A Forum on State Bankruptcy

by Reihan Salam

My colleague at Economics 21 organized a panel — a genuinely fascinating panel, though I’m obviously biased — on the virtues and pitfalls of David Skeel’s proposal for allowing state governments to declare bankruptcy. You can watch the panel here.

Clayton Gillette, a professor at NYU Law School, raised what I see as a key issue:

The core question is how bankruptcy for fiscally distressed states compares to the alternatives of a federal bailout or of allowing states to use their internal political and legal processes to deal with the situation. Bankruptcy has the potential benefits of bringing all stakeholders to the table to create an orderly disposition of claims and to allow consideration of which burdensome obligations might be rejected. Bankruptcy law, as federal law, could also overcome difficulties that arise from state constitutional and federal constitutional provisions that limit state capacity to alter existing arrangements. But bankruptcy plausibly could create contagion that spills over to other states and to the federal government, and thus that would justify or require a federal bailout. Because the federal government cannot credibly commit against bailouts, state bankruptcy cannot easily be seen as avoiding the moral hazard related to federal bailouts. Indeed, the availability of a bankruptcy option could create incentives for strategic behavior in negotiations about the terms of a bailout.

All that said, David Skeel has drawn our attention to the dire fiscal condition of state governments, and the political paralysis that is the ultimate source of the problem.