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Getting the Fiscal Fundamentals Wrong

Stockton’s fiscal meltdown isn't the result of a dumb idea or corruption. That's why it’s particularly scary.

When analyst Meredith Whitney predicted that there would be a huge number of municipal defaults in 2011, she was roundly derided, and in fact things didn't turn out that way last year. But I wonder if she might just have missed the timing by a little.

On Tuesday, the city council in Stockton, Calif., approved a plan for the city to default on about $2 million in debt payments through the end of its current fiscal year and begin a process of mediation with its major bond holders to try to get a break on its debt. The city's leaders hope that the plan they've set in motion will enable Stockton to avoid being the largest U.S. city to file for Chapter 9 bankruptcy.

So what happened? In some of the cases where local governments have defaulted, it's been due to one big thing that was stupid or illegal. I had a discussion recently with Bob Attmore, chairman of the Governmental Accounting Standards Board, about financial troubles in municipal governments. "There's usually a gimmick somewhere imbedded in all these problems," he observed. And you can see his point: Harrisburg, Pa.'s attempt at filing for bankruptcy resulted from a long series of misadventures with the city's trash incinerator. The Jefferson County, Ala., bankruptcy resulted from a series of risky bond-swap agreements compounded by corruption that resulted in several public officials going to jail. In other cases, such as with Vallejo, Calif., cities have filed for bankruptcy primarily to gain leverage over public-employee unions.

In the case of Stockton, however, there seems to be no one big thing that is the proximate cause of the fiscal crisis. City Manager Bob Deis says the city's financial management is "simply horrid" and that "in my 32 years of managing finances for local government, I have not heard of nor seen a situation such as this." Apparently he wasn't paying attention for most of those 32 years. The kinds of financial-management mistakes Stockton made—such as errors in reconciling accounts, accidentally double-counting parking ticket revenues and looking at financial decisions on a "pay-as-you-go" basis rather than at long-term cost management—happen regularly in local governments across America, and they are frequently documented in municipal audit reports. Those are serious problems, but they haven't driven other cities to bankruptcy—yet.

Here's the thing. Stockton's management errors happened in a city with the second-highest foreclosure rate in the country and crime and unemployment rates that are among the highest. They happened in a city twice ranked as one of America's most miserable cities.

And here's why Meredith Whitney might end up being right after all. In one of the articles attacking her, DWS Investments said, "The investment public now seems to be recognizing that the fundamentals in the muni market are improving." That's nuts. Here's a "fundamental" for you: Hourly wages in the United States have not kept pace with inflation for the past 40 years. Real hourly earnings peaked at $20.30 per hour in January 1973. In constant 1982-1984 dollars, the real hourly wage in January 2012 was $10.24.

If you want to understand what's going on in cities, look at what's happening to the people living in them. In 2012, the vast majority of average Americans are hurting economically. It's not surprising that their cities are hurting as well.

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