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Bankruptcy Politics and State Bankruptcy

posted by Adam Levitin

I have a new paper out, Bankrupt Politics and the Politics of Bankruptcy, that examines state bankruptcy proposals and then uses them as a jumping-off point for sketching out a political theory of bankruptcy as a "creditor's armistice," an unstable political bargain, rather than an economic bargain ala Jackson & Baird's "creditor's bargain."  

The paper argues that bankruptcy is unlikely to do much good for the states because states' fiscal woes are akin to business model problems, rather than simple overleverage, and bankruptcy cannot fix business models.  States' business model--US fiscal federalism--is an inherently procyclical business model that is exacerbated by a moral hazard problem in state politics. Bankruptcy can no more fix this bad business model than it can make a buggy whip manufacturer (or a brick-and-mortar bookstore or video store) a viable operation.  

The intensely and patently political nature of the issues raised by state bankruptcy show a major set of deficiencies in contractarian theories of bankruptcy law, which have been developed primarily in the business bankruptcy context.  While others (such as our former co-blogger Elizabeth Warren) have criticized the creditors' bargain for failing to account for all of the stakeholders in bankruptcies, I argue that the inclusion or exclusion of various interests in bankruptcy is itself an essential part of a dynamic system of competing rent-seeking interests.

I don't attempt a formal exposition of an alternative political theory of bankruptcy in this paper--that's for another day--instead, I use this paper to lay out the idea and start linking the sovereign debt, subnational debt, business debt, and consumer debt literatures into a "unified theory" (yeah, I'm going to aim big, why not?) of debt restructuring (as in bankruptcy with a small "b").  The abstract is below the break:

The most recent round of state budget crises has resulted in calls to permit states to file for bankruptcy in order to restructure and reduce their financial obligations. This Article argues that these proposals are misguided because states’ financial distress is primarily a political problem created by fiscal federalism – the financial relationship between the federal government and the states – and exacerbated by political agency problems. Accordingly, state bankruptcy proposals need to be evaluated in political, rather than financial terms. 

Bankruptcy can no more remake fiscal federalism than it can fix a firm with an untenable business model. While bankruptcy might provide a tool for mitigating political agency problems, it is more likely to be used to provide judicial cover for partisan agendas. 

Attempts to use bankruptcy to solve political problems invite a reevaluation of the “creditors’ bargain,” the dominant theory of bankruptcy law, which argues that bankruptcy law tries to replicate the bargain that creditors would have made themselves. This Article argues that contractarian approaches to bankruptcy are necessarily incomplete because they do not account for the politics of bankruptcy. 

Instead, this Article sketches out a new theory of bankruptcy law as the dynamic “armistice line” between competing interest groups. Bankruptcy is fundamentally a distributional exercise and the shape of bankruptcy law is an expression of distributional norms and interest group politics rather than an exercise in economic efficiency. A proper theoretical understanding of bankruptcy must therefore commence from a political rather than economic perspective.


Not exactly on the subject of your paper, but I wonder if "state bankruptcy" would even be constitutional. There are plenty of policy reasons why it shouldn't be, primarily that a state bankruptcy would essentially be a plenary act of Congress (via the Article I courts) to arbitrarily trump taxation and expenditure laws of the "sovereign" state.

Conceptually, this is in conflict with both the 10th amendment and, more significantly, the policies of the commerce clause (i.e., cabining federal action to interstate matters to protect state sovereignty). I don't think there is any reason to read the Bankruptcy clause so broadly as to permit something that so glaringly conflicts with other well-established constitutional policies.

After a bit of research, I see that this same argument was raised in response to the initial passage of (what would later become) Chapter 9. Ashton v. Cameron County Water District, 298 U. S. 513. In fact, the argument prevailed there! And Congress went ahead and passed it again, right about when Roosevelt was trying to pack the Court. Interesting.

"The paper argues that bankruptcy is unlikely to do much good for the states because states' fiscal woes are akin to business model problems, rather than simple overleverage, and bankruptcy cannot fix business models."

This is a very interesting point!


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