The Agenda

Josh Barro’s Cautionary Note on State Bankruptcy

At Public Sector Inc., a new project of the Manhattan Institute, MI fellow Josh Barro cautions fiscal conservatives against relying on state bankruptcy as a tool for tackling public sector compensation:


The idea of using state bankruptcy as an avenue to “smash unions” is very short-sighted. A rash of state bond defaults would destabilize the financial markets and impoverish retirees who have invested their savings in tax-exempt muni bonds. And it is no sure thing that a bankruptcy trustee will be appropriately tough on public employee unions–indeed, many municipal bankruptcies have left employee pension obligations entirely untouched, while bondholders took haircuts.

More broadly, we should be discouraging governments from taking on liabilities they cannot repay. A bankruptcy option would reduce the cost of profligacy, and make it even easier for states to spend and borrow more than they should. Instead, states should balance their books the old fashioned way–by negotiating better contracts with public employee unions, and by amending their bargaining and arbitration laws as necessary to make that possible.

There is a place for bankruptcy–some municipalities manage to dig themselves into holes that they cannot surmount with any plausible amount of austerity. (This is also what happened to Greece.) But states have more flexibility to levy added taxes to pay their debts than municipalities do; and while their debts (explicit and implicit) are in some cases large, no state currently has a liability load that has reached the point of unserviceability.

I find Josh’s argument intuitively convincing. But I’d like to know what David Skeel, the Penn law professor who has called for a mechanism to allow states to declare bankruptcy, makes of it. I will say, however, that state bankruptcy should certainly be seen as a last resort, and that the conservative enthusiasm James Pethokoukis describes in his recent column is misplaced:

From the Republican perspective, the fiscal crisis on the state level provides a golden opportunity to defund a key Democratic interest group. For the GOP, it’s an economic and political win.

This is exactly what many public sector workers and their ideological allies fear — that those of us who want to reform public sector compensation actually intend to wage war on the public sector workers. That is not the right debate. Rather, the right debate is over what we can do to improve the cost-effectiveness of public services. This will generally mean giving public sector workers more autonomy and responsibility, e.g., increasing compensation for effective teachers who choose to take on more students, as Rick Hess and Olivia Meeks recommended in “Sounding the Alarm.” Instead of lockstep pay increases, the goal is greater reliance on performance incentives that have raised the productivity of other sectors that rely heavily on skilled professionals. 


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