Slow Down on State Bankruptcy

RALEIGH – With North Carolina and most other state governments across the country facing big budget deficits again in 2011, national pundits and policymakers have been talking about various ways that Washington can “help.”

Some Democrats and liberals want Congress to fund another round of federal bailouts for states and localities. A significant percentage of the projected 2011-12 budget deficits – a bit over 40 percent of North Carolina’s $3.7 billion gap, for example – represent the expiration of previous federal bailouts. Why not just renew them?

There are three reasons. The fiscal reason is that the federal government has run humongous deficits the past two years, between 9 percent and 10 percent of GDP, and should not continue such reckless borrowing.

The economic reason is that increasing federal debt to fund overextended state governments is not a recipe for economic growth, because rational households and businesses see the practice as a promissory note for future tax hikes, and thus respond in ways that minimize their exposure as well as any stimulative effect.

The political reason is that Republicans just took over the U.S. House, picked up half a dozen U.S. Senate seats, and achieved their largest gains in state legislatures since 1928 by running against reckless federal borrowing and bailouts. Voters have spoken.

Instead of feeding the states more borrowed money, some say, Congress should rewrite the nation’s bankruptcy code to offer explicit authority for states to file for bankruptcy protection, as businesses, households, and localities can currently do. Because a state bankruptcy filing would be an extreme response, inflicting damage on the state’s credit rating for years to come, proponents argue that just the prospect of it might give governors and legislatures the impetus and bargaining position to renegotiate unaffordable obligations to vendors, creditors, and public employee unions.

David Skeel, a law professor at the University of Pennsylvania, has been one of the most visible advocates of a bankruptcy option. Here is the crux of his argument:

The case for bailing out financial institutions rested on a concern that their creditors would “run” if the bank defaulted, and that the big banks are so interconnected that the failure of one could have devastating spillover effects on the entire market.

Bankruptcy isn’t perfect, but it’s far superior to any of the alternatives currently on the table.

I can understand why Skeel, Grover Norquist of Americans for Tax Reform, and other observers think a bankruptcy option for states offers a route for achieving the necessary fiscal restructuring. But I am persuaded by other analysts, such as E.J. McMahon and Nicole Gelinas of the Manhattan Institute, that authorizing state bankruptcy could well cause more problems than it would solve.

For one thing, to assume that would-be budget cutters would be the ones opting for bankruptcy is a stretch. “It’s more likely,” McMahon writes, “that a state like California would pursue bankruptcy if powerful unions and other budget-dependent interest groups saw this as a way to deflect some of the pain to bondholders.” That rings true to me.

As for getting out from under excessive bonded debt, the state bankruptcy model may be designed for yesterday’s problem, not today’s. States such as New York, Gelinas observes, have “run up ‘their’ debt indirectly. They issue bonds through tens of thousands of separate legal entities. New York ‘state’ doesn’t owe all of that $78.4 billion in debt – it owes only $3.5 billion in ‘general-obligation’ debt.” Sorting at all the complexities could be challenging and time-consuming.

Before inviting another round of fiscal irresponsibility and unintended consequences, members of Congress should slow down, study up, and see how state governors and legislatures handle their deficits in 2011. Washington should focus on getting its own fiscal house in order, not rewriting the mortgage terms for others.

Hood is president of the John Locke Foundation.