Think States Like Illinois Can’t Default? Think Again.

by Natalia Castro: Illinois is breaking national records, but perhaps not for the best reasons; Illinois is the only state to have operated without a complete and balanced budget for over 700 days. For nearly two years, Illinois has been in fiscal freefall, and now the state is finally crashing. As potential bankruptcy looms in Illinois’ future, states across the nation must ensure their debt is secure, because as history makes clear, not even states are safe from default.

Illinois leads the nation in state budget shortfalls, pension funding crises, and unpaid bills to public universities, schools, social services agencies and government vendors; causing the state to sit on a backlog of unpaid bills totaling $14.7 billion, according to Eric Pianin of Business Insider.

However, as Pianin asserts, “Unlike city and county governments, states cannot legally declare bankruptcy as a means of shedding debt by forcing creditors, bondholders, and government retirees to absorb some of the loss.”

But this is only partially true, and herein lies the root of the states’ problem.

While a state might not be able to declare bankruptcy, it is still eminently possible for a state to default. Throughout U.S. history, this has been clear.

In one of the first major compromises of Congress after the ratification of the Constitution and the first round of elections was the Funding Act of 1790, in which the federal government authorized the assumption of $18.5 million in state debts to cover expenses from the Revolutionary War and the Articles of Confederation. In an effort to prevent state default — which was eminently possible — and reinforce national unity, the federal government increased the national debt by nearly 30 percent.

Conversely, with the passage of the 14th Amendment Congress reinforced the legitimacy of federal debt, and refused to take on the debt of the Confederate states. This forced them to restructure their debt payments and undergo a “selective default,” paying back cotton bonds to England but defaulting on many other junk bonds. If Confederate states were going to reintegrate into the Union, a default and economic reorganization was necessary.

In modern history, the best — and only — example of state default is Arkansas. In 1933, that state in the midst of the Great Depression as thrown into default. For years, Arkansas’s government made promises to build highways and collected bonds that the state found itself unable to pay off.

A March 2016 working paper by O. Emre Ergungor for Federal Reserve Bank of Cleveland explains, on March 1, 1933, with over $155 million in debt Arkansas stopped payments on all of its highway bonds. In order to resolve the issue and prevent a full bankruptcy, Arkansas’ bond holders filed suit against the state.

Arkansas was forced to prioritize their debt, ultimately, by a deal between bond holders and the state, which took the form of Act 11 of 1934. The Cleveland Fed analysis finds that in the deal, “state bondholders — the senior secured creditors — lost the least amount of money. They received a portion of their coupons in cash in the first five years, and for the difference, they received new coupon-paying bonds. District bondholders — the junior secured creditors — lost a sizeable chunk. They exchanged their bonds for state bonds of the same face value but with much lower coupons… Unsecured creditors lost the most.”

While state bankruptcy might not be written in the constitution, state default is written clearly in our history. The point is they are possible, even if there is nothing in the United States Code providing for a federal bankruptcy judge to hear the case.

Which runs contrary to conventional wisdom, which is that states cannot go bankrupt, often citing federal law that allows cities and other municipalities file for bankruptcy, but not states. For that reason, states generally get lower interest rates for their bond issues, since they are thought to be guaranteed payment. But filing for bankruptcy and default are not the same thing.

Opponents also tend to cite Article I, Section 10 of the Constitution stating, “No State shall…pass any…law impairing the obligation of contracts…” Yet, as Arkansas discovered, one need not pass a new law to wind up in a funding crisis, although one may be necessary to exit it.

Today, Arkansas’ experience may be helpful to understanding the present dilemmas facing Illinois, which has $101 billion in unfunded pension liabilities, a series of unsustainable lies told to state workers that they will have money after retirement — when the defined benefit pension plans adopted by the legislature have become insolvent.

Only 14 states have 100 percent funding for their pension plans, leaving 36 at risk for potential default. Illinois is just the first state sliding toward default on their unfunded promises.

The assumption that states’ debt would ultimately be assumed by the federal government if states prove unable to pay keeps interests rates low, because states are seen as risk free, but this is far from the case.

In the end, if default results in the needed reforms at the state level that federal assumption of state debts would disincentivize, then U.S. taxpayers might be better off letting states pay for their mistakes.

If Illinois is pushed into default, they will be forced to resolve their budget problems the same way Arkansas did, through debt restructuring to pay bond holders; in Arkansas, this meant some creditors received no compensations and were forced to push costs to state and local business.

Illinois and states across the country need to get their debt under control before they have no choice. In U.S. history, the potential of default has caused economic distress in states since the Revolution — in Arkansas’ case it took decades for the stigma to wear off — and now states must learn their lesson before they all look like Illinois.
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Natalia Castro is a contributing editor at Americans for Limited Government.
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ARRA Editor's note for retired Illinois university professors, administrators and others who are presently drawing pensions under the State Universities Retirement System (SURS) system. Per a SURS retirement counselor, the current Illinois negative fiscal situation does not affect individuals drawing of retirements via the SURS pension funds.  SURS retirements are fully funded to meet retirements for at least the next 10 years per a conversation with a SURS retirement counselor. The impact on other retired or retiring Illionis state employees was not determined. For years Illinois was exempted from the the National Social Security System and Illinois state retirements were paid in leu of Social Security to retiring indiviuduals.

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