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Robert Feinberg: When States Go Broke

By    |   Tuesday, 13 November 2012 02:00 PM

The American Enterprise Institute and the Federalist Society recently held a book forum to discuss a collection of essays titled "When States Go Broke: The Origins, Context and Solutions for the American States in the Fiscal Crisis," co-edited by David Skeel, Jr., the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School, and Peter Conti-Brown, academic fellow at Stanford University’s Rock Center for Corporate Governance.

Skeel has also done provocative work on the erosion of the rule of law and has identified a number of court decisions that represent arbitrary interventions that distort the economy.

As the fiscal plight of states is well-known, Skeel presented his proposal to create a bankruptcy provision for the restructuring and resolution of unsustainable state debts. The ensuing discussion considered the effects such bankruptcies might have on bond markets, pensions of state employees, sovereignty and principles of federalism.

Skeel began his presentation by referring to a brief, fierce debate that took place two years ago on whether it would be a good idea for states to be permitted to file for bankruptcy, which cities and counties already can do, but states cannot, an option Skeel had advocated in a magazine article in The Weekly Standard in 2010 and in an op-ed piece in the Los Angeles Times. He said it was "cool," for one not usually involved in policy matters, to be getting calls from reporters and congressional staffers, and he had hopes of changing the world, but after four or five weeks, "the debate fizzled as quickly as it started."

According to Skeel, the debate was initially framed as a way to "whack" public employee unions, and an op-ed by Newt Gingrich and Jeb Bush supported this view. The Democrats in Congress were immediately alienated, and the bond market started whispering to Majority Whip Rep. Eric Cantor, R-Va., and in January 2011, Cantor issued a statement that this would happen over his dead body. So that was the end of the debate, but Skeel finds that both parties were wrong in their adverse response.

Skeel allowed that his key argument is a counterintuitive one — that in evaluating the proposal for state bankruptcy, the proper analogy is not to corporate bankruptcy but to personal bankruptcy. In the corporate case, the purpose of bankruptcy is to prevent a viable firm from being dismembered, but states have sovereign immunity — they're not subject to liquidation, whereas consumer can get overwhelmed by debt and tend to underestimate the long-term costs of borrowing.

Advantages of state bankruptcy are that it can incentivize settlements outside of bankruptcy, cause creditors to take a more realistic view of the costs of state pensions, provide a mechanism for restructuring state bonds and pensions and enable a more equitable distribution of the sacrifice among creditors. Finally, it provides an alternative to a state defaulting on its debt or being bailed out by the federal government.

Arguments against state bankruptcy are that the bond markets would be spooked, an argument Skeel finds implausible, because it assumes bond markets can't price bonds, that it would unfairly whack unions, that bankruptcy is not a solution to political problems and that the states can muddle through without bankruptcy.

Regarding three recent developments that affect the debate, Skeel challenged the conventional wisdom that real cities don't use Chapter 9 bankruptcy, but he noted that the counties of Birmingham and Jefferson in Alabama, several cities in California and Harrisburg, Penn., have tried to file for bankruptcy, so a "small laboratory" has been created for the study of the potential effects of state bankruptcy. So far, contrary to received wisdom, it has been possible to restructure pensions, as in the case of Central Falls, R.I.

The Supreme Court decision that partially struck down state Medicaid programs contained a discussion of state sovereignty as an issue of individual rights, but Skeel discounts that the decision will ultimately affect state bankruptcy, because there is independent authority for that. Finally, Skeel predicted that the European Union will ultimately go bankrupt, with the principal debt holders being big banks, but he suggested that the holders of state debt are rich individual investors in, for example, California.

Damon Silvers, an associate general counsel for the AFL-CIO and a contributor to the essay collection, said he had a problem with the title, because states can't literally go broke under current law. He noted that there's no legal framework for them to go bankrupt, and, in a deeper sense, the title is a misnomer, because unlike companies, public entities have taxing power. There can be a point at which there's insufficient taxing power, such as in Greece. Arkansas at the end of the Hoover administration was another example.

However, in general, governments are not actually incapable of paying their debts, but "they're incapable of making the decisions necessary to pay their debts," or at least they're asserting that this is the case. Silvers attributed the current financial problems of state governments not to truly unsustainable finances, which he said is not borne out by the numbers, but in Jefferson County the government got into arrangements with bond dealers that were exploitative, and he acknowledged that some entities might have entered into pension agreements "that don't make any sense." He referred to some cities in California where the management of the cities engaged in "some pretty appalling stuff."

He pointed to President Franklin Delano Roosevelt's pump-priming policies as the mechanism for resolving the problems of Arkansas and other states, when "states were truly on an unsustainable path in the spring of 1933."

Countercyclical measures were put in place to head off future depressions, most notably Medicaid and unemployment insurance, which are administered by the states without authority to borrow to fund them, so there was implicit backing by the federal government. But since 1989, the U.S. economy has been marked by "long, slow recoveries from, essentially, financially driven recessions." This is a circumstance that states are not set up to support.

There has also been a structural erosion of state revenues due to the real estate crash. Furthermore, there's no consensus as to the need for the federal government in supporting the states in meeting their obligations.

Silvers argued that bankruptcy is not the answer to the failure to design a fiscal system that can meet these obligations, but states will not be allowed to default, because the federal government tends to step up, and, as Arkansas discovered, along with New York City in the 1970s, the courts will require state and local governments to pay their debts.

In summary, Silvers identified the ultimate challenge as one involving the interaction between pensions and bonds. Bluntly, he observed that, "The labor movement's experience with private-sector bankruptcy in the last 25 years has not reinforced [Skeel's] notion that the bankruptcy system would be a fairer way of allocating these things."

However, he stated that labor is interested in finding a mechanism that can produce "shared sacrifice" where that is needed, for all parties with an interest in the services that support the competitiveness of the United States and the states "to make mutually fair arrangements." He pronounced himself "not at all persuaded that this is something that cannot be done politically."

Therefore, he is "deeply skeptical that we ought to turn this over to a bankruptcy judge" in expectation of a fair outcome. The problem, according to Silver, boils down to one "not of solvency but of politics, the need to 'pay the price of civilization.'"

Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.

Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.

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The American Enterprise Institute and the Federalist Society recently held a book forum to discuss a collection of essays titled "When States Go Broke: The Origins, Context and Solutions for the American States in the Fiscal Crisis.
Tuesday, 13 November 2012 02:00 PM
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