Massive and growing state debts combined with concerns about breaching contractual obligations, massive federal bailouts increasing the national debt, and political stalemates from Sacramento to Albany have led to calls for new tools to combat overspending and bloated, unaffordable pensions and benefit plans.

David Skeel, a law professor at the University of Pennsylvania, believes that creating a bankruptcy option for states should be on the table. In a recent Weekly Standard article, Skeel writes:

Whether states like California or Illinois would fully take advantage of such powers is of course open to question. During his recent campaign, Governor-elect Jerry Brown promised to take a hard look at California's out-of-control pension costs. But it is difficult to imagine Brown taking a tough stance with the unions. Even in his reincarnation as a sensible politician who has left his Governor Moonbeam days behind, Brown depends heavily on labor support. He doesn't seem likely to bring the gravy train to an end, or even to slow it down much.

But as Voltaire warned, we mustn't make the perfect the enemy of the good. The risk that politicians won't make as much use of their bankruptcy options as they should does not mean that bankruptcy is a bad idea. For all its limitations, it would give a resolute state a new, more effective tool for paring down the state's debts. And many a governor might find alluring the possibility of shifting blame for a new frugality onto a bankruptcy court that "made him do it" rather than take direct responsibility for tough choices.

Skeel does an excellent job of describing the mechanics of how a state bankruptcy would work. He also addresses some of the obvious concerns that a state bankruptcy, with its restructuring requirements and liquidations, would bring:

One can imagine something like a liquidation sale for cities and even states. Indeed, in the early 1990s, professors Michael McConnell and Randal Picker proposed that Congress amend the existing municipal bankruptcy chapter to allow just that. They argued that many of a city's commercial, nongovernmental properties could be sold in a municipal bankruptcy, and the proceeds simply distributed to creditors. (They also suggested that municipal boundaries could be dissolved, with a bankrupt city being absorbed by the surrounding county.) Although California has taken small steps in this direction on its own-it recently contracted to sell the San Francisco Civic Center and other public buildings to a Texas investment company for $2.33 billion-it seems unlikely that Congress would give bankruptcy judges the power to compel sales in bankruptcy. Nor could it do so with respect to any property that serves a public purpose. Liquidation simply isn't a realistic option for a city or state. (The same limitation applies to nation-states like Ireland and Greece, whose financial travails have reinvigorated debate about whether there should be a bankruptcy-like international framework for countries.) 

With liquidation off the table, 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. This eliminates the hold-out problem-the refusal of a minority of bondholders to agree to the terms of a restructuring-that can foil efforts to restructure outside of bankruptcy.

The idea is intriguing. Reihan Salam at The Agenda has blogged about this idea and finds it interesting and worthy of discussion. However, some caution against bankruptcy as a panacea. Joshua Barro at the Manhattan Institute writes:

The idea of using state bankruptcy as an avenue to "smash unions" is very short-sighted. A rash of state bond defaults would destabilize the financial markets and impoverish retirees who have invested their savings in tax-exempt muni bonds. And it is no sure thing that a bankruptcy trustee will be appropriately tough on public employee unions--indeed, many municipal bankruptcies have left employee pension obligations entirely untouched, while bondholders took haircuts.

More broadly, we should be discouraging governments from taking on liabilities they cannot repay. A bankruptcy option would reduce the cost of profligacy, and make it even easier for states to spend and borrow more than they should. Instead, states should balance their books the old fashioned way--by negotiating better contracts with public employee unions, and by amending their bargaining and arbitration laws as necessary to make that possible.

There is a place for bankruptcy--some municipalities manage to dig themselves into holes that they cannot surmount with any plausible amount of austerity. (This is also what happened to Greece.) But states have more flexibility to levy added taxes to pay their debts than municipalities do; and while their debts (explicit and implicit) are in some cases large, no state currently has a liability load that has reached the point of unserviceability.

I hope that discussion and debate about this idea and others continues. Given the gravity of the looming state fiscal crisis, we will need effective tools and soon.

Filed Under : Unemployment Insurance

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