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Column: Detroit and the importance of failure - James Saft

By James Saft

(Reuters) - Here is the real meaning of Detroit: human institutions sometimes fail and we are far better off acknowledging and accommodating this than fighting it.

Information from failure is a large part of the value created by markets and by experimentation, and we ignore and suppress that information, as we are now in the banking system and elsewhere, only at great cost.

Detroit filed for what would be the largest municipal bankruptcy in U.S. history on Friday, a move which will be bitterly fought in the courts by its creditors and by municipal workers who stand to lose promised retirement and health benefits.

There is plenty of blame to be divided; politicians, company management, unions, Wall Street and the voters of Detroit all played their role. And while it is worth debating and litigating who is at fault and who should suffer most, some underlying facts have to be reckoned with. Detroit's population and tax base have shrunk while its obligations to the holders of its $9 billion in debts and a (contested) additional $9 billion to municipal pensioners have not. That leaves the city, with a high crime rate and a 58-minute average response time for emergency calls to the police, critically unable to provide even basic services.

If we were going to live in a world where all contracts were always honored, no matter the cost, we'd still have debtors' prisons. In Detroit's case, if we expect the people and businesses which make up its current tax base to continue paying out interest and benefits in exchange for very bad services, we are going to have to be prepared to build a wall to keep them in.

There are plenty of things, then, to bemoan about Detroit, but its bankruptcy is not one of them. Bankruptcy is one of the truly great institutions of the modern financial system. And while a municipal bankruptcy, in which federal authority in the form of the bankruptcy judge is limited by the division of powers under the constitution, presents problems, it allows for the great benefits of failure to be more fairly, if imperfectly, apportioned. This isn't something to resist, it is something to welcome.

First, it allows for the debts and obligations of the bankrupt town to be whittled back to a reasonable proportion compared to its revenues. That, by restoring some services, can help to staunch the bleeding of people and businesses which otherwise would flee.

LISTENING TO FAILURE

Second, the bankruptcy, let's call it failure for short, sends out really good and useful information, not just to creditors and others who will lose out, but to everyone. In this case, municipal bondholders, past, present and prospective, will learn that lending money to a government, especially one with a dwindling tax base, involves a goodly bit more risk than perhaps they believed.

That will raise the cost of financing in these situations and will encourage governments to get to grips with their woes sooner, rather than simply floating another bond or engaging in a speculative interest rate swap and hoping that the sweep of history starts breaking their way again.

It is unclear what will happen to pensioners, who may be protected under state law, but the result may well be a loss of expected benefits. That is awful, and arguably unjust and unfair, news for them, but is truly valuable information for the millions of current and future pensioners in underfunded or pay-as-you-go pension plans elsewhere.

Failure provides feedback and encourages experimentation, which produces both more failure and also, sometimes, success.

What is happening in Detroit is quite a contrast with how the U.S. approached the effective failure of some of its largest financial institutions during the crisis. Rather than forcing them into some form of bankruptcy, installing new management and forcing creditors and investors to recognize losses, we instead kept the industry on a variety of forms of life support.

And while these banks may be solvent and profitable today, crucial feedback has been missed, and investors have been encouraged to invest not with their heads but based on faith in the government's willingness to bail out banks and create easy conditions for them, no matter the cost to the rest of the economy.

That missed feedback is doubly dangerous.

We are rebuilding imbalances in the economy and seeing the growth, once again, of things like advertisements for plastic surgery loans for people with bad credit.

We are also, arguably, suffering a long-running economic malaise precisely because we did not, as Detroit will now, destroy unmanageable debts, learn from our mistakes and move on.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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