A Switch in State Bankruptcy Rules

Abstract

U.S. states are sovereign entities and can’t declare bankruptcy as cities and municipalities. This paper examines the impact of a switch in sovereign bankruptcy rules that allows declaring bankruptcy from an economics model perspective. Allowing bankruptcy increases ex-ante risks for the government to refuse repayment, but provides ex-post benefits of reducing default costs and saving federal bailouts. This paper provides a simple framework to analyze this tradeoff. Whether allowing for bankruptcy increases or decreases borrowing costs depends on the level of income and borrowing for the government.

Keywords: Sovereign bankruptcy, bankruptcy rules, bailouts, state government

JEL Classification: H74, F34, H81