Why the US shouldn’t let states go bankrupt

No, states shouldn’t go bankrupt. Yes, they have to deal with their budgets — and need federal help to do so.

Senate Majority Leader Mitch McConnell’s suggestion that maybe states and cities should just go bankrupt amid the coronavirus-induced economic crisis they’re facing has not been particularly well-received. A big part of the issue: As the law stands right now, states can’t declare bankruptcy.

But the controversy points to a broader problem states across the country are facing — their costs have skyrocketed and their revenue has plummeted, and unlike the federal government, they can’t run a deficit. They’ve got to balance their budgets so that they take in what they put out. And right now, a lot of states are sounding the alarm that they’re going to need to make deep spending cuts unless the federal government steps in.

New Hampshire Gov. Chris Sununu, for example, warned his state could need to make $500 million in cuts next year. Missouri Gov. Mike Parson estimated he’ll have to cut $700 million and has already put a pause in $227 million in state funding. Los Angeles Mayor Eric Garcetti has said he plans to furlough thousands of city workers.

The problem — at least with most states and cities — isn’t that they’ve managed their finances particularly poorly. It’s that they’re in the midst of an unprecedented crisis.

“States have balanced budget rules to keep them from doing things that are fiscally imprudent. In practice, when we’ve hit recessions that’s led to difficulty,” explained Kim Rueben, director of the state and local finance initiative at the Urban Institute. States are able to raise more tax money when the economy is doing well, not when it’s doing poorly, even though that’s often the time when it needs money for things like unemployment and health care most. Many states have rainy day funds to cover downturns — the 50-state total recently hit $75 billion.

“Not all of the states were good, but on average, they had actually put money away to try and handle what is your normal economic cycle,” Rueben said. “What we are entering into right now is not normal in any way, shape, or form.”

No, it’s not a good idea for states to declare bankruptcy

States and cities are coming under an enormous amount of financial pressure amid the coronavirus crisis, and while the federal government has provided some relief, many leaders and lawmakers are calling for it to do more in follow-up legislation after the $2.2 trillion stimulus package signed into law in late March. And last week, McConnell offered an alternative to support: Perhaps states should just declare bankruptcy.

“I would certainly be in favor of allowing states to use the bankruptcy route. It saves some cities. And there’s no good reason for it not to be available,” he said in an interview with conservative radio host Hugh Hewitt. “My guess is their first choice would be for the federal government to borrow money from future generations to send it down to them now so they don’t have to do that. That’s not something I’m going to be in favor of.”

The reaction to his comments was swift. New York Gov. Andrew Cuomo called McConnell’s remarks one of the “saddest, really dumb comments of all time” and emphasized the dark message this would send to the markets and to the world about the state of the American economy. “You want to send a signal to the markets that this nation is in real trouble? You want to send an international message the economy is in trouble? Do that,” he said.

But under federal law, states can’t declare bankruptcy. So McConnell would have to change the law. Municipalities have been allowed to declare bankruptcy since 1937, but the only option for states is just to not pay their debts. Jim Saska at Roll Call explained:

In casual conversation, “bankrupt” and “broke” may be interchangeable terms. But bankruptcy is a legal process in which a person, company or municipality reorganizes its debts. It happens when an entity is insolvent — when there isn’t enough money to pay everyone what they’re owed. Companies also have the added option of shutting down and selling assets to pay off as much of the debt as possible.

One reason for bankruptcy to be unavailable to states is that they have the ability to raise taxes, and thus get the money to pay their debts. State bankruptcy thus risks being used for political purposes.

States defaulting on their debts is rare — the last time it happened was Arkansas in 1933 during the Great Depression.

McConnell has suggested that federal money to the states right now would be used to “bail out state pensions.” And while pension funds are indeed a chronic challenge in some states, that’s not what’s going on right now. What’s happening right now is we’re in a pandemic.

“Trying to blame the current need for federal assistance on things like public pensions seems dishonest to me and is sort of laying the blame of where are right now at the feet of the wrong culprit. There are long-term issues that states are going to have to deal with, but now is not necessarily the time to do it,” Rueben said. “We need to put out the fire before we rebuild the house.”

To be sure, McConnell’s suggestion that states go bankrupt could be more of a political play than an actual policy proposal. The Kentucky Republican has begun to talk about wanting to avoid a “blue state bailout” and cast this as a Democratic state issue. As Vox’s Dylan Matthew notes, he has also seemingly rediscovered he’s worried about the deficit. And it’s not just McConnell who is using city and state aid as a bargaining chip — President Donald Trump wants to use it as leverage to get cities and states to change their immigration policies.

But balanced budget amendments are a thing

While the state bankruptcy conversation isn’t great, a conversation about what balanced budgets require could be helpful.

To back up a bit, the first state to put in place a balanced budget amendment in its constitution was Rhode Island in 1842, and other states followed. As of 2015, 46 states plus Washington, DC, have some sort of balanced budget requirement, which basically means they can only spend as much revenue as they’re bringing in. How stringent these requirements are varies by state; some experts say the only state that doesn’t have to balance its budget is Vermont, as Matthews explained:

Virginia doesn’t require the legislature or governor to pass or sign a balanced budget, for example, but bans deficit carryover, which de facto requires a balanced budget. Arizona and Indiana ban taking out debt altogether, also de facto requiring a balanced budget. Colorado and Nebraska also ban taking out debt, and at least 12 other states require voter approval of new debt, greatly limiting legislatures’ ability to borrow.

Urban Institute/Kim Rueben and Megan Randall

The concept at the core of balanced budget amendments is generally a sound one — you don’t want to be dealing with 50 states in varying levels of financial distress and health. But they become an issue in times of crisis.

“In order to effectively manage our finances, we need both to have our expenditures lining up with our revenues, as a country, but we also need to have the ability to spend more than we’re taking in a year because there are certain times when … if you don’t deal with the immediate crisis, a recession is going to get worse,” said Michael Leachman, director of state fiscal research at the left-leaning Center on Budget and Policy Priorities (CBPP).

He added, “We need the fed government to be able to have the capacity to do that. But at the state level, we don’t need states to also have that capacity, and having states be required to have balanced budgets, it assures that their finances are in order.”

States can’t print money, but the federal government can.

The option states are left with is that they have two choices: They can cut their spending, or they can increase revenue, or do some combination of those things. The problem right now is that the ways states usually generate revenue — sales and income taxes — have fallen off of a cliff, and spending on responding to the crisis — health care and unemployment — has skyrocketed.

And so states wind up making cuts where they can: They lay off and furlough public employees, meaning teachers, police officers, and fire fighters, they make cuts to K-12 and higher education, and they scale back infrastructure spending, among other mechanisms. That creates an even bigger drag on the economy, making the downturn worse and the recovery slower.

“It’s the worst possible time for that to be happening, to have another round of layoffs. It’s just going to make the recession worse, and that’s why it’s so crucial for the federal government to step in,” Leachman said.

States do have some budgeting maneuvers to try to push different expenses into different fiscal years (most state budgets run on fiscal years from July 1 to June 30), explained Josh Goodman, state economic development officer at Pew Charitable Trusts. So, for example, a payment to a school district slated for late June can be made in the first week of July.

“There are things like that that states can do — that budget is still balanced on paper,” Goodman said. “In thinking about balanced budget requirements, it’s important to acknowledge that they have a very real impact on how states make budget decisions, especially compared to the federal government, but they aren’t these iron-clad limitations, at least in most states.”

This is why the federal government needs to do more

States and cities, whether they are blue or red, translate to businesses and to people. And state and local governments can only do so much to keep their finances in check right now. The more cuts they make, the worse the economic downturn becomes, the harder the recovery, whenever it gets here, is as well. California and Alabama, New York and Iowa, they’re all America.

As I recently explained, Congress and the Federal Reserve has provided some assistance, but it is going to need to do more if it doesn’t want to make the United States economy — and many people’s lives — worse:

The $2.2 trillion CARES Act provides $150 billion to state, tribal, and local governments. The package also includes $30 billion for education, $25 billion for mass transit systems, $5 billion for community development block grants, $3.5 billion for child care, and $400 million for elections. And it has the Paycheck Protection Program, the $349 billion loan program to small businesses meant to support them and keep their workers employed. The Families First Coronavirus Response Act, which was signed into law in March, temporarily increases federal funding for Medicaid.

The United States has a system where many of the country’s priorities are handled at the state and local level — our local school systems, colleges and universities, infrastructure, prisons and jails, our health care systems. The federal government is supposed to work in partnership with states and cities, it’s by design, the idea being that they’re closer to the ground on understanding the needs and wants of their citizens.

“You want the financing of them to be solid,” Leachman said. “It’s in the national interest to make sure that that happens, and it’s another reason why it should be a no-brainer for the federal government to provide the fiscal relief that states and localities need right now.”

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