Should states be able to go bankrupt?

By Felix Salmon
December 7, 2010

Jimmy P has discovered a secret GOP plan to push states to declare bankruptcy in order to avoid bailing them out. Like most secret plans, it was splashed all over the Weekly Standard in a piece by David Skeel, and it does make a certain brutal sense:

Although bankruptcy would be an imperfect solution to out-of-control state deficits, it’s the best option we have, at least if we want to have any chance of avoiding massive federal bailouts of state governments…

The effectiveness of state bankruptcy would depend a great deal on the state’s willingness to play hardball with its creditors. The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. Ideally, bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances.

Skeel doesn’t mention the single biggest problem with this idea. If it were implemented, or if it even looked like it might get implemented, prices of municipal bonds would plunge, and most states would find it pretty much impossible to borrow money. As such, facing a massive and immediate liquidity crisis, they would be in more need of a federal bailout than before the bankruptcy legislation was seriously mooted.

The fact is that there’s only one reason to invent a Chapter 8 bankruptcy provision for states—and that’s to come up with an efficient and legal way to impose losses on bondholders and other creditors. (Chapter 9, which applies to cities and other municipal entities, doesn’t apply to states.) The creditors, fully aware of this, would immediately cease lending, certainly to the rockier states like California, Illinois, and New York. That’s not what we want. As a result, unless or until those states can bring their budgets into a primary surplus, introducing such a provision would certainly do more harm than good. And if those states can bring their budgets into a primary surplus, then we don’t need the bankruptcy provision, since they’ll be easily capable of rolling over their debts.

If the states had a bankruptcy provision all along, then I’m sure some people would be thinking seriously about whether it made sense for one or more states to file. But they don’t, and there’s basically no way of getting there from here. As such, the idea’s a non-starter.

11 comments

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This is almost certain to get political. Red states like Texas, Virginia and Indiana are in (relatively) solid fiscal shape as are most of the red states in fly-over country. Long-term blue states like California, New York, Illinois, Oregon and Michigan are a disaster.

If 60 senators can’t be found isn’t effective bankruptcy inevitable?

Remember, California and New York each have the same number of Senators as Wyoming, Idaho, North Dakota, South Dakota, Nebraska, Iowa, Oklahoma, Utah, etc. etc.

Posted by DanHess | Report as abusive

You define non-starter your way, I’ll define it mine; a federal bailout of profligate states like those you mentioned is a non-starter. Unless you actually want to start Civil War II.

Posted by MattJ | Report as abusive

Sounds like Merkel redux…

Posted by lemarin | Report as abusive

Just so we understand, I’m in the west, we’ve got the nukes, the radiation will blow east, and other than the Smithsonian and the Met… okay, and the pandas, but otherwise…

I highly recommend ‘This Time is Different’ by Carmen Reinhart and Ken Rogoff. It’s an attempt at an empirical history of financial default, and wonderfully detailed. I was reading it last night and wondering whether California isn’t already in technical default on some of its debt with the voucher thing it did earlier this year. Bottom line is it’s not uncommon, not unheard of at varying levels in our history, and we will survive. I note that a Reuters sometimes blogger named Agnes Crane has been poking around the bond issue :}} for a while now.

Posted by ARJTurgot2 | Report as abusive

This is all just real silly.

Read here for an actually informed opinion.

https://self-evident.org/?p=876

Posted by JimPP | Report as abusive

JimPP: Good link. It’s what were seeing in my area (Colorado). The local water district just sold a bunch of BABonds, and pushed them out the door in a hurry, but it was going to do the bonds anyway, it has the revenue, and the rushed BAB thing was simply a way of getting cheaper interest. Maybe there will be some distressed states, but they will simply refinance the debt. There are many scarier things in the world than California muni bonds, and the banks seem to be able sell those.

Posted by ARJTurgot2 | Report as abusive

ARJ

Indeed so.

Posted by JimPP | Report as abusive

In response to the subject of this thread, Felix: Of course states should be allowed to go bankrupt. Creditors made bad loans, and ultimately they should suffer.

In response to the topic within this thread, Felix: Read the self-evident post – that’s the only source worth considering.

Posted by Unsympathetic | Report as abusive

48/50 states are in fiscal trouble. The conservative paradise of TX bailed itself out using stimulus dollars. The reality is that most red states are tax parasites. IOW they receive more federal dollars back than they send in for taxes to the federal level.

(Most of the state bankruptcy proposals are nothing more than a attempt to lower wages for even more employees….)

In our system we have developed a transfer payment system where the feds set mandates (often unfunded) and the states administer the programs.

Posted by hm2viking | Report as abusive

“The reality is that most red states are tax parasites. IOW they receive more federal dollars back than they send in for taxes to the federal level.”

I belive that is true of all 50 states… think about it, the federal goverment currently spends very roughly 150% of what it collects… so all states get more than they pay in.

I accept that there is inequity between states and that red states get a better deal than blue states… but all states eat more gubmint cheese than they paid for.

It will be very unpopular for stingy states to bail out generous ones. Can you imagine states where workers get 60% final average salary pensions at 65 are asked to bail out states that get 100% of final average sallary pensions indexed for inflation at 60? Hardly fair.

Best hopes for more forced savings in the future… otherwise the prudent will be required to support the shortsited more than they currently do.

Posted by y2kurtus | Report as abusive