There is a debate raging right now about whether Congress should create legislation giving states the option to file for bankruptcy, something along the lines of the existing law allowing for Chapter 9 municipal bankruptcy. To be sure, states are in big trouble: Total state debt is estimated at over $1 trillion, and that’s in addition to unfunded liabilities (from pensions and other obligations), which are estimated at over $3 trillion. Given the federal government’s $9 trillion in existing debt — which, according to a recent CBO report, will double in the next ten years — taxpayers cannot afford to bail out the states. Nor can we afford the precedent it would set. Federal bailouts should be off the table.

In light of this looming problem, many people have argued for state-bankruptcy legislation — most recently, Newt Gingrich, writing with Jeb Bush at the Los Angeles Times. Gingrich and Bush argue that this legislation would

allow states in default or in danger of default to reorganize their finances free from their union contractual obligations. In such a reorganization, a state could propose to terminate some, all or none of its government employee union contracts and establish new compensation rates, work rules, etc. The new law could also allow states an opportunity to reform their bloated, broken and underfunded pension systems for current and future workers. The lucrative pay and benefits packages that government employee unions have received from obliging politicians over the years are perhaps the most significant hurdles for many states trying to restore fiscal health.

It would also

allow for the restructuring of a state’s debt and other contractual obligations. In a voluntary bankruptcy scenario, states, like municipalities, will have every incentive to file a reorganization plan that protects state bondholder claims and their ultimate recovery.

The bankruptcy idea is definitely appealing, but after reviewing arguments from both sides, I think that state bankruptcy could create more problems that it would solve.

For instance, critics of the plan contend that bankruptcy will only make states’ problems worse by jeopardizing their ability to continue to borrow and finance their debt. In the New York Times, Paul Maco summarized this concern:

The mere introduction of a state bankruptcy bill could lead to “some kind of market penalty,” even if it never passed. That “penalty” might be higher borrowing costs for a state and downward pressure on the value of its bonds. Individual bondholders would not realize any losses unless they sold. […] A deeply troubled state could eventually be priced out of the capital markets.

Interestingly, Standard and Poor’s believes that the potential “market penalty” of bankruptcy would be so large that it would discourage states from even considering bankruptcy as a real option:

We believe the financial implications, in terms of increased borrowing costs and reduced market access, of a bankruptcy filing typically outweigh the benefits of restructuring debt service, which on average represents only 4 percent of expenditures for states.

To that argument Bush and Gingrich respond that states would “consider their long-term lending potential and credit worthiness” in restructuring, thus minimizing the market penalty.

Now, unlike some critics of state bankruptcy, I am in favor of states being priced accurately by the bond market for the risk they truly represent, even if it means default and inability to borrow more money for some of them. It beats the current situation, where investors are under the illusion that giving more money to nearly bankrupt cities and states is a profitable investment. However, I am not sure that this readjustment in interest rates should be brought about by introducing legislation to allow states to go bankrupt. One reason is that such legislation would rattle the bond markets for the states as a bloc; the spread would be wider for the most troubled states, but it would likely raise the cost of borrowing for all states. Not every state is in the same financial situation; the interest rates they face should be tailored to their position and their willingness to improve it. However, with the introduction of state-bankruptcy legislation, the most troubled states could cause serious negative externalities for relatively less troubled states.

Besides, as the Manhattan Institute’s Nicole Gelinas explained in this Boston Globe piece, “Bond-market brinkmanship and bankruptcy threats can’t save the states from themselves.”

A more damning argument against state-bankruptcy legislation is it that it may forestall needed reforms. Think about it this way: Constitutionally, states cannot be forced into bankruptcy by their creditors. That means that any bankruptcy proceeding would have to be voluntarily initiated by state legislatures. But what makes us think that they would do that? Writing in the Wall Street Journal last week, E. J. McMahon explains:

For constitutional reasons, any federal law enabling state bankruptcy would have to be voluntary, meaning states would have to invite federal judges to play tough with their unions. But if Gov. Jerry Brown and the California legislature are unwilling to rewrite their collective bargaining rules—signed into law by Mr. Brown himself, 33 years ago—why assume they would plead with a federal judge to do it for them?

In many states, bankruptcy will be an option for lawmakers if and only if powerful unions and other interest groups see it as a way to force the state’s budget problems onto the state’s bondholders. In the end, it could be a way for these interests to postpone needed pension and public-sector-union reforms. 

Keep in mind that one of the hazards of bankruptcy is that it allows the state to continue budgeting under the same structure as before. In other words, state bankruptcy could give states a new start without giving them the proper incentives to change what is at the core of their financial problems: overspending in education, public pensions and benefits, and state workforce. It could be the equivalent of paying down your sister’s gigantic credit-card balance without taking the credit card away or making sure that she won’t pile up new debts.

And, as McMahon reminds us over at the excellent Public Sector Inc: “Local governments, which employ the bulk of public-sector workers, can already go bankrupt.” But it hasn’t helped them address their problems with overspending, red tape, federal mandates, and unfunded liabilities.

More important, I think, is that states have and are already using other options to force concessions from powerful public-employee unions. For instance, as McMahon writes in this Wall Street Journal piece:

State officials committed to cutting costs already have options for putting the squeeze on their unions. One is the threat of mass layoffs, which most governors can impose unilaterally. Governors and legislators also can prospectively freeze wages or even cut them through involuntary furloughs, as California and several other states did over the past two years.

Other options include reforming collective bargaining and state-workforce rules; McMahon suggests removing the protections that allow state workers to collectively bargain with government employers for wages and benefits, which would give lawmakers more leeway during negotiations and would open the door to outsourcing and privatization:

This is not as unlikely as it may sound. At least 18 states already outlaw collective bargaining with some categories of government employees; Virginia and North Carolina prohibit it for all public workers. Two newly elected Republican governors, Scott Walker in Wisconsin and John Kasich in Ohio, have threatened to dismantle their state bargaining statutes if unions fail to make concessions.

Gov. Mitch Daniels did away with collective bargaining in Indiana through an executive order in 2005. In other states, like Wisconsin, it would take action by the legislature.

There are many other paths that could and should be pursed to address states’ budget issues — pension reforms (e.g., accounting reform, switching from defined-benefit plans to defined-contribution plans) and fundamental reforms to the federal-state relationship (e.g., moving to block grants for Medicaid, ending federal mandates).

I will leave the “bottom line” to McMahon:

Bottom line: state bankruptcy promises no clear benefits and plenty of potentially negative unintended consequences.  It’s good that Bush and Gingrich are calling attention to the problems of states, and warning Washington to beware of bailout pressure.  However, rather than focusing on bankruptcy as an all-purpose solution, it would be better for Congress to root out  federal mandates and red tape that make it more difficult for states to save money and reform bloated programs.  A good place to start: the proposal by Paul Ryan and Alice Rivlin to convert the federal share of Medicaid into a block grant for states.

If you are interested in this issue, you should really read these excellent articles by Nicole Gelinas, here and here.

Update: This morning The Hill reports  that “a majority of voters oppose both a federal bailout of ailing states, and allowing states to file for bankruptcy.” The polls, “commissioned by Rasmussen Reports, indicate that the public does not want to extend major lifelines to states with serious financial problems.” In the surveys, “just 26 percent of likely US voters said they wanted the federal government to provide bailout dollars for individual states with major fiscal issues” while 53% were opposed. In a separate poll, 17% “thought states should be able to pursue bankruptcy as an option, while 54 percent opposed the idea.”