For most of the twentieth century, New York City’s financial history has been a cycle of boom and bust. During prosperous times, city spending surges, as it did during the 1960s and again in the 1980s. The 1960s spending surge set the stage for the prolonged fiscal crisis of the mid-1970s. And predictably, with the downturn of the economy since 1989, there are signs that the city is headed for the fiscal rocks once again. Indeed, without a sharp reversal of its budget priorities and spending habits, the city’s financial problems are likely to become extremely severe. To make matters worse, the midtown Manhattan office market and the financial services industry, both of which fueled the city’s last two recoveries, will not be of much help this time.

One beneficial consequence of the 1975 fiscal crisis is that city financial reporting is now generally clear and forthright. Budget gimmicks like those the state so shamelessly indulges in are no longer possible in the city. The state, for example, recently raised cash by, in effect, selling highways to itself; in the old days, the city was even more brazen, selling bonds and notes secured by fictional federal aid receipts.

On the surface, the city’s recent financial performance appears to have been commendable. The fiscal year ending this June will mark the 13th consecutive year that the budget has been in balance. From the mid-1980s until the current fiscal year, when both revenues and expenditures declined, the budget grew at a steady pace of slightly more than 6 percent a year, somewhat faster than the rate of inflation. Total city revenues grew steadily, from $21.9 billion (in nominal dollars) in 1987 to $24.4 billion in 1989. Despite the recession, revenues continued to increase, to $28 billion in 1991. While the city’s debt has grown almost twice as fast as its budget, total outstanding debt is not yet egregiously out of proportion to the revenue base. The 1992 fiscal year ended with a $566 million surplus, which was used to prefinance a much more difficult 1993 budget.

Where has the money come from to finance a growing city budget during a deep recession? Figure 1 shows the breakdown of city revenues from 1987 to 1992. Of the categories shown, receipts from the sales and use tax, “other taxes,” and “all other revenues” have been virtually flat in nominal dollars (and have therefore declined after adjusting for inflation) for several years. Sales tax receipts have been declining since the onset of the regional recession in fiscal 1990 and are expected to show little growth in the current fiscal year, despite the strong national Christmas retail season. Income tax revenues have been growing somewhat, though more slowly on average than the local inflation rate. The $400 million jump between 1990 and 1991 was the result of two substantial income tax surcharges, which are due to lapse over the next several years.

Two sources of city revenue, however, have grown substantially since 1987: categorical aid and the real estate tax. These are the city’s biggest revenue sources, together accounting for almost half of all city revenues. The steady growth in categorical aid—state and federal grants that must be spent on particular programs—is not a healthy sign for the city’s finances. These funds are heavily concentrated in welfare and medical assistance, so the large increase (about 8 percent a year) suggests that dependency is rising. Moreover, the city is required to match these grants with its own funds, reducing its fiscal flexibility.

A Real Estate Boom?

The greatest increase to city revenues came from the real estate tax, the traditional mainstay of city finance. Revenues from this tax shot up at a rate of 9.1 percent a year from 1987 to 1992, for a total increase of more than 50 percent.

Yet the sharp rise in real estate taxes has taken place during a decline in the real estate market that has been nothing short of catastrophic. New York City is one of the two or three worst real estate disaster areas in the country, the center of what may be the region’s worst real estate slump in fifty years. The downturn has been particularly severe in commercial real estate, especially the Manhattan office market.

The decline in the office market has been a national phenomenon. American real estate developers built more office space in the 1980s than in all the previous years of our republic’s history. Between 1980 and 1985, the nationwide office vacancy rate soared from 4.6 percent to 16.9 percent. According to census data, however, New York City was at first relatively insulated from the national office market crash of the 1980s. Because the city was in the midst of a financial services boom, the market stayed relatively healthy: Citywide office vacancy rates were only 7.9 percent in 1985, up from a tight 3.1 percent in 1980.

But after the stock market crash in 1987, the city’s office market deteriorated rapidly. Vacancy rates rose to 15.1 percent by 1989 and to 17 percent by mid-1991. The current rate is estimated at about 20 percent, with few signs that the market’s decline is ending. According to the New York City Real Estate Board, overall office sales activity is at the lowest level since the late 1970s. Prices for office space are dropping accordingly: Baring Property Advisers, in a recent survey of prime Park Avenue office buildings, estimated that asking rents have fallen 19 percent since 1989 and 14 percent in just the last year. The surveyors caution that their data probably understate the price decline since building owners are also being forced to offer perks, such as free renovations and initial periods of rent abatement, in order to induce companies to rent from them. Data from the Corcoran Group show that Manhattan co-op and condominium prices followed the office market downward, falling more than 25 percent on a per-room basis between 1989 and 1991.

There is every reason to believe that the office market will get worse. Office leases that were negotiated at very high rates in the mid-1980s are now running out, and the owners of the newer space are typically very heavily indebted. According to the Real Estate Board, many office buildings are taking in barely enough rent revenues to cover the mortgage and operating costs; as rents decline and more leases come up for renewal, buildings will go into default. For many buildings, the steady upward push in real estate taxes has been a last nail in the coffin: In just three years, the real estate tax delinquency rate has more than doubled.

The recent history of 55 Water Street, a prime lower Manhattan property, is a sobering case in point. Knowledgeable institutional real estate investors put up more than $500 million for the building’s AA-rated first-mortgage bonds, reassured by strong lease revenues from blue-ribbon tenants that more than covered debt service and operating costs. But when a spate of leases came up for renewal over the past few years, tenants left for lower-cost space elsewhere. By summer 1992, the building’s vacancy rate was 24 percent, and some experts foresee it going to 40 percent. The first-mortgage bonds traded for as low as 29 cents on the dollar before the holders finally traded them in for the building’s equity.

The sharp rise in real estate taxes during this disastrous market was made possible by the idiosyncrasies of the methods the state and city use to determine taxable property values. The State Board of Equalization and Assessment is responsible for producing full market valuations (estimates of the actual value of properties) each year, while the city’s Department of Finance administers a separate system of estimating taxable assessed values (a proportion of market value on which the property tax bill is based). Both systems have produced bullish growth in valuations since the mid-1980s: The state’s full-market valuations grew at a ridiculous 15 percent annual pace right through 1992, while the local taxable assessments grew at a somewhat more reserved 7.3 percent per year over the same period.

State officials make no attempt to defend the accuracy of their market valuations. Because of budget problems, according to a spokesman for the Board of Equalization, the agency has fallen several years behind its annual assessment schedule and has been merely projecting previous valuations forward. Since the valuations are based on the average of the previous five years, the strong upward momentum of the early 1980s is still built into the base numbers. Because of the state’s nonfeasance, the city’s taxing ability appears to be much higher than it really is. State law bars the city from raising real estate taxes for operating purposes (as opposed to debt service) to a level greater than 2.5 percent of market valuation. Because market values are artificially high, there appears to be a massive amount of room under the 2.5 percent ceiling. But when the state finally produces more realistic figures, the downward revaluation could be enough to severely hinder the city’s taxing ability. A drop of about one-third from the current inflated market valuations is all that would be required; such a decline is quite possible, particularly if the slump continues for a few years longer.

The city’s assessed valuations are kept current, but bear only an indirect relationship to actual market values because different assessment policies apply to each type of property. Single-family residences have always been intentionally undervalued. In effect, the same is true of co-ops and condominiums, which are treated as if they were rent stabilized, with their values limited by the inability to raise rents to whatever the market would bear. For residential properties, then, these practices substantially diminished the effects of the 1980s’ “bubble” economy on property tax rates.

The city’s commercial assessments, however, are based on market values, although the effects are muted by a five-year phase-in period. But the phase-in period also causes assessments to continue rising in the early years of a real estate bust. Thus, the tax base of city commercial property rose by one-third between fiscal 1989 and 1992. Even with that rate of increase, the city pushed up the tax rate-from 9.7 percent of assessed value in fiscal 1989 to 10.6 percent in 1992—in order to accommodate its ever-growing appetite for more real estate tax revenues.

For the time being at least, the illusory increase in real estate taxing capacity seems to be over. In 1992, spurred by complaints from property owners and a variety of class-action lawsuits, Mayor Dinkins promised that the tax rate will not be increased again. Meanwhile, the fall in real estate values is beginning to be reflected in the city’s assessments, which have stopped rising and could well start to decline. The net result is that real estate tax revenues arc projected to grow only some 2.2 percent in the current fiscal year, and should be flat or even declining in nominal dollars for the foreseeable future.

Since it is unrealistic to assume that either the state or the federal government will provide substantial additional financial assistance—indeed, cuts in aid seem likely, given the fiscal troubles in both Washington and Albany—the city is probably headed for a full-blown fiscal crisis once again if it continues on its current course. Even based on fairly optimistic forecasts about spending discipline, state and federal aid, and local economic recovery, the city faces a built-in budget gap well in excess of $2 billion.

Can Wall Street Save Now York?

The last major fiscal crisis, of course, was ended by the economic boom of the 1980s. With the national economy apparently on the road to recovery after a prolonged recession, can New York hope simply to grow out of its current troubles? Regrettably, no—at least not in the same way it did during the last two fiscal cycles.

With its manufacturing base almost totally gone, New York City’s economy is critically dependent on the Manhattan-based financial services industry. Manhattan accounts for about 75 percent of the city’s economic output; the FIRE industries (finance, insurance, and real estate), almost entirely located in Manhattan, generate roughly one-third of the city’s total output and account for 15 percent of the city’s employment. No other private-sector industry comes close in importance to financial services; indeed, one-third of all city-based jobs are in the government and the nonprofit, health, education, and social services sectors—all of which consist for the most part of tax consumers rather than tax contributors.

In fact, official figures probably underestimate the proportion of the city’s private-sector economic product that depends on financial services. A host of other businesses—from law and accounting firms to restaurants and limousine services—feed off the financial sector. It is no exaggeration to say that as the financial services sector in New York goes, so goes the private-sector economy, the office market, the real estate tax base, and the city’s fiscal health.

The city’s dependence on financial services was clearly evident in the last several fiscal cycles. The financial markets and the city’s economy were both depressed in the latter years of the Wagner administration, furnishing a major campaign theme for John Lindsay in 1965. Wall Street boomed again in the mid-1960s; by the end of Lindsay’s first term, New York had the lowest unemployment rate of any big city in the country. City spending boomed along with the stock market, setting the stage for fiscal collapse during the long market stagnation of the 1970s. When the markets boomed again in the 1980s, both the state and the city suddenly looked financially healthy. Predictably, spending increased once more, culminating in the painful squeeze of the last few years as the markets again turned down. But it is very hard to be optimistic about the prospects for another financial services boom in New York City, despite the lavish incentives the Koch and Dinkins administrations have bestowed to retain leading firms like Prudential Securities and Chase Manhattan’s back office operations.

Superficially, Wall Street’s fortunes turned decisively upward in 1992, with all-time high revenues and profits. Securities industry employment, which had fallen about 20 percent since the 1987 crash, has begun creeping up once again. But much of Wall Street’s recent upturn in revenues is likely to be short-lived. Almost half of the securities industry’s revenues in 1992 came from bond trading and interest profits. During 1992, the Federal Reserve drove short-term interest rates to the lowest levels in years, while medium- and longer-term rates remained relatively high. Wall Street carries huge bond inventories that it finances with short-term paper-that is, it has been able to borrow at 3 percent or even less and invest the money in medium-term bonds that pay 6 percent or more. As spreads between short- and long-term interest rates ,widened to historic levels, the profits rolled in. But with the recent reduction in long-term rates, no one expects this situation to last.

The second major revenue source in 1992 was record-breaking underwriting fees. Again, this seems mostly a one-time event. In the 1980s, Wall Street collected huge fees by selling junk bonds and other instruments that were used to buy up stock; now it is collecting huge fees for selling stock to pay off the junk bonds. That may continue for another year or so, but then underwriting activity will dip back down to more normal levels.

Meanwhile, the securities industry is facing a fundamental restructuring of the sort that affected almost all other American industries during the 1980s. This process will have a profound effect on financial services as a source of employment and a consumer of office space in New York City. The restructuring, which involves a move toward discount brokerages and computerized trading, is proceeding at a rapid pace: It is far easier to automate the processing of information, after all, than the manufacture of cars.

The nature of the business has changed dramatically over the last decade. In 1980 most stock trading was done by individuals, who paid very high brokerage fees for the privilege. Today individuals account for at most 30 percent of trading. Individuals’ holdings of stocks and bonds are growing strongly, but they are investing through mutual funds and pension funds, which pay much lower fees for their trading. Stockbrokers held on to their customers by switching from selling stocks to selling mutual funds. When interest rates on bonds were high, this was wildly profitable: In the early 1980s, customers switching out of a bank passbook savings account were delighted to get 12 percent on their savings, and hardly cared that the fund managers were keeping another 2 percent or so each year for themselves. But with short-term rates down to the 3 percent level, many brokerages and fund companies are now giving away their money market funds for free.

The restructuring of the mutual fund industry is being led by direct marketers like Fidelity and Vanguard, which offer the most modern technology, much lower loads and costs, and excellent round-the-clock service by capable representatives who are paid much less than the Wall Street standard. For example, a fairly typical state municipal bond fund currently sold through brokers carries a front-end load of 4.75 percent and annual service and sales charges of about 1.25 percent. That is, to put $100 into such a fund, an investor would have to pay $4.75 up front and $1.25 a year in other charges. A virtually identical portfolio offered by Vanguard, the low-cost leader, has no up-front charge and annual fees of only about 0.25 percent. Investing $100 in this fund costs an investor 25 cents a year—period.

Retail customers, confused by complicated mutual fund fee schedules, are still paying high loads for broker-mediated funds, but the trends are unmistakable, Fidelity and Vanguard by themselves have accounted for about one-third of all funds growth over the past five years. As customers slowly catch on, there is extreme pressure on fees throughout the industry; to stay competitive, brokers will have to cut their costs—and therefore their profits and employment—for the foreseeable future.

The restructuring is reverberating through every corner of the industry. When most stocks were traded by individuals, it was easy for professional money managers to beat the market. Now that professionals do most of the trading, they are the market, so it is hardly surprising that over the past decade most professionals failed to beat the standard market indices most of the time. Big investors have increasingly resorted to “indexed funds,” computer-managed pools designed merely to match the leading market indices, at a fraction of typical funds management costs. Calpers, the nation’s biggest pension fund, has about 75 percent of its equity holdings indexed. Indexed funds are also becoming increasingly popular in the retail market. As might be expected, funds management fees for institutional investors have been dropping steadily throughout the industry.

Some restructuring trends will have a particular effect on New York City. The system of trading shares on the New York Stock Exchange (NYSE) is organized around specialist firms physically located on the floor of the exchange. The NASDAQ over-the-counter market, on the other hand, has no exchange floor; bid and ask prices appear on traders’ computer screens and transactions are conducted electronically. NASDAQ was originally created for small, thinly traded stocks that did not qualify for major market listings. But a lot of once-small companies are now very large and still trade through NASDAQ: Microsoft and Intel, for instance, have market capitalizations larger than that of General Motors and about the same as IBM’s. Even NYSE-listed stocks are increasingly bought and sold off-exchange as big institutional players essentially trade directly with each other. NYSE officials can cite many reasons why their system is still superior, but the long-term trend toward off-exchange trading is as unmistakable as the trend toward lower brokerage and funds management fees.

A similar trend is the increasing popularity of book-entry trading. The treasury market has long since dispensed with physical certificates for notes and bonds, relying simply on computer register entries. To accommodate institutional investors, more corporations are giving their customers the choice of whether or not to hold stocks in the form of physical instruments. The movement, recording, and custody of physical certificates is a big, employment-intensive business in New York that will inevitably go the way of the horse-drawn milk cart.

New York City has held up well as a world financial market: The share of global capital that flows through New York is steady, even rising. But because of the increased automation of the industry, this does not portend continued high levels of employment and office space consumption by the city’s financial services sector. The days when financial services served as a well-paid affirmative action program for presentable, moderately literate Ivy League graduates are ending—as, sadly, are the days when the stock market provided ready employment for legions of semiskilled clerks and runners. The industry that is emerging will be completely computerized, almost entirely without paper transaction records; much less labor- and space-intensive; and with much tighter cost and profit constraints. A long-term recovery in financial services, in short, no more implies a healthy New York City than the recovery of the American automobile industry means a healthy Detroit; just as the automobile industry has done, financial services is becoming less dependent on its traditional geographic base. The financial services industry, which has sustained the city through multiple cycles of contraction and recovery, is unlikely to do so again.

Restructuring the City

It is easy to be optimistic about the future of the national economy. America is now as internationally competitive as it has been in years. Fears that the Japanese would dominate computers and high technology the way they dominate television sets have proven unfounded, and Ford is once again head-to-head with Honda.

It is much harder, however, to be optimistic about the future of New York City’s economy—unless the city’s government makes major changes in its priorities and practices.

For at least the last thirty years, the city’s primary objective, as measured by its spending patterns, has been to provide income, medical care, housing, and other services to its indigent population. At the same time, it has given short shrift to traditional municipal functions that help ensure civic order and safety, provide clean and well-maintained public spaces, and offer a hospitable environment for raising families and conducting business. Nonetheless, its total per capita spending level is far higher than that of any other local area in the United States.

The city has been able to finance its largesse from the vibrant Manhattan office tower economy. There was a time when corporate offices had to locate in New York City if they wished to be truly plugged in to the world of high finance. As long as they had no choice, they endured the city’s financial exactions, but many hastened to move out when economic and technological changes made it possible to do so. Irreversible trends in the financial services industry are similarly loosening the links that bind the leading firms to New York, while at the same time the industry’s role as an employer is diminishing.

If the city’s finances hit the wall, the state, whose budget has been steadily growing for the past decade, will be in no position to help. The Federal Government, to put it mildly, has its own problems. And there will be no Wall Street recovery just around the corner to bail the city out once again.

But adversity creates opportunity. New York’s future lies not in stripping yet more revenues out of a shrinking office economy or in hoping for a Wall Street rebound. It lies, rather, in the armies of new, diligent immigrants who are taking over the outer boroughs. These immigrants aspire to build businesses, raise families, and join the American middle class. Enabling them to do so in New York City must be a top priority at city hall. A program for achieving this goal might include such measures as reducing the tax and regulatory burdens that make the city an unattractive place to start or maintain a small business; dealing seriously with the quality-of-life problems that drive middle-class New Yorkers to the suburbs; improving the public schools; and, to pay for all this, rethinking New York’s commitment to the idea that its municipal government must do more, and spend more, than its counterparts anywhere else in the nation.

The wealth and glitter of Manhattan and the huge tax revenues it generated have always allowed New York to expand its government to huge proportions, to paper over the problems of the outer boroughs, and to escape the disastrous fate of cities such as Detroit and Philadelphia. But the days of that special dispensation are ending. The hope for New York’s future lies in a restructuring of city government, one that could create a regenerated New York, a city of small businesses as well as global headquarters, a New York in which each of the five boroughs is a source of economic vitality.


City Journal is a publication of the Manhattan Institute for Policy Research (MI), a leading free-market think tank. Are you interested in supporting the magazine? As a 501(c)(3) nonprofit, donations in support of MI and City Journal are fully tax-deductible as provided by law (EIN #13-2912529).

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