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Could States Declare Bankruptcy?

e21 | February 9, 2011

On Wednesday, the House Oversight committee will hold a hearing to examine whether it’s a good idea to pursue a new law that would enable states to file for bankruptcy. David Skeel, the chief proponent of this idea, is scheduled to testify. 

Reuters’ James Pethokoukis summarized the concept on Tuesday for The Weekly Standard:

It’s a solution of apparent Alexandrian elegance and simplicity: Empower America’s cash-strapped states to slice cleanly through a strangling knot of debilitating debt and government union cronyism by letting them file for bankruptcy. Long-term liabilities could be restructured, unaffordable labor contracts rewritten, fiscal health restored. No federal bailouts necessary.

In addition to being one of the first hearings of the new congress, this one should be especially interesting because GOP heavyweights are strongly split on the issue. In late January, House Majority Leader Eric Cantor dismissed the idea saying that states already had the necessary tools to address their fiscal problems. Meanwhile, Newt Gingrich and Jeb Bush vigorously called on Congress to adopt the policy change.

Some of the leading scholarly critics of the idea are Nicole Gelinas and E. J. McMahon, both from our partner organization, the Manhattan Institute.  McMahon wrote previously in The Wall Street Journal:

For constitutional reasons, any federal law enabling state bankruptcy would have to be voluntary, meaning states would have to invite federal judges to play tough with their unions. But if Gov. Jerry Brown and the California legislature are unwilling to rewrite their collective bargaining rules—signed into law by Mr. Brown himself, 33 years ago—why assume they would plead with a federal judge to do it for them?

It's more likely that a state like California would pursue bankruptcy if powerful unions and other budget-dependent interest groups saw this as a way to deflect some of the pain to bondholders. California is one of the states that constitutionally guarantees its general obligation debt, and whose bondholders are now seemingly untouchable. That could change with a bankruptcy option.

A preview of Gelinas’s written testimony explains why the fiscal problems of states are much greater than the type which can be overturned in a bankruptcy.

As a practical matter, though, state bankruptcy is unlikely to help states solve their fiscal problems. Nor would bankruptcy allow the federal government to avoid the bailout question. Bankruptcy also does not address the key drivers of states’ fiscal problems—provision in their laws and constitutions that restrain states from balancing their books, and federal grants for programs like Medicaid and education that encourage higher spending.

With all of the political, policy and legal complexities surrounding this issue, we anticipate that the hearing is really just the beginning of a wide-ranging debate. That’s why e21 is assembling experts to hold a panel discussion with the goal of working through the tough questions and reaching some conclusions. Tuesday, Feb 15, at the National Press Club, Skeel, McMahon, and Gelinas, along with Clayton Gillette and David Schleicher will hash out their views in a discussion moderated by Jim Pethokoukis.  Details to follow.

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