A Bankrupt Option

States should not be allowed to file for bankruptcy.

The 50 states, as we have seen recently in Wisconsin and elsewhere, are in serious fiscal trouble. Total state debt is estimated at more than $1 trillion, and that doesn't include another $3 trillion in unfunded liabilities from pensions and other obligations. We can afford neither a federal bailout of this sum nor the precedent it would set. But how about giving states the option of filing for bankruptcy, as municipalities can do via Chapter 9?

University of Pennsylvania law professor David Skeel, a specialist in corporate finance and bankruptcy, thinks that's a good idea. Writing in The Weekly Standard last November, he argued that a procedure for bankruptcy could instantly reduce states' bond debt and chop the fat out of bloated contracts with public employees by allowing states in default or in danger of default to reorganize their finances free from their contractual obligations. In January former House Speaker Newt Gingrich and former Florida Gov. Jeb Bush endorsed the concept in the Los Angeles Times, arguing that a new law could give states a chance to reform their unaffordable and underfunded pension systems. In "a voluntary bankruptcy scenario," they wrote, "states, like municipalities, will have every incentive to file a reorganization plan that protects state bondholder claims and their ultimate recovery."

Critics contend that bankruptcy will only make states' problems worse by jeopardizing their ability to borrow and finance their debt. Paul Maco, who was head of the Securities and Exchange Commission's Office of Municipal Securities during the Clinton administration, told The New York Times that even introducing a state bankruptcy bill could precipitate "some kind of market penalty." As the Times summarized Maco's argument, that penalty "might be higher borrowing costs for a state and downward pressure on the value of its bonds. Individual bondholders would not realize any losses unless they sold.…A deeply troubled state could eventually be priced out of the capital markets." According to Reuters, the ratings agency Standard & Poor's believes that the potential "market penalty" for bankruptcy would be so large that states would be discouraged from even considering the option. Bush and Gingrich responded to that argument by saying states would "consider their long-term lending potential and credit worthiness" in restructuring, thus minimizing the costs.

Unlike some critics of state bankruptcy, I think state borrowing should be priced accurately by the bond market for the risk it represents, even if it leads to some defaults. That beats the current situation, where investors are under the illusion that states are too big to fail. But such a readjustment in interest rates shouldn't be brought about by rewriting bankruptcy law in a way that could delay needed reforms. 

Constitutionally, states cannot be forced into bankruptcy by their creditors or the federal government. That means even if a bankruptcy law was adopted, any proceeding would have to be initiated by state legislatures voluntarily. But what makes us think they would do that? As Manhattan Institute economist E.J. McMahon put it in The Wall Street Journal in January, "if Gov. Jerry Brown and the California legislature are unwilling to rewrite their collective bargaining rules—signed into law by Mr. Brown himself, 33 years ago—why assume they would plead with a federal judge to do it for them?"

In many states, bankruptcy will be an option only if powerful unions and other entrenched interest groups see it as a way to force budget problems onto the state's bondholders rather than public employees. Bankruptcy in these conditions would allow the state to continue budgeting under the same structure as before, basically giving statehouses a clean slate without providing incentives to change the core of their financial problems: overspending in education, excessive public pensions and benefits, and a swollen state work force. You wouldn't want to pay down your sister's credit card balance without taking away her ability to pile up new debt.

Local governments already have the power to go bankrupt, and the results to date have not been inspiring. For the most part it hasn't helped them address problems of overspending, red tape, federal mandates, and unfunded liabilities. Vallejo, California, is a case in point. A few years ago, a bankruptcy judge gave city leaders the authority to void union contracts in their effort to reorganize under the crushing load of public-sector compensation. But nothing happened.

The good news is that states have other options for forcing concessions from powerful public employee unions. One is, in McMahon's words, "the threat of mass layoffs, which most governors can impose unilaterally. Governors and legislators also can prospectively freeze wages or even cut them through involuntary furloughs, as California and several other states did over the past two years."

Another reform would be to remove the protections that allow state workers to collectively bargain for wages and benefits, giving lawmakers more leeway during negotiations and opening the door to privatization. Some 18 states already bar some categories of government employees from collective bargaining, and Virginia and North Carolina prohibit it for all public workers. Indiana Gov. Mitch Daniels did away with all public employees' power to bargain collectively through an executive order in 2005. In other states—such as Wisconsin, where at press time Gov. Scott Walker is trying to limit collective bargaining—decommissioning requires action by the legislature.

States also could improve their pension systems through accounting reforms and by switching from defined-benefit plans to defined-contribution plans, in which employees' benefits reflect the amount of money they or their employers deposit in their accounts. The federal government could adopt block grants for Medicaid, which would provide a fixed sum to states and give them flexibility on program design. There is no shortage of reforms that would help restore some fiscal sense to the states. But they will require hard political work to pass.

Bankruptcy may sound like a silver bullet that could solve budget woes, dismantle cronyism, fix pensions, and forestall a federal bailout. But it contains plenty of potentially counterproductive consequences. Restoring the states' fiscal health requires fundamental changes to the way they do business. Until that happens, their balance sheets will be bleeding red ink, whether they are officially bankrupt or not. 

Contributing Editor Veronique de Rugy ([e-mail]), a senior research fellow at the Mercatus Center at George Mason University, writes a monthly economics column for reason.