Let States Go Bankrupt

At 12:01 a.m. on Dec. 11, 2014, Detroit officially exited bankruptcy, thus concluding the largest municipal bust in American history. Bankruptcy allowed the long-suffering city to restructure its pension and bond obligations, thereby heaving off about a third of its $18 billion debt load. The deal—struck among Detroit's creditors, public-sector unions, retirees, and a bevy of private foundations—provided an additional $1.4 billion in municipal spending to upgrade the city's rapidly deteriorating infrastructure. As a result of the successful bankruptcy process, Detroit will "move further along the path toward financial stability and success as a viable and attractive place to live, work, and invest," said Kevyn Orr, Detroit's emergency manager, in a statement last year.

Bankruptcy has long been a crucial option for struggling cities to clear away crushing financial obligations. But federal law doesn't allow states to go bankrupt. Federal bankruptcy law should now be changed to allow for state bankruptcy, says David Skeel, a professor at the University of Pennsylvania Law School. He has become the leading public proponent of the idea, writing widely on the subject (including in The Weekly Standard, where I work) and testifying before Congress.

"If a state's financial distress is truly irresolvable, the only current options are a federal bailout or a massive default," Skeel told me. "Bankruptcy would provide an additional, more orderly alternative." Default would cause chaos; state governments would have to choose willy-nilly which services to fund. Bankruptcy, by contrast, compels stakeholders to come together and work out a legally binding solution, blessed by a judge. Bankruptcy also allows for drastic adjustments—major haircuts for bondholders, for example—that the normal political process cannot, in many cases, legally accomplish.

The idea of allowing state bankruptcy gained traction as the economy reeled from 2009 to 2011, and states from coast to coast faced severe financial problems. In 2011, Jeb Bush and Newt Gingrich cowrote an op-ed in the Los Angeles Times supporting the concept. Prominent conservative activist Grover Norquist also publicly backed the idea. Congressional Republicans began to draft a bill to provide for state bankruptcy, but it stalled in early 2011 after failing to draw support from prominent GOP leaders such as then-House Majority Leader Eric Cantor.

State bankruptcy didn't gain much in the way of public Democratic support either. The imprimatur of Norquist and the like almost certainly made Democrats more hesitant to back the idea. Democrats also worried that state bankruptcy would probably weaken public-sector pay packages, and they hinted at ulterior political motives. "I think it's a way to attack public-sector employees because [Republicans] don't like their politics," then-California state Treasurer Bill Lockyer said in 2011.

Questions were also raised over the constitutionality of state bankruptcy, because states are treated as sovereign entities under the Constitution, and a federal bankruptcy law could be construed as undue interference in state business. In response, Skeel has written, "This concern is easily addressed. So long as a state can't be thrown into bankruptcy against its will, and bankruptcy doesn't usurp state lawmaking powers, bankruptcy-for-states can easily be squared with the Constitution."

As the economy has steadily improved and states have begun collecting more revenue, the issue has receded among Democrats and Republicans alike. But that won't last, according to Skeel. He argues that the current economic uptick will provide only a temporary respite for states facing deep structural deficits. (Some critics on the left, including the Center on Budget and Policy Priorities, disagree with this. The Center argues that states have "adequate tools and means" to meet their financial obligations over the long term.) According to data from State Budget Solutions, a conservative think tank, California carries unfunded pension liabilities of $754 billion, despite favorable economic conditions. Illinois, another state with perennial budget woes, has some $330 billion in pension obligations it won't be able to meet.

"Detroit showed that it's possible to restructure pensions ... without leaving people out on the streets," Skeel told me. Indeed, Detroit retirees in the general system were subject to only a 4.5 percent monthly benefit cut, the elimination of cost-of-living increases, and reduced health care benefits (they will still have access to Medicare). It's little wonder, then, that more than three-quarters of Detroit retirees backed the deal. For the first time in decades, Motown may serve as something very different from its usual role as cautionary tale: It could be a model to emulate.

This article appears in the January 31, 2015 edition of National Journal Magazine as Let States Go Bankrupt.