Are Republicans Trying to Bankrupt States?

This certainly sounds like the sort of thing that political conspiracy theorists would talk about in dimly lit D.C. bars: are the Republicans secretly planning to force fiscally troubled states to declare bankruptcy? As crazy this might be to imagine, James Pethokoukis at Reuters actually makes the idea sound pretty plausible. The purpose would be twofold: to avoid a bailout of state governments and to stick it to public employee unions.

As proof that this might really be on the minds of Republicans, Pethokoukis notes their staunch refusal to allow the Build America Bonds program to continue as a part of the new tax cut compromise. He says Republicans also intend to make issuing debt more difficult for states in general, by forcing stronger scrutiny of their pension finances before allowing them to issue tax-exempt bonds. And without the ability to easily issue new debt, some states would find themselves in a great deal of trouble.

Obviously the goal of wanting to avoid federal bailouts of states sounds sensible enough. New Hampshire and Georgia shouldn't have to pay for California's overspending, for example. And that's the sort of thing a federal bailout of a state would amount to.

But the other objective is a little bit more subtle. How would public employee unions be affected? Providing states the ability to declare bankruptcy would allow them to renegotiate state employee salaries and benefits. Of course, the renegotiation would more likely take the form of slashing, as some of lavish compensation packages are part of the reason why these states are in such a mess.

Yet could Republicans really make this happen? It's extremely hard to believe that Democrats would allow it. As we saw with the automaker bailouts, they have a very strong allegiance to the unions. It's difficult to imagine President Obama signing a bill that would result in a bloodbath for public employee unions. But then, until recently, it was also pretty hard to imagine him going along with tax cuts for the rich. So if compromise really is his new game, nothing is impossible.

Inaction could be enough for Republicans to accomplish their goal, however. Even without the ability to declare bankruptcy, if they are unable to issue enough debt to cover their costs, then they'll have to slash costs somehow. Democrats and the President will then be left with the choice of higher unemployment if contracts can't be renegotiated or lower wages and fewer benefits for state workers if they can. From a political perspective, each option is ugly, but the latter is arguably less poisonous than the former.

From an economic perspective, this plan is a dangerous one considering the U.S.'s present situation. It essentially boils down to another austerity measure. Republicans would force states to rethink their fiscal recklessness by forcing them into bankruptcy. Like other austerity measures, this one is probably a good idea in a time of economic stability -- but not right now. One thing a cautious recovery doesn't need: states declaring bankruptcy. That will send financial markets into disarray, increase unemployment, and reduce wages. While Republicans are ultimately correct about the necessity of these states to behave more responsibly, now isn't the time to teach them a lesson.

State bond investors should pay close attention to how the politics evolve here. If Pethokoukis is right, and Republicans really are slowly setting the stage for state bankruptcies, then there's a lot of money to be lost by the market as these bonds begin to go bad. It's also worth mentioning that state and municipal debt is often held by many relatively conservative bond funds, as it is often taken to be implicitly guaranteed by the federal government. So losses could hit lots of ordinary investors outside Wall Street.