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Michael Barone: Bankruptcy Could Be the Answer for California

Bond market is further evidence that a crisis is looming in states with out-of-control spending and public employee unions calling the shots

We won’t be able to say we weren’t warned. Continued huge federal budget deficits will eventually mean huge increases in government borrowing costs, Erskine Bowles, co-chairman of President Barack Obama’s deficit reduction commission, predicted this month. “The markets will come. They will be swift, and they will be severe, and this country will never be the same.”

Michael Barone
Michael Barone

Bowles is talking about what the business media call bond-market vigilantes. People with capital are currently willing to lend money to the federal government, by buying U.S. bonds at low interest rates. That’s because interest rates are generally low and because Treasury bonds are regarded as the safest investment in the world.

But what if they aren’t? What if investors suddenly perceive a higher risk and demand a higher return? That’s what Bowles is talking about, and there are signs it may be starting to happen. The Federal Reserve’s second round of quantitative easing — QE2 — was intended to lower the interest rate on long-term bonds. Instead, the rate has been going up.

The federal government still seems a long way from the disaster Bowles envisions. But some state governments aren’t.

Gov. Arnold Schwarzenegger went to Washington earlier this year to get $7 billion for California, which resorted to paying off vendors with scrip and delaying state income tax refunds. Illinois seems to be in even worse shape. A recent credit rating showed it weaker than Iceland and only slightly stronger than Iraq.

It’s no mystery why these state governments — and those of New Jersey and New York, as well — are in such bad fiscal shape. These are the parts of America where the public employee unions have been calling the shots, insisting on expanded payrolls, ever higher pay, hugely generous fringe benefits and utterly unsustainable pension promises.

The prospect is that the bond market will quit financing California and Illinois long before the federal government. It may already be happening. Earlier this month, California could sell only $6 billion of $10 billion revenue anticipation notes it put on the market.

Individual investors have been selling off state and local municipal bonds this month. Meredith Whitney, the financial expert who first spotted Citigroup’s overexposure to mortgage-backed securities, is now predicting a sell-off in the municipal bond market.

So it’s entirely possible that some state government — California and Illinois, facing $25 billion and $15 billion deficits, are likely suspects — will be going to Washington within the next two years in search of a bailout. The Obama administration may be sympathetic. It’s channeled stimulus money to states and TARP money to General Motors and Chrysler in large part to bail out its labor union allies.

But the new Republican-controlled House of Representatives isn’t likely to share that view, and it’s hard to see how tapped-out state governments can get 60 votes in a 53-47 Democratic-controlled Senate.

How to avoid this scenario? University of Pennsylvania law professor David Skeel, writing in The Weekly Standard, suggests that Congress pass a law allowing states to go bankrupt.

Skeel, a bankruptcy expert, notes that a Depression-era statute allows local governments to go into bankruptcy. Some have done so: Orange County in 1994, Vallejo in 2008. Others — perhaps a dozen small municipalities in Michigan — are headed that way.

A state bankruptcy law wouldn’t let creditors thrust a state into bankruptcy — that would violate state sovereignty. But it would allow a state government going into bankruptcy to force a “cram down,” imposing a haircut on bondholders, and to rewrite its union contracts.

The threat of bankruptcy would put a powerful weapon in the hands of governors and legislatures: They can tell their unions that they have to accept cuts now or face a much more dire fate in bankruptcy court.

It’s not clear that governors such as California’s Jerry Brown, who first authorized public employee unions in the 1970s, or Illinois’ Pat Quinn will be eager to use such a threat against unions, which have been the Democratic Party’s longtime allies and financiers.

But the bond market could force their hand and seems already to be pushing in that direction. And, as Bowles notes, when the markets come, they will be swift and severe.

The policy arguments for a bailout of California or Illinois public employee union members are incredibly weak. If Congress allows state bankruptcies, it might prevent a crisis that is plainly looming.

Michael Barone is a senior writer for U.S. News & World Report and principal coauthor of The Almanac of American Politics. Click here to contact him.

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