Bankruptcy Coming Soon to a State Near You?

Most attention regarding public debt tends to be riveted on the Federal ocean of debt.  However, several states have also gotten themselves into a fiscal morass.  California faces a pension shortfall of half a trillion dollars.  Comparatively speaking, Illinois is in the worst shape of any state in regard to public employee pensions, with a shortfall of 54 billion. Illinois was in the red 13 billion this year and Democrats in the General Assembly want to borrow 4 billion in new debt to make this year’s pension payments.

This cannot go on.  States like California and Illinois have amassed debts that they simply cannot pay under any reasonable forecast of state tax revenue over the next two decades.  Even if spending were slashed to the bone in these states, continuing to operate the state governments and meet the present obliagtions appears to be mathematically impossible.  This leaves two options for the debt of these states.  The first option is a federal bailout.  Although I do relish the image of a bankrupt Federal government bailing out bankrupt state governments, this is simply not going to happen in the current political environment.  The second option is that the states go bankrupt.  Current law allows local governments, cities, counties, towns, etc to go bankrupt but  not states.  The bankruptcy code would have to be amended to allow this, and the only way for this to be done is for Congress to do it.  Mainstream commenters like Michael Barone are beginning to seriously discuss the prospect of states going bankrupt.

I do not see the political will yet to amend the code in Congress, for the President to sign it if such an amendment were to pass, or for states to declare bankruptcy if the option becomes available.  However, I do see it coming eventually.  Already California has found it difficult to sell recent bond issues, and Illinois bonds have been downgraded in credit ratings.  However, assuming states in fiscal holes reach a point where they can no longer borrow, and we may reach that point sooner rather than later, bankruptcy may be the least terrible option.

If Congress were to amend the code to allow states to go bankrupt, quite a few questions would have to be answered:

1.  Federalism challenge-Would a constitutional amendment be necessary to do this?  Without such an amendment does the federal government have the power to allow a state to go bankrupt?  Since bankruptcy is a specifically delegated power in the Constitution to the Congress, my guess is that Congress does have the power, but my guess also is that there would be a fair amount of litigation on the issue.

2.  Voiding debts-Could bankruptcy for a state allow it to void in whole or in part a debt?  Leaving aside state constitutions and their impact on this issue, we have section 10 of Article One of the US Constitution:

Section 10.

No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.

I think any attempt to void a debt by a state through federal bankruptcy would clearly be a law impairing the obligation of contracts.  I think a constitutional amendment would be necessary to get around this and around similar provisions in state constitutions.  The fourteenth amendment is instructive on this point.  The Confederate debt was repudiated by the federal government after the Civil War.  It was thought necessary to include section four in the fourteenth amendment to make certain that the Confederate debt would never be repaid:

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

I am certain that a similar amendment would be necessary to allow states to shed debts in bankruptcy.

3.  State Income-States would be unusual bankruptcy debtors on many points, but especially on the item of debtor income.  States can determine their income to a fair amount by increasing or decreasing taxes.  Would federal bankruptcy judges have the power in a state bankruptcy to order an increase of taxes in order to cut a better deal for creditors?  This issue can be sidestepped by explicitly stating in any amendment of the bankruptcy code that bankruptcy judges would not have such a power.  If they were granted this power, it would be time for another constitutional amendment or two.

4.  Seizure of assets-Bankruptcy courts can normally seize assets of a debtor to satisfy creditors, if the assets exceed in value the exemptions allotted under the code.  An amendment to the code would have to address both the questions of exemptions for states and what assets, if any, could be seized to satisfy creditors if the exemptions are exceeded.

5.  Ranking of creditors-What creditors would rank ahead of other creditors?  Where would public employee unions stand?  What about income tax refunds owed to state taxpayers?  Debts owed as a result of federal entitlements?  Debts owed to the federal government?  Debts given special status under state constitutions?

6.  Who decides-If a state is to enter bankruptcy who would decide to do so?  The governor?  The legislature?  Both?  Presumably the code would indicate who would have the ability to bring the state into bankruptcy.  This of course also raises federalism questions as going into bankruptcy would have a massive impact on state government.  I could imagine a governor deciding to declare bankruptcy, a state legislature refusing to cooperate, and state and federal courts feuding as to who would have jurisdiction to resolve the dispute.

The questions just keep coming.  State bankruptcies may ultimately be a means of resolving the problem of spend thrift states, but the complexities of doing this have not yet been seriously considered, and once they are, the political battle royal across the nation would be a memorable one.