Why Bankruptcy is Not a Magic Wand for Illinois

TDB's picture

Via The Daily Bell

What if everyone declared bankruptcy, would that solve all financial woes? Or rather, would it be the ultimate debt bubble burst? Bankruptcy is a “solution” that would become disastrous if everyone were to use it. So can it truly be considered a solution at all? It just shifts the financial burden to someone else.

Most people just don’t care though, because usually, it is the big bad credit card companies or debt collectors who seem to be getting screwed. People with mountains of debt are told that they were preyed on by lending companies. Look at this excerpt from an article by a law firm about the myths of bankruptcy.

We are all so programmed all our lives to pay our bills and to think we have to that it’s just hard to believe that…if we file bankruptcy…we may NOT have to.  The law says that you have to pay all your bills all the time, but the law also says: “except if you file bankruptcy”.  If it helps, think of filing bankruptcy as something that works like magic. “Now you owe…POOF!…now, you don’t“.   Why?  Because that’s just how it works.

That’s just how it works. But how does it work when we are not talking about an individual declaring bankruptcy?

Whispers are starting among debt-laden states, and Illinois is starting to talk bankruptcy.

So can they just wave a magic wand and, poof, all their worries go away? No, but they can transfer all their worries onto the lenders.

Chapter 9 bankruptcy protection could be extended to states if Congress took up the issue, although Stanford Law School professor Michael McConnell noted in an article last year that he believed the precedents are iffy for extending the option to states. Nevertheless, Illinois is in a serious financial pickle, which is why radical options such as bankruptcy are being floated as potential solutions.

Ratings agency Moody’s Investor Service earlier this month downgraded Illinois’ general obligation bonds to its lowest investment grade rating, citing the state’s growing pile of unpaid bills and its mounting pension deficit. Illinois, by the way, has the lowest credit rating of any state. Lower ratings mean higher borrowing costs, since lenders view such borrowers as riskier bets.

And indeed Illinois is quite the risky bet for lenders. Lenders may have assumed that since states could not go bankrupt, they would eventually be paid back, with massive interest rates added on. This means the state would either have to substantially cut its spending or raise taxes.

In a state with such robust unions, who arguably helped drive the debt crisis when it comes to unfunded pensions for state employees, it is unlikely that spending could be seriously curtailed. The Illinois Supreme Court overturned a law that would have reduced pensions because it violated the Illinois Constitution which says the state cannot change what they agreed to for retirement benefits.

So that leaves raising taxes. But who is going to pay the sky high tax rates when everyone flees?

Adding to the state’s financial pain is a shrinking tax base. For the last three consecutive years, Illinois has lost residents. Its population is now at its lowest in a decade. Tepid wage growth on top of fewer residents puts a strain on the state’s ability to grow its tax revenue.

Bankruptcy is being sold as a panacea to financial irresponsibility, but what exactly changes when the debt is wiped clean or drastically reduced? The same politicians will be in power. Will they suddenly change their big spending ways?

And what happens to those unfunded pensions? Illinois could have to borrow more of anyone will lend, at an even higher interest rate, in order to pay for them. Or they will continue the cycle of raising taxes and scaring off residents. What happens if the pensions ultimately cannot be paid?

There is nothing magic about bankruptcy. For individuals, it can at least be a wake-up call to be more fiscally responsible. A government, however, cannot change in the same way, because it is a headless conglomerate of interests, lobbies, and citizens all pushing and pulling for their own particular view.

Fiscal responsibility is the only answer for individuals and governments. Under no circumstances should debt be taken on which is unable to be paid back, as is the case in unfunded liabilities.

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WirePoints's picture

What this author doesn't understand is that bankruptcy cuts pensions.

Stormtrooper's picture

Get this straight!  Illinois is a separate and sovereign state!  The federal government is the agent of Illinois and 49 other separate and sovereign states.  Federal bankruptcy law DOES NOT APPLY to sovereign states.  Any attempt to apply it is invalid.  Sovereign states have the power to simply DEFAULT on their debts and walk away (as has been done numerous times before, Ohio included).  They do not report to anyone for a restructuring.  They will pay their dues when they try to issue bonds into the market.  I'm really tired of the can the  states declare bankruptcy BS.  Answer: NO!