With Detroit having officially declared bankruptcy, the inevitable comparisons have started being discussed with Washington DC and the poor fiscal situation of the U.S. federal government.  For this post, I am going to offer what I think are similarities and differences between the two situations.

First, some people are saying that Detroit filed for bankruptcy because it was put in the hands of a single manager who made the decision.  But I think bankruptcy was inevitable.  For me, things always seem to play out longer than I would think possible, and this was another one of those situations.  Detroit has been a fiscal mess (along with being a mess in general) for many years now.  There was simply no possible way to fulfill all of the promises that were made by previous politicians.

Next, it is important to realize right off the bat the major difference between Detroit and Washington DC.  The federal government has a monopoly over the money supply.  There is a central bank (the Federal Reserve), which can create money out of thin air at any time.  The government in the city of Detroit obviously has no capability to create money.  It only has the ability to tax and that was not working much because most people with money were getting out of Detroit.  I also saw a statistic that almost half of the property owners in Detroit were delinquent in paying their property taxes.  Who can blame them?

It is often said that the Fed can print money out of thin air.  In today’s world, it is actually more accurate to say that the Fed can create digital money out of thin air.  Most of the new money supply is not in the form of currency, but in the form of digits in bank accounts.  Regardless, it is still essentially the same thing with the same bad consequences.

There is a mistake that is made by some, including many libertarians, that assumes that there are absolutely no limits to the Fed and its ability to create money.  But in reality, there actually is a limit to their effectiveness.  The limit is hyperinflation.  There might also be a limit in the sense of what the American people are willing to put up with.  If the velocity of money picks up (money demand weakens) and price inflation starts to pick up significantly, the Fed will eventually be forced to stop its monetary inflation, or at least cut back significantly.  I don’t think the Fed is going to risk hyperinflation, as it would simply ruin itself and all of its credibility.

It is also important to consider that hyperinflation would not really solve the problems of the massive unfunded liabilities.  Medicare is the biggest one.  Social Security is another big one.  If the Fed simply tries to pay off the unfunded liabilities through massive inflation or hyperinflation, it won’t work because the cost of living will also go up, along with medical expenses.  If the government pays doctors for Medicare services at today’s prices while the cost of living goes up 5 times what it is now, then doctors will simply stop treating Medicare patients.

Regardless of what the federal government does at this point, there is going to be a default of some kind.  The Fed simply cannot just keep creating new money out of thin air like crazy without Americans suffering major consequences.  You can only kick the can down the road for so long, as retired government workers from the city of Detroit have found out.  Washington DC can kick the can down the road a bit further because of the Fed, but there are still limitations.

I think another major difference between Detroit and DC is that we are not going to see a full default announced in one day from the federal government as we just saw with Detroit.  It is going to be a series of mini defaults, group by group.  We have already seen the so-called sequestration.  We will start to see means testing with Social Security and Medicare.  We will see reduced pensions for government employees.  We will see a rise in the official retirement age to collect Social Security and Medicare.  Even this will probably come in steps.  Special interests will be cut, one by one.  There will be a lot of wailing and complaining, but there is simply nothing that can be done about it short of hyperinflation, which would still not really solve anything.  The politicians, since at least the days of FDR, have simply made more promises than can be kept.

In conclusion, I think it is fair to make comparisons between Detroit and Washington DC.  But the bankruptcy in DC is going to be a lot slower and drawn out.  It is going to happen in a series of steps in a more informal way.  But just like the pensioners in Detroit, the American people are not going to know what hit them.