Bankruptcy May Be the Only Solution for a State Like Illinois

In the early days of the Republic, Alexander Hamilton and Thomas Jefferson fought over whether the federal government should assume debts incurred by the states during the Revolutionary War. The ghosts of this argument are lingering today over the capitals of several of America’s largest “blue states,” like Illinois and California.

The 1790 assumption argument was won by Treasury Secretary Hamilton, the architect of Wall Street as America’s financial capital. Hamilton pushed for a robust central government, a national bank, and the federal excise taxes necessary to pay the newly-assumed states debts.

Equally important, from Hamilton’s perspective, was the signal the move sent both to America’s embryonic financial class and his European geopolitical rivals: America is an emerging great nation, and it will pay its debts. That’s why you should bank on, and invest in, the U.S. of A.

That he only had to accede that the nation’s political capital would be relocated to shores of the Potomac River now seems a distantly secondary decision made “in the room where it happens.”

What is bankruptcy?

Bankruptcy, of course, is a means for the voluntary discharge of debts. It allows a person, a company, or a municipality to gain relief from creditors and restructure previously-impossible financial repayment obligations. Individual bankruptcies are generally filed under Chapter 7 of the bankruptcy code, which liquidates assets and discharges debts. Companies frequently use Chapter 11 to restructure debt payments and buy themselves more time to figure out the execution of a better business plan.

Since 1937, reorganization-style bankruptcy has also been available to municipalities – including cities, counties and water districts – but not to states. Detroit’s $18 billion bankruptcy in 2013 was the largest ever, exceeding $4 billion by Jefferson County, Alabama, in 2011.

And why are states not able to take advantage of a so-called “fresh start”? Well, federal bankruptcy law doesn’t allow for it. And the U.S. Constitution prohibits state governments from its ability to “impair the obligation of contracts.” As Mark Glennon writes in an article on bankruptcy for Illinois:

Skeptics think putting state finances under control of a federal bankruptcy court would upset the notion that states, unlike municipalities, are “sovereigns.”  They cite the 10th Amendment, which reserves to states powers not granted to the Federal government, and the 11th Amendment, which prohibits lawsuits in Federal courts against a state by citizens of another state. For those interested in the details, see the article linked here by Michael McConnell, a Stanford Law School professor.

The problem with Illinois… and California, and Connecticut and New Jersey

Illinois has total debt above $150 billion, which is set to balloon due to unfunded government employee pension obligations. Their bonds were flirting with a junk credit rating until, on July 6, lawmakers passed the first state budget in three years. It includes massive personal and corporate tax hikes.

All of this will pay the immediate $15 billion in short-term bills and keep its bond rating at an embarrassing BBB- level. But it does nothing to address the structural problems of the pension fund that continues to threaten Illinois with an unprecedented plunge into the fiscal abyss.

Although Illinois is the worst offender, California, Connecticut and New Jersey – all politically “blue” states – also suffer from overly-generous state pension guarantees.

California might have been instructive way out. Over the past 15 years, it’s wrestled with paying its state retirees. Some experts believe that the state has averted through creative funding sources. These address short-term shortfalls, but they don’t fix the underlying problems. They’re averting disaster by merely postponing it.

David Crane, who served as pension advisor to Governor Arnold Schwarzenegger, came up with the idea “Deficit Reduction Bonds” to stave off fiscal collapse. He now admits that his brainchild “didn’t solve anything. They just covered up the problem, with interest to boost.”

Crane is now critical of Governor Jerry Brown’s plan for “pension-obligation bonds,” which, according to the Government Finance Officers’ Association, would dip into the state’s pension funds and invest the money in “higher-yielding asset classes” in order to “achieve a rate of return that is greater than the interest rate owed over the term of the bonds.”

In other words, take the money that they’re supposed to pay pensioners, bet it on investments with a high rate of return, and hope that it’s enough to cover their rear ends. While that’s not quite as bad as taking all the pension money and putting it on a couple of hands of blackjack, but it’s not too far off, either.

Which ‘cure’ is worse: Bankruptcy or a bailout with punitive taxation?

Unfortunately, there’s no easy fix. Raising taxes eventually produces diminishing returns as businesses flee the higher rates, so the only reliable way to get costs under control is to spend less. Yet those kinds of cost-cutting plans inevitable encounter resistance from Democratic-dominated state legislatures and a toxic environment of heavy spending and powerful public-employee unions.

The closest we have gotten to a state – a territory, actually — declaring bankruptcy is the case of Puerto Rico. Last year, a bipartisan majority in Congress passed PROMESA legislation permitting the island territory to file a bankruptcy in all but name.

The federal government kicked in $70 billion in “restructured” funds, appointed a seven-member oversight board (something similar happened in the case of Detroit) to ensure that the federal government’s assumption of debt doesn’t go astray.

Or as Glennon writes:

The key here is that, on the face of Chapter 9, the bankrupt government — basically, the incumbent politicians — have exclusive power to submit the plan of reorganization. But it’s essential, if a bankruptcy is to be successful, that the same politicians and special interests responsible for bankrupting a government not control the bankruptcy, too. Otherwise, that government is doomed forever and a day.

Bankruptcy would burden those best-situated to pay

The very notion of states declaring bankruptcy puts some in the municipal bond community on edge. But the truth is, it’s the least bad of the options on the table.

Illinois’s most recent budget passed only when the Democratic-majority state legislature, consisting of Democrats and a handful of Republicans, overrode a veto by GOP Gov. Bruce Rauner. The legislators were motivated by fear that credit ratings agencies would further drop the state’s bond rating. The truth is even worse. The real budget deficit is two to three times larger than the official one.

So here’s the point worth remembering: Somebody will pay for obligations assumed, just as somebody paid for the states’ Revolutionary War debts when Hamilton had his way with the Treasury Department.

And there are three basic ways the Illinois and other blue-state pension crises can be averted:

First, state politicians slowly and over the course of decades gain fortitude through better fiscal management. This is what red states tend to do. But Illinois and the other states can’t do it all at once – and that’s why it isn’t going to happen.

Second, a future Congress could step in and bail blue states out of their pension obligations, crafting a new federal standard to deal with the matter nationwide. Much to the dismay of progressives – who’ve recently begun to complain about an apparent imbalance of federal outlays in favor of red states – this option isn’t going to happen either.

That leave a third option on the table. Congress could bow to reality that some states may need to declare bankruptcy to get through their crises, just as happened in Puerto Rico. It would also need to create a process and legal framework for its administration.

Creditors and pensioners will suffer from this, yes. But are they any more innocent than future Illinois taxpayers, or than the citizens of other states? In other words, it may be that a state-wide bankruptcy, or the threat of bankruptcy, is the only solution available to clean up a blue-state mess in a place like Springfield, Illinois.

(Photo of New Jersey Gov. Chris Christie and Illinois Gov. Bruce Rauner in September 2014 by Scott Olson/Getty Images; photo of Constantino Brumidi’s 1872 painting of Thomas Jefferson, Alexander Hamilton and George Washington in the U.S. Capitol by the architect of the Capitol.)

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The Jack News brings a fresh pragmatism to our political world. We are committed to freedom, common sense, and choices beyond nationalism and progressivism. We want smaller government and more individual liberty.

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