Beach Blanket Bankruptcy would be a great name for a 1960’s-style surf movie about California’s state and local finances. Alas, although Frankie Avalon still is with us, the beauteous Annette has gone the way of fiscal solvency.
Already in recent years, four Golden State cities have declared bankruptcy: Vallejo in 2008, and Stockton, San Bernardino, and Mammoth Lakes in 2012. The last is a small city of 8,300 that lost a lawsuit. The other three cities fell into bankruptcy because of fiscal disasters. Stockton, a gritty industrial and port city of 300,000 east of San Francisco, blew $68 million on the Stockton Arena for hockey, indoor soccer, and arena football. In 2007 Stockton took out $165 million in pension obligation bonds, which is like paying off one credit card with another while hoping you’ll win the lottery. Indeed, one consistent cause of fiscal foolishness for all three was pension problems.
Only the improving economy of 2013-14 precluded bankruptcy by Montebello, Atwater, and, looming like a CGI King Kong in a Hollywood remake, Los Angeles, population 3.9 million. In 2013, right after Detroit declared bankruptcy, a warning for Los Angeles came from Dan Pellissier, president of California Pension Reform. He told HuffPost Live, “I think your city of Los Angeles is probably two to three years away from being in the same position that Detroit is where there is not enough money to pay the bills.”
The next recession will likely tip these municipalities, and many others, into bankruptcy. Bankruptcies on a scale this large would rock the state’s own shaky finances. Despite Gov. Jerry Brown’s recent assurances that “California is back,” it isn’t. His budget proposal for fiscal year 2014-15, which begins on July 1, is “balanced,” spending $106.8 billion in the general fund with a small “rainy day fund” of $1.6 billion. Yet even this proposal acknowledged that the California State Teachers’ Retirement System needs $4.5 billion more per year than he proposed just to stay solvent.
Brown’s proposal called for spending $11 billion to pay down what he dubbed the “wall of debt” of $24.9 billion that the state faces, which includes bond obligations. And his budget document conceded that pension-fund obligations push the debt total to $355 billion.
Actually, the real total of state and municipal debt is $1.1 trillion, according to an analysis by the California Public Policy Center, a conservative think tank. That figure includes, for example, $205 billion for retiree healthcare, a number usually not accounted for.
Given this grim reality, the state itself should declare bankruptcy and sharply reduce these debts. As with Detroit’s bankruptcy, retirees would not lose all of their pensions. For starters, about 40 percent of funding comes from actual investments in stocks and bonds. On top of that, while the state wouldn’t pay the 60-percent remainder, it would pay something, perhaps 30 percentage points. So state pensioners would still get quite a bit.
State bondholders would take a haircut. But that’s exactly what President Obama did to the bondholders of GM and Chrysler during their bankruptcies in 2009, instead favoring the United Auto Workers, a key Obama ally. And in any case, bondholders in other states might see a need to be more prudent.
Currently, the California Constitution, at least on the interpretation favored by most lawyers, mandates that the state pay all its pension and other obligations. But that could be changed, or reinterpreted by the courts.
The biggest obstacle to bankruptcy would be the federal government, which oversees bankruptcy via the U.S. Constitution’s Commerce Clause. It’s easy to see how that works when a corporation fails and has no money. But a state, even one run as poorly as California, still has tremendous resources to pay its bills.
When the topic came up in Illinois in 2013, J. Fred Giertz, an economist who is director of the University of Illinois’s Institute of Government and Public Affairs, told the Champaign-Urbana News Gazette, “It’s not provided in the federal bankruptcy laws. There is a provision for municipalities and any other kind of organization in the state to go bankrupt, but not the state itself.”
When the finances of California and other states looked most dire in 2011, some called for the federal government to bail out the state governments like they bailed out the corporations they dubbed “too big to fail” in 2008. Writing in the Los Angeles Times in January that year, former Gov. Jeb Bush and former House Speaker Newt Gingrich called on Congress to
prepare a fair, orderly, predictable and lawful approach to help struggling state governments address their financial challenges without resorting to wasteful bailouts. This approach begins with a new chapter in the federal Bankruptcy Code that provides for voluntary bankruptcy by states, a proven option already available to all cities and towns across America. . . . A bankruptcy option for the states would look very similar to Chapter 9 municipal bankruptcy, with some necessary modifications.
They said such a law, following municipal bankruptcy law, would be voluntary on the part of the states; allow states in default or in danger of default to reorganize their finances free from their union contractual obligations; allow for restructuring state debts; prevent a bankruptcy judge from ordering tax increases a state doesn’t want; and mandate that a bankruptcy settlement be approved by the state legislature, or by initiative in states that have it, such as California.
As with municipal bankruptcies, not all of the debt would be wiped away. It would be restructured, reducing debts to tolerable amounts.
Response to the proposal was as fast as swiping an EBT card through a scanner. Union-backed liberals unsurprisingly opposed the idea. “Democratic California Treasurer Bill Lockyer called it a ‘phony crisis’ that Republicans have drummed up to roil markets and make life difficult for big-spending states with large debts to finance,” reported the Washington Times.
It’s always heartwarming to see Republican politicians being so sensitive to the interests of their constituents—who are on Wall Street, not Main Street. Reported the Times,
The market reaction to the Gingrich proposal was so sharp that within days other Republican leaders moved to downplay the possibility of any change in bankruptcy law for states. House Majority Leader Eric Cantor, Virginia Republican, said he thinks states already have all the legal tools they need to wrestle down bloated budget deficits and recalcitrant unions.
Maybe a change in federal law actually isn’t needed.
Historically, states have gone bankrupt. In the 1893 book The Repudiation of State Debts, William A. Scott describes the collapse of state finances following the Panic of 1837. He starts by addressing the constitutional issue on two counts. Article I, Section 10, prohibits a state from passing a law “impairing the obligation of contracts.” And Article III, Section 2, grants federal judicial power over
controversies between two or more States; between a State and a citizen of another State; between citizens of different States; between citizens of the same state claiming lands under grants of different states; and between a state, or the citizens thereof, and foreign states, citizens or subjects.
On first glance, he writes, it seems to say that “the first one made it unlawful for a State to repudiate her just debts, and that the second one provided that in case she did thus incriminate herself, she could be brought to justice before the federal courts.” But citing several Supreme Court decisions, Scott concludes that,
If a State owes a debt, her obligation seems to depend entirely upon the laws in existence for the enforcement of contracts against States. If there are no such laws, the contract, though legal, is really worthless if the State sees fit to disregard its provisions.
Scott cites Chief Justice Taney’s opinion in Bronson v. Kinzie (1843):
It is manifest that the obligation of a contract, and the rights of a party under it, may in effect be destroyed by denying a remedy altogether, or may be seriously impaired by burdening the proceedings with new conditions and restrictions, so as to make the remedy hardly worth pursuing. And no one, we presume, would say that there is any substantial difference between a retrospective law declaring a particular contract or class of contracts to be abrogated and void, and one which took away all remedy to enforce them, or encumbered it with conditions that rendered it useless or impracticable to pursue it.
The upshot is that, if a state can’t possibly uphold its part of a contract because it has no money, then it doesn’t have to do so. Of course, if this ever came up again, numerous court cases would settle the matter. The word bankruptcy would likely be avoided, with such euphemisms as insolvency, default, and repudiation used instead.
The matter wouldn’t even go through federal bankruptcy court, but through the regular federal-court system, as, for instance, an attempt by a pension fund to force the state to make payments.
The alternative would be for the federal courts to order the state to pay a particular bill, such as to a pension fund, by whatever means necessary, including raising taxes. But under California’s initiative system, citizens can limit tax increases, as they have under Proposition 13, which passed overwhelmingly in 1978. In this case, even liberals might support this way of talking back to federal dictates.
Or suppose during an economic crash revenues fall by 50 percent, as nearly happened in California during the Great Recession. A federal court orders the state to make paying the pension funds its first priority. The state, 40 percent of whose general fund goes to local schools, disobeys so it can keep the schools open. The president sends the U.S. Marines from Camp Pendleton to Sacramento to force lawmakers to fund pensions instead of schools.
The out-of-school students then start a riot in Los Angeles worse than that of 1992. The president orders the Marines out of Sacramento to restore order in the City of Angels and allows the legislature to restore school funding to get the kids off the streets, while stiffing the pensioners.
Another state bankruptcy occurred more recently—Arkansas in 1933. In the 1920’s the state began an ambitious road-building program and assumed the debts of many local governments. Floods smashed the state, washing out many of the new roads. Then the Great Depression hit in 1929, reaching its depths in 1933. According to a recent New York Times story, “By some historians’ estimates, the state owed half its annual revenue to debt payments, and others say the payments were even higher.”
So the Natural State stopped paying its bonds, and then restructured them. The bankruptcy forced fiscal discipline on the state. And the federal government allowed it to happen.
It should be kept in mind how California state pensioners would be affected by a bankruptcy. The pension funds have vast investments. The California Public Employees’ Retirement System, the country’s largest such fund, currently has a total investment value of $279 billion. And the California State Teachers’ Retirement System—whose actual motto is “How Will You Spend Your Future?”—enjoys a current investment-portfolio value of $181 billion.
Those amounts would be perfectly adequate based on the rules in play before 15 years ago. The problem is that, in 1999 and 2000, state legislators and local governments “spiked” the pensions, based on the assumption that the dot-com boom in stock values would continue forever. It didn’t. The assumption now is that the taxpayers will fund the unreality under which the funds operate.
The pension spiking of 15 years ago is finally kicking in, as Baby Boomers who earned the higher salaries of recent years are retiring. The “$100K Club”—retirees pulling down more than $100,000 per year in pension payments from the state—now includes more than 14,000 members. That number is “up 700 percent in less than a decade,” reported the Orange County Register, when the rate of inflation was just 38 percent.
That’s why the only way to restore balance to the system will be bankruptcy.
Here is a possible scenario: A Greater Recession hits, including another dot-com bust, socking Silicon Valley the way the previous dot-com bust did in the early 2000’s. The state’s finances heavily rely on rich billionaires paying the state’s top 13.3 percent income and capital-gains tax. Billionaires today become Starbucks baristas tomorrow. There’s no income, no gains, and no tax.
The state’s finances tank. Even the California Teachers Association, the most powerful political force in the state, divides between paying current teachers and retired teachers. The legislature passes a tax increase, which is repealed by voters at the next election. With no alternative, the legislature and governor agree to cut payments to bondholders and pension funds by 20 percent. The matter goes through the court system, eventually making it to the U.S. Supreme Court. Citing Bronson, the Court refuses to hear the case.
California effectively goes bankrupt. The governor announces, “It’s not bankruptcy: We’re only delaying the payments until the economy improves.” The schools are funded, albeit at lower levels after teacher layoffs. But the lively young scholars are kept off the streets and busy learning political correctness, Drug Ed, Sex Ed, and Death Ed (all real courses). Funding for the School Police (what they actually call truant officers in Los Angeles) continues.
New York, Illinois, New Jersey, Maryland, and other states with shaky finances follow suit. Their credit ratings take dings, preventing borrowing for a couple of years, which forces them to bring to bear further needed austerities. As actually happened recently in bankrupt San Bernardino, the politicians who oversaw the fiscal foolishness are replaced by those who are more frugal. Even the states that remained solvent become more cautious with debt.
State bankruptcy: It should happen.
It will happen.
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