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Could the Coronavirus Renew Efforts to Allow States to Declare Bankruptcy?


Senate Majority Leader Mitch McConnell (R-Ky.) recently floated the idea of changing bankruptcy laws to allow states to file.

On a right-leaning radio talk show last week, Senate Majority Leader Mitch McConnell (R-Ky.), who has been actively engaged in negotiations on the next phase of the government’s response to the coronavirus, dropped what seemed like a bombshell. “I would certainly be in favor of allowing states to use the bankruptcy route,” he said. “There’s not going to be any desire on the Republican side to bail out state pensions by borrowing money from future generations.”

If we look at not-too-distant history, however, the GOP leader’s statement was not actually that earth-shattering. The idea is one past Republican presidential candidates have supported, and some lawmakers have explored.

But there are potential – serious – pitfalls with the majority leader’s preferred option for states facing fiscal crises in the midst of the coronavirus pandemic. Before exploring those issues, though, it is worth noting that Sen. McConnell has walked back his comments a bit. Yesterday, he said the next federal stimulus bill is likely to include aid to help states and localities weather the COVID-19 storm. Unclear, however, is whether Sen. McConnell and congressional Republicans will support the funding levels that a number of Democratic governors, including from states like New York and California, are requesting.

One possible reason for Sen. McConnell’s shift? Members of his own party erupted after his radio show comments. Rep. Pete King (R-N.Y.) said the majority leader’s initial position was “shameful and indefensible.” Larry Hogan, the Republican governor of Maryland said, “The last thing we need in the middle of an economic crisis is to have states filing bankruptcy all across America and not able to provide services to people who desperately need them.” Gov. Hogan suggested Sen. McConnell probably regrets his radio show statement.

To be sure, it was not only Republicans from Democratic states who were outraged. Sen. Shelley Moore Capito of West Virginia said she did not agree with her Senate leader. She argued there could be a “devastating impact” if states and local governments had to lay off large number of public workers.

But another reason for the slight modification in Sen. McConnell’s language might be the fact that states actually cannot declare bankruptcy—and changing that fact would be very difficult. As The Hill summarized, while local governments can declare bankruptcy if their state agrees, U.S. bankruptcy law simply does not allow the option for states.

Why not?

Well, because the founders didn’t really like the option. Vincent Buccola, assistant professor of legal studies and business ethics at the University of Pennsylvania’s Wharton School, told Politifact, the primary reason for the lack of state bankruptcy provisions is the U.S. Constitution. He said, “Under the Constitution, states are ‘sovereign’ entities, and the federal government has limited power to act on them directly.” Northern Kentucky University law professor Kenneth Katkin went into greater detail. He explained, “[T]he contracts clause of the Constitution prohibits state governments from ‘impairing the obligation of contracts.’ As originally understood and enforced, this clause prohibited state legislatures from passing any laws to relieve either private debt or the state government’s own debt.”

Even if Congress were to change federal law now and allow states to declare bankruptcy—a big lift under normal legislative circumstances, much less when Washington is laser-focused on a global pandemic—the issue would not ultimately be settled by the House and Senate. Katkin told The Hill that a move by federal lawmakers to allow states to file under Chapter 9 would likely spur a case that would likely go all the way to the Supreme Court—and it is “not clear” how Chief Justice John Roberts and the rest of the Court would rule.

There also is this fact: as Richard Grossman, professor and chair of the department of economics at Wesleyan University, told Newsweek, states might have to change their own constitutions even if the Supreme Court upheld a statutory change permitting states to file bankruptcy. That is because most states have clauses in them mandating balanced budgets.

Then, of course, there are political considerations. Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University, told The Hill that allowing state policymakers a way out through Chapter 9 “would save too many governors and state legislators from making hard decisions.” No lawmaker is going to want to appear to be shirking one of their most basic responsibilities—to decide how taxpayer dollars are spent—during a global crisis.

The idea of expanding bankruptcy law to include states is not new. In fact, the idea has been raised a couple of times over that last 10 to 12 years. The U.S. House held one hearing to consider the option during the aftermath of the Great Recession, but, according to Politifact, “the concept drew fire from Wall Street, public-employee unions, and governors from both parties, who worried about the risk of rising interest rates.” (And how many issues can unite these disparate groups?)

It was supported by several prominent Republicans, however.

In an article this past weekend, Atlantic writer David Frum reminded readers, “Back in 2011, Jeb Bush and Newt Gingrich published a jointly bylined op-ed advocating state bankruptcy as a solution for the state of California. The Tea Party Congress elected in 2010 explored the idea of state bankruptcy in House hearings and Senate debates. Newt Gingrich promoted it in his run for the 2012 Republican presidential nomination.” According to a New York Times article in 2011, Sen. John Cornyn (R-Texas) even was exploring the idea with then-Federal Reserve Chair Ben Bernanke.

That history gets at the crux of Majority Leader McConnell’s support for bankruptcy. While fighting COVID-19 has undoubtedly made the fiscal situation worse, several states, including some of the largest and most Democratic, were experiencing financial difficulty long before the coronavirus pandemic hit them.

State pension systems, in particular, have been in dire straits for a long time. In the summer of 2017, Council on State Governments Research Analyst Jennifer Burnett wrote, “States face colossal fiscal pressures, including mounting public pension obligations that now represent a $1 trillion unfunded gap, according to the Pew Center on the States.” The states’ fiscal pressures were growing so profound that they had “led to a national conversation about whether states should be allowed to file for bankruptcy.” (Remember that statement was made eight years after the official end to the Great Recession.) CBS News speculated in 2017 that, if Congress changed bankruptcy laws to allow states to file, Illinois would be at the front of the line. (CBS noted that, on a per-household basis, Illinois’ pension debt burden stood $27,000.)

No matter where the bankruptcy debate goes today, there is another option for states, and it is one that has been used before—although sparingly.

State governments are able to default on their debts. During the depression of 1841, eight states and one territory did so. After the Civil War, many southern states refused to pay their Reconstruction-era debt and, more than 60 years after that, during the Great Depression, Arkansas defaulted on its debt.

In a 2011 article, The Wall Street Journal explored the repercussions of the 1841 defaults. It reported, “When the defaults began in January 1841, investors dumped state bonds, pushing yields above 12 percent in early 1841, and to nearly 30 percent by 1842. The consequences of those defaults would last for decades:” The Journal also notes that, “Among historians, the rule of thumb is that U.S. states would pay interest rates one percentage point higher than Canadian issuers the rest of the 19th century.” And while most of those eight states did pay back their debts, by 2011, “Mississippi hasn't paid back some of those bonds, even after a 100-year English bid to collect.”

Could the same thing happen today?

Yes, but according to the inside-the-Beltway news outlet Axios, “Debt default is not really a viable alternative for states” today. That’s because “Debt service payments don't make up enough of states' budgets to make default worthwhile.” Today these payments are only about five percent of the average state’s budget. Back when Arkansas defaulted, debt service payments were more than half its total budget, Axios said.

With the burden of COVID-19, and growing state pension burdens, the only choices to really help states might be changing U.S. bankruptcy, or a major infusion of federal dollars. It might not be what Sen. McConnell wants, but one of those options has fewer hurdles than the other.

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