The main argument in favor of allowing states to declare bankruptcy is that it could instantly reduce states’ bond debt and allow state governments to chop the fat out of their contracts with public employees. In January, former House speaker Newt Gingrich and former Florida governor Jeb Bush endorsed this argument, adding that a state-bankruptcy law would also give states an opportunity to reform their bloated, broken, and underfunded pension systems. In “a voluntary bankruptcy scenario,” they wrote, “states, like municipalities, will have every incentive to file a reorganization plan that protects state bondholder claims and their ultimate recovery.”
The problem is that it is unlikely to work out that way, as the case of Vallejo, Calif., shows. A few years ago, a bankruptcy judge gave the city’s leaders the authority to void existing union contracts as part of the city’s effort to reorganize. Nothing happened. The New York Times explains in a story titled “Broke Town, U.S.A.”:
Vallejo, which ran out of money when the economy imploded, is more representative. A blue-collar city of 110,000, it had been hurting since a naval base closed in the 1990s. In 2007, the Wal-Mart left town. Then, with the recession, property taxes crashed from $29 million to $20 million. Vallejo cut back on street repairs and vehicle maintenance and reduced its staff by a third. The city sought pay cuts from the police and fire unions, whose members’ pay and benefits accounted for about 80 percent of the budget; the unions offered to defer pay raises. The council considered, but rejected, the idea of putting a tax increase to a referendum. Rob Stout, the outgoing finance director, who noted that the police chief is retiring on a $200,000 pension, says the general attitude was one of resistance to footing the bill.
Vallejo was a failure of political will. It is also an example of why bankruptcies for cities don’t work. All the constituencies who might have hoped to avoid hardship are being walloped anyway. Labor costs are being cut (though not pensions) and holders of $54 million in city bonds will suffer losses — how much won’t be known for years. Even Marc Levinson, a partner with Orrick, Herrington & Sutcliffe, which represents the city, calls the bankruptcy a waste of money and time. “It’s better to cut a deal than go through the pain we have in Vallejo,” he says. Pain is coming regardless. In some cities, bondholders will be burned.
The story goes on to talk about the potential municipal bond crisis and the distortions introduced by federal grants and state pensions. It’s a good illustration of the fact that these messes are a mix of many different things, including lawmakers’ tendency to buy votes by making unsustainable promises, their lack of political will, and terrible incentives all around, leading to an extreme case of moral hazard.
Thanks to Matt Mayer for the pointer.