When States Go Broke

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Just out from Cambridge University Press: When States Go Broke, a fine volume on “The Origins, Context, and Solutions for the American States in Fiscal Crisis” edited by Peter Conti-Brown and David A. Skeel, Jr.  Skeel had an excellent essay in 2010 in The Weekly Standard that explored some of the thinking in this volume “Give States a Way to Go Bankrupt.”  The insane price ($99) may reflect the publisher’s judgment that if states go broke, they might as well take book buyers and libraries along for the ride. ‘Tis a pity, because the volume is unusually timely and thought-provoking. A few notes on some of the essays, with no prejudice to the other contributors:

Olivia S. Mitchell surveys the evidence on state public pension programs. The depressing numbers lead her to conclude that “the size of the public pension shortfall remains dauntingly large and discouragingly expensive to fix. And few of the changes explored to date will help to fill the gap very much…” In many states, the situation is far worse than the aggregate figures suggest. Illinois will exhaust its pension fund by 2020, with New Jersey following close behind. You’d need an immediate and continuing tax hike in the range of $2,000 or more per household to amortize the accumulated shortfall. That’s not going to happen. Instead, states write risky CDSs, park money with vulture funds (Bain Capital, anyone?), and issue pension obligation bonds at six or seven percent. Disaster is just around the corner.

What to do? Jonathan Rodden draws a helpful distinction between “hierarchical” and “market” mechanisms to discipline spending by states that gamble on a federal bailout. “Hierarchical” means top-down controls on lower governments’ fiscal conduct: you merkel them until they surrender. This actually works, more or less, at the state level. Some states have established financial control boards to take over near-insolvent municipalities, and some facilitate intervention before the locals get into a predicament that would require a difficult work-out. The awkward, semi-sovereign status of the states, coupled with the fact that federal transfer programs have incentivized their spendthrift behavior, may seem to suggest something similar vis-à-vis states. However, whatever one may think of the constitutionality of a voluntary bankruptcy process for states (Michael McConnell’s essay surveys the legal arguments and professes agnosticism on the answer), compulsory federal receivership is quite plainly beyond the constitutional pale.

That leaves market mechanisms. Bond interest rate spreads (and CDS prices, which provide a purer measure of interest rate and default risk) in the muni market widened considerably after 2008, suggesting that folks in this notoriously opaque market do have some grip on reality. Rodden sensibly suggests a strengthening of market mechanisms. Foremost, he writes, we should make intergovernmental grants, which currently exacerbate state boom-and-bust cycles, anti-cyclical. “This would help firm up the center’s no-bailout commitment by putting an end to the ad hoc scramble for implicit bailouts and would help state governments make more rational expenditure decisions.”  Can that be done? Sure, on an economist’s blackboard. In the real world, it’s been a losing proposition for several decades. (Rodden does not say so, but he is far too good a scholar not to know it.) In my estimation, the only way to dampen the pro-cyclical effect of transfer payments is to curb them.

Several contributors (David A. Skeel, Adam J. Levitin, Michael McConnell, George Triantis) discuss the option of a bankruptcy process for states, perhaps modeled on Chapter 9 bankruptcy for municipal governments. My own, diffident views on that subject appear here. Regardless of what one makes of the particular proposal, the discussion goes in the right direction: the time has come to think seriously about fire walls and crisis plans.

By “fire walls,” I don’t mean the trillion-dollar financial fire walls that have failed to work in the EU; I mean credible political fire walls that promise to  block a lurch into the next circle of hell. For an obvious example, we should make it unmistakably clear that the Fed will not purchase Illinois or California bonds when the market keels over; and that the Fed and Treasury will neither guarantee those instruments nor cram them into some “systemically important financial institution” by means of fiscal repression (“Dear SIFI: buy those bonds, or go directly to jail.”) Don’t tell me this can’t happen: it will, unless we take affirmative steps to ensure that it won’t.

As for crisis and contingency plans: all the nightmare scenarios would play out in the context of extremely complicated intergovernmental schemes. Currently, we have no way of managing or unwinding those arrangements if and when one of them hits a wall. For example, states build highways under contract with the feds. If they fail or refuse to pay their private contractors (as some already do), what happens—do we let the roads crumble, or should the feds have some way to claw back the grants and build and repair the roads under direct DoT command?  For another example, healthy and sensible states have considered the option of exiting No Child Left Behind and/or Medicaid. The federal statutes allow that option (they’d be unconstitutional without it) but provide no orderly mechanism for what, in practice, would be a complicated transition requiring the good-faith cooperation of both sides. Negotiating a Medicaid exit with Mrs. Sebelius on an open field does not look like a promising option: she holds the purse strings, and her conduct may not even be subject to APA review.

When States Go Broke powerfully illustrates the need for meaningful reforms. Most likely, we will undertake none of them. Perhaps I should stand by my earlier prediction: next stop, Argentina.