Veronique de Rugy, of Mercatus, has an article in Reason magazine dismissing the idea that states should be allowed to go bankrupt. She states:
Bankruptcy may sound like a silver bullet that could solve budget woes, dismantle cronyism, fix pensions, and forestall a federal bailout. But it contains plenty of potentially counterproductive consequences. Restoring the states’ fiscal health requires fundamental changes to the way they do business. Until that happens, their balance sheets will be bleeding red ink, whether they are officially bankrupt or not.
More specifically, her concern is:
In many states, bankruptcy will be an option only if powerful unions and other entrenched interest groups see it as a way to force budget problems onto the state’s bondholders rather than public employees.
The problem I have with her argument is that bondholders would not let them get away with leaving them holding the bag. Even without new issues of bonds, states are always in a state of roll-overs–issuing new bonds to pay off the old ones. Any hint of default would send the price of issuing new bonds into the stratosphere. This would then have an immediate impact on the budget either because the state would have to fund the roll-over out of tax revenue (pay-off the bond) or pay higher interest payments on the new bonds.
As such, bondholders do have an immediate way to punish a state that looks to default on their bonds. The negative budget impact would likely result in tax increases since nearly every state has a balanced budget requirement. That, in turn, may stoke voter backlash. The bondholders can wait until maturity to be made whole . . . politicians don’t have that luxury.
I still can’t help but think that having the bankruptcy law on the table would change incentives in a positive direction by shaking bondholders out of their lethargy. I agree that it isn’t a silver bullet that will work in all states, but bankruptcy may help save a few of those on the margin. Those states that may fulfill Veronique’s prophecy may already be too far along to save anyway.