Given their long-term budget challenges, states might need bankruptcy protection in the future. At least that’s the argument some advocates are pursuing. The latest issue of Bloomberg Businessweek offers details.
States, unlike cities and counties, currently can’t declare bankruptcy. The case for allowing it is that a well-run proceeding apportions losses fairly and fast. Lenders and bondholders absorb some of the pain, but so do government workers and retirees. Taxes go up and government services are cut back, but ideally not as severely as in an uncontrolled default. The result is a government that’s streamlined, not gutted.
“Bankruptcy lets you get ahead of the problem,” says David Skeel Jr., a professor at University of Pennsylvania Law School and a leading advocate of giving federal bankruptcy protection to states. Without that option, he says, “what inevitably happens when you’re in deep financial distress is that you have to cannibalize other stuff. You cut police, schools, other services. You reinforce the downward spiral.”
In another scenario, a state that goes broke and has no recourse to bankruptcy may end up seeking help from the federal government. “We want to cut off the politicians from assuming that at the end of their wild overspending they can just dump the responsibilities on other taxpayers,” says former House Speaker Newt Gingrich.
Gingrich and Jeb Bush co-wrote an op-ed in the Los Angeles Times supporting state bankruptcy in 2011, the last time it was seriously debated. At the time, states were reeling from the aftereffects of the financial crisis. During a congressional hearing that year, Senator John Cornyn (R-Texas) raised the issue with then-Federal Reserve Chairman Ben Bernanke. (Bernanke responded that states “have the tools to deal with their fiscal problems and debt.”) …
… There are some tricky constitutional issues with state bankruptcy. Juliet Moringiello, a professor at Widener University Commonwealth Law School in Pennsylvania, says it could violate the contracts clause, which prohibits states from interfering with contracts, and the 10th Amendment, which says states are sovereign. (Bankruptcy would put states under the authority of a federal judge.) Penn’s Skeel thinks these objections could be surmounted—for one thing, it would be voluntary for states. But he’s not sure how current Supreme Court justices would rule.
Legalities aside, the strongest argument for state bankruptcy is that it clearly signals to bondholders that they could lose money if a state behaves badly.
