As a kid, I learned that when people don’t meet their financial commitments, creditors could take their things. A music store that the local bank had financed went belly-up, so for more than a year, the bank peddled repossessed clarinets and guitars from its basement. And my mother told me that people who don’t pay their debts find it hard to borrow in the future. But I am not sure Newt Gingrich or Tim Pawlenty really understands all this yet.
The former senator from Georgia and the quasi-presidential candidate from Minnesota have emerged as advocates of new federal legislation making it possible for states and local governments to declare bankruptcy. At first this may seem odd. Facilitating bankruptcy has never ranked high on the GOP agenda.
In this case, however, the attractiveness of a bankruptcy option for governments lies in the belief that it would give state and local officials an enormous weapon against public employees in bargaining over future wage and benefit packages. And, if structured correctly, it might give states the power to shed pension commitments regardless of whether constitutions specifically protect public pensioners.
Public-sector wages and benefits are a legitimate problem at many levels of government, although one that lends itself to much distortion. We had decades of political moral hazard in which elected officials chose to keep current spending low by promising higher benefits in the future. And in many states, public employees’ unions have enormous political power.
Nevertheless, as local tycoon Denny Hecker is finding out, bankruptcy doesn’t always turn out as one wants, especially if you try to game the system.
Start by recognizing fundamental differences between private individuals or businesses on one hand and units of government on the other. At any point, the assets and liabilities of private entities are determinable and one can make fairly good estimates of future potential earnings. This is much more difficult with government.
Moreover, until the introduction of Chapter 11 reorganizations a few decades ago, bankruptcy generally meant winding down a business completely, selling any assets and distributing the money received to sundry creditors in accordance with established law. Governments, however, are by their very nature, “going concerns.”
No one is going to liquidate a state, county or city. Whether or not we enact a specific bankruptcy law for government, the city of St. Paul and the state of Minnesota will be with us for some time. They have assets and they will continue to have income. Creditors can have claims on both.
Enthusiasts who see bankruptcy as a panacea for public fiscal woes might be chagrined if a bankruptcy judge awarded Stillwater prison or Itasca State Park to some group of public retirees. Roads or highways might be equipped with tollbooths and auctioned off for bondholders. Possibilities for seizing assets are myriad.
Furthermore, in privatesector bankruptcies that don’t end in liquidation, judges can require that some fraction of the individual’s or business’ future earnings go to creditors. State and local governments inevitably will have future tax and fee income, and creditors might have solid claims on some portion of that.
The very mention of future tax revenue opens a can of worms. Bankruptcy itself is inherently predicated on some debtor not having income to meet financial obligations. But what would a court do with a unit of government that was unable to meet its obligations simply because its citizens or elected officials did not want to pay higher taxes?
Indeed, this is the core issue for state and local finances right now. Listen to anti-tax demagoguery and one might conclude that rising taxes are forcing parents to pull crusts of bread out of the mouths of their starving infants.
Reality, as usual, is less dramatic. In the 1970s, all state and local government taxes and fees lumped together averaged 11.4 percent of GDP. For the 1980s it was 11.8 percent and in the 1990s 12.7 percent. It remained at that same average, 12.7 percent, from 2000 through 2007, the year for which consolidated data is available. However much politicians may view taxpayers as tapped out, judges may not automatically agree.
The final issue is the broadest. The very act of making bankruptcy easier for state and local government may result in their tearing off their cheap bonding noses to spite their public salary faces.
Such governments have always been able to borrow at very low interest rates because defaults have been rare and formal bankruptcy nearly unknown. Open the bankruptcy gate and potential bond buyers will have to rethink things. The logical result will be higher borrowing costs for every new school and road we build.
Yes, bond-rating agencies still will try to distinguish between the historically responsible and irresponsible. Yes, a federal bankruptcy law for government could be tailored to give maximum preference to bondholders at the expense of current and retired public employees. But making bankruptcy easier will make borrowing more expensive.
Pawlenty earned a law degree and Gingrich is a bright guy with a Ph.D. in history. They should know the role of unintended consequences in history and how often bold but poorly thought-out initiatives rebound on their designers.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.