States Can't Go Bankrupt

The Wall Street Journal carried an op-ed last week arguing that many key provisions of President Obama’s jobs bill are intended as a bailout for “blue states” (defined as Democratic states with heavy union presences) and that other aspects of the same bill might make things worse for the same states.

The two authors, Paul Peterson and Daniel Nadler, muster a lot of impressive evidence to support their case and suggest that we’re better off simply allowing states to go bankrupt if they are poorly managed. I agree that bailing out poorly managed states presents a terrible moral hazard and should be off the table for Congress and the administration.

But there’s one problem. States, contrary to what Peterson and Nadler write, can’t go bankrupt at all.

Bankruptcy is a formal process with a clear legal outcome that leads to a partial or total discharge of debts. It’s available only to individuals and certain classes of organizations. Individuals, most private companies, and local governments can go bankrupt but state governments, banks, and insurers can’t. (Banks and insurers “become insolvent” and have government-run or mandated insurers pay some or all what they owe.)

States, if they can’t pay, instead must “repudiate” their debts. But state debt repudiation isn’t even a formal process like bank and insurer insolvency either; it’s more of a legislature saying “We won’t pay and, because we’re the government, we don’t have to! So there!” A lot of state constitutions require states to pay their debts so, in many cases, an effort to repudiate debts would cause a state constitutional crisis that could lead to things like courts ordering tax increases or asset sales. In short, state bankruptcy doesn’t appear to really be possible.

While the federal government, as Peterson and Nadler say, hasn’t bailed out states, it’s also true that only one state has gone for repudiation since 1900 and it actually paid back its debts the year after default. The record for local governments is mixed, Orange County was allowed to go bankrupt in 1994 but, New York City—after it bought it self some breathing time and agreed to tough conditions—did get big federal loans to help it through its late 1970s fiscal crisis.

So, while Peterson and Nadler make a very good point, I tend to think that "let them go bankrupt" requires a little more thought.