Go to Top

The Bankrupt State We’re In

Generals always fight the last war, and policymakers always try to prevent the last crisis. Usually these are the wrong strategies.

The failure of the private credit markets has brought the world economy to its knees. Consequently, lawmakers are scrambling to fortify us against similar disasters in the future.

The problem is that the next big crisis may well come from the failure of government, not private, borrowers. The financial fortifications we are building today are not going to help when that economic tsunami hits us from an unexpected direction.

The fiscal paralysis that struck state capitals from Hartford to Sacramento last week is just a taste of what may come. Governors and legislators in at least eight states struggled to close budget gaps that loomed for the fiscal year that began July 1. At least three large states — California, Pennsylvania and Illinois — were unsuccessful, creating the prospect that vendors and workers might be paid with IOUs or might have to borrow money themselves to make ends meet until state governments can make good on their markers.

Virtually every state and local government is legally required to balance its annual budget. They are not allowed to use the federal government’s approach of borrowing to meet chronic deficits.

But in many cases those state and municipal governments circumvent the law. They use asset sales and accounting gimmicks to overstate revenue and bury expenses, especially when times are hard and real belt-tightening is in order. They impose higher taxes to generate short-term revenue without considering the future income that is being sacrificed when residents and enterprises respond by relocating. And, above all, they borrow money for today’s purposes while making staggering unfunded promises that bind future taxpayers.

It is, in short, a recipe for insolvency. Today’s state financial squeeze is primarily a function of the present recession, which has dried up sales and income tax revenues at precisely the same time as it has expanded burdens for social spending. The much bigger crises of the future, which I expect will occur 20 years from now give or take a decade, will be triggered when today’s unfunded obligations come due.

Walter Wriston, then the chairman of Citicorp, famously said in 1982 that a country cannot go bankrupt. His company’s Citibank unit was at the time a major lender to Latin American governments, which soon thereafter defaulted on debts on a massive scale. The U.S. Treasury stepped in to reorganize those debts under the Brady Bond program. This was national bankruptcy by another name.

Similarly today, some commentators maintain that an American state cannot go bankrupt, because states have their own taxing authority under our federal system. True enough, the federal bankruptcy law makes no provision for states to have their finances reorganized in court — but it should. State governments, just like national governments, can default, and I have no doubt that some will.

Massive defaults by state governments and their municipal subdivisions (which can reorganize under Chapter 9 of the bankruptcy code) may imperil other institutions just as defaults by private institutions threatened to knock down other financial dominos last year.

The law presumes that a state will reorganize its own finances through tax increases, spending cuts or settlements with creditors. But the current deadlocks in various state capitals are a warning that we cannot rely on this. In fact, some states may be so tied up in procedural logjams (such as California’s requirement that state budgets pass by a two-thirds majority) that they may literally be incapable of resolving future financial crises. Federal supervision may be the only practical alternative.

Of course, nobody wants to see the federal government become the financial overseer of the states. Fair enough: A state that confines its taxing and borrowing to its own borders probably ought not to fall under federal supervision. But that does not reflect today’s world. Once a state borrows money across state lines, or from institutions whose solvency the federal government regulates, it gives Washington a vested interest in the state’s financial position. Especially when the state fails to honor its obligations.

The best time to prepare a new financial regulatory and reorganization regime for state and local borrowers is right now. We still have enough time before the big obligations come due to make adjustments that will not be as disruptive and wrenching as what is liable to come later.

But, unfortunately, it probably will not happen. Washington is unable to get its own financial house in order at present. It has little appetite for cleaning up the clutter in the states’ attics. We are likely only to see a response during and after the next crisis. In other words, even with states handing out IOUs instead of money, it is still business as usual.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

Related Posts

The views expressed in this post are solely those of the author. We welcome additional perspectives in our comments section as long as they are on topic, civil in tone and signed with the writer's full name. All comments will be reviewed by our moderator prior to publication.

, , ,