Politics

A Bankrupt Option

States should not be allowed to file for bankruptcy.

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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 (vderugy@gmu.edu), a senior research fellow at the Mercatus Center at George Mason University, writes a monthly economics column for reason.

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  1. New at Reason: Veronique de Rugy on State Bankruptcy

    But, why are you featuring a photo of Governor Moonbeam? Are you trying to tell me something???

    1. As a joke, we should advocate for moonbeam power and see how many environmentalists jump on the bandwagon.

      1. I'm in.

  2. Initially reading the headline I wanted to hate it, but I didn't. Well done, stick it to overpowered public sector benefits and unions!

  3. The states need to be broken up during their bankruptcies. Need about 90-120 states for a population of this size.

    1. Intriguing. What is your reasoning for 90-120 states?

      1. Efficiency. My state Maryland has a larger population than the entire US at the time of the ratification of the US constitution. A breakup of the entire US into smaller confederacies (voluntarily, and likely anyway when our economy goes kablooey) would be good for all.

        1. on the other hand, we should have a flat "senator fee".

    2. I agree with this. I wish California was broken up so that I could move to another state that's more fiscally responsible without moving far at all.

  4. "states would "consider their long-term lending potential and credit worthiness" in restructuring, thus minimizing the costs." No the States would not if they did we wouldn't be in this position in the first place.

  5. Restoring the states' fiscal health requires fundamental changes to the way they do business.

    True of every level of government. The county government here has been complaining about cuts they had to make to school budgets, including firing a lot of teachers. Now it's installing elaborate, expensive security systems in the schools that don't appear to add any actual security.

  6. "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?"

    If California's experience has taught us anything, it's that they'll never make the necessary changes willingly. They'll make the necessary changes when the market forces it on them--or they'll never make the necessary changes at all.

    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.

    Hear, hear!

    If California is so messed up that the only constraint on their budget is what the market will bear, then the solution is NOT to free California from the only constraint left on its budget.

    1. Bankruptcy is a mechanism for bringing what the market will bear into line with what a state spends. It is obvious that our political class is broken. Bankruptcy at least brings another decision-maker (the bankruptcy judge) into the process. Not sure why the municipal bankruptcies have left cramdowns to the discretion of the failed political class, but I would think a judge could order new contract terms with unions and pubsec employees. Why not? They do it to businesses all the time.

      Bakryptcy for states is interesting, because the income side of the equation is completely different than it is for businesses. States can theoretically just extract more income via taxes, an option unavailable to businesses.

      1. Interesting, indeed. Could a bankruptcy judge order a state to raise taxes?

        1. Could a bankruptcy judge order a state to legalize prostitution?

      2. I don't trust judges to keep government in line.

        1. How does a judge stop a legislature from reworking public employee pensions? ..or passing more spending?

          This is why California wanted to require a supermajority. This is why we passed Prop 13...

          To keep state employees employed and overpaid, the California State Legislature will do everything short of selling us all for medical research. They all but emptied the jails rather than cut spending!

          The idea that our politicians would vote to cut spending out of fear of the voters--that's completely out the window. That isn't even a real possibility.

          ...there's no substitute for a legislature that cares about how much of the taxpayer's money it spends--and we don't have one of those. So, the only hope is containment.

          You can't stop an elected government that feeds on its own people, but you can slow it down some. Freeing them from under the yoke of the debt they've created is freeing them from one of the only restraints on spending we have left.

          California's problem isn't that it has to pay its creditors; it's that it's taken on too much debt.

          If they can't bring themselves to cut their spending, then when the market isn't willing to buy their bonds at reasonable rates anymore, they'll just be out of money! I wish we were at that point already.

  7. This was enjoyably predictable:

    http://www.theregister.co.uk/2.....nesian_mp/

    An Indonesian MP who was instrumental in passing the country's controversial and tough anti-pornography law fell on his sword yesterday after being caught ogling smut in parliament.

    The mono-monickered Arfinto, of the "staunchly Islamic" Prosperous Justice Party, was captured last Friday by a local photojournalist as he copped an eyeful during a debate on plans to build a new parliament building.

    According to AP, images of the outrage were soon splashed across the Indonesian press, and the 50-year-old father of five resigned on Monday. He told a press conference: "It's my decision. Nobody tried to coerce me."

    Arfinto may now face prosecution under the same anti-porn law he so vociferously supported. Among other things, it prohibits "broadcasting, possessing and storing pornographic material", and was earlier this year used to jail pop star Nazril "Ariel" Irham after videos of the singer romping with a couple of young ladies surfaced on the internet.

    National Police spokesman, Boy Rafli Amar, said yesterday that the powers that be were attempting to determine if Arfinto had indeed earned himself an appearance before the beak. He said: "We need to be cautious. We need to make sure we're not violating any privacy laws." ?

    1. How disappointing. I was really hoping that in Indonesia, he really would have fallen on an actual metal sword.

      1. When the great Gichi-Kuktai was Mikado he condemned to decapitation Jijiji Ri, a high officer of the Court. Soon after the hour appointed for performance of the rite what was his Majesty's surprise to see calmly approaching the throne the man who should have been at that time ten minutes dead!

        "Seventeen hundred impossible dragons!" shouted the enraged monarch. "Did I not sentence you to stand in the market-place and have your head struck off by the public executioner at three o'clock? And is it not now 3:10?"

        "Son of a thousand illustrious deities," answered the condemned minister, "all that you say is so true that the truth is a lie in comparison. But your heavenly Majesty's sunny and vitalizing wishes have been pestilently disregarded. With joy I ran and placed my unworthy body in the market-place. The executioner appeared with his bare scimetar, ostentatiously whirled it in air, and then, tapping me lightly upon the neck, strode away, pelted by the populace, with whom I was ever a favorite. I am come to pray for justice upon his own dishonorable and treasonous head."

        "To what regiment of executioners does the black-boweledcaitiff belong?" asked the Mikado.

        "To the gallant Ninety-eight Hundred and Thirty-seventh ? I know the man. His name is Sakko-Samshi."

        "Let him be brought before me," said the Mikado to an attendant, and a half-hour later the culprit stood in the Presence.

        "Thou bastard son of a three-legged hunchback without thumbs!" roared the sovereign ? "why didst thou but lightly tap the neck that it should have been thy pleasure to sever?"

        "Lord of Cranes of Cherry Blooms," replied the executioner, unmoved, "command him to blow his nose with his fingers."

        Being commanded, Jijiji Ri laid hold of his nose and trumpeted like an elephant, all expecting to see the severed head flung violently from him. Nothing occurred: the performance prospered peacefully to the close, without incident.

        All eyes were now turned on the executioner, who had grown as white as the snows on the summit of Fujiama. His legs trembled and his breath came in gasps of terror.

        "Several kinds of spike-tailed brass lions!" he cried; "I am a ruined and disgraced swordsman! I struck the villain feebly because in flourishing the scimetar I had accidentally passed it through my own neck! Father of the Moon, I resign my office."

        So saying, he gasped his top-knot, lifted off his head, and advancing to the throne laid it humbly at the Mikado's feet.

    2. "Boy Rafli Amar"

      Named after my favorite, fabulous hero!

  8. No kidding. Talk about a tease.

    1. Dammit--In reply to RC Dean above.

  9. "bankruptcy will only make states' problems worse by jeopardizing their ability to borrow and finance their debt" - how is this bad again? If you don't have any money to spend, spending gets cut.

    1. No kidding. The solution to deficits isn't E-Z Credit, its lower spending.

  10. Bankruptcy may sound like a silver bullet that could solve budget woes

    TINSTAAFL

    Along those lines, would someone *kindly* explain how a federal "bailout" of a state makes sense?

  11. The Volokh Conspiracy has has several posts on this idea in the last few months. Given that states are already sovereign and can simply tell their creditors to go pound sand (repudiate the debt), I don't see what a state bankruptcy law really gives them that they do not already have.

  12. So there is no moral argument according to Reason. ? This is about right and wrong. It's not an accounting exercise. Of course the states should go bankrupt. No man has the right to force debt on another man, especially on people not old enough to vote. The taxpayers have the moral right to the fruits of their labor. Debt at every level of government should be entirely repudiated on moral grounds, then made illegal.

    1. http://www.youtube.com/watch?v.....e=youtu.be

      "Sandy Springs has no long term liabilities."

      Imagine that.

  13. Wouldn't a state bankruptcy reduce the bond sales of other states, preventing future unsustainable growth in state budgets. Also, if a government goes bankrupt can another legitimately step in an replace it?

  14. States are sovereign. Creditors to a state have no recourse to an authority higher than the state, no recourse to the federal government for debts owed by that state.

    By what mechanism could authority for a bankruptcy court possibly be granted? Does anyone really think that the legislature of a state would cede its authority to make financial decisions to a court judge, presumably employed by the federal government -- and even if it did, that such a law wouldn't be struck down as unconstitutional by the first court seeing a challenge to it? Utter insanity.

    Alternately, if a national constitutional amendment were proposed to enable such bankruptcy (nothing short of such an amendment would be valid), could anyone actually think that it would pass a single chamber of congress, let alone both, let alone get a president's signature, and THEN see ratification by 3/4 of the state legislatures?

    The entire concept of state bankruptcy is complete fantasy. We might as well be talking about farming seaweed on the sun to help state budgets. This topic is nonexistent, and the article is pointless.

  15. Bankruptcy would be great for California since it would lock us out of the bond market. Please people stop buying our bonds.

  16. Or we could just dissolve all 50 state governments, since they are totally unnecessary and involved in criminal activity.

  17. Oh, yes, bankruptcy for the various states in financial difficulty. What a wonderful idea!! A grand and glorious way to allow our illustrious President Barack Hussein Obama the opportunity to unconstitutionally exercise his high and mighty presidential powers in a judicial proceeding to the short-term and ultimate benefit of his political servants and allies and to the short-term and ultimate detriment of the rest of us!! Do you not suppose that His Exhalted Highness would not interfere in California's bankruptcy? What of that of Illinois, New York, Michigan ... the list is endless. That, coupled with more excuses for bail-outs, this time for the states who are filled with his voters and political allies, all paid for by the rest of us. A 'two-fer' as we used to say, whereby he aids and rewards his cronies and allies in those states and punishes his enemies - and in case you've been sleeping the last two years, that last category includes you and me. No, thank you. Bankruptcy for states? Rather have a high colonic of battery acid and napalm; thank you very much. Idiotic idea in my opinion. Just in case you miss-took the sarcasm, etc, above for genuine comment.

  18. It needs to be universal knowledge: lending money to any government is always a bad idea.

  19. Collective bargaining rights cannot be taken away in the united states without breaking the law. I wish people would stop referring to the prevention of closed shops in the public sector as "removing collective bargaining rights," because it isn't. Nobody is stopping anybody from joining together with like minded co-workers, donating to common causes, and going on strike. However, without being a member of a closed shop, you would have to worry about being fired in the event of a strike.

    I wish that people would stick to the actual subject of the discussion, which is whether or not closed shops should exist in the public sector, instead of being side tracked by the argument that people are losing "collective bargaining rights."

    Those two issues are not the same thing.

  20. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  21. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  22. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  23. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  24. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  25. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  26. I did'nt know the consequences of lending money to other states until now and also that it could be so troubling.Your blog always posts such interesting posts.

  27. ty rights, etc. seem like a more accurate measure of freedom than democracy.

  28. ty rights, etc. seem like a more accurate measure of freedom than democracy.

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