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

• Date: 01 March 2019
• Published date: 01 March 2019
• Author: Lang (Kate) Yang
• DOI: http://doi.org/10.1111/puar.12986

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

governments.

E-mail: langyang@gwu.edu

Research Article