Bankrupt Politics and the Politics of Bankruptcy

Abstract:     
The most recent round of state budget crises has resulted in calls to permit states to file for bankruptcy in order to restructure and reduce their financial obligations. This Article argues that these proposals are misguided because states’ financial distress is primarily a political problem created by fiscal federalism - the financial relationship between the federal government and the states - and exacerbated by political agency problems. Accordingly, state bankruptcy proposals need to be evaluated in political, rather than financial terms.

Bankruptcy can no more remake fiscal federalism than it can fix a firm with an untenable business model. While bankruptcy might provide a tool for mitigating political agency problems, it is more likely to be used to provide judicial cover for partisan agendas.

Attempts to use bankruptcy to solve political problems invite a reevaluation of the “creditors’ bargain,” the dominant theory of bankruptcy law, which argues that bankruptcy law tries to replicate the bargain that creditors would have made themselves. This Article argues that contractarian approaches to bankruptcy are necessarily incomplete because they do not account for the politics of bankruptcy.

Instead, this Article sketches out a new theory of bankruptcy law as the dynamic “armistice line” between competing interest groups. Bankruptcy is fundamentally a distributional exercise and the shape of bankruptcy law is an expression of distributional norms and interest group politics rather than an exercise in economic efficiency. A proper theoretical understanding of bankruptcy must therefore commence from a political rather than economic perspective.

Number of Pages in PDF File: 45

Keywords: bankruptcy, fiscal federalism, budget deficits, political agency, moral hazard, public choice, creditors' bargain, political economy, state fiscal crises, Chapter 9

working papers series