Subnational Bankruptcy

Includes: AGG, DIA, QQQ, SPY
by: Modeled Behavior

By Karl Smith

Krugman and Rodrick offer explanations for why a state like California going bankrupt is a different beast from Greece going bankrupt.

First, we have huge interregional labor mobility. (Blanchard and Katz (pdf) is the classic reference). This helps in the boom as well as the slump: when there’s an inrush of money into a state, that draws in workers, but does not do too much to drive up wages relative to the rest of the country. That way, when the music stops, costs aren’t as much out of line as they are in, say, Spain right now.

Second, fiscal integration: booming states pay a lot in taxes, slumping states get a lot of automatic transfers.

Finally, what we’ve learned now is that an integrated banking system and common deposit insurance / FannieFreddie and all that mean that the vicious circle running through sovereign debt and banks is a lot less severe.

A subtle point here is that Washington’s “no bail out” commitment is rendered credible by the direct support residents of California get from Washington, DC. This support limits the economic/political fallout in California. By contrast, the bankruptcy of the Greek government condemns the entire Greek financial system and sends the entire Greek economy down the drain.

In other words, because the state of California has no “sovereign powers,” it is effectively just like any other moderately large borrower. The consequences of its bankruptcy are no more or less serious.

I don’t have the numbers laid out before me either but this seems essentially wrong to me.

Except for the ability to initiate capital controls, California has a fair bit of sovereignty granted to it by the U.S. constitution.

More deeply, the real issue here isn’t that a sovereign might go bankrupt. It is that a chain of large scale defaults could be initiated, which in turn would bankrupt the global financial system.

It is precisely the fact that a large creditor – Italy in particular – would possibly default that makes this entire fiasco a big deal.

If California were to default it would likely also be a big deal, though I don’t know how much debt California has outstanding and what the exposure is.

The issue is that the U.S. government would almost certainly force an orderly resolution to any California bankruptcy. Most likely it would engage in some sort of Federal bailout but even short of that it would arrange for a modest haircut and restructuring and it would likely do this through extra-legal means.