Legal Commentary

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.

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:

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.