Bankruptcy, backwards: the problem of quasi-sovereign debt.

• Author: Gelpern, Anna

FEATURE CONTENTS INTRODUCTION I. OUASI-SOVEREIGNS AND THEIR DEBTS A. Quasi-Sovereign and Private Debtors B. Quasi-Sovereign and Other Public Debtors II. QUASI-SOVEREIGN DEBT: DISTRESS, RELIEF, AND RESTRUCTURING A. Public Debt Overhang (Efficiency) B. Jubilee and Odious Debt (Autonomy and Legitimacy) C. Quasi-Sovereign Debt Restructuring III. MAPPING TO BANKRUPTCY CONCLUSION INTRODUCTION

Bankruptcy--a set of legal institutions to manage private debt distress--has long captivated thinkers and politicians solving public debt problems. (1) Adam Smith observed in 1776 that a sovereign state, like an individual, may find it necessary "to declare itself bankrupt," and that "a fair, open, and avowed bankruptcy" was more constructive and honorable than printing money "to cover the disgrace of a real bankruptcy." (2) Yet the intellectual success of sovereign bankruptcy has far outstripped its policy traction: there is no bankruptcy regime for nation-states; examples of subnational bankruptcy are rare and limited to nonsovereign localities. (3) This seems puzzling, because sovereign debt history is replete with examples of distress, default, and messy restructuring. (4)

My Feature considers the puzzle in light of recent proposals to adapt bankruptcy institutions for U.S. states (5) and members of the European Union. (6) These public debtors share a quality that sets them apart from the protagonists in earlier bankruptcy debates: they remain sovereign but have ceded important aspects of their sovereignty to a central government in the name of economic and political integration. The fiscal troubles of "quasi-sovereign" (7) states present a distinct economic context for bankruptcy as a public debt management tool, and a constellation of political interests potentially more amenable to trading sovereignty for solvency.

The latest proposals were quickly abandoned, even as public debt problems have continued to dominate the policy agenda on both sides of the Atlantic. Their demise revives an old question: is state bankruptcy a good idea perennially thwarted by bad politics, or a tempting analogy courting problems it cannot solve? Although the answer is probably both, I argue that it is closer to the latter.

In the recent crop of initiatives, even the best had it backwards. They started with a bankruptcy solution, and extrapolated to the state debt problem. To be sure, they have prompted a useful conversation joining previously disparate scholarship about credit market institutions, sovereign debt, fiscal federalism, and local government. But framing the conversation mainly in bankruptcy terms is unhelpful for three reasons. First, starting with bankruptcy flips the logical sequence: it posits an institutional fix for a theoretically undefined and empirically contested problem. As a result, a debate that should be filling gaps in public debt theory yields yet another chapter on the uses of bankruptcy. Second, the bankruptcy label presumptively narrows the inquiry, making creditor collective action problems and the Contracts Clause of the U.S. Constitution play host to broader principles of fiscal policy and democratic governance. That such broad principles arise in response to bankruptcy concerns, not vice versa, is distortive. Third, the bankruptcy label injects the intellectual and political conflicts of bankruptcy into the world of public debt. "Bailout" and "cramdown" are fighting words in both worlds, but such overlaps are misleading. Talking about state debt as "state bankruptcy" sets the stage for replaying entrenched arguments from a different field, and threatens to derail a useful exchange for the wrong reasons.

My Feature is an effort to reframe but continue the conversation. The goal is to refocus on the problem of quasi-sovereign debt, without losing the benefit of the debate that started with state bankruptcy.

Over the past year, supporters have offered a wide range of rationales for state bankruptcy. Writing about U.S. states, David Skeel asks bankruptcy to reduce public debt overhang and moral hazard from bailouts, and to improve fairness and process legitimacy in public finance. (8) Creditor collective action problems loom large for Francois Gianviti and colleagues in the EU, (9) and for Steven Schwarcz in the United States. (10) For Jeb Bush and Newt Gingrich, bankruptcy is a tool to battle interest groups (here, unionized state workers). (11) Daniel Gros and Thomas Mayer would use bankruptcy elements to overcome structural asymmetries in the design of eurozone institutions. (12)

Diverse ways of framing the problem are at the heart of private bankruptcy theory (13) and are consistent with the history of public bankruptcy initiatives. For example, the mission of municipal bankruptcy in the United States has gone from neutralizing holdout creditors to comprehensive rehabilitation; (14) elsewhere municipal bankruptcy has served as a vehicle for negotiating federalism; (15) meanwhile, proposals for international sovereign bankruptcy have shifted from targeting holdouts to battling bailouts and moral hazard. (16)

That bankruptcy can promise to solve all of the above problems--and that theorists can debate its mission for decades--testifies to its richness and elasticity. But there is a downside. "Bankruptcy" can become all things to all people, a heuristic for managing debt distress in general that confuses and disappoints when transplanted to a particular new setting. To wit, Adam Smith's place in sovereign bankruptcy debates: eminent advocates have claimed him as an intellectual ancestor, (17) but it is doubtful that his "avowed bankruptcy" would have resembled the collective debt adjustment process at the heart of modern proposals. (18) Much as Smith has brought cache to diverse sovereign bankruptcy proposals, "bankruptcy" is becoming the banner under which good people battle all manner of public debt problems.

With bankruptcy's public debt mission noted (at least in the alternative), the discourse quickly shifts to implementation, constitutional logistics, and transition costs. Which design will clear the state consent requirement in constitutional jurisprudence ? Which will win the most votes in today's political climate? Is bond market contagion a danger? Does it follow from enacting bankruptcy, or from invoking it? (19) All these questions become relevant only if bankruptcy does in fact help solve the debt problems of quasi-sovereign states. If it does, its benefits might even outweigh the costs of constitutional or treaty change, and could certainly outweigh the political and market risks of enactment.

Over a year into the debate, the link between quasi-sovereign debt problems and bankruptcy solutions remains tenuous. Debt overhang requires debt relief, not bankruptcy. Relief can come from default, fiscal transfer (bailout), ad-hoc renegotiation, or bankruptcy. Is bankruptcy the best path? Similarly, process problems in quasi-sovereign debt restructuring remain a matter for speculation. The modern history of sovereign debt distress is remarkable for its dearth of collective action problems of the sort that traditionally motivate bankruptcy for private debt. (20) Is it just a matter of time before they appear or are properly diagnosed--and should bankruptcy be adopted preemptively? Bankruptcy's capacity to rehabilitate, and not just deleverage, municipalities and individuals is limited by law; its rehabilitation record is underwhelming. Bankruptcy is at best unproven, and at worst unsuited to overtly political tasks, such as mediating among political interest groups and brokering fiscal federalism. (21) For this and related reasons, municipal bankruptcy in the United States studiously avoids the appearance of political meddling.

Saying that bankruptcy's utility for quasi-sovereign debt is unproven does not foreclose its relevance, or expose it as political subterfuge. A debtor insolvent on account of dysfunctional politics needs debt relief no less than one that has fallen victim to bad luck or mismanagement. If bankruptcy tools can help, they should. And if bankruptcy tools can be adapted or improved for use in public debt, all the better: for example, the answer to bankruptcy's poor municipal rehabilitation record may be to expand its powers, (22) not limit its scope. The challenge is to diagnose the debt problem before evaluating the proposed solution on its merits and in political context.

In what follows, I first map the problem of quasi-sovereign debt distress and restructuring before considering bankruptcy in light of recent proposals. I begin with the distinctive characteristics of quasi-sovereign debtors and their debt problems, and end by asking how bankruptcy might help. With the rich history of quasi-sovereign debt distress, (23) I feel safe in assuming the occasional need for debt relief among this category of debtors. This allows me to steer clear of arguments about the current sustainability of eurozone debt and U.S. state pension commitments, which are tangential to the case for a standing bankruptcy law. Put differently, I assume the possibility of a debt overhang, but not problems with the debt restructuring process, such as coordination failure, where bankruptcy might ultimately hold a special advantage. To the greatest extent possible, I try to generalize from U.S. and other examples. I look for structural flaws in the quasi-sovereign debt management toolkit before considering any bankruptcy tools that might help fax them. Whether the fix should be called bankruptcy and get a part in the U.S. Code or the European treaty complex is a question of implementation beyond the scope of this project.

I proceed as follows: Part I describes quasi-sovereign debtors, highlighting the ways in which they differ from private debtors commonly eligible to file for bankruptcy and from other public debtors, especially fully sovereign states and nonsovereign localities. Part II begins with...