During the 2008 financial crisis, the federal government reacted in a frantic, ad hoc fashion, tapping taxpayers for bailouts galore, running roughshod over the rights of bondholders and catching the American people unaware and unprepared. In contrast, we still have time to prepare for the looming crisis threatening to engulf California, Illinois, New York and other state governments.
The new Congress has the opportunity to prepare a fair, orderly, predictable and lawful approach to help struggling state governments address their financial challenges without resorting to wasteful bailouts. This approach begins with a new chapter in the federal Bankruptcy Code that provides for voluntary bankruptcy by states, a proven option already available to all cities and towns across America.
The figures for next year's budgets are staggering. California, which faces a $25.4 billion budget shortfall, will pay $100,000-plus pensions to more than 12,000 state and municipal retirees this year. A Stanford study puts the state's unfunded pension obligations at more than half a trillion dollars. Illinois has a $15 billion budget deficit, prompting its governor and lame-duck legislature to hike its personal income tax rate by 66 percent. New York, where 73 percent of the government work force is unionized, is staring at a $10 billion deficit.
There has been an organized federal bankruptcy process for municipalities since the 1930s, and a handful of cities, towns and counties — most notably California's Orange County in 1994 — have gone through municipal bankruptcy and gotten their fiscal houses back in working order. A bankruptcy option for the states would look very similar to Chapter 9 municipal bankruptcy, with some necessary modifications.
First, as with municipal bankruptcy, it would have to be completely voluntary. Neither the federal government nor state creditors could push an unwilling state into bankruptcy, no matter how catastrophic the state's finances may be, as this would violate the U.S. Constitution's protection for a state's sovereign immunity.
Second, as with municipal bankruptcy, a new bankruptcy law would allow states in default or in danger of default to reorganize their finances free from their union contractual obligations. In such a reorganization, a state could propose to terminate some, all or none of its government employee union contracts and establish new compensation rates, work rules, etc. The new law could also allow states an opportunity to reform their bloated, broken and underfunded pension systems for current and future workers. The lucrative pay and benefits packages that government employee unions have received from obliging politicians over the years are perhaps the most significant hurdles for many states trying to restore fiscal health.
Third, the new law should allow for the restructuring of a state's debt and other contractual obligations. In a voluntary bankruptcy scenario, states, like municipalities, will have every incentive to file a reorganization plan that protects state bondholder claims and their ultimate recovery. States will evaluate their future access to bond markets and their prospective borrowing rates as they formulate the optimal restructuring plan.
When California refused to bail out Orange County, the county entered bankruptcy and emerged within 18 months. Within three years, the county returned to an investment grade rating, and it repaid 100 percent of the principal of the vast majority of its investors by 2000 without raising taxes.
The lesson is that voluntary bankruptcy offers taxpayers the option to restructure state finances responsibly to achieve long-term fiscal health.
Fourth, the federal judge reviewing the state's reorganization plan would have the power only to accept the plan as permissible under the federal bankruptcy law, or reject it as inconsistent with that law. Just as with municipal bankruptcy, this new law for states must explicitly forbid any federal judge from mandating a tax hike or carrying out any other government function.
Fifth, the new law should provide for triggering mechanisms to initiate the bankruptcy process that respect the sovereignty of the people of a state. A state legislature acting by a majority vote, with the approval of the governor, would fit this test. The new federal bankruptcy law should also allow those states that provide for the right of initiative, like California, to put the question to voters whether they support a reorganization of their state government under the U.S. Bankruptcy Code.