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Finance | The Nation

Bankruptcy for States Raises
the Issue of Moral Hazard

By Lynndee Kemmet

The news is out that federal policymakers have been considering options that would allow states to declare some form of bankruptcy. It should perhaps come as no surprise that such discussions are taking place considering the dire financial situation facing many states, and their local governments as well.

The possibility of state bankruptcy raises an issue often discussed in economics and financial markets but rarely discussed in reference to public finance — moral hazard.

There is some validity in the argument that states are so messed up they’ll never be able to pull up before crashing. What is wrong with state and local governments isn’t just the economy. Both states and local governments have long had serious structural problems but the boom years prior to the recent Great Recession masked those structural defects. The recession did not cause the state and local fiscal crisis. It merely brought to the open a problem already there.

But state and local governments have seemed powerless to address their fiscal mess. Whether this is simply due to a lack of will, a lack of knowledge on how to address the problem or an inability to act because of political roadblocks from citizens, business interests or public unions is hard to say. I suspect it’s a bit of all three. A benefit of bankruptcy is that it allows one to hand over the problem to a higher level of government, that is perhaps Congress, or to a court, with the authority to do what elected officials have not been able to do. In other words, bankruptcy could allow public officials to hand over responsibility for fixing their fiscal mess.

When applied to the world of finance, moral hazard is used to imply that when risks are subsidized, people will take more risk. For example, if banks know the federal government thinks they are too big to fail and will step in to save them, then those banks will take risks they wouldn’t if they had no government safety net. In other words, they can take the risk of making bad loans figuring if all those loans go south and they face a financial crisis the government won’t let them fail.

While there is still much debate over whether or not moral hazard really exists and influences risk-taking, I would argue that the possibility cannot be dismissed. And this brings us back to state and local governments. There are only three ways these governments can address their unbalanced budgets — reduce expenditures, raise more revenue or do both. Raising more revenue in this economy will be tough and few taxpayers, already overburdened with their own financial problems, will allow dramatic tax increase, although they might have to accept that some increases are necessary.

What really needs to happen is a serious restructuring of financial obligations and this means hard discussions with constituents — citizens, business interests, public employee unions and any other creditors — about what programs, services and obligations must be dramatically reduced or go out the door completely. If states and local governments haven’t got the wherewithal to do this on their own, then maybe bankruptcy is the only answer. Maybe a court can make and enforce the hard decisions that governments can’t seem to make.

The word of warning, however, is that bankruptcy must not become the moral hazard problem in public finance. Bankruptcy cannot become the safety net for state and local governments when they make bad financial decisions. Public officials, citizens, public employee unions, the business and investor communities have all contributed to the public financial mess by placing huge demands on the resources of state and local governments. That said, all should share in the pain of those decisions. On the plus side, pain broadly spread is far less severe on any one individual or group.

Lynndee Kemmet is a visiting research fellow at the American Institute for Economic Research and author of “Follow the Money: A Citizens Guide to Local Government.”