The Magazine

When States Go Bust

The bankruptcy debate heats up.

Feb 14, 2011, Vol. 16, No. 21 • By JAMES PETHOKOUKIS
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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.

When States Go Bust

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.”

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