not functioning well.  Many workers have special expertise from long experience. Close supervision is usually difficult and supervising the supervisors is harder, and paying piece rates makes no sense.  Thus the city can work reasonably well only if morale is reasonably good.

      By introducing a stomach-churning uncertainty into the lives of city workers, a long crisis undermines morale and invites quitting by the most qualified. This is not just normal uncertainty (“is it going to rain tomorrow?”); instead it is a fundamental uncertainty about what they had taken as foundational wisdom around which they had built their careers and their plans for their families.  Why should they do their jobs right when they might be out on the street no matter how hard they try and how proficiently they perform?  Why should they think that doing their jobs well is important when those jobs could disappear tomorrow—eliminated by the same folks who are telling them today that those jobs are important to do well?

      In Newark, the morale problem has been compounded by the institution of furloughs.  Furloughs are often a sensible policy for businesses hit by transitory reductions in demand. Newark’s problems are not transitory. Normal furloughs end when times get better and workers return to their normal schedules. Newark’s will end when enough workers get laid off.  Furloughs in this case do nothing but hurt morale, reduce services, and send workers the implicit message that their jobs are not important enough to be worth doing on the Friday before a long weekend.

      Not all city workers are angels.  Some would do their jobs terribly no matter what.  Others are so dedicated that they will continue to soldier on no matter how bizarre their behavior appears to their co-workers.  But most city workers are humans who are affected by what they see around them and respond to incentives.  As long as the crisis continues, they will perform poorly and Newark’s residents and businesses will suffer.

      Mischief is the final problem that long crises engender.  Under normal conditions, most people connected to city government think that there is a good chance that they will continue to enjoy power and influence if they don’t fail at anything spectacularly or are not caught doing anything spectacularly wrong. This hope for the future serves as a check on both gambling and rapacity, and so promotes good government (although it obviously cannot guarantee good government).  A crisis removes this predictable hope for the future.  Some politicians will conclude that their careers are likely to be over whatever they do, and so concentrate on enriching themselves and their followers.  For others, the crisis will induce them to gamble on improbable schemes—since they will be little worse off if the scheme fails than they would be if they did not try it.  In the private world, for instance, the greatest damage in the 1980s savings and loan collapse came in the last stages as virtually bankrupt banks (“zombies”) gambled on redemption by pumping out high-interest, high-risk loans, most of which failed.

      We can already see these three problems in Newark and they will grow worse if the crisis is allowed to fester.

      The morale problem can be seen by anyone who visits City Hall (if you’re lucky enough to pick a non-furlough day), and may have a connection to the rise in violent crime in Newark this summer.  The other two problems—unproductive borrowing and mischief—are evident in the Municipal Utilities Authority (MUA) controversy that wracked Newark this summer and is likely to return in 2011.  Under this plan, which the Mayor proposed, an independent authority would be set up and borrow huge amounts of money with the city’s guarantee.  Part of these funds would be used to pay a vast coterie of lawyers, accountants, engineers, other consultants, and newly hired executives, and most of the rest of the money would be funneled into payments to the city for “purchasing” the water and sewer systems.  These payments would be used to forestall the crisis for a year or two, while the debt would be paid off over several decades in the form of ever-escalating water and sewer bills for Newark residents and businesses.  In the current situation, the MUA was both a lifeboat for administration loyalists, and a way to make the future pay for today’s indecision.  No one would have been foolish or desperate enough to propound such a scheme in normal times.

    8. What keeps the crisis from being short?
    9. Since long crises are so destructive, why can’t we just have a short crisis?  Because most of the key players have goals that are more important to them than making the crisis short.

      To begin with, the Mayor and Council lose their standing and probably some of their perks if they acknowledge the depth of the crisis.  Saying that there is a crisis of this magnitude is saying that you have promised your constituencies far more than you can deliver.  Both Mayor and Council gain from pretending that they are in charge as long as they can do so.  Moreover, they have no reason to balance the budget themselves as long as they hope they can wring some assistance out of the unions or the Governor.

      The unions, on their part, have little reason to make serious concessions to the Mayor because he can strike no final bargain.  Any concessions they make now are likely to be only preludes to the concessions they will have to make to the Governor when he gets involved.

      The Governor, in turn, can only be hurt when he becomes involved, because he will have to give up something—either a piece of his reputation or a piece of his money—and so he has every reason to avoid involvement as long as possible, and hope something miraculous solves the problem without him.  The negotiating table in this instance is a place where people make concessions; the Governor like everyone else wants to stay away from it if he can.  But there is no reason for the other players to make enough concessions to resolve this crisis until the Governor is involved.  Remember how the New York City crisis settled down only after President Ford stepped in.

      The actual political calculations in the crisis are far more nuanced and person-specific than this, of course, and there are many more players.  But for almost all important people, denial, delay, and delusion are the individually optimal strategies. Most leaders now have bad incentives.

      But leaders aren’t the only people who matter and not everyone who is a leader now will still be one after the crisis is resolved.  The next generation of leadership in Newark will emerge from this crisis; when the emperor in fact has no clothes, saying so in the right way can bring a big payoff.  Unproductive borrowing, mischief, and morale-destruction can be minimized, but only if enough people realize soon enough what is happening.

    10. Conclusion
    11. The New York City crisis occurred during the 1974-1975 recession, but most local governments survived this recession without similar crises (Yonkers is an exception).  Similarly now, the recession is hurting all state and local governments, but in the aggregate the reduction in revenues appears to be in the 5% neighborhood that matches the fall in GDP.  Governments move slowly and most have reserves, and so it’s no surprise that the problems are more serious now than they were in 2009.  Recessions like this kick up a lot of straw and some of that straw will break some camels’ backs, but only of those camels that were heavily laden already.  People who say Newark is in trouble because of the recession are answering the question of why the Newark crisis is occurring now and not some other time; they are not answering the question of why Newark and not East Orange.

      Crises are also about changes—somewhat unexpected changes—not about levels.  In the end, if the crisis is not prolonged and mischief is controlled, Newark will emerge with an equalized property tax rate not above the Essex County median,  and per capita police strength at least that of most cities its size.  Most explicitly crises are not a product of poverty.  New York City and Orange County (where the largest municipal bankruptcy in history occurred in 1994) are among the richest places in the US, not the poorest.  When the crisis becomes public in Newark, all the national reporters will say “gritty” and “hardscrabble” and attribute the problems to poverty, but Newark had a lot more poverty and more serious problems in the 1970s when it did not have a crisis.  The crisis came about not because Newark was poor, but because Newark had enough money to get used to living beyond its means, and its leaders did not have the strength to do anything about that.

      Newark can get through this crisis, as it got through 1934 and New York City got through 1975, but the damage will be great unless the crisis is short. Many powerful people, however, have strong incentives to obfuscate and prolong the crisis. Denial, delay, and delusion are the order of the day now, but they cannot be so for long.  Understanding where we really are is the first step in reducing the damage this crisis will cause.

    Appendix: Projecting the 2011 Budget Gap

    This appendix is based on the report of the Newark Budget Working Group (NBWG), from which the $100 million deficit number has been publicized.  I’ve updated that projection in light of events after September 28, when the report was released.   Two tables are attached, one for revenues and one for appropriations.  I exclude grants, water, and sewer.

    I compare 2009, the last year in which a sound simple budget was adopted, and 2011, the year we are interested in now.  Basically, over that period, non-property tax revenues go down by $116 million, but property taxes go up by only $54 million.  In the absence of the 2010 cuts, appropriations would have gone up by $107 million, but the cuts reduce appropriations from what they would have been by about $69 million.  All told, the remaining gap for 2011 is a little over $100 million.

    Considerable uncertainty surrounds these numbers; I would be surprised if they were off by less than $10 million, but they are equally likely to be off in either direction.  The two major uncertainties are the savings from the RIF and 2010 property tax collections.

    The RIF I model is what the NBWG was told was reasonable, and it includes voluntary retirements and quits.  There is uncertainty about whether layoffs will actually take place, about whether jobs will in fact stay vacant, and about how many people with what salaries will quit or retire.  To my knowledge the city has not instituted a hiring freeze.  I am also assuming that the state will allow the city to spread termination costs over five years.  This is another unproductive borrowing, and adds to the debt that future taxpayers will be saddled with, but if it does not occur, the 2011 gap would be about $14 million greater.

    I assume that the privatization of sanitation and motors will occur; since it saves little money, if it does not occur there would be no major change in the gap.

    Tax collections for 2010 are uncertain because the fourth quarter bills (due November 1 normally) have not been received yet, and will contain large increases.  I guessed that the tax collection rate would fall from 92% in 2009 to 88% in 2010.  A larger fall would have little impact on revenue projections (surplus would go down but anticipated delinquent tax collections would go up almost as much) but would force the city to set aside a larger reserve for uncollected taxes on the appropriations side.

    I have used the tax levy cap law and the 2010 tax levy to estimate the 2009 tax levy.  I allowed close to a 4% increase because of the added debt costs from the sale-leaseback and other items.

    I have not provided a calculation for 2012, although the NBWG report has these forecasts.  If the 2011 gap is filled by borrowing or one-shot revenue, the 2012 gap would be considerably worse because the property tax is only a fraction of the city budget: even if the city appropriation grows at 2% a year, the municipal tax levy cannot keep up.


    Table 1: Revenue comparison: 2011 and 2009
    All numbers are millions of dollars
    2009 2011
    Tax abatement etc 23.4 21.1
    Port Authority lease 71.1 71.1
    Municipal courts 14.2 14.6
    Interest on taxes 5.3 4.4
    Interest on investments 4.4 0.7
    Other section A revenues 4.6 4.6
    State aid 118.7 91.3
    UCC fees 2.9 2.8
    State building aid allowance 8.7 7.8
    Hotel tax 5.2 4.7
    Payroll tax 36.9 35.8
    Parking lot tax 20.5 18.9
    Municipal court additional 0 3.2
    Port authority settlement 40 0
    Easement rights 0 8
    PVSC pilot 0 0.7
    Water and sewer reimburse 5 5
    Sewer debt reimburse 0.3 0.4
    Cable TV fees 0.5 0.6
    Fringe benefit reimburse 5.5 6
    Fire safety act fees 0.7 0.7
    Host municipality-incinerator 6.6 5.8
    Employee health reimburse 0 1.9
    Due from capital 5.7 0
    Other miscellaneous 1.1 1.1
    Delinquent taxes 30.7 35
    Surplus 50.7 0
    Total non-property tax rev. 462.7 346.2
    Property tax levy 301.3 355
    Total revenue 764 701.2

    Table 2: Appropriations
    2009 2011
    Schools 98.7 104.8
    County 71.7 76.7
    Reserve for uncollected tax 33.3 42.6
    Municipal debt 28.6 28.3
    Sale/leaseback 0 7
    School debt 14.2 14.8
    Other non-departmental 4.2 5.7
    Police salaries 111.3 121.6
    Police other pay 23 25.1
    Fire salaries 55.6 60.8
    Fire other pay 8 8.7
    Other workers salaries 85.3 88.8
    Other worker other pay 3.7 3.9
    Benefits 78.1 93.8
    Pensions 36.4 65.9
    Library 10.8 11.5
    Museum 7 7.4
    Other major contracts 50.3 58.1
    Other services by contract 31.3 32.9
    Materials and supplies 9.1 9.7
    Equipment 1.5 1.6
    Miscellaneous 1.2 1.2
    Total before 2010 actions 763.3 870.9
    Reductions from 2010 actions
    Library cut 3
    Museum cut 2
    Other service cuts 5.7
    Cost of additional refuse contract -7.4
    Cost of additional motors contract -1.6
    167 police 18.538
    150 firefighters 17.213
    500 civilians 31.831
    Total reduction 69.282
    After 2010 reductions 763.3 801.61
    Less revenue 764 701.2
    Gap -0.7 100.41
The Newark Budget Debacle: What Happens Next?