In What Circumstances Would the Threat of State Bankruptcy Be Credible?

Michael McConnell’s Liberty Forum essay does an excellent job of outlining the legal case that enabling states to declare bankruptcy is not necessarily inconsistent with constitutional principles or with existing case law.

From the perspective of a public choice economist, however, there is another salient issue. What those who study the outcomes of institutional arrangements and changes in those arrangements should want to know is: 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?

At best, it would leave fiscal calculations unaffected, I believe; at worst, it could damage fiscal discipline in a state—the opposite of what would be hoped from extending a bankruptcy option to officials in the governments of the 50 states. There may be one exception to this, pension restructuring, but before we get to that, let’s consider whether bankruptcy is a credible alternative for states that have gotten themselves into a fiscal mess in the near-term.

To start, think about the institutional and political context in which the “nuclear option” of bankruptcy would exist. The most common scenario would be one in which a state has spent or over-leveraged itself into a corner and its only choice is declaring bankruptcy. In addition, assume a bankruptcy proceeding would likely be seen as a last resort after negotiations between stakeholders (in this case, political interest groups) break down. That is often how we see the bankruptcy threat play out in the private sector—after extended negotiation has failed and the only remaining option is intervention by a bankruptcy judge.

But the applicability of private sector examples to the public sector is limited, to be sure. When private parties negotiate a debt-restructuring (usually in the context of pension adjustments, as in the case of most major U.S. airlines over the past 20 years), both of the parties know that a solution could be imposed on them by a bankruptcy judge if they fail to come to terms. The threat of bankruptcy is credible. In addition, those negotiating have shareholders and a board of directors to whom they are accountable for their actions.

Where will the leverage come from, by contrast, in the public sector? It doesn’t have customers or shareholders. It has a relatively captive supply of taxpayers. The parties negotiating over the looming insolvency of a state are not trying to maximize future profit potential or the continuity of a corporate brand, nor are they accountable to shareholders or a board or directors guarding its profits. Political actors in the public sector are trying to maximize other things, such as re-election.

A political actor may feel less compelled to play a game of brinksmanship with the negotiators on the other side of the table, since they could have more political leverage than he or she has even if the bankruptcy option gave the state legislature or Governor more fiscal leverage. To put it another way, the bankruptcy option, absent other reforms, wouldn’t inherently change the complexion of the fiscal negotiations that took place in most states—which tend to be about annual, run-of-the-mill, ongoing current services financed by state taxpayer monies such as transportation, education, and law enforcement. (Again, we are reserving the issue of pension obligations.) This suggests that bankruptcy would rarely be invoked by state officials.

A different, and potentially worst-case, outcome is hinted at in McConnell’s essay. He writes that, to invoke bankruptcy protection, a jurisdiction must

be insolvent. In order to determine the solvency of a governmental entity, which owns little attachable property and whose revenues are taxes, the court must evaluate the tax rate, along with the state’s obligations and expenses. If the court is not satisfied that the state has exhausted its ability to raise revenue and reduce spending, presumably the court will not find the state insolvent.

Here the problem is that the political actors, understanding that, might actually prefer a bankruptcy court’s intervention to reaching a budget agreement that would obligate them to take unpopular actions like raising taxes or cutting the state’s budget.

Looking at legal history in the United States since World War II, one is hard put to find examples of courts ruling that a government had “exhausted its ability to raise revenue”—nor are there too many cases in which budget cuts were deemed inadequate. On the contrary, what recent memory provides is examples of various lawsuits against state governments, in which the matter in question—motivated by interest groups using the legal system to pursue a solution they failed to obtain by legislative means—was whether a state was spending enough on services like education.

And for whatever reason, judges have tended to side with those who want to raise taxes or to strike down limits on the expansion of state government. Perhaps bankruptcy judges would not be equally disposed to do so. But courts today appear to lack an ability or willingness to grapple with the public choice dynamic that heavily influences budget decisions.

This, then, is the not-very-propitious environment in which the bankruptcy option would be weighed by officials of state governments.

As it turns out, to help us answer the question of whether and how the prospect of bankruptcy would influence the behavior of politicians, we have a few thousand subjects in an ongoing, real-world natural experiment: American municipalities, which currently have the option of declaring bankruptcy.

Most of them don’t in fact exercise it. Governing Magazine reports that, between 2008 and 2012,  around 0.06 percent of municipalities or eligible general-purpose local governments actually declared bankruptcy. This may not be surprising. For one thing, cities often have other remedies short of bankruptcy, such as merging with neighboring cities. (States don’t realistically have that luxury.) For another, there are the penalties that accompany bankruptcy. Cities that have declared bankruptcy generally have a problem thereafter getting favorable interest rates on bond issues.

To be sure, the other measures short of bankruptcy also carry penalties, and these rarely restrain the actions of municipalities. Take, for instance, constitutional debt limits that apply to cities. Many cities in the United States are bound by them. Yet many still issue debt for various and sundry purposes, often at excessive levels, and flirt with possible default even though the possibility of an interest-rate penalty risk always hovers in the air. Or take Stockton, California or Jefferson County, Alabama, two of the recent and biggest bankruptcies at the level of local government. Both jurisdictions were bound by constitutional debt limits that simply did not temper elected officials’ profligate behavior.

Part of the reason debt limits didn’t work is that they were not a credible threat. Judicial decisions over the past five decades in the states have poked wide loopholes in these limits, ruling that certain types of debt and bonds that could eventually leave taxpayers holding the bag would not have to be considered part of the debt limit. That left massive amounts of debt—indeed, most of the debt load of cities and states—outside the reach of constitutional debt limits.

This is relevant to bankruptcy at the state level for two reasons. First, and more obviously, the political forces governing the fiscal process in many states and cities are simply more powerful than the threat of penalties, either judicial or bond-market based, or the existing constitutional constraints. Those tangible and intangible constraints are not credible threats.

The second reason is more technical. As a bankruptcy judge is seeking to determine if a state is indeed insolvent, he or she may turn to judicial precedent to help decide whether a state has tapped out its taxing or bonding capacity. As it exists now, that body of law suggests that as long as a court and a municipality or state are willing to agree to exclude these governmental debt instruments from existing bond limits— declining to legally define bonds as debt even though it is, which they are almost always willing to do in some form—they will continue to issue debt and conclude that a restructuring or reckoning with the potential consequences is not necessary.

To put it another way, a state bankruptcy option airlifted into the current policy environment, in which political interest groups that aren’t directly accountable to voters have substantial sway in a government spending and debt process that is not effectively constrained by limits to its taxing and spending authority, might have the perverse effect of enhancing the incentives to tax and spend that got the state into its fiscal mess in the first place. The bankruptcy option alone may not be enough to change the behavior of political actors in the budget process—at least not without better limits on the power to tax and issue debt, and not without courts willing to enforce those limits.

The problem of defining what would trigger bankruptcy action is a tricky one, too, confounded as it is by politics. McConnell suggests that bankruptcy would most likely be exercised in the case of a “genuine fiscal meltdown,” but defining what such a meltdown would look like is difficult. As we’ve seen, attempts to define what constitutes a true general-obligation debt that falls on taxpayers has not led to the codification of any reasonable or empirically defensible standard. Instead, it has become a rationalization designed to benefit the government that issued the debt in the first place, much to the dismay of those whom the rules were designed to protect (that is, the taxpayers). “Genuine fiscal meltdown” is in the eye of the beholder.

As a policy matter, it may be more fruitful to consider a state bankruptcy option only after existing constitutional limits on governmental behavior—like debt, tax, and spending limits—have been given more teeth. That’s the environment in which a state bankruptcy option could potentially pose a credible threat, one less likely to backfire and diminish fiscal discipline. But we’re not there yet.

In the current state of the world, McConnell suggests that the “essential elements of bankruptcy protection are the ability to restructure debts and the ability to reform pension liabilities.” I’ve already stated my doubts about bankruptcy’s changing much about bonded debt levels and structure. However, I am in complete agreement with him that the movement toward reforming pension liabilities could benefit from the state bankruptcy option.

Let me be clear: this is not to say it would somehow be a requirement of pension reform. There have been a number of healthy state-level reforms of pension systems across the country to date even without the threat of bankruptcy proceedings. The reason I believe pension systems could benefit from the bankruptcy option is the reality of how they function. While annual general fund budgets for ongoing government services are funded by all taxpayers, the political calculus for pensions systems is different: they are meant to be financed by payroll taxes assessed only on those workers within a pension system.

As the future benefit levels rise too high or as unfunded liabilities mount—even as the tax base on which those plans are built shrinks—policymakers and beneficiaries face much tighter political constraints on what they can realistically do to bring about reform. Heaping new funding obligations on taxpayers who did not have to fund a pension system previously, and from which they receive no tangible benefit, is not likely to go well (at least not in the long term as the dollar amount of the liabilities become staggering and more transparent).

That’s a different political climate than one in which all taxpayers are asked to pay for current services that a populace generally agrees have broad benefits for the entire population, like education or transportation. Being asked to pay for a very concentrated and expensive benefit for a small share of the population tends to yield more political demand for reform and less support for the status quo.

Here, in the context of negotiating reform of the pension system for a state’s employees, the threat of that state’s declaring bankruptcy might actually be credible. A change in federal law specifically tailored to allowing states to call upon a bankruptcy court to arbitrate pension restructuring might well be palatable. And if it came down to a choice between a state bankruptcy option and federal bailouts of state pension systems, it could be just the reform we need.