THE BLOG

The Catastrophic Debt Crisis Confronting America's States

02/03/2011 05:26 pm ET | Updated May 25, 2011

The massive structural deficit that has overwhelmed California's legislators is only the most extreme manifestation of a rapidly metastasizing fiscal cancer that is threatening almost all of America's fifty states with financial insolvency. Illinois and New York also are in a fiscal black hole of significant size, however, many small states are in a similar financial jam. The causes are both recent and longstanding; a convergence of the Great Recession that continues to erode state coffers, and the sustained failure to adequately fund pension programs promised to public employees. The growing danger of collective state insolvencies is no longer a secret that can be swept under the rug. Witness the front page headline that appeared only days ago in The New York Times, "State Bankruptcy Option Is Sought."

As reported in the Times, "policymakers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers." And not just the underfunded state pensions. Bankruptcy, not currently a legal option for state government (though a viable and at times utilized option for counties and municipalities) would allow the virtually insolvent states to inflict a haircut on bondholders. Yet, that option, though on the surface an enticing possibility for desperate state governors and legislators, is a double edged sword. Given how dependent state governments are on the bond market to finance their operations, any hint that bankruptcy might be actively explored by policymakers on the federal level could dry up access to credit for state governments, or at the least drive up yields to a level that guarantees an earlier day of disastrous fiscal reckoning for the states.

In an e-mail exuding panicky agitation, Bill Lockyer, who serves as California's Treasurer, stated in response to the New York Times headline story that, "to the folks in Congress cooking this baloney: Don't bother. States didn't ask for it. We don't want it. We don't need it."

However, it appears that a growing number of policymakers and politicians on Capitol Hill believe the states do need it. In part, some of the effort stems from Republicans, including possible 2012 presidential hopeful Newt Gingrich. They believe that creating a legal path to state bankruptcy will punish the labor unions, viewed by the GOP as incorrigibly pro-Democratic. However, there is more to this scenario than party politics.

The fiscal conundrum confronting America's states is so massive, it is virtually insoluble. States have fiscal restrictions that do not face the federal government; a requirement for a balanced budget, combined with restrictions on taxation, as is the case with California, and no state version of the Federal Reserve to print money or buy up state bonds. The situation is so bad, it threatens to unleash a second financial crisis that would derail even the meager economic recovery the Obama administration claims is underway. This leaves open the possibility of the states coming to Washington for a bailout, presenting the ultimate examples of being "too big to fail." However, the states are also too big to bail out, which may be the primary driver of the behind-the-scenes exploration by policymakers for a possible structured bankruptcy by the states

What has failed to materialize thus far in these discussions, however, is an even more daunting fiscal challenge facing the federal government. If in fact a scenario was devised that enabled the most financially challenged states to declare bankruptcy and cleanse their balance sheets of obligations to public workers and investors, how much confidence would the bond market retain in the credit worthiness of the U.S. federal government? What is being discussed behind closed doors now in connection with an unsustainable debt burden of the states may be but an interlude before a full-blown sovereign debt crisis strikes directly at Washington, leading to even more apocalyptic reflections by policymakers.