In his illuminating and timely Liberty Forum essay on the constitutional impediments to a state-level bankruptcy procedure, Michael McConnell emphasizes the importance of the sovereignty of the states in the framework of American federalism. Unlike Detroit and San Bernardino, and perhaps unlike Puerto Rico, the states are considered fully sovereign with respect to taxation, expenditures, and borrowing in the Supreme Court’s understanding of the U.S. Constitution. As Professor McConnell points out, some of the key features of bankruptcy are hard to square with this understanding of the states’ sovereignty.

Indeed, it is difficult to envision an effective bankruptcy process that does not involve a temporary and voluntary reduction in state sovereignty. However, this response posits that one of the most important arguments in favor of an ex ante process to structure orderly defaults is that it would be a way of guarding against bailouts, which pose a far greater and more permanent threat to the sovereignty of the states than the temporary involvement of control boards or courts. Rather than representing a threat to state sovereignty, bankruptcy could be a way of preserving it.

First, I make a distinction between what it means to be sovereign in terms of taxing and spending, and what it means to be a sovereign borrower.

Second, I explain how these two notions of sovereignty sometimes become uncoupled, with disastrous consequences for taxpayers.

Third, I suggest that by agreeing ex ante on an orderly default process well before the moment of insolvency, states and the federal government can lower the probability of such worst-case scenarios becoming a reality.

I conclude by considering whether this assessment of the merits of bankruptcy is likely to win the day either in the court of elite opinion or in the Supreme Court. In addition to the more abstract reservations about the sovereignty of the states highlighted by McConnell, such a default process, however orderly, would be unsettling to bondholders, investment banks, and public sector unions, all of whom would prefer to reserve the right to lobby and litigate to the bitter end in the event that a state could no longer fulfill its obligations.  These are formidable foes, and their involvement in debates about state bankruptcy leads me to share Professor McConnell’s skepticism.

Sovereign Spenders and Sovereign Borrowers

Professor McConnell points out that extending Chapter 9 bankruptcy procedures to states would implicate the courts in determining whether or not a state is solvent, which would require it to weigh evidence about whether the state could cut expenditures or raise taxes in order to pay its obligations to pensioners and creditors. This would cut rather deeply into the states’ power of taxation, which is, as he notes, “as much at the core of sovereignty as anything could possibly be.”

This problem seems even more severe in a large American state like Illinois than in a municipality like Detroit or in Puerto Rico, where it was relatively clear to all interested parties that the cash was simply not available to make payments and the revenue base was only shrinking as residents and businesses departed. Similarly, a municipality like Washington Park, Illinois—which has attempted to file for bankruptcy twice in the last decade or so—can credibly claim that even a tax increase would not enable it to fund its pension obligations. In the case of Illinois itself, however, bondholders and public sector unions will argue that increased taxes and further cuts to the university system are always possible, even if these would speed up capital flight and undermine future growth prospects. These are thorny questions for a federal judge to answer.

McConnell might have gone even further. A crucial design challenge for a state bankruptcy process would be to avoid making it a politically attractive choice for state governments that, though troubled in the short term, could achieve fiscal sustainability by making reforms. Bankruptcy must be a last resort that is costly to invoke. That is why it typically involves a rather direct loss of sovereignty via the appointment of something like a temporary control or “oversight” board with exclusive authority to negotiate with creditors and make crucial tax and expenditure decisions—as in the case of Washington, D.C. and the legislation recently crafted for Puerto Rico.

When we think of the sovereign powers of the U.S. states or the countries that belong to the European Union, we think of the power to tax and spend according to local priorities without interference from higher-level governments. The U.S. Constitution, in comparison with many other federal constitutions, has long been a safeguard of this type of sovereignty against forces favoring centralization. It is difficult to reconcile this vision of federalism with the notion of control boards and federal judges making decisions about taxing, spending, and borrowing, even if a Governor voluntarily cedes this authority.

It is important to understand that the U.S. states are different from provinces or states in many other federations in another closely related respect: The U.S. states are sovereign borrowers. Their fiscal obligations are neither explicitly nor implicitly guaranteed by the federal government.

This independence is rooted in U.S. history—specifically, in a painful episode of defaults by state and territorial governments in the 1840s. After the federal government allowed several states and territories to default in spite of intense pressure from creditors in favor of a federal bailout, voters and creditors learned to treat U.S. states as miniature sovereign borrowers and to assess their credit quality accordingly.  

This episode laid the foundation for a long period characterized by effective market discipline among state governments. While the federal government has flirted with various forms of special assistance (for example, extra Medicaid payments or “Build America Bonds”) in the wake of recessions, it has eschewed overt bailouts of troubled states. Requests from states like California for special assistance in managing obligations to pensioners and bondholders have been denied, and states have been forced to make politically painful decisions on their own. Most recently, the federal government denied requests for a bailout of Puerto Rico in the face of default.

When Sovereign Spenders Are Not Sovereign Borrowers

It might seem obvious that these two forms of sovereignty go together. That is, we might expect that states or provinces with the sovereign power to tax and spend without interference from higher-level governments are also sovereign borrowers.  However, this is often not the case.  Voters and creditors might perceive that a central government that is constitutionally prevented from regulating subnational taxation and expenditures nevertheless provides an implicit guarantee of its debt.

Perhaps the most obvious recent example is the European Monetary Union (EMU). Debt that had been issued by sovereign member states was viewed by creditors as carrying an implicit guarantee from the EMU, in spite of its formal no-bailout pledge. Above all, creditors evaluated the European banking system and understood that the EMU—and Germany in particular—would not be able to allow Greece to default, since this would have led to failures of some of the largest German banks. As a result, bond yields converged in the Eurozone, reducing the incentives for weaker member states to start making prudent fiscal decisions.

A similar logic led to bailouts of the Brazilian states by Brasilia in the late 1980s. While Brazil’s constitution made it very difficult for the federal government to intervene in the fiscal decisions of the states, the center was unable to turn a blind eye to imminent defaults by large states because this would have led to the failure of some of the country’s largest banks and a host of additional negative externalities.

In both cases, lower-level governments were sovereign spenders but not sovereign borrowers—and market discipline failed because market actors harbored strong expectations that officials at the higher level would step in to save the day. When these expectations were fulfilled, bailouts became associated with rancorous efforts to limit the sovereignty of the lower-level governments over their taxing and spending decisions. In Brazil, the central government was able to use its leverage over bailouts to extract concessions that permanently weakened the fiscal sovereignty of the states.

The same logic is at work on a smaller scale in many other settings. Creditors and voters are quick to pick up on any clues that higher-level governments might be induced to provide assistance to forestall defaults of lower-level governments. U.S. state governments worry that defaults by municipalities will raise the cost of credit for the entire state. For example, Pennsylvania has been creative in coming up with ways to funnel additional resources to Harrisburg in order to prevent it from pursuing debt restructuring. In such situations, creditors face weaker incentives to distinguish between the credit quality of different municipalities in a state, which in turn weakens the municipal officials’ will to pursue prudent fiscal policies in order to preserve their towns’ or cities’ creditworthiness.

In short, the U.S. states exhibit what is in fact a rare combination: they are sovereign not only over taxing and spending but also over borrowing. But their status as sovereign borrowers is fragile and easily undermined. Expectations of being bailed out, while far lower for U.S. states than for states or provinces in many other federations, or for some U.S. municipalities, are not completely absent—and they can easily grow.

While Washington has resisted calls for bailouts throughout the Great Recession, and has reaffirmed the federal government’s non-intervention commitment once again in the case of Puerto Rico, 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.

As in the cases of the European Monetary Union and Brazil, the chaos and panic of disorderly default can make a bailout suddenly seem like the only plausible way forward. A disorderly default culminating in a bailout would permanently alter federalism in the United States by sending the message to voters, creditors, and state governments that states are no longer sovereign borrowers.

Furthermore, a bailout would likely engender a challenge to the sovereignty of the states over taxing and spending. Presumably, federally funded debt relief would come at the cost of some rather onerous form of federal supervision. In that case, the Supreme Court would end up assessing the constitutionality not of a bankruptcy law, but of federal receivership.

Bankruptcy as a Bulwark of Sovereignty

Such scenarios are not fanciful. Illinois’ debt burden and unfunded pension obligations appear to have placed that state on an unsustainable fiscal path. Should Springfield be allowed to declare bankruptcy in the future?

On the one hand, market-based fiscal discipline has survived for almost two centuries without a formal set of rules to structure state-level defaults. On the other hand, the threat of a disorderly default culminating in bailouts is arguably greater than in the past due to the buildup of unfunded pension obligations over the last several decades.

As Springfield’s fiscal situation grows more insoluble, the current federal policy is to look away and insist that neither bailouts nor defaults are possible. This was the policy of the European Monetary Union vis-à-vis Greece even as it became clear that Greece was on an unsustainable fiscal path. Although this stance has a shade more credibility in the United States, carrying on with the status quo (to admit the obvious) carries considerable risks.

In retrospect, the European Monetary Union might have been better off if it had specified an orderly default process from the beginning. The current question in the United States is whether the time is right to clarify a set of uniform rules for orderly defaults before the moment of truth arrives. If a U.S. state defaults, courts will in any event be deeply involved, and in ways that are likely to chip away at state sovereignty. The question is whether it would be better to lay out some ex ante rules that centralize and rationalize this involvement.

Perhaps the strongest case for some type of orderly default procedure is that it provides an alternative to the chaos and pain of a disorderly default, and hence lowers the probability of bailouts. Perhaps the temporary and voluntary loss of sovereignty associated with the involvement of courts and oversight boards would be preferable to the risks to state sovereignty associated with bailouts.

A related argument in favor of an orderly default process is that it could make state governments, creditors, and public sector unions likelier to come to the table and negotiate as a way to avoid invoking the formal process. The recent experience with the bankruptcy process in Detroit demonstrated that, at least under the Chapter 9 process, bondholders and public sector workers might well be forced to accept haircuts.  Uncertainty about their amounts might prompt the parties involved to work out deals ahead of time.

When there is no possibility of invoking a bankruptcy process, as is the case for municipalities in states like Illinois that have not established a bankruptcy statute for lower-level governments, public sector unions and creditors face no incentives to consider any type of restructuring, even when the municipality reaches the point where it exists only to pay creditors and retirees while residents and businesses depart and the money runs out. In the absence of a bankruptcy process, various classes of creditors and public sector unions often believe that their best strategy on the eve of default is to engage in a war of attrition and litigate and lobby to the bitter end, hoping to obtain either a favorable ruling and/or a bailout.

For this reason, the status quo—no formal process of orderly defaults for states—is preferred by creditors and public sector unions. The uncoordinated rush to the courthouse in the event of default, while bad for taxpayers in the troubled state, and potentially bad for the entire federation, is preferable for the interest groups with the most at stake. They have a realistic hope of achieving the best outcome for them: a federal bailout or favorable court ruling that imposes the restructuring or haircut on someone else. In contrast, if a bankruptcy process could be invoked, these best-case scenarios might be off the table.

Looking Ahead

Hopefully the most troubled U.S. states can find ways of returning to fiscal sustainability without bailouts or defaults. However, if a state government eventually must choose between making payroll or making a bond payment, the United States is ill-prepared for the consequences. The most compelling reason to consider some form of orderly default process is that if that moment arrives, it can provide an inoculation against bailouts, and perhaps even encourage stakeholders to agree on restructuring and reform before the moment of default.

On the other hand, the most compelling argument against such a law is that, if structured poorly, it might allow solvent states to avoid hard choices and walk away from their obligations. This, however, is a matter of design. It is crucial to include in any such legislation a politically costly loss of sovereignty during the restructuring. Professor McConnell is probably correct in predicting that such provisions would not likely withstand constitutional scrutiny, even if the ultimate goal were to protect rather than abrogate state sovereignty.

In any case, the biggest challenge to such a law would not be the Supreme Court, but the Wall Street banks, Main Street bond investors, and public sector unions, who see themselves as better off with the current de facto regime of disorderly default.

The legislation recently crafted to structure the default of Puerto Rico was sold by its supporters as a one-off deal for territories that could not possibly apply to any U.S. states going forward. However, the broad contours of this deal may very well set a precedent. Once it is absolutely clear that a state will default—possibly after missing payments on unsecured debt and signaling an intention to default on general obligation bonds—Congress might scramble to vote on an eleventh hour bill to create some framework that would forestall the chaotic rush to the courthouse. As in the case of Puerto Rico, this bill would be subject to intense lobbying by hedge funds, bondholders, and labor unions.

If such a law is in fact inevitable, it would be better to craft it under more relaxed circumstances, when default is not imminent and the stakes are less clear for each specific interest group in a particular state. For instance, the prioritization of state constitutional protections can cut very differently in different states. The constitution of Puerto Rico ostensibly protects bondholders, while the constitution of Illinois protects pensioners. Likewise, the nature of the distributive battle between various unsecured creditors would vary considerably from one state to another.  It would be unfortunate for the future of U.S. fiscal federalism if it must be structured by a late-night deal among special interest groups on the eve of a missed bond payment in a single troubled state.

Regrettably, in an era of political polarization, ugly last-minute deals on the eve of default may be the only deals that get done in the United States Congress. Furthermore, Professor McConnell may be correct in predicting that the Supreme Court would only be willing to swallow its objections on the eve of a crisis.