Should States be Allowed to Declare Bankruptcy?

To most consumers, declaring bankruptcy is a scary prospect. Sure, you get out of paying your debts. But a bankruptcy stays on your credit report for seven years, which means good luck finding anyone but a payday lender to give you a loan. Many people would likely also feel a sense of guilt about failing to meet their financial responsibilities.

But imagine if your entire state declared bankruptcy. It boggles the mind. Thousands of local businesses that sell products and services to the government might never be paid. Suddenly the state would find it difficult or impossible to sell bonds – government’s version of taking out a loan. Big construction projects would be put on hold, others scrapped. Public schools and hospitals could close. Roads might crumble.

That, anyway, is the fear.

“Bankruptcy would make a state scramble,” says Marilyn Cohen, owner of Envision Capital, a California company that invests in government bonds. “It would be cataclysmic.”

[Resource: Bankruptcy Survival Guide]

A small but powerful cadre of top Republicans thinks that fear is overblown. With so many states facing record deficits, bankruptcy would give them an opportunity to dynamite their current budgets and start from scratch.

Perhaps most important to Republican leaders, bankruptcy would allow states to renegotiate pay and pension contracts with public employees’ unions, which they say have become too bloated.

On Jan. 21, former House Speaker Newt Gingrich told Reuters that a bill giving states the option to declare bankruptcy would be introduced in Congress within the month.

“I think it’s an important tool for states,” says Grover Norquist, an influential Republican strategist and leader of Americans for Tax Reform, a conservative lobbying group. “It would make it easier for states to reorganize themselves if they get into too much trouble.”

No Quick Fix »

Image: Don Hankins, via Flickr.com

No Quick Fix

For many states, the budget crisis is deep and immediate and solutions must be found quickly. In Illinois, Gov. Pat Quinn won permission from the legislature to plug the $13-billion hole in the budget by increasing the state income tax by 67% (to 5.3%), and hike the corporate tax 45% (to 10.9%). And the tax hike still isn’t enough; Quinn reportedly is looking to borrow billions more to fill the gap.

Governor Jerry Brown proposes getting rid of California’s $17.2-billion deficit with a combination of tax increases and spending cuts on services including assistance to children in low-income families, education and health care for the poor. According to CNN, he recently announced a state government-wide hiring freeze, he said, “until agencies and departments prove that they can achieve these savings.”

“California faces a crisis that is real and unprecedented,” Brown said in his state of the state speech. “Kicking the can down the road . . . is simply out of the question.”

[Resource: Emergency Fund: How to Plan for a Financial Emergency]

In this act-now environment, giving states the right to declare bankruptcy would be no quick fix. First there’s a constitutional question to answer: Since states are co-sovereigns with the federal government, could they cede control of their budgets to a federal court? Whatever the answer, deciding it would require a long court battle which in all likelihood would ultimately land in the U.S. Supreme Court.

“The idea that [state bankruptcy] will help states solve their short-term budget crisis is silly,” says Max Neiman, a professor of government relations at the University of California, Berkeley. “But it plays to the crowd, and the crowd is angry about the Great Recession.”

Even if state bankruptcy were legal today, the process itself would be slow, bankruptcy experts say. Big corporate bankruptcies sometimes take years to wend their way through court. Compared to a state bankruptcy, that would be a cakewalk.

“In a corporate reorganization you can shed shareholders and creditors,” says James Spiotto, lead bankruptcy attorney at Chapman and Cutler, a Chicago law firm. In a government bankruptcy, however, “you have the same taxpayers, the same shareholders. And you usually have to pay off the same creditors. It’s a far more time-intensive and expensive process.”

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David Skeel, a law professor at University of Pennsylvania, started the whole debate over state bankruptcy by writing an editorial for the conservative Weekly Standard calling for states to be given the right to declare bankruptcy. In it, Skeel drew on the experience of cities and other local municipalities winning the same right in the 1930s to argue that the case for state bankruptcy is relatively simple.

“The constitutionality of bankruptcy-for-states is beyond serious dispute,” wrote Skeel, who did not return phone calls seeking comment.

Bankruptcy experts aren’t so sure. Cities “took four years and a couple Supreme Court decisions” in the middle of the Great Depression to win the right to declare bankruptcy, Spiotto says. “That process would be significantly more complex for states.”

Would it Help or Hurt State Finances? »

Would it Help or Hurt State Finances?

Laying aside the procedural barriers to state bankruptcy, is it a good idea? In his article, Skeel argued that it is, even as he noted how radical it sounds.

“Anyone who proposed even a decade ago that a state should be permitted to file for bankruptcy would have been dismissed as crazy,” wrote Skeel. “But times have changed.”

Some conservative Republicans agree. Giving states the option to declare bankruptcy provides them and their creditors and more orderly process than default, says Vince Haley, vice president of policy at American Solutions, a nonprofit lobbying organization formed by Gingrich to advance his policy goals.

Default “would be a longer, more cumbersome, and far more uncertain situation facing every creditor of the state than would be the case with federal bankruptcy protection,” Haley said in an e-mailed response to questions.

[Resource: Peer-to-Peer Loans: An Option for Consumers with Excellent Credit]

Others say that even discussing the option of states declaring bankruptcy has been enough to give investors the jitters. That was one reason why mutual funds that invest heavily in government bonds saw investors pull $25 billion out of the funds in December an January, according to the report by the Investment Company Institute.

“I think that’s been part of the selling wave you’ve seen from municipal bond funds,” Cohen says.

As fewer investors buy government bonds, and more people come to see bonds as risky, states are forced to offer to pay higher interest rates to lure the investors who remain. Even small rate increases can double the cost of borrowing money over a ten-year period, Spiotto says.

Attacking the Wrong Problem? »

Attacking the Wrong Problem?

Republicans have not been shy about the fact that one of their main goals of pushing a state bankruptcy option is to break the power of public employees’ labor unions. Many unions won higher pay and retirement benefits for their members in recent years, even as many private sector workers are losing jobs and benefits, and states they serve sink deeper into debt.

A recent Forbes magazine story describes the case of Glenn Goss, who retired as a police commander in Del Ray Beach, Fla., in 2005 at age 42. He is guaranteed to receive $65,000 in annual pension benefits, and the amount will rise with inflation. Given that the average American man has a life expectancy of 78, Goss’s retirement will cost Florida taxpayers $2 million.

“If California could explain to its government workers, who are trying to bankrupt the state trough pension and other obligations, ‘Look guys, if you keep doing this we’ll go bankrupt,’ then I think we may be able to turn it around,” says Norquist.

[Resource: How to Get Unemployment Benefits]

Others point out that exorbitant-seeming pension benefits for public employees have multiple causes that bankruptcy cannot address. One problem is that many states that faced smaller budget crises in recent years found short-term fixes to their problems by depleting funds set aside for pensions, and by freezing or cutting state workers’ pay for a year or two in exchange for promises of higher benefits later.

“How did we get into this problem to begin with?” Spiotto says. “We got here by not paying into these benefit funds what we promised. If we paid the required contribution amount every year, the problem would go away.”

Moreover, states’ current budget crises have little to do with their long-term pension commitments, which consume just 3.8% of most states’ budgets, according to a recent report by the Center for on Budget and Policy Priorities, a left-leaning think tank. Budget shortfalls are mostly the result of lower tax revenues due to the recession, the center found, and require merely short-term adjustments to keep government functioning until the economy recovers.

Media reports of huge state budget deficits “create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown,” according to the report. “Such claims overstate the fiscal problem.”

Instead of upending the entire government budget process, critics of the bankruptcy proposal say the solution lies in the same messy, complicated arena of electoral politics that created the problem of underfunded pensions in the first place.

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“These are decisions made by public sector managers and state legislators, and they should take responsibility for fixing them,” Neiman says. “Throwing our hands up in the air and walking away from these contracts strikes me as very bizarre.”

Conservatives counter that states’ immediate and long-term financial health are inextricably linked.

“If a state bankruptcy option allows a state to demonstrably improve its long term financial profile, its short term budget crisis will be a lot easier to handle,” Haley says. “States will have greater credibility in going to the public markets for greater amounts of short term financing if creditors see structural corrections allowing greater fiscal health over the long term and thus greater ability to pay off its short term debts.”

What Does the Future Hold? »

What Does the Future Hold?

For all the heat and smoke generated by the debate over state bankruptcy, it’s hard to tell if there’s any fire.

Three days after Gingrich announced that the state bankruptcy bill would be introduced, the leader of Gingrich’s own party in the House, Virginia Republican Eric Cantor, declared the idea dead on arrival.

“I don’t think that that is necessary, because state governments have at their disposal the requisite tools to address their fiscal ills,” Cantor told Reuters.

Some have dismissed the entire debate as an effort by Gingrich to win headlines as he mulls a campaign for president in 2012.

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“This is a cynical proposal intended to incite a panicked response to a phony crisis,” California Treasurer Bill Lockyer, a Democrat told the San Francisco Chronicle, comparing the proposal to scares about aliens and killer bees. “No state wants to or would declare bankruptcy. It would severely injure the economy, local businesses, investors and taxpayers.”

“All presidential candidates like to be associated with polices that gain the nation’s attention,” says Neiman. “And I think [Gingrich] is scapegoating public employees to exploit public anger” over the recession. Though the proposal appears stalled at the moment, conservative activists say they plan to continue pushing for it.

“With the dire financial situation of many states today,” Haley says, “Gingrich is merely proposing that states should have the same flexibility to restructure their finances.”