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Lessons From the Past and the Case for State Bankruptcies

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Lessons From the Past and the Case for State Bankruptcies

May 26, 2020

State and local governments, individually and collectively, are facing their greatest fiscal crisis in over ninety years. Today’s COVID-19 pandemic and consequent “stay-at-home” orders are estimated to have led to a 20 percent decline in national income and a comparable loss in state and local income and sales taxes and fee revenues.

It is the third such crisis in our nation’s history. The first, in 1840,1 was triggered by the financial panic of 1837 and the subsequent decision by the Bank of England to tighten lending to US firms, banks, and governments. With the restrictions on further credit, state investments in local railroads and banks collapsed, and nine states defaulted on their loans. The second was caused by the Great Depression of 1930, which led to a 30 percent decline in national income, and a comparable fall in state and local tax revenues. As a result, 4,000 local governments declared bankruptcy.

Following the 1840 crisis, Congress refused any immediate relief for the nine defaulting states out of fear that such relief would only encourage speculative governmental investments. This had the desired effect and led to the nearly universal (Vermont remains the lone exception) adoption of balanced budget amendments before states could reenter the capital markets. The cost of fiscal discipline, however, was ten years of stagnant economic growth. In contrast, following the fiscal crisis of the early 1930s, Congress responded in 1935 with the passage of two new programs to be administered by state governments – unemployment insurance and aid to needy families – which provided over $2 billion in direct transfers to states. Total assistance equaled 3 percent of annual GDP at the time. Both of these programs were instrumental in restoring the fiscal health of the states and in helping the economy to recover by 1940.

How should we respond today?

Senator McConnell has embraced the 1840 strategy of fiscal discipline, while Speaker Pelosi has advocated for the approach of the 1930s stressing fiscal relief and economic stimulus. Both options have important roles to play as we work our way out of today’s state and local fiscal crisis and move forward to a post-COVID environment.

More money

The 1930s strategy is what is needed now, both to maintain essential services provided by state and local governments and to provide a needed stimulus for economic recovery. To ensure that essential state and local government services can be maintained, revenues lost because of the expected 20 percent decline in national income should be replaced. I anticipate that state and local income and sales taxes will fall in proportion to the decline in GDP, or by $275 billion up to June 30, 2021. The fees collected by state and local governments, most importantly college and university tuition and lottery revenues, are also likely to decline. I estimate that this revenue loss may reach $95 billion, again through June 2021. Together this is a decline in revenue of $370 billion. Revenue losses that would be incurred during a normal 3 percent recessionary decline in income should, however, be covered by the state’s own rainy day funds. To maintain incentives for states to save for such ordinary recessionary events, I would deduct an expected $12 billion contribution to revenues from states’ rainy day funds. This leaves a $358 billion contribution toward lost state and local revenues due only to the COVID-19 pandemic.

Furthermore, required increases in state health care spending and COVID-19 related state unemployment insurance benefits should be covered. This federal assistance should be paid to and administered by the states. The CARES Act has already advanced $150 billion to state and local government for such expenses. We can also anticipate an increase in both the number of eligible Medicaid recipients and expenditures per recipient because of COVID-19. The CARES Act provides for a 6.2 percent increase in the federal government matching rate for such increased state Medicaid spending over the next three months, at an estimated cost of $35 billion. Those added costs will, however, continue into fiscal year 2021. Conservatively, a 10 percent increase in the matching rate from July 1, 2020 to June 30, 2021 may be needed to cover future Medicaid outlays, at an estimated cost of $69 billion. Thus, the total of additional health care expenditures through June 30, 2021 is likely to reach $254 billion, of which $185 billion has already been reimbursed through the CARES Act, leaving $69 billion in COVID-related costs not yet covered.

In addition, state unemployment insurance claims have increased eightfold from a national total of five million eligible unemployed in a typical pre-COVID year to the most recent estimates (as of May 21) of 40 million potential claimants. The CARES Act has provided for significant increased benefits for claimants funded directly by the federal government, but that still leaves states responsible for their own state-legislated benefits, averaging $5,300 per claimant in a typical non-COVID year. States should retain primary responsibility for funding benefits for their expected five million non-COVID annual claimants. The increase in expected state benefits for the new 35 million COVID-related claims, each receiving the average state-funded benefit of $5,300 per claimant, will therefore be $186 billion.

The total COVID-related fiscal burden on state and local governments not yet covered by the CARES Act will thus be $613 billion – $358 billion to replace lost revenues plus $69 billion for anticipated new Medicaid expenditures plus $186 billion for increased state-legislated unemployment benefits. This $613 billion in new fiscal relief should be allocated to those states – and within states, to those local governments – that have suffered proportionally greater losses. Each state’s losses will be proportional to COVID-related increases in unemployment claims and to its expected numbers of COVID-19 cases before the state’s adoption of social distancing and stay-at-home policies.

This proposal for fiscal relief for state and local governments has two important virtues. First, the payments are structured as an efficient insurance policy for the fiscal losses from this national disaster. Losses are covered, but only those directly related to COVID-19's impact on state and local budgets. Losses from typical recessionary events that should be covered by the state’s rainy day fund and by surpluses in the state’s insurance trust fund are deducted from benefits paid in order to encourage future fiscal responsibility. Further, in order to encourage efficient health care spending, coverage for COVID-related health care costs is shared with the states through the use of Medicaid’s matching (or copay) rate of reimbursement. In addition, benefits paid for revenue relief are based on expected COVID cases, not actual cases. This encourages states to continue to adopt prudent policies to limit the spread of the virus. As fiscal insurance, losses are covered by targeted payments with deductibles and copays to promote efficient fiscal behaviors by states going forward. Importantly, this relief is not a bailout allocated as a simple per capita grant to all state and local governments.

Second, to combat the impact of COVID-19 on the national economy, the fiscal relief strategy proposed here makes use of two policies proven to be most effective in stimulating our national economy following the Great Recession of 2009: increased unemployment insurance benefits and increased Medicaid payments. Both policies provide income relief to lower income and out-of-work families. These families are the ones most likely to spend assistance immediately and thus provide the greatest stimulus, or multiplier, for each dollar of federal spending.

To ensure continued provision of essential state and local government services and to stimulate increased economic activity, a version of the 1930s relief strategy is needed now. As was true for the 1930s policy, our targeted relief package of $613 billion is also 3 percent of current GDP.

More discipline 

Once the COVID fiscal crisis is behind us, an 1840s strategy for saying NO to bailouts is also needed. Here I follow the lead of my colleague, Professor David Skeel of the University of Pennsylvania Law School, and recommend a new federal law allowing for state bankruptcies. In the post-COVID environment, at least eight states will be at risk for the consequences of their state-specific fiscal crises. They are the Democratic states of Illinois, Michigan, New Jersey, and Pennsylvania, and the Republican leaning states of Florida, Kansas, Missouri, and Ohio. Kentucky too, Senator McConnell’s home state, is likely to face significant fiscal challenges in the post-COVID world. All of these states share the same pre-COVID burdens of large unfunded pension obligations, low reserves in their rainy day and insurance trust fund accounts, and a reliance for future revenue on cities with large face-to-face service economies. It is for these states that a federally allowed and court-supervised state bankruptcy procedure may be appropriate.

The primary virtue of bankruptcy for states in deep fiscal distress is that it would allow the time and provide a forum for fashioning long-term solutions to their structural fiscal problems. Much as balanced budget rules did after the 1840 crisis, state bankruptcies can help discipline state budgets going forward, for three reasons. First, as part of any negotiated settlement, each of the parties to the bankruptcy – bondholders, current and future state and local employees, and current state residents – will share in meeting the state’s debt obligations. Bondholders will incur capital losses, employees will receive lower wages and/or pensions, and residents will pay higher taxes and/or receive fewer services. All three groups will come to recognize that past deficit financing, which may have felt like “free money” then, has real costs now. Second, the workout itself would remove fiscal uncertainty, which likely had adverse effects on negotiated borrowing rates and made fiscal compromises between residents and between residents and employees more difficult. Gridlock is most easily addressed by borrowing money and paying high interest rates. Third, and perhaps most importantly, bankruptcy can allow for fiscal oversight, either by a court or federally appointed (with state approval) expert panel. Such panels have proven particularly valuable in helping to assure fiscal discipline for New York City, Philadelphia, Detroit, and Puerto Rico after their fiscal crises. Improved fiscal discipline means less need for a nationally funded bailout of a troubled state’s finances, which is the intent of Senator McConnell.

As costly as the current COVID pandemic is in terms of lost lives and jobs, there is some benefit in its raising for analysis the structural weaknesses in how we now finance essential state and local services. Our elected officials have been shortsighted, saving and investing too little for moments like this. We are fortunate that today, low-cost federal debt can finance essential state and local fiscal relief. Relief just needs to be structured efficiently, perhaps along the lines outlined here. Once COVID is behind us, we should then be looking for structural reforms that encourage more forward-looking practices by state and local governments. State bankruptcy constitutes one such reform.

Robert P. Inman is the Richard K. Mellon Professor (Emeritus) and currently Professor of Finance, Economics and Public Policy, Wharton School and the University of Pennsylvania. He is the author (with Daniel Rubinfeld) of the new book, Democratic Federalism: The Economics, Politics, and Law of Federal Governance (Princeton University Press, 2020).

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  • 1. For those interested in the details of the 1840's fiscal crisis, I recommend William English, “Understanding the Costs of Sovereign Default: American State Debt in the 1840's,” American Economic Review, March, 1996; for the 1930's fiscal crisis, John Wallis, “Lessons From the Political Economy of the New Deal,” Oxford Review of Economic Policy, No. 3, 2010; for how to design fiscal insurance for fiscal crises, Democratic Federalism, Chapter 8; and for the case for allowing state bankruptcy, David Skeel, “States of Bankruptcy,” University of Chicago Law Review, No. 2, 2012.

Photo by Tasos Katopodis/Getty Images 

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