Staff Report 501

Pay with Promises or Pay as You Go? Lessons from the Death Spiral of Detroit

Thomas J. Holmes | University of Minnesota, Federal Reserve Bank of Minneapolis
Lee E. Ohanian | Consultant

Published July 14, 2014

As part of compensation, municipal employees typically receive promises of future benefits. Motivated by the recent bankruptcy of Detroit, we develop a model of the equilibrium size of a city and use it to analyze how pay-with-promises schemes interact with city growth. The paper examines the circumstances under which a death spiral arises, where cutbacks of city services and increases in taxes lead to an exodus of residents, compounding financial distress. The model is put to work to analyze issues such as the welfare effects of having cities absorb pension risk and how unions affect the likelihood of a death spiral.

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