The case for al­low­ing U.S. states to de­clare bank­ruptcy

▶ ▶ States can’t seek le­gal pro­tec­tion from their debts, but there’s a move on to change that ▶ ▶ With­out the op­tion, hard-pressed gov­ern­ments “have to can­ni­bal­ize other stuff”

Bloomberg Businessweek (North America) - - Contents - �Peter Coy

Puerto Rico is trapped in a fi­nan­cial cri­sis so deep that Pres­i­dent Obama says the only way out for the ter­ri­tory is to make it el­i­gi­ble for a bankrupt­cy­like process to shed some of its debts. None of the 50 states is nearly as bad off as Puerto Rico. But some in­flu­en­tial peo­ple are ar­gu­ing that if a state does get into deep fi­nan­cial trou­ble, some kind of bank­ruptcy would be the best op­tion—cer­tainly bet­ter than a tax­payer bailout.

States, un­like cities and coun­ties, cur­rently can’t de­clare bank­ruptcy. The case for al­low­ing it is that a well-run pro­ceed­ing ap­por­tions losses fairly and fast. Lenders and bond­hold­ers ab­sorb some of the pain, but so do govern­ment work­ers and re­tirees. Taxes go up and govern­ment ser­vices are cut back, but ideally not as se­verely as in an un­con­trolled de­fault. The re­sult is a govern­ment that’s stream­lined, not gut­ted.

“Bank­ruptcy lets you get ahead of the prob­lem,” says David Skeel Jr., a pro­fes­sor at Univer­sity of Penn­syl­va­nia Law School and a lead­ing ad­vo­cate of giv­ing fed­eral bank­ruptcy pro­tec­tion to states. With­out that op­tion, he says, “what inevitably hap­pens when you’re in deep fi­nan­cial dis­tress is that you have to can­ni­bal­ize other stuff. You cut po­lice, schools, other ser­vices. You re­in­force the down­ward spiral.”

In an­other sce­nario, a state that goes broke and has no re­course to bank­ruptcy may end up seek­ing help from the fed­eral govern­ment. “We want to cut off the politi­cians from as­sum­ing that at the end of their wild over­spend­ing they can just dump the re­spon­si­bil­i­ties on other tax­pay­ers,” says for­mer House Speaker Newt Gin­grich.

Gin­grich and Jeb Bush co-wrote an op- ed in the Los An­ge­les Times sup­port­ing state bank­ruptcy in 2011, the last time it was se­ri­ously de­bated. At the time, states were reel­ing

from the af­ter­ef­fects of the fi­nan­cial cri­sis. Dur­ing a con­gres­sional hear­ing that year, Sen­a­tor John Cornyn (R-texas) raised the is­sue with then-fed­eral Re­serve Chair­man Ben Ber­nanke. (Ber­nanke re­sponded that states “have the tools to deal with their fis­cal prob­lems and debt.”)

Pub­lic em­ployee unions and their sup­port­ers trashed the bank­ruptcy op­tion last time around, afraid that it would give states an easy way to slash their pen­sion obli­ga­tions. State gov­ern­ments said they didn’t want to be el­i­gi­ble for bank­ruptcy, fear­ing that the very pos­si­bil­ity would spook in­vestors in mu­nic­i­pal bonds and drive up their bor­row­ing costs. And some an­a­lysts wor­ried that it would re­duce the pres­sure for bud­get ac­tion. “If you had this out, it would make it a lit­tle bit more dif­fi­cult to per­suade peo­ple that they need to raise taxes or cut pro­grams,” says El­iz­a­beth Mcni­chol, a se­nior fel­low at the Cen­ter on Bud­get and Pol­icy Pri­or­i­ties.

Trea­sury Sec­re­tary Ja­cob Lew is seek­ing to wall off fed­eral re­lief for Puerto Rico from the ex­plo­sive ques­tion of state bank­ruptcy. In a let­ter to House Speaker Paul Ryan on Jan. 15, he point­edly didn’t ask Congress to make Puerto Rico el­i­gi­ble for pro­tec­tion un­der the fed­eral bank­ruptcy code. In­stead, he said Puerto Rico needs “an or­derly process to re­struc­ture its debts,” cou­pled with “strong, in­de­pen­dent fis­cal over­sight.” Some­thing like that could be done through the fed­eral law gov­ern­ing Puerto Rico and the other ter­ri­to­ries, sidestep­ping the bank­ruptcy code. Ryan has given law­mak­ers un­til March 31 to act.

There are some tricky con­sti­tu­tional is­sues with state bank­ruptcy. Juliet Moringiello, a pro­fes­sor at Wi­dener Univer­sity Com­mon­wealth Law School in Penn­syl­va­nia, says it could vi­o­late the con­tracts clause, which pro­hibits states from in­ter­fer­ing with con­tracts, and the 10th Amend­ment, which says states are sov­er­eign. (Bank­ruptcy would put states un­der the au­thor­ity of a fed­eral judge.) Penn’s Skeel thinks th­ese ob­jec­tions could be sur­mounted—for one thing, it would be vol­un­tary for states. But he’s not sure how cur­rent Supreme Court jus­tices would rule.

Le­gal­i­ties aside, the strong­est ar­gu­ment for state bank­ruptcy is that it clearly sig­nals to bond­hold­ers that they could lose money if a state be­haves badly. Know­ing that, in­vestors will de­mand higher yields from states with bad bud­get prob­lems, thus en­cour­ag­ing the states to get their fi­nan­cial houses in or­der. With the no­tion of state bank­ruptcy in the air again, “mu­nic­i­pal in­vestors should no longer as­sume that state gov­ern­ments them­selves will never have ac­cess to pro­tec­tion” from cred­i­tors in bank­ruptcy court, Matt Fabian, a part­ner in the re­search firm Mu­nic­i­pal Mar­ket An­a­lyt­ics, wrote to clients in De­cem­ber.

The prin­ci­ple that states are re­spon­si­ble for their own debts goes back to the 1840s, when Congress re­fused to as­sume the debts of states that had over­bor­rowed to fi­nance a canal- and rail­road-build­ing craze. Chas­tened by the episode, many states passed bal­anced-bud­get amend­ments and took other steps to keep their debt un­der strict con­trol. It was “a piv­otal mo­ment in the his­tory of U.S. fed­er­al­ism,” Jonathan Rod­den, a political sci­en­tist at Stan­ford and the Hoover In­sti­tu­tion, wrote in a 2012 pa­per.

The ef­fects have lasted into the present. A state hasn’t de­faulted since Arkansas, in the throes of the Great De­pres­sion, in 1933. When states be­have badly, their bor­row­ing costs rise. The cost of pro­tec­tion against de­fault by the fi­nan­cially trou­bled state of Illinois is now three times as high as that of Cal­i­for­nia.

Mar­ket dis­ci­pline may be weak­en­ing, how­ever. The fed­eral govern­ment re­lies on the states to carry out some pro­grams, such as Med­i­caid. In­vestors and state gov­ern­ments could start to con­clude that Wash­ing­ton has an im­plicit duty to come to their res­cue if they get in trou­ble. If so, states would be tempted to over­spend and bond in­vestors to over­lend. If Wash­ing­ton were on the hook for the states’ prob­lems, it would nat­u­rally want con­trol over their fi­nances—but un­der the Con­sti­tu­tion, it can’t have that.

Mak­ing bank­ruptcy a last-ditch op­tion, writes Stan­ford’s Rod­den, would re­in­force the U. S. tra­di­tion of mar­ket dis­ci­pline. “It is not too late,” he wrote in a chap­ter for a 2014 book, The Global Debt Cri­sis: Haunt­ing U. S. and Euro­pean Fed­er­al­ism. “In fact, the tim­ing might be quite good to clar­ify once and for all that states can and will de­fault if they do not achieve fis­cal sus­tain­abil­ity.”

The bot­tom line As Puerto Rico seeks fed­eral help with its fi­nances, a de­bate re­sumes over what to do when states get in over their heads.

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