A State Bankruptcy Policy and the Constitution: Michael McConnell Responds

I am grateful to Jonathan Rodden, Jason Sorens, and Steve Slivinski for their thoughtful responses to my Liberty Forum essay, entitled “Extending Bankruptcy Law to States: Is It Constitutional?” I am particularly grateful because they addressed the many public policy issues about state bankruptcy, which I did not. I confined my essay to the legal/constitutional questions. But the question of state bankruptcy transcends the issues of constitutional text and Supreme Court precedent, on which I focused. It demands consideration of how state bankruptcy fits in the broader scheme of competitive federalism established by the Constitution.

The three responses put forward three quite different perspectives. With apologies to the authors for oversimplifying their positions, Jason Sorens is doubtful that precedents allowing extension of federal bankruptcy law to municipalities were correctly decided, and advocates“[l]etting insolvent states default on their own debts according to their own legal and political processes.” While the availability of bankruptcy protections might be in the interest of (some) state governments, it is not in the interest of their citizens, whose rightful private claims (bonds and pensions) would be abrogated, and worse yet, it would mask the consequences of the different fiscal policies that states have been pursuing. He points out that some states defaulted on their debts in the 1840s and – much like economists who argued against the bailouts of Bear Stearns, Lehman Brothers, AIG, and the auto companies – seeks to avoid the moral hazard of state bankruptcy by leaving the profligate states on their own.

Jonathan Rodden warns that disorderly defaults by some state governments would be far more disruptive now than in the 1840s, and would have major externalities for other states. When an entity, public or private, becomes insolvent, creditors rush for the courts to get the biggest possible piece of a too-small pie. Typically, creditors as a whole would be better off agreeing on a coherent program of debt extension and reduction, but without bankruptcy law the willing creditors cannot force hold-outs to go along. Worse yet, he warns, “it is not difficult to imagine a scenario in which a severe fiscal crisis in one or several large states ends with disorderly defaults that generate externalities for bond markets in other states, or where the pensions of retirees, or perhaps even current wages, go unpaid. In such scenarios, the lobbying of a bailout coalition might be too strong for the federal government to resist.” If the political pressure to bail out financial giants like Bear Stearns was too great to resist, how can Washington be expected to stand back and allow some of our largest states to cease providing basic public functions and millions of public employment retirees to lose their pensions? Federal bankruptcy protection, which could be crafted ahead of the crisis, is the alternative to chaos and almost inevitable bailout. But there is a Catch-22: to avoid the moral hazard problem, federal bankruptcy protection must be conditioned on “a politically costly loss of sovereignty” akin to Detroit’s subjection to a state receiver. These conditions, however, run precisely into the constitutional difficulties I discussed in my opening post.

Steve Slivinski writes that we need to focus on the question: “Would a state bankruptcy option be a credible threat that would change the political behavior of those policymakers on whom it would be expected to have the biggest impact—that is, on actors in the realm of fiscal policy?” His answer is “no.” With the exception of pension restructuring – a very big exception, in my opinion – Slivinski maintains that the availability of federal bankruptcy will not produce any change in the incentives of state political actors to tax and spend, and might even make them worse.

As between Sorens and Rodden, I am inclined to agree with Rodden that the 1840s approach of letting insolvent states default in their own juices is unlikely to withstand political pressures for bailouts today. I incline to agree with Slivinski that the availability of federal bankruptcy will not, in itself, improve the incentives facing state politicians, but I do not think that improving incentives is the rationale for extending bankruptcy law to the states. Rather, federal bankruptcy is primarily a device for circumventing Contracts Clause limitations that otherwise make it difficult or even illegal for states to force interest groups to take their share of the pain of a negotiated restructuring of debt.

In an ideal world, the people of various states and localities decide for themselves the levels of public services they wish to fund. Some jurisdictions will be high tax – high service states; others will be low tax – low service states. In my opinion, constitutional structure should be neutral as to these choices. The only constraint is that people pay for what they get. They should not be able to pass the costs of more generous public services to the residents of other states, either through extraterritorial taxation or federal bailout, nor should they be able to pass those costs onto future generations. Future generations are entitled to get the benefits of what they pay in taxes, just as the current generation should be limited to the benefits of what they pay.

The legitimate function of public debt in this ideal world is to align, not to skew, these benefits and costs. If State A builds an expensive highway or office building that will yield value for decades to come, the cost of construction should be spread across those decades by borrowing the money today and paying off the bond over the life of the asset. Without the ability to sell bonds to pay for infrastructure, current taxpayers would be unwilling to undertake long-term investments. On the other hand, it is an abuse for state and local governments to finance current operations, such as the salaries of teachers or policemen, by borrowing. Such borrowing shifts costs from those who benefit from them to future taxpayers. Most state constitutions attempt to prevent this abuse by various kinds of balanced budget requirements or limitations on the issuance of debt – but as Slivinski points out, judicial decisions have “poked wide loopholes in these limits.” More importantly, the nearly ubiquitous practice of underfunding defined benefit pension plans has the effect of off-budget borrowing. Residents get the services of teachers and policemen today, and a big part of their compensation, their pensions, is passed onto the future. These abuses – excessive and inappropriate borrowing and underfunded pension plans – are the underlying core of the current state-local fiscal crisis. The crisis is aggravated by a vicious spiral of population and economic decline, leading to higher taxes and lower services, leading to further population and economic decline. That is how Detroit and Puerto Rico got where they are. Illinois is almost there.

The prospect of state fiscal meltdown produces a clash between three antagonistic interests. In one corner are the state’s current residents and taxpayers.  They are asked to pay not only for current services, but for a hefty share of the cost of services rendered long ago. Chicago taxpayers, for example, recently saw their property tax bills double or triple to fund the pensions of retirees. Moreover, current residents typically suffer declines in the quality of current services. Under the law, payment of debt has priority over provision of services. All over the country, Americans are seeing their universities, schools, police departments, roads, and other services cut to the bone in order to free up the money to service bonds and underfunded pension systems. At some point, they won’t take it any more.

The second interest group is public employee pensioners, represented by public employee unions. They have a powerful interest in protecting past pension promises, and care little about tax increases or service cuts. They often are the principal donors to the Democratic Party machines that control most cities.

The third interest group is bondholders. They want interest and principal on the public debt. Their leverage comes from the threat of not lending any more, and provoking a spike in interest rates. In time of fiscal meltdown, they have much less political power than the first two groups.

What would federal bankruptcy protection bring to this struggle? Three related things. First, it would provide a platform for negotiated reductions in financial claims, both bonds and pensions, with the legal ability to cram down the negotiated solution over the objections of holdouts. The threat of a cram down may bring the interested parties to the table.

Second, because bankruptcy law is federal and federal law (within the scope of federal power – a big question in the context of extending bankruptcy law to states) is supreme over state law, the orders of a federal bankruptcy court would prevail over state laws such as those treating pension obligations as sacrosanct, which they are not in the private sector. In other words, bankruptcy takes questions of taxing, spending, and repaying temporarily out of state politics, which produced the mess in the first place, and substitutes a more-or-less objective system in which debts are given appropriate legal (rather than political) priority.

Third, and arguably most importantly, federal bankruptcy allows the violation of contracts that would be unconstitutional if done on the authority of the state government alone. The Contracts Clause of Article One, Section 10, prohibits states but not the federal government from enacting “laws impairing the obligations of contract.” The courts of California, Illinois, and many other states have taken the extreme position that even negotiated reductions in the formula for accruing future pension benefits are unconstitutional as applied to current workers. This makes it impossible for cities and states to stop making the pension mess worse – let alone to negotiate band-aids to make it better. The federal bankruptcy power may be the only legal mechanism to break the power of profligate promises backed up by the Contracts Clause.

Steve Slivinski properly directs our attention to the incentives created by federal bankruptcy law, or its absence. He fears that if federal bankruptcy protection were extended to the states, politicians would be even more inclined to tax and spend. But there is another incentive we also need to worry about: that the relevant interest groups will resist reform in the expectation that the resulting meltdown will result in a federal bailout. Public employee unions will resist any and all reform, joined by bondholders who see no reason to adjust their claims when union claims are protected, and state courts will make things worse by holding forward-looking pension reforms illegal (as in California and Illinois). The best argument for bankruptcy law for states is as an alternative to that. That does not, however, make it constitutional.


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