The False Hope of State Bankruptcy

Welcome to Politics Bites, where every afternoon at It's A Free Country, we bring you the unmissable quotes from the morning's political conversations on WNYC. Today on The Brian Lehrer Show, Nicole Gelinas, contributing editor at the Manhattan Institute's City Journal and author of After the Fall: Saving Capitalism from Wall Street and Washington, talked about her Congressional testimony on the fiscal woes of state and local governments — and whether bankruptcy should be an option.

In the first year after the end of the federal stimulus package, states across the country are looking for ways to deal with their accumulated debt. On Wednesday, New Jersey’s bond rating was reduced by Standard & Poor's from AA to AA-, which will mean higher interest rates, potentially making it even more difficult for the state to dig out from its debt. 

The Manhattan Institute's Nicole Gelinas testified at a Congressional hearing on Wednesday on whether states should be allowed to declare bankruptcy. Gelinas said permitting this kind of default would have massive and likely negative implications.

Analyst Meredith Whitney, who was one of the first to predict the Citigroup meltdown, predicted recently that there will be dozens of municipal defaults as cities scramble to cover their costs. Gelinas is less concerned and pointed out that bond debt obligations are only four-to-five percent of most city and state budgets.

If [Meredith Whitney] is talking about small-scale municipal defaults... and having more defaults than we usually have because of the recession... that would not be unexpected and it would not be a disaster. If she is talking about fifty defaults —  where it would be ten states and thirty big cities defaulting — I think that would be a different thing and I don’t see that happening.

Municipalities are allowed to declare bankruptcy if their home states allow it, even if the states themselves are not. Some 600 municipalities have declared bankruptcy in the last fifty years. Gelinas said that state bankruptcy would be a much different thing. 

For a small city that got itself into to trouble to go bankrupt is terrible for the people who live there and depend on them, but it is not the end of the world for the financial markets or the economy. It’s a completely different thing from, say, the state of California bankrupting.

A big part of the problem right now with investor confidence in state bonds has to do with the financial industry as a whole, said Gelinas.

There’s just a lack of trust in the financial industry now, so no matter what the merits of the investment... [investors] are not going to listen to their advisors this time, whether or not they should… This is a problem that goes back to how we haven’t fixed the financial industry.

Gelinas said the downgrading of New Jersey is more about future obligations than current ones. 

One thing that’s interesting about the New Jersey downgrade is that Standard & Poor's specifically talked about the state’s pension fund. New Jersey’s pension fund is one of the worst funded in the country… Standard & Poor's is looking out five or six years and saying that if New Jersey doesn’t start to get it together and put money into this pension fund, it’s going to see serious problems down the road.

Gelinas agreed that New Jersey will have to choose at some point between pensions, benefits, and public services. She said while Whitney’s predictions of widespread bankruptcies are premature, those predictions do highlight future problems that states will be forced to face.

These are long term problems and we still have time to solve them. If we wait for a crisis then it will be too late.

The hot button issue now is whether the law should be changed to allow states to declare bankruptcy. Gelinas said there are good reasons for not changing the law. 

State bankruptcy is a solution in search of a relevant problem…How are you going to take pension benefits that are the obligation of one public authority away, so that you can pay bond holders at another public authority? There is no way to put all of this stuff in one pool without ripping up tens of thousands of pre-existing agreements, covenants, laws. It would be Congress changing the rules of the game in the middle of the game, which is not a good idea in almost any circumstance.

A caller from South Brunswick said there has to be some restructuring of what people receive, especially of state workers, but it should be fair and across the board.

Whether we like it or not, something has to happen. We cannot support people as they go into their older age and just continue to pay for their medical coverage.

Another caller from Marine Park pointed out the danger of a default driving investors away.

Why would anybody invest when they could simply switch to something else?

Gelinas agreed that the current benefit structure is unsustainable, but said bankruptcy won’t fix the problems. She said without a change of state law, states will still be held to their current expensive contracts and obligations.

These are questions that markets can’t solve, you’ve got to fix them through the democratic process — which means, unfortunately, people are still stuck pressuring their politicians to do the right thing, but there’s no way around that in a democracy.

Several callers expressed concern that state bankruptcy would be problematic. Gelinas agreed.

The only thing state bankruptcy statute would get you is years and years of litigation. If we’re looking for a silver bullet, this is not it.

Some conservatives have ideological reasons to want state bankruptcy, of course, as it could deal a huge blow to unions and potentially rally the conservative base.  Gelinas noted it is only people like Newt Gingrich and Jeb Bush, who themselves are not in office, who are pulling for states to be allowed to declare bankruptcy. People in current office are not asking for bankruptcy powers.

When you’re in office, you’ve got to look at the details of things before you start talking about them and I think they’ve realized this is not the answer. This is a problem endemic to politics — people without responsibility happy to go off saying things that are not going to work in practice.