Should States be Allowed to Declare Bankruptcy?

Would it Help or Hurt State Finances?

Laying aside the procedural barriers to state bankruptcy, is it a good idea? In his article, Skeel argued that it is, even as he noted how radical it sounds.

“Anyone who proposed even a decade ago that a state should be permitted to file for bankruptcy would have been dismissed as crazy,” wrote Skeel. “But times have changed.”

Some conservative Republicans agree. Giving states the option to declare bankruptcy provides them and their creditors and more orderly process than default, says Vince Haley, vice president of policy at American Solutions, a nonprofit lobbying organization formed by Gingrich to advance his policy goals.

Default “would be a longer, more cumbersome, and far more uncertain situation facing every creditor of the state than would be the case with federal bankruptcy protection,” Haley said in an e-mailed response to questions.

[Resource: Peer-to-Peer Loans: An Option for Consumers with Excellent Credit]

Others say that even discussing the option of states declaring bankruptcy has been enough to give investors the jitters. That was one reason why mutual funds that invest heavily in government bonds saw investors pull $25 billion out of the funds in December an January, according to the report by the Investment Company Institute.

“I think that’s been part of the selling wave you’ve seen from municipal bond funds,” Cohen says.

As fewer investors buy government bonds, and more people come to see bonds as risky, states are forced to offer to pay higher interest rates to lure the investors who remain. Even small rate increases can double the cost of borrowing money over a ten-year period, Spiotto says.

Attacking the Wrong Problem? »