A Note on Allowing State Bankruptcy

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 trade-off. Event analysis shows that an unexpected switch in bankruptcy rules that allows for bankruptcy would decrease government debt-to-GDP ratio by 9.2 percentage points, increase consumption by 0.69 percent, but increase spread by 1.1 percentage points.

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

JEL Classification: H74, F34, H81