James Pethokoukis

Politics and policy from inside Washington

More on states going bankrupt

January 21, 2011

Lots of buzz about this NYTimes story that says Washington policymakers (Republicans, really) are “working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.” (My blog post from six weeks ago that said the same thing is here.)

Government unions don’t like the idea, of course. Neither does Reuters’ Felix Salmon, always a reliable guide to what the liberal blogosphere is thinking. He and others have several objections. A big one is this: States wouldn’t be able to borrow, being shut out from credit markets.

I supposed for a time that might be true, but only for a time.  Orange Country eventually returned to borrowing, as has Argentina. In the case of the OC, it took five years for their debt to return to investment grade. So their borrowing costs rose.  In the meantime, would states need some sort of bridge loan to from Uncle Sam to keep paying their day to day bills? Not necessarily. Tax revenue would continue to flow in. Budget cutting would commence in earnest. Assets, such as roads and bridges, could be sold or privatized. Would bankruptcy mean a radical reorganization of state government? Yes, that’s the whole point.

In his recent WSJ op-ed Prof. David Skeel, a bankruptcy expert and intellectual godfather of this idea, make a couple of great observations:

First, the governor and his state could immediately chop the fat out of its contracts with unionized public employees, as can be done in the case of municipal bankruptcies. In theory, the contracts could be renegotiated outside of bankruptcy, and many governors are doing their best, vowing to freeze wages and negotiate other adjustments. But the changes are usually small, for the simple reason that the unions can just say no. In bankruptcy, saying no isn’t an option. If the state were committed to cutting costs, and the unions balked, the state could ask the court to terminate the contracts.

Second, the state could reduce its bond debt, which is nearly impossible to restructure outside of bankruptcy. While some worry about the implications for bond markets, the alternative for the most highly indebted states—complete default—is far worse. Randall Kroszner, a former Federal Reserve governor now at the University of Chicago Booth School of Business, showed in a 2003 study that the price of corporate bonds went up during the New Deal when the Supreme Court upheld legislation that reduced payments to bondholders. The reduction increased the prospect that bondholders would get paid. The prospect of state bankruptcy could have a similar effect, and even if it didn’t a reasonable reduction in state bond debt is essential to restructuring their finances.

I am not sure a state bankruptcy would look exactly a municipal bankruptcy. The details are still being worked out. But I do know the status quo with government unions cannot hold. Also in the NYT this week was this story:

As San Francisco struggles under ballooning pension and health care costs, the city’s retirees will receive unexpected cost-of-living bonuses totaling $170 million. The city’s anticipated budget deficit for the coming year is $360 million. …

On Jan. 4, an actuarial firm reported that the $13.1 billion San Francisco Employees’ Retirement System now had an unfunded liability of $1.6 billion — triple its shortfall a year earlier. Gary A. Amelio, the system’s chief since January 2010, did not respond to questions.

In spite of the shortfall, Mr. Amelio and the system’s board quietly decreed in mid-December that “excess” earnings on investments in 2010 entitled retirees to an unexpected cost-of-living increase of as much as 3.5 percent this year. The special $170 million bonus is in excess of regular cost-of-living adjustments, or COLAs.

“The irony of issuing bonus payments to retirees at a time the pension fund is a billion dollars down is insane. It really is,” said Jeff Adachi, San Francisco’s public defender and the chief proponent of Proposition B, which he says would have saved the city $120 million this year. “It’s like a bankrupt corporation paying dividends to its shareholders.”

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