House Kicks Off Debate on State Debt Crisis

by Andrew Stiles

Wednesday was an eventful day on Capitol Hill: Rep. Paul Ryan (R., Wis.) and the House Budget Committee grilled Federal Reserve Chairman Ben Bernanke; GOP House leadership face an open revolt on spending cuts; and the Craigslist Congressman, Chris Lee (R., N.Y.), was exposed and then, almost instantly, resigned. But it was also an important day on a less glamorous political front that is sure to play a prominent role in the budget fights ahead: The House Oversight Subcommittee on TARP and Financial Services held its first hearing Wednesday to discuss the potentially catastrophic debt crisis brewing at the state and municipal level.

According to the Government Accountability Office (GAO), absent any significant reform to current policy, state and local governments will face a “fiscal gap” of nearly $10 trillion over the next five decades. To illustrate the magnitude of that shortfall, the GAO estimates that during that period, state and local government will have to reduce spending, or increase revenues, by 12.3 percent each year just to break even.

As the true extent of the states’ fiscal woes becomes apparent, speculation has increased over the probability, or even the necessity, of a federal bailout to head off default. This speculation has created an equal amount of pushback from lawmakers who refuse to accept a bailout as a viable option. Rep. Patrick McHenry (R., N.C.), the subcommittee chairman, said a federal bailout of the states was out of the question. “The era of the bailout is over,” he declared in his opening statement. The purpose of the hearing was to determine what — if a federal bailout is off the table — is the best (or least worst) option for dealing with fiscally derelict states.

Some have urged congress to amend the Federal Bankruptcy Code to let state governments to file for bankruptcy, an option currently prohibited under the law but which would allow some of the worst-off states to renegotiate their debt in order to prevent default. Former Florida governor Jeb Bush (and 2012 presidential candidate?) and Former House speaker Newt Gingrich (ditto) proposed this in a January 27 op-ed in the Los Angeles Times:

During the 2008 financial crisis, the federal government reacted in a frantic, ad hoc fashion, tapping taxpayers for bailouts galore, running roughshod over the rights of bondholders and catching the American people unaware and unprepared. In contrast, we still have time to prepare for the looming crisis threatening to engulf California, Illinois, New York and other state governments.

The new Congress has the opportunity to prepare a fair, orderly, predictable and lawful approach to help struggling state governments address their financial challenges without resorting to wasteful bailouts. This approach begins with a new chapter in the federal Bankruptcy Code that provides for voluntary bankruptcy by states, a proven option already available to all cities and towns across America.

But the idea has yet to gain any traction. In fact, has been rather poorly received on both sides of the aisle. Public-sector-union leaders have (predictably) slammed it as a “scare tactic.” House Majority Leader Eric Cantor (R., Va.) was also dismissive of 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.”

Three of four witnesses who testified at Wednesday’s hearing were quite adamant that state bankruptcies would cause far more problems than they would solve. States could, and must, reform from within the confines of their own laws to avoid catastrophic consequences, such as default. Only David Skeel, a corporate-law professor at the University of Pennsylvania, was supportive of the idea to let states file for bankruptcy “as an absolute last resort.” Arguing that states shouldn’t have the option to declare bankruptcy, Skeel said, was akin to “saying there’s no need for a fire department because most homeowners never have fires in their houses and if one starts they can probably stop it in time. This is true, but we still need fire departments for the rare case where a fire burns out of control.”  That said, almost everyone seemed to agree that a federal bailout would be an even worse approach. Even the members from Illinois, one of the most destitute among the states, along with California and New Jersey, were adamant that a bailout was unacceptable.

The timing of the hearing was fitting, as it coincided with reports that President Obama’s 2012 budget proposal will provide a ‘mini-bailout’ to fiscally-strapped states in the form of a two-year moratorium on interest payments on debt owed to the federal government.#more# In the past couple of years, states have borrowed tens of billions from the federal government to cover the soaring cost of unemployment benefits. The total interest on those loans is estimated to be almost $4 billion through 2012. Obama’s plan would also impose a sharply higher payroll tax beginning in 2014 designed to help states pay off their debts to Washington.

Republicans immediately panned the proposal, and introduced their own plan for beginning to address the state fiscal crisis: A bill that would to force states to honestly account for their debt. The Public Employee Transparency Act, introduced by Rep. Devin Nunes (R., Calif) with the support of Reps. Paul Ryan (R., Wis.) and Darrell Issa (R., Calif.), would require states to be more transparent in regard to their public employee pension liabilities — considered to be the primary factor driving state debt. “Public employee pensions represent trillions of debt carried by the American taxpayer,” Nunes said in a statement. “Unfortunately, this debt is masked by accounting practices that would never be tolerated in the private sector. It’s time to open up the books.”

Eileen Norcross, a senior research fellow at the Mercatus Center at George Mason University, told the Oversight subcommittee that state’s efforts to hide the true extent of their pension liabilities were complicating efforts to deal with the problem. “State and local governments report an estimated pension shortfall of $1 trillion,” she said. “However, when using methods that economists agree are correct, the shortfall increases to $3.5 trillion.”

McHenry agreed that the first step should be to demand an honest and accurate accounting of the situation. “The baseline of any 12-step program is to stop doing the wrong thing,” he said. For states engaged in mischievous accounting, that means coming clean. He said Wednesday’s hearing was merely the first in a serious of hearing dedicated to state and local debt issues — a formal report would be released sometime in the next few months. 

Judging from consistency of the witness testimony, and McHenry’s comments to reporters following the hearing, the subcommittee’s recommendations are likely to include the following: States must reform public-sector pensions, whether by raising retirement ages, increasing worker contributions, switching to 401k plans, or simply trimming benefits (or all of the above). Medicaid, as well, is in desperate need of reform. Nicole Gelinas of the Manhattan Institute said the best solution would be to do away with matching federal grants to the states and gradually switch to a block-grant system that encourages states to save money rather than rewarding them for spending more. She said congress could play a key role by using any federal funding whatsoever as leverage to demand meaningful reform from the states — the massive influx of ‘stimulus’ funds (with no real strings attached) being an missed opportunity to do just that.

Because in the end, getting the policy right is immaterial if politicians — at any level of government — lack the initiative to act. “The problem is not that we don’t understand the problem,” Gelinas said. “It’s getting the political will to do what is needed.”

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