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Thursday, December 09, 2010

Why Allowing States to Go Bankrupt is a Horrible Idea

At the end of November, an article by David Skeel in the Weekly Standard got many conservative folks a-chattering about letting states go into bankruptcy.  The new meme apparently has already had policy ramifications, as James Pethokoukis reports:

Congressional Republicans appear to be quietly but methodically executing a plan that would a) avoid a federal bailout of spendthrift states and b) cripple public employee unions by pushing cash-strapped states such as California and Illinois to declare bankruptcy. This may be the biggest political battle in Washington, my Capitol Hill sources tell me, of 2011.

That’s why the most intriguing aspect of President Barack Obama’s tax deal with Republicans is what the compromise fails to include — a provision to continue the Build America Bonds program.  BABs now account for more than 20 percent of new debt sold by states and local governments thanks to a federal rebate equal to 35 percent of interest costs on the bonds. The subsidy program ends on Dec. 31.  And my Reuters colleagues report that a GOP congressional aide said Republicans “have a very firm line on BABS — we are not going to allow them to be included.”

In short, the lack of a BAB program would make it harder for states to borrow to cover a $140 billion budgetary shortfall next year, as estimated by the Center for Budget and Policy Priorities. The long-term numbers are even scarier. Estimates of states’ unfunded liabilities to pay for retiree benefits range from $750 billion to more than $3 trillion.

It's clear that states like California and Illinois are much closer to financial default than anytime in the recent past.  But allowing states to go bankrupt -- i.e., creating a mechanism which would allow a court to restructure a state's future financial commitments -- is a bad idea with terrible consequences.

Why is bankruptcy necessary?  As Skeel makes clear throughout the article, the main culprits are overpaid public employees:

California—recently dubbed the “Lindsay Lohan of states” in the Wall Street Journal—has a deficit that could reach $25.4 billion next year, and Illinois’s deficit for the 2011 fiscal year may be in the neighborhood of $15 billion. There is little evidence that either state has a recipe for bringing down its runaway expenses, a large portion of which are wages and benefits owed to public employees. . . .

With liquidation off the table, the effectiveness of state bankruptcy would depend a great deal on the state’s willingness to play hardball with its creditors. The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. . . .

California’s most important creditors are its bondholders and its unionized public employees.  . . . 

Are public employees overpaid?  Well, it depends what you mean.  If you mean that they are paid more than the states can afford, given the current tax revenue, the answer seems to be "yes" in many states.  But are they paid more than they negotiated?  No.  Are they paid more than comparable private employees?  The evidence is mixed.   For example, look at this article in the Oregonian about public employee pay:

Yet one fundamental question underlying the debate is whether Oregon's public employees are overpaid. 

The objective answer is generally no. Not yet anyway. 

It's true that on average, state employees make more than private-sector workers. But the average says more about the professional-type jobs dominating the public work force, and the vast number of unskilled, low-paying jobs in the private sector, than it does about state pay practices. 

When the analysis focuses on comparable jobs and education levels, the total compensation of state employees is slightly less than their private-sector counterparts and slightly more than public employees at other levels of government and in neighboring states. That conclusion is consistent whether the data comes from the state's compensation surveys, academic and private-sector analyses, or federal data.

Moreover, look at this graph from the Oregonian:

GS.11FEVR124.jpg

The highest point on the graph -- the 2004 pay and benefits to the average employee -- is $61,301.  That's the highest point on the graph.  Average 2009 salary is $41,200.  The average California public employee salary is $57, 536.  By the way, click on that link and you'll see that the five highest paid public employees are two head coaches (each making over $2 million) and three med school professors.

So yeah, let's allow states to go bankrupt.  The bondholders would likely get killed -- and who knows what the interest rates on state bonds would go up to.  Skeel is sanguine: "The bond market wouldn’t be happy with a California bankruptcy, but it is already beginning to take account of the possibility of a default."  Um -- I think the possibility of bondholders losing money is MUCH greater once Congress allows states to go bankrupt, and I think the bond market would "take account" of that much differently.  Oh -- "And bondholders can’t pull their funding the way a bank’s short-term lenders or derivatives creditors can."  So that's nice -- they're trapped like rats, so what they do about it doesn't really matter.  And state bondholders are usually older folks who need "safer" holdings, but I guess that only means they won't be around so long to complain about it!

What about that other group of creditors?  

As for California’s public employees, there is little reason to suspect they will be running anywhere.

Do I hear a little chuckling after that?

If the public thinks it's overpaying its public employees, there's an easy remedy -- elect representatives who won't pay as much.  Of course, this is when the same folks who defend Citizens United will bemoan the awesome political power of public unions -- like this, perhaps:

During his recent campaign, Governor-elect Jerry Brown promised to take a hard look at California’s out-of-control pension costs. But it is difficult to imagine Brown taking a tough stance with the unions. Even in his reincarnation as a sensible politician who has left his Governor Moonbeam days behind, Brown depends heavily on labor support. He doesn’t seem likely to bring the gravy train to an end, or even to slow it down much.

So the only answer is to cut off federal assistance.  And rather than raising taxes or slashing expenses, the current leadership of states like California and Illinois can take the state into bankruptcy and tell its bondholders and employees to go jump off a pier.

I'll give Skeel one point for consistency -- he was against the AIG and Bear Stearns bailouts; he thought they should have gone bankrupt, too.  But they didn't.  To me, the case for a federal bailout of a state is much stronger than a bailout of a financial institution.  The state isn't going anywhere.  The feds can get their money back in a variety of ways.  And whereas a bankrupt business cannot get more money out of non-existent customers, a state can always raise taxes or even sell off public holdings.  It may not be pretty, but the money is there.

One final note -- a point that shows the absurdity of where we are.  If this federal government bails out AIG so that Goldman can get a $1 for every $1, but then lets states restructure their debts so that a 65-year-old ex-cop get $0.25 on the dollar, there may in fact be rioting in the streets.  And that would be bad for the economy, no?

UPDATE:  Felix Salmon also thinks the bond market would freak out.

Posted by Matt Bodie on December 9, 2010 at 11:56 AM in Corporate, Current Affairs, Tax | Permalink

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Comments

So I guess we differ about how much responsibility the bond market should take for making sure that states are borrowing responsibly. But how about employees and pension funds? I understand forcing concessions as to current and future contracts, but not as to past agreements. Why should they be forced to make concessions as to their negotiated agreements? Have they negotiated irresponsible levels of high compensation? And would they then act more "responsibly" in negotiating contracts in the future? Asking the bond market to take risk into account seems a lot different than asking employees to take "risk" into account when negotiating their salaries and benefits.

Posted by: Matt Bodie | Dec 14, 2010 11:10:45 PM

It is worth observing that while getting judgments against states for defaulting on their obligations is easy, enforcing those judgments against a state government is already essentially impossible, even in the absence of a bankruptcy, without the state's consent.

Posted by: ohwilleke | Dec 14, 2010 3:41:15 PM

Well, I would not want a full payback of bonds, because there should be a signal to bondbuyers that they need to pay attention to the fiscal responsibility of public borrowers. To continue your analogy, I want the credit card rate charged to my college-age daughter (now a freshman) to reflect her own actual credit-worthiness and not the card issuer's bet that I will be guilted into paying off her fiscally irresponsibly incurred debts.

So the bondbuyers need to get a haircut, and the fiscally irresponsible states need to be charged more in bond interest in the future. This will tame their profligate ways and also insulate more responsible borrowers from such interest rate hikes. (E.g., Responsible Indiana should not be charged the same interest rate as profligate California because bondbuyers think that Uncle Sam will bail them both out).

How much of a haircut? A federally supervised bankruptcy proceeding could decide, by (a) raising taxes, (b) forcing pension funds and public employees to make concessions, and (c) re-scheduling bond payments. With luck, such a proceeding could insure that bondbuyers think twice -- or double default premiums -- before lending, which should cure some states with bad track records of riotous living.

Posted by: Rick Hills | Dec 14, 2010 2:06:17 PM

Rick:

I think you and I are closer than your comment suggests. I was not talking about the pros and cons of a bailout versus default, and I was not proposing a bailout. I was talking about bailout versus bankruptcy. Bankruptcy would allow for the continuation of the "irresponsible" and "idiotic" practices you condemn, as some portion of the states' debt (10%? 50%? 90%) would be wiped clean. On the other hand, a bailout could be structured to make sure that the state pays back what it got along with interest -- something along the lines of what Clay Gillette suggested in the comments to your post.

You and I also agree that if there's anything here, it's a liquidity issue. There are cuts to made and taxes to be raised that, if not painless, would not be impossible or even that onerous. The politics of default are interesting here -- what obligations would a state default on? Salaries? Bond payments? New construction? Legal judgments? I am working with a student who is writing a paper about Illinois falling behind on its workers comp judgments. What would a "default" mean in this context? Eventually, everyone would still have to get paid, no? Without bankruptcy, the state could never get rid of its judgments, unless it ceased to exist. That might be an interesting bargain -- if the state forsakes its statehood, the feds will assume the debts. The Federal District of California.

Since you refer to "political infantilism" in the other post, I'll run with that for the following parable. Let's say the state is a minor who owes money to various folks, and the feds are the parents. (And let's put aside the contract enforceability problems for the moment.) The feds could let the kid "default," in which case the child has judgments that will eventually have to be repaid. Or the parents could step in, pay back the debt, and then take the money (with interest) out of the child's allowance. I'd prefer the second scenario, I guess, but I would prefer both to the third Skeel scenario: the parents go to court, have their child declared "bankrupt," and pay back 25% of the debts to the creditors. I don't think that teaches a very good lesson to the child.

Posted by: Matt Bodie | Dec 14, 2010 11:52:02 AM

I am already on record as praising the Democrats of the 1840s for letting nine states default on their bonds after the Panic of 1837, and I will not repeat my argument here. Of course, based on my remarks in the earlier post, it will come as no surprise that I agree with Skeel and disagree with Matt.

But here are two relevant points that Matt ignores.

(1) Contrary to Matt's claim that a federal bailout "would prevent a state from having to raise taxes to a crushing level in the short term," there is little evidence that Californians, Illinoisians, and New Yorkers are now so over-taxed that raising revenue from their own resources would some "crush" their taxpayers. Far from it: Irresponsible tax revolts, idiotic voting rules in state legislatures (witness California's preposterous super-majorities for new taxes), and sheer state politicians' demagoguery, not lack of tax capacity, have led to state "insolvency." Richard Ravitch (among others) has outlined a nice menu of revenue measures that could gradually pull New York out of insolvency . The state legislature simply refuses to take the political risk of requiring state voters to pay for what they have consumed. Matt's proposal for a federal bailout is, therefore, just a proposal to subsidize state politicians' political cowardice and state voters' political infantile belief that they can get something for nothing.

(2) There is a large theoretical and empirical literature out there on the consequences of eroding hard budget constraints at the the subnational level with federal bailouts. (See, e.g., Jonathan Rodden, Hamilton’s Paradox and Erik Wibbels, Federalism and the Market. Such bailouts insure that bondbuyers will rate state bond issues not by the prudence of the issuer but rather the tax capacity of the nation, allowing every state to loot the national fisc every time they borrow money. To avoid giving California et al the capacity to impose this fiscal externality on more prudent states, the feds need bond buyers to at least a bit of a bath.

There is one bailout that I would be prepared to endorse --a federal bankruptcy scheme for states that side-stepped the 11th Amendment and allowed federal judges to impose higher taxes on state politicos who refuse to "bell the cat" by adopting revenue measures that everyone knows are required to save their fisc. If the feds assumed the bondholders' debts and then sued the states directly to recover the debts, the 11th Amendment should not pose an obstacle to suit, and then -- assuming that the federal authorities could resist caving in to the debtor states' blandishments, backed by some hefty packages of electoral votes -- the federal court could supervise a rational settlement that would surely involve a mix of tax increases, benefit cuts for public employees, and bondholder haircuts.

Posted by: Rick Hills | Dec 13, 2010 10:33:00 PM

"state bondholders are usually older folks who need "safer" holdings"

State bonds are tax exempt, and as such provide the highest after tax returns to investors with the highest marginal tax rates. The discount of tax exempt bond returns relative to non-tax exempt bond returns consistently shows discounting comparable to that expected from investors who have the highest possible marginal tax rates. They also typically provide the most tax benefit to in state investors who might otherwise owe state income taxes on them. A gross disproportion of these investors come from people who have the top 1% of annual income who are subject to those top rates.

The holders of these bonds are thus typically top tax bracket in-state investors who want an income investment that is lower risk.

While these bondholders, and indeed all bondholders, are much older than the average person or even the average investor, the tax advantages of state bonds probably causes them to have a younger average investor age than less tax preferenced safe investments such as holders of investment grade corporate bonds and Treasuries.

Posted by: ohwilleke | Dec 13, 2010 6:15:09 PM

A bailout would prevent a state from having to raise taxes to a crushing level in the short term and/or having to sell off valuable state assets and/or having to refuse to pay for organ transplants for its Medicaid patients and/or having to go into default and get sued for failing to make payments to suppliers, employees, etc. Going forward, the state would have to raise taxes and/or cut expenditures, but it could do so over a longer time period and thus avoid some of the short-term liquidity problems they find themselves in. That's what the TARP bailout recipients (including all the major banks) argued -- they just needed the money in the short term. And the feds could get the money back from a state simply by giving the state less money in the future.

Posted by: Matt Bodie | Dec 9, 2010 11:38:31 PM

Ok, if a state wants to elect representatives who won't pay as much, what good will that do? Is there some power or legal doctrine that allows those representatives to abrogate the contracts the state previously entered into? My impression was that the only sacrosanct contracts are with public employees unions.

If a state can always sell of buildings or raise taxes, then what's the need for a bailout? Seems like there's a solution at hand.

Posted by: Thomas | Dec 9, 2010 8:53:14 PM

Yeah, because Goldman had contracts, which are sacrosanct. Oh, wait ...

Posted by: Mark McKenna | Dec 9, 2010 1:00:38 PM

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