Negative Externality of Fiscal Problems: Dissecting the Contagion Effect of Municipal Bankruptcy

Date01 March 2019
Published date01 March 2019
156 Public Administration Review March | Apr il 20 19
Public Administration Review,
Vol. 79, Iss. 2, pp. 156–167. © 2018 by
The American Society for Public Administration.
DOI: 10.1111/puar.12986.
Abstract: The fiscal decision of one local government may spill over to other localities, and such externality could
justify and inform policy making by a higher-level government. Theories of municipal bond market contagion
postulate that once a local government files for bankruptcy, localities sharing similar characteristics will be perceived
negatively by creditors and charged a higher interest rate. In this article, empirical examination of the second-largest
municipal bankruptcy in American history shows no support for general contagion based on geographic proximity.
That is, nearby localities did not pay a higher interest rate after the bankruptcy. However, case-specific contagion
formed around borrower- and bond-specific characteristics contributing to the bankruptcy: general-purpose borrowers
and general-obligation bonds experienced increased borrowing costs after the bankruptcy. These findings have
implications for states considering granting authorizations for municipal bankruptcy or providing financial assistance
to struggling localities, as well as for local governments planning to access the municipal bond market.
Evidence for Practice
• This article provides evidence against the general contagion hypothesis, which posits that the bankruptcy of
one locality will increase the borrowing costs of nearby localities or all local governments in the state.
• Because of the lack of general contagion to nearby jurisdictions, fiscal externality of bankruptcies should not
be a reason for states to refuse to authorize municipal bankruptcy or provide bailouts to prevent bankruptcy.
• After the second-largest municipal bankruptcy in American histor y, the municipal bond market charged a
higher interest rate on general-obligation debt backed by the full faith and credit of a government borrower.
• Statutory liens may be of interest to state policy makers to mitigate contagion related to the growing failure
to pay on general-obligation debt.
Negative Externality of Fiscal Problems:
Dissecting the Contagion Effect of Municipal Bankruptcy
Lang (Kate) Yang
George Washington University
Sustainability—meeting the needs of the
current generation without compromising
the ability of future generations to meet their
own needs—is a desirable characteristic of public
organizations. However, the fiscal sustainability
literature points to rising concerns across levels of
governments, including continuous federal deficits,
spending pressure due to growing health care
costs, and retiree benefit challenges, as revealed by
the implementation of new accounting standards
(Chapman 2008; GAO 2013; Tang, Callahan, and
Pisano 2014). Local governments’ ability to finance
spending demanded by their constituents and pay
for liabilities in the long run has implications for
local governance and citizen welfare. Highly visible
bankruptcy cases, including Detroit, Michigan,
and Jefferson County, Alabama, demonstrate how
unsustainable financial management practices can
expose localities to extreme risk of fiscal failure,
especially during economic downturns. Bankrupt
local governments have to cut back service provision,
reduce postemployment benefits, and face increasing
barriers to accessing the municipal bond market
(Gillette 2012; Kimhi 2010).
The intergovernmental environment in which a
local government operates exerts pressure on and
responds to challenges of fiscal sustainability. The
intergovernmental relations literature shows that
state and local policies and management operate in
neither a hierarchical nor an autonomous structure
but are interdependent in nature (Agranoff and
McGuire 2003; Kincaid and Stenberg 2011; Wright
1988). For example, unfunded mandates from
higher-level governments direct revenue away from
locally preferred purposes and exacerbate the fiscal
gap between available resources and spending needs,
calling for state attention (Chapman 2008; Ross
2018). Further, when a local government fails to
finance a basic level of service provision, such failure
may have a spillover effect on other jurisdictions.
Researchers have identified how the fiscal decision
of one locality affects others, especially overlapping
and nearby jurisdictions, through competition in
Lang (Kate) Yang is assistant
professor in the Trachtenberg School of
Public Policy and Public Administration
at George Washington University. Her
research focuses on public finance and
financial management in state and local
Research Article

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