It’s a solution of apparent Alexandrian elegance and simplicity: Empower America’s cash-strapped states to slice cleanly through a strangling knot of debilitating debt and government union cronyism by letting them file for bankruptcy. Long-term liabilities could be restructured, unaffordable labor contracts rewritten, fiscal health restored. No federal bailouts necessary.

This intriguing idea quickened last November when former House speaker Newt Gingrich gave it an animating shoutout during a speech at a Dallas think tank. That was followed by a detailed explanation in this magazine by David Skeel, a corporate law professor and bankruptcy expert at the University of Pennsylvania (“Give States a Way to Go Bankrupt,” November 29, 2010). As conservative Republicans on Capitol Hill began cooking up legislation to change the federal bankruptcy code, the concept exploded across the Internet—not to mention in Wall Street research departments.

Liberal bloggers, in particular, seemed to perceive the danger to a status quo where Big Labor elects state and local legislators who then return the favor by agreeing to contracts that, say, allow police officers to retire at age 50 with pensions equal to 90 percent of their highest salary. It’s a system that’s made government unions crazy powerful within the Democratic party while also helping states rack up some $3.5 trillion in unfunded pension and health care liabilities. (And that’s in addition to the anticipated $250 billion shortfall in state budgets over the next two years.) Kevin Drum of Mother Jones put it this way: State bankruptcy “promises to become a pretty serious battle. For Republicans it’s got everything: The tea parties will love it, it provides an alternative to raising taxes, and .  .  . it helps defund a key Democratic interest group. What’s not to like?”

Surprisingly, quite a bit—at least among some Republicans and conservatives. In a January 24 session with reporters, House majority leader Eric Cantor brushed off the idea. “I don’t think [permitting states to declare bankruptcy] is necessary because state governments have at their disposal the requisite tools to address their fiscal ills.” The Virginia Republican added, “They have the ability to enter into new negotiations if there are any collective bargaining agreements in place. They have the ability to adjust levels of spending as well as revenues at the state level.”

A more pointed critique was offered by members of the highly respected free-market Manhattan Institute, Nicole Gelinas and E. J. McMahon, in the op-ed pages of the Wall Street Journal and other papers. Among their many objections to state bankruptcy: It would violate the constitutions of many states; it would damage the balance sheets of banks holding a quarter of a trillion dollars in state and municipal bonds; it might even cause such investor panic as to risk repeating the 2008 financial meltdown. “Bond-market brinkmanship and bankruptcy threats can’t save the states from themselves,” Gelinas wrote in the Boston Globe on January 23.

Even as ardent a supporter as Skeel readily concedes he hasn’t discovered a silver bullet to state fiscal woes. As he wrote back in November, “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.” Of course, that’s the essence of wise policy-making. Every “solution” inevitably comes with trade-offs. The challenge is to find answers with large enough net benefits to justify the inevitable costs and problems.

But the case for state bankruptcy may be better than some naysayers suggest. Even critics don’t really deny that bankruptcy—or even the mere threat of it—would be a powerful tool in reducing labor’s bargaining power. Government unions and their advocates certainly understand this. On January 24, California treasurer Bill Lockyer joined with the union-backed Economic Policy Institute in a conference call for reporters to denounce state bankruptcy as “a cynical proposal intended to incite a panicked response to a phony crisis.” And now that the bankruptcy option has been raised, liberal think tanks that had been arguing for more federal assistance to bolster state finances are suddenly painting a much rosier fiscal picture. As they used to say in the Soviet Union, “It’s no coincidence.”

Second, it’s not clear that pension clauses in state constitutions would bar the sort of union contract restructuring that bankruptcy would allow. The Illinois state constitution, for instance, says pension obligations “shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.” But there’s an obvious possible loophole, legal experts say, in that the document does not specifically identify the state as the guarantor of state public employee pension funds. Short version: There’s no ironclad guarantee. No one knows what the courts would ultimately decide, but there’s no reason for preemptive pessimism or surrender.

Third, obsession with financial market reaction is a recipe either for permanent inaction or for another federal bailout. Almost every reform Republicans have contemplated to deal with profligate state and local governments—such as ending the Build America Bond subsidy or linking the tax-exempt status of muni bonds to more accurate estimates of pension liabilities—has been met with a scowl from Wall Street. And it was fear of a financial panic that led to the TARP bailout, the very precedent that advocates of state bankruptcy hope to forestall. (Stanford University economist John Taylor in fact has persuasively argued that it was the frantic, back-of-the-envelope nature of the TARP bailout itself that freaked out investors.)

Then again, some Washington critics might be as worried about Wall Street’s financial support as its emotional state. Republicans have a realistic chance next year to retake the Senate, strengthen their hold on the House, and knock off an unpopular sitting president. But that’s going to take lots of spending money. Team Obama is already hinting at raising $1 billion for the president’s reelection effort. And to do that, it’ll need plenty of Wall Street support. But one of the big stories of the 2010 election cycle was how Wall Street—angry about financial reform and Obama’s anti-bank rhetoric—dramatically shifted its giving to Republicans from Democrats. Goldman Sachs, through its employees and political action committee, allocated 59 percent of political contributions to Republicans in 2010 against just 26 percent in 2008. For JPMorgan, it was 54 percent in 2010 versus 40 percent in 2008, Bank of America 58 percent versus 43 percent, and Citigroup 54 percent versus 33 percent.

The GOP would certainly like that rekindled relationship with the financial community to burn brightly right through November 2012, both to fill its coffers and deny Democrats’. But Wall Street loathes the idea of states being given the power to file for bankruptcy. The municipal bond market, which has recently been rocked by fears of possible local government defaults, could suffer another round of volatility if the legislation gained momentum. The idea is “clearly not beneficial to an already fragile municipal market,” says Chris Mauro, a bond strategist for RBC Capital Markets.

Some Wall Street firms also make big dough off the public pension system and don’t want to get on the wrong political side of the issue. Take the Blackstone Group, the giant private equity firm whose billionaire CEO, Stephen Schwarzman, is a big Republican moneyman. (He’s also the fellow who famously likened Democratic efforts to slap higher taxes on private equity firms to Adolf Hitler’s invasion of Poland.) More than a third of Blackstone investors are public pensions, and the firm recently waded into the bankruptcy issue with this statement: “We believe a pension is a promise. .  .  . We oppose scapegoating public employees by blaming them for the structural budget deficits that cities and states face. We at Blackstone are committed to helping public employees retire with confidence in the strength and reliability of their pensions.”

Despite Wall Street objections and divisions within their own party, expect Republicans to still offer a state bankruptcy bill. A spokesman for Senator John Cornyn recently told Bloomberg news that the Texas Republican is considering ways to deal with state financial woes, “including amendments to the bankruptcy laws.” A bill should emerge in the House as well. And if Gingrich runs for president, the idea will certainly get increased media play. Still, given vigorous Democratic opposition, changing the U.S. bankruptcy code won’t be easy, even as the public grows more aware of state debt problems and the role government unions play in them. But as Alexander the Great himself once said, “There is nothing impossible to him who will try."

James Pethokoukis is a columnist for Reuters.

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