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Dude, Can You Spare A Trillion?

Part one of a two-part series. Read part two.

What happens when a state is unable to pay its creditors?

The gap between state government spending and revenue has widened for years. The recent deep recession and the halting economic recovery that followed have put an already fragile system under pressure and are making it impossible to ignore long-standing problems.

California has long appeared to be the state in the worst financial shape, but Illinois, New York, and New Jersey are all facing equally daunting fiscal prospects. The possibility that some states will be unable to repay their bonds or meet other financial obligations is no longer remote.

California has already flirted with this situation, offering IOUs to vendors and citizens in lieu of payment last year. While not as bad as a bond default, the move showed just how dire California’s financial position had become. Banks honored the IOUs, staving off larger problems, and the situation eased after the state solved its immediate cash flow problems, but the reprieve was temporary. California still faces ongoing budget deficits and large unfunded liabilities. Banks are not likely to accept IOUs indefinitely if the state faces another, more protracted, cash crunch.

If state governments were companies, the threat of bankruptcy would loom for several of them. However, states are considered sovereign entities. Like countries, they cannot declare bankruptcy, nor can they be sued by angry, unpaid creditors if they don’t pay their debts, according to Slate’s Christopher Beam. Some commentators have speculated about what state bankruptcy might look like by using Chapter 9 of the U.S. Bankruptcy Code as a launching point. That law, however, only covers municipalities. Without a major legislative overhaul, bankruptcy simply isn’t an option for a state government.

However, states can, and do, default. Nine states did so in the 1840s, for example. They eventually paid their creditors back, but so much has changed since then that the example doesn’t serve as much of a bellwether for what a state default today might look like.

Perhaps a better way to approach the issue is to look at countries that have defaulted in recent years. Examples include the Mexican peso crisis in 1994, the financial crisis in Russia in 1998, and Argentina’s economic meltdown in 2002.

While Mexico was able to pay back its loans in full, ahead of schedule, and Russia recovered fairly rapidly, the fallout from Argentina’s default was messy and protracted. According to a Congressional Research Service report by J.F. Hornbeck, it was the largest sovereign default in history.

Hornbeck writes, “When a country defaults, resolving its financing shortfall entails adopting policy changes, obtaining official emergency financial assistance from the International Monetary Fund (IMF), and undertaking debt restructuring.”

In Argentina’s case, the government’s efforts to repay its creditors and the IMF were tempered by the need to address rampant social ills, such as a staggering 50 percent poverty rate. With time and effort, Argentina did repay all its IMF debt. Some original debt holders are still holding out today, however, because they are unwilling to accept a loss of 70 percent on their initial investment. Though the situation has improved, the crisis isn’t over.

This is to say nothing of the crisis’ impact on Argentina’s citizens. From the riots and bloodshed in 2002 to the thousands of “cartoneros” picking through garbage to find something to exchange for food years later, Argentines paid a high price for their government’s default.

Though things aren’t yet as dire for them, Greek citizens are still far from pleased with the consequences of their own country’s debt crisis. Earlier this year, protests and rioting met the announcement of an austerity package including salary cuts, higher taxes on alcohol and cigarettes, and stricter retirement rules. Should Greece end up restructuring the way Argentina did, the citizenry will certainly face even greater losses.

There has been much debate over whether Greece should default and restructure. While some argue that, by bailing out the Greeks, more responsible countries are being penalized for Greece’s irresponsibility, others point out that Greek banks would be likely to collapse if a default occurred. Given the interconnection between Europe’s banking systems, banks in France, Spain or Germany could then fail as a result of the substantial amounts they have lent to Greek institutions or to the Greek government itself. The European Union has ample reason to make sure Greece stays afloat if at all possible.

The parallel between a country at risk of defaulting and a state in the same position isn’t exact, of course. States do not have their own currencies, and investors cannot easily sanction individual states as a means of pressuring them to pay their obligations. However, states like California still face some of the same problems that countries like Argentina and Greece have grappled with. And, much like the EU with regards to Greece, the United States does not want its individual states defaulting, for a variety of reasons.

The federal government can intervene on the state’s behalf in several ways. It can, for one, lend a state the money to meet its obligations. Unlike the states, the federal government can print its own currency, and could theoretically keep doing so until the state’s needs were met. However, this seemingly free money would create inflationary pressure that would affect residents of 49 states besides the one being rescued. Creditors, who would get their money back but would have its buying power reduced, would also be none too pleased.

If the federal government decided not to rescue a state, it might put the state into receivership. In his Slate article, Beam explains that this process could be similar to bankruptcy; an accountant would be assigned to manage state debt under the oversight of a judge. Unlike bankruptcy, though, receivership would not follow a structured set of steps, nor would the accountant have the power to make decisions about the state’s budget. That power would remain with the politicians.

Hypothetically, the legislature could appoint an independent organization to evaluate the state’s budget and make recommendations for the state’s fiscal well-being. It’s unlikely that a state would give such an organization the power to make binding decisions, but the panel would give legislators a political scapegoat against populist backlash, and creating it would demonstrate at least an outward commitment to making difficult changes.

If a state defaults, the adversely-affected creditors will include anyone who holds state bonds, anyone who has a contract with the state, current or retired state employees who are due back wages or pensions, and a host of others. In addition, citizens will face reduced or suspended public services as the government goes through the painful process of restructuring. Such decisions won’t win politicians many happy constituents. Without the state entering receivership, few legislators would likely be willing to enact such measures.

Citizens of California (or any other state facing default) do have an option that Greek and Argentinean citizens don’t. While emigration is costly and difficult, moving between states is not. Facing unemployment, cuts in government programs and extreme budget measures, frustrated Californians can simply pack their bags and move to North Dakota, where unemployment is currently the lowest in the nation.

This outcome would be disastrous for indebted states. With taxpayers fleeing, state revenues would drop, but many expenses would remain constant. States would still house the same number of prisoners, still support the same pensioners. The more of its population left, the more a state would have to cut spending and raise taxes, which might prompt even more residents to depart. Think Detroit.

Unfortunately, we don’t know exactly what a state’s default would do to the lives of its citizens, or to the national economy. But every indication is that the effects cannot be good for anyone. Politicians, citizens and creditors all have reason to look for other solutions. If things do not change quickly, however, it is becoming more and more likely that we’re all going to feel the pain.

In part two of this series, I will discuss how stakeholders can protect themselves from the worst consequences of a state default.

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