ILLINOIS IS A CONSTITUTIONAL CRISIS

A crucial design challenge for a state bankruptcy process would be to avoid making it a politically attractive choice for state governments that, though troubled in the short term, could achieve fiscal sustainability by making reforms. Bankruptcy must be a last resort that is costly to invoke. That is why it typically involves a rather direct loss of sovereignty via the appointment of something like a temporary control or “oversight” board with exclusive authority to negotiate with creditors and make crucial tax and expenditure decisions—as in the case of Washington, D.C. and the legislation recently crafted for Puerto Rico

It is important to understand that the U.S. states are different from provinces or states in many other federations in another closely related respect: The U.S. states are sovereign borrowers. Their fiscal obligations are neither explicitly nor implicitly guaranteed by the federal government.
This independence is rooted in U.S. history—specifically, in a painful episode of defaults by state and territorial governments in the 1840s. After the federal government allowed several states and territories to default in spite of intense pressure from creditors in favor of a federal bailout, voters and creditors learned to treat U.S. states as miniature sovereign borrowers and to assess their credit quality accordingly.

This episode laid the foundation for a long period characterized by effective market discipline among state governments. While the federal government has flirted with various forms of special assistance (for example, extra Medicaid payments or “Build America Bonds”) in the wake of recessions, it has eschewed overt bailouts of troubled states. Requests from states like California for special assistance in managing obligations to pensioners and bondholders have been denied, and states have been forced to make politically painful decisions on their own. Most recently, the federal government denied requests for a bailout of Puerto Rico in the face of default.
It might seem obvious that these two forms of sovereignty go together. That is, we might expect that states or provinces with the sovereign power to tax and spend without interference from higher-level governments are also sovereign borrowers. However, this is often not the case. Voters and creditors might perceive that a central government that is constitutionally prevented from regulating subnational taxation and expenditures nevertheless provides an implicit guarantee of its debt.
Perhaps the most obvious recent example is the European Monetary Union (EMU). Debt that had been issued by sovereign member states was viewed by creditors as carrying an implicit guarantee from the EMU, in spite of its formal no-bailout pledge. Above all, creditors evaluated the European banking system and understood that the EMU—and Germany in particular—would not be able to allow Greece to default, since this would have led to failures of some of the largest German banks. As a result, bond yields converged in the Eurozone, reducing the incentives for weaker member states to start making prudent fiscal decisions.

A similar logic led to bailouts of the Brazilian states by Brasilia in the late 1980s. While Brazil’s constitution made it very difficult for the federal government to intervene in the fiscal decisions of the states, the center was unable to turn a blind eye to imminent defaults by large states because this would have led to the failure of some of the country’s largest banks and a host of additional negative externalities.
In both cases, lower-level governments were sovereign spenders but not sovereign borrowers—and market discipline failed because market actors harbored strong expectations that officials at the higher level would step in to save the day. When these expectations were fulfilled, bailouts became associated with rancorous efforts to limit the sovereignty of the lower-level governments over their taxing and spending decisions. In Brazil, the central government was able to use its leverage over bailouts to extract concessions that permanently weakened the fiscal sovereignty of the states.
The same logic is at work on a smaller scale in many other settings. Creditors and voters are quick to pick up on any clues that higher-level governments might be induced to provide assistance to forestall defaults of lower-level governments. U.S. state governments worry that defaults by municipalities will raise the cost of credit for the entire state. For example, Pennsylvania has been creative in coming up with ways to funnel additional resources to Harrisburg in order to prevent it from pursuing debt restructuring. In such situations, creditors face weaker incentives to distinguish between the credit quality of different municipalities in a state, which in turn weakens the municipal officials’ will to pursue prudent fiscal policies in order to preserve their towns’ or cities’ creditworthiness.

I find myself increasingly thinking this has been done on purpose to shift the narrative and cause more manageable chaos.

While Washington has resisted calls for bailouts throughout the Great Recession, and has reaffirmed the federal government’s non-intervention commitment once again in the case of Puerto Rico, it is not difficult to imagine a scenario in which a severe fiscal crisis in one or several large states ends with disorderly defaults that generate externalities for bond markets in other states, or where the pensions of retirees, or perhaps even current wages, go unpaid. In such scenarios, the lobbying of a bailout coalition might be too strong for the federal government to resist.
As in the cases of the European Monetary Union and Brazil, the chaos and panic of disorderly default can make a bailout suddenly seem like the only plausible way forward. A disorderly default culminating in a bailout would permanently alter federalism in the United States by sending the message to voters, creditors, and state governments that states are no longer sovereign borrowers.
Furthermore, a bailout would likely engender a challenge to the sovereignty of the states over taxing and spending. Presumably, federally funded debt relief would come at the cost of some rather onerous form of federal supervision. In that case, the Supreme Court would end up assessing the constitutionality not of a bankruptcy law, but of federal receivership.

Such scenarios are not fanciful. Illinois’ debt burden and unfunded pension obligations appear to have placed that state on an unsustainable fiscal path. Should Springfield be allowed to declare bankruptcy in the future?
On the one hand, market-based fiscal discipline has survived for almost two centuries without a formal set of rules to structure state-level defaults. On the other hand, the threat of a disorderly default culminating in bailouts is arguably greater than in the past due to the buildup of unfunded pension obligations over the last several decades.
As Springfield’s fiscal situation grows more insoluble, the current federal policy is to look away and insist that neither bailouts nor defaults are possible. This was the policy of the European Monetary Union vis-à-vis Greece even as it became clear that Greece was on an unsustainable fiscal path. Although this stance has a shade more credibility in the United States, carrying on with the status quo (to admit the obvious) carries considerable risks.
In retrospect, the European Monetary Union might have been better off if it had specified an orderly default process from the beginning. The current question in the United States is whether the time is right to clarify a set of uniform rules for orderly defaults before the moment of truth arrives. If a U.S. state defaults, courts will in any event be deeply involved, and in ways that are likely to chip away at state sovereignty. The question is whether it would be better to lay out some ex ante rules that centralize and rationalize this involvement.

>>132124997
thanks for the read. do you have any predictions on what will likely happen?