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Felix Salmon has a very good post on the discussion about state bankruptcies. He points out, correctly, that the states have adequate tools to deal with their problems and that should they ever get the right to avail themselves of a bankruptcy solution the exercise of that option would spell disaster for all municipal borrowers. In the meantime, the talk is spooking the muni markets.

It’s worth remembering here that most municipal bondholders are individuals, rather than sophisticated institutional investors. If your aunt Sally put her savings into state bonds, she is not going to be happy if she can’t get her money back, and she is certainly not going to be mollified by talk of lower deficits in future. The deficits are what allowed her to buy the bonds in the first place; she doesn’t particularly want them to go away. But there’s no way she’ll stand for a haircut. And, of course, she votes.

The fact is that states are not going to declare bankruptcy, and they’re not even going to beallowed to declare bankruptcy. So the worst thing that can happen, for the municipal bond market, is that people continue to talk about municipal bankruptcy for the next couple of years. Let’s take the option off the table, once and for all, rather than taking it seriously and thereby only making it harder for states to borrow the money they need.

I found myself in pretty much complete agreement with his observations. Let the states get on with renegotiating union contracts, right-sizing their workforces and prioritizing expenditures without the false promise of bankruptcy as the easy exit. Then along came John Mauldin throwing me a curve ball.

A few more thoughts on state and local spending. First, Congress needs to go ahead and authorize a bill allowing states to file for bankruptcy. At the very least, this sends a very clear message to the states that the federal government will not come to their aid. It is not fair to ask states that have done what they need to do to keep their fiscal houses in order, to support states that have overspent, typically by trying to fund their pensions and run other well-intentioned but underfunded programs.

Second, states need the ability to force public unions to come to the table. Many states have overpromised, and they are simply in a very deep hole and need concessions. Private workers have had to take the brunt of the recent crisis, and meanwhile government workers get far more on average than private employees.

OK, I still probably agree with Felix. BK is the easy way out of the pension problem, but if it were available its use would sour relations for ever more. Still better for the states to deal with the unions and their employees as adults. Recognize the status quo isn’t sustainable and renegotiate something all can agree to, live with and not remain a source of rancor for ever more.

But that part about bailouts worries me. Life is forever complicated, isn’t it? I hope that there isn’t some nefarious Progressive plot here to scotch the bankruptcy option in order to open the door to some plan to save California, Illinois and California. I’ll choose to believe that isn’t the case but I would really like the end game to be one in which there is a public commitment to eschew any lifelines on the part of those opposed to the bankruptcy option.

So, I’m throwing in with Felix. I’m going to trust that he believes the states can work this out and that’s the best option. I hope I’m not Charlie Brown taking a boot at a football that Lucy will pull away at the last moment.

Source: The State Bankruptcy Debate: Agreeing With Felix Salmon