In the two months since David Skeel, a law professor at the University of Pennsylvania, published this article arguing in favor of a bankruptcy code for the states, public policy experts have been vigorously debating the merits and drawbacks of such a radical prescription to the states' fiscal ills.

Josh Barro of the Manhattan Institute sounded some cautionary notes about bankruptcy here (http://www.nationalreview.com/agenda/254761/josh-barros-cautionary-note-state-bankruptcy-reihan-salam), in particular about some conservatives' and Republicans' desire to "smash public sector unions.

Last week, Skeel, in a Wall Street Journal op-ed (subscription might be required), reiterated his desire to see Congress enact a bankruptcy code for the states and sought to mollify some of his critics' concerns. As to the concerns that bankruptcy could roil the bond markets with several major defaults, Skeel writes:

"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."

Further, with regard to the fear that bankruptcy would usurp state sovereignty, Skeel says that there are constitutional and legal safeguards already in place. Skeel points to the Supreme Court's decision in United States v. Belkins (1938), which said that the key requirement for constitutional government bankruptcy is that the government not be forced to declare bankruptcy against its will and political decision-making authority is not commandeered.

However, some critics are still not convinced. E.J. McMahon of the Empire Center for New York State Policy responded to Skeel only six days later in another Wall Street Journal op-ed (subscription may be required). While recognizing the severity of the states' fiscal problems, McMahon argues that the problem is more political than economic in nature. He suggests that governors and legislators muster the political will to use the many tools at their disposal, such as reforming collective bargaining laws, public employee pensions, and state budgets, to address the fiscal mess. McMahon also addresses some of what he sees as the fundamental problems of state bankruptcy:

"Such an option would certainly rattle the bond market-which bankruptcy proponents see as a good thing. Yet this ignores the potential for collateral damage and disruption. While bond spreads might get wider for the most troubled states, the enactment of a state bankruptcy law is likely to raise the cost of borrowing for all municipal issuers."

McMahon also points out that bankruptcy proponents' focus on the spiraling cost of pensions as the root of state ills may be misplaced.

"[W]hile most public pension liabilities are pooled in statewide, off-budget trust funds, they largely reflect the cost of retirement benefits promised to teachers, cops and firefighters-who mainly work for municipalities, not state governments. This raises another complication: Could a judge in a state bankruptcy proceeding interfere with the pension obligations of localities?"

Nicole Gelinas, also of the Manhattan Institute, made similar warnings in an op-ed published by the New York Post.

Nevertheless, leading policymakers continue to see bankruptcy as a way forward through the states' fiscal mess. Newt Gingrich, a potential GOP presidential candidate, has come out strongly in favor of a state bankruptcy code to spur action by the nation's governors before it's too late.

Not to be outdone, I have also weighed in on the state fiscal crisis with my own op-ed, but I'm taking a more nuanced approach to whether there should be a bankruptcy code for the states. While we may need to consider a bankruptcy (or some other kind of organized financial restructuring) option to address the state fiscal problems before us, I do not think we should do so before the states and the federal government have exhausted all of their powers to reduce spending and fix the budget problems that brought us to where we are today.

Of course, whether Congress will take up a bankruptcy code is anyone's guess. Media reports suggest that leading members of Congress have made inquiries with Skeel and others about the particulars of a bankruptcy code. But some Congressional leaders, notably Rep. Eric Cantor, the House Majority Leader, appear to have ruled out a new bankruptcy code for the states. A bipartisan group of governors, including Texas' Rick Perry (R) and Connecticut's Dan Malloy (D), have called bankruptcy a bad idea; Perry even referred to it as a "bailout." 

Stay tuned for more news and action on this front.

Filed Under : State Bankruptcy

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