When a former adviser to President Bill Clinton was asked what he wanted to be re-incarnated as, he answered, “The bond market. Everybody’s scared of the bond market.” If he was right, then the current discussion regarding the federal government enacting a law making it possible for a state to file for bankruptcy should be over before it really gets started.

Even a hint that Congress is considering a state bankruptcy law could send the bond market into a tailspin. Bond rates would rise forcing states to pay even more of their dwindling budgets for debt service and reducing even further the level of government services they provide to taxpayers. The threat that states could default on their debt, most of which is backed to the hilt with promises of repayment, sends shivers up the spines of bondholders.

New Jersey Governor Chris Christie noted in a speech that health care costs were on a path to “bankrupt” the state. A New Jersey municipal bond offering was pulled within minutes. The bond sellers were not happy, but a governor saying his state is headed toward bankruptcy can’t be ignored by bond buyers, even if the statement was an exaggeration.

In late November, law professor David Skeel published an article in The Weekly Standard suggesting that a state bankruptcy law was preferable to massive federal bailouts of individual states. Details of the plan aside, the goal is to reduce the states’ long-term contractual, pension, and retiree health plan obligations to public employees. In much the same way that General Motors Co. (NYSE: GM) was able to renegotiate union contracts and eliminate other obligations from its balance sheet, states would be allowed to do the same.

How bad are state deficits? According to the non-partisan Center on Budget and Policy Priorities (CBPP), not bad at all. The following graph is included in the CBPP’s report, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm.”  Outstanding debt is within a normal range over the last 35 years.

The CBPP found that the states’ operating deficits on tap for the 2012 fiscal year “are caused largely by the weak economy.” The deficits result from cyclical issues, they are not structural, and budgets will recover with the overall economy.

Interest payments on bonds, according to the CBPP, are just 4%-5% of current expenditures, about the same as payments in the late 1970s. Between 1970 and 2009, just four defaults have been recorded from cities or counties. In the past century, only one state has ever defaulted, and that was in 1934 at the depth of the Depression.

The CBPP also concluded that the pension and retiree health cost problems faced by most states could be remedied with relatively minor adjustments. The study did note that some states, including California and Illinois, have “grossly underfunded their pensions in past years and/or granted retroactive benefits without funding them.” These states will need to make more than minor adjustments.

The CBPP also points out that states “have adequate tools and means to meet their obligations” without enacting a state bankruptcy law. Those tools and means are increased taxes and reduced spending.

The state of Illinois recently increased its state personal income tax level a whopping 66% — from 3% to 5%. If that doesn’t sound too whopping, maybe it’s not. Corporate taxes in Illinois rose from 4.8% to 7%. The new rates fall to 3.25% for personal income and 5.25% for corporate income in 2015.

Other states are avoiding income tax hikes, preferring instead to raise a variety of less visible taxes and fees. State spending is also being reduced, but that is especially difficult in tough economic times when the demand for state services rises.

Standard & Poor’s has issued a new report saying that the firm plans to retain its medium to high investment-grade ratings on state and local debt in 2011. According to the press release, “U.S. state and local governments will need to continue to make sometimes difficult and unpopular budget choices and pay increasing heed to bond market conditions and pension costs.”

In other words, the situation isn’t great, but state and local governments are in reasonable shape. Move along, there’s nothing to see here, move along.

If the US Congress approves a state bankruptcy law, the approval will almost certainly reflect political considerations more than the current condition of state deficits. At this point, no law is necessary. What is required is some hard thinking and some difficult decision-making. Whether state and local government can succeed at that is an open question.

Paul Ausick

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