In the weekend WSJ, New York Lt. Gov. Dick Ravitch talked about our state's fiscal woes. He said that "creating a bankruptcy code for states is one possible solution, though he's not sure it's constitutionally possible."
Ravitch is right not to dwell on bankruptcy as an avenue through which states could restructure their future liabilities. Though the idea has gotten much attention lately, it could be a rabbit hole.
States can't file for federal bankruptcy -- the only kind -- because in the Depression, the Supreme Court ruled that the nation's first bankruptcy law for public-sector entities violated their sovereignty. In response, Congress specifically designed a statute for cities, towns, and other municipalities. The code requires that each state explicitly authorize its municipalities to declare bankruptcy; some states, then, don't allow their municipalities access to the federal code, and some do it on a case-by-case basis.
It's theoretically possible that Congress could design a more robust law for states or that the Court would rule differently today. Even if a state-bankruptcy law passed Constitutional muster, though, each state likely would retain the right to opt in or out of the code, and no federal court could readily force a "bankrupt" state to change its laws or its constitution at the behest of creditors.
To see how such restrictions would be important, consider that New York State, for example, has a law on the books prohibiting the Metropolitan Transportation Authority (MTA) from filing for bankruptcy as a corporate entity. The state could further pass a law prohibiting itself from filing bankruptcy if the federal government made such an option feasible. Then what would happen? At best, years of legal uncertainty.
Plus: What would it mean for a "state" to file bankruptcy? States raise money through all kinds of vehicles, including structured trusts into which tax revenues automatically flow to cover debt costs before filtering into state coffers. If the feds created a bankruptcy code for states, structured-finance bankers and state fiscal advisers would be busy keeping one step ahead of the code.
States -- and their many creditors --shouldn't hope that the deus ex machina of bankruptcy will clear a way through future liabilities soon. Instead, states should do what they already can do: pare back future pension, healthcare, and other commitments through legislation and contract negotiation, and contain spending so that they can spend cash on maintaining infrastructure, rather than borrowing for that purpose.
To be sure, states would benefit from market discipline, something that's missing now, as bondholders figure (probably correctly) that these debtors are too big to fail. Creating an environment of market discipline for sovereign bodies will be hard -- ask Angela Merkel -- but pursuing a distraction won't help in the task.
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