Congress must plan for states to go insolvent.

A number of states, including large ones like New Jersey, Illinois, and Ohio, could become insolvent during the next decade.

These states are burdened with underfunded pensions and other post-retirement benefits (mainly health care) that will impose a growing burden on governments as more baby boomers retire. At the same time, the states’ ability to fund these pensions will be compromised by two factors. The first is a long-term fall in the labor participation rate, requiring younger workers to bear a heavier burden of funding legacy costs. The second is a decrease in long-term growth rates, which will cause both tax revenues and returns on pension investments to fall below expectations.

Reforms are needed to restore fiscal solvency.

It is not too early for Congress and the next president to start planning for a state to go insolvent. Both the Detroit and Puerto Rico bankruptcies were preceded by years of denial in the face of inevitable facts. Given the combination of high unfunded liabilities, slow growth, deadlocked politics and, in some cases, legal barriers to reform, some states are likely beyond the point of saving. Illinois is a good bet to go first, but five or 10 states are in similar positions.

One approach is for Congress to pass legislation dealing with the specific state involved. This need not be a bailout. In fact, a bailout would be extremely unwise. It would tax states that had managed their finances responsibly, reward unions and bondholders who had enabled poor government, and eliminate any pressure to deal with the problems early. However, the legislation must contain enough financial assistance to restore both short-term liquidity (the ability to pay bills now) and long-term solvency (the ability to stay afloat). This assistance need not cost the taxpayer much. Indeed a careful combination of loan guarantees conditioned on significant structural reforms may be all that is needed. This process would resemble that followed in New York City and Washington, D.C., both of which are widely regarded as successes.

A benefit of this approach is that it allows for continued financial supervision of the state’s finances, thus maximizing the chance of overcoming barriers to reform and ensuring a return to long-term solvency.

A large problem with this approach is that it may not be able to reduce the state’s debt burden. Congress’ ability to erase debts may be limited legally to the formal bankruptcy process. Although governments may use a combination of economic and legal pressure to encourage creditors to settle their claims for less than par, it would have a much more difficult time forcing holdouts to accept losses. In such circumstances, it could be that the political and economic burdens of making all creditors whole are just too great outside of the bankruptcy process.

The odds of a state becoming unable to pay its obligations grow every year. Many state retirement plans are significantly underfunded and are unlikely to meet their investment goals over the next decade. The financial demands on state budgets will increase significantly. At some point, making a concerted effort to catch up imposes too much political pain and only delays the inevitable. When the end game happens, it usually comes as a surprise to many.

Congress can nevertheless prepare for insolvency by choosing its strategy now. The ideal solution would treat holders of unsecured debt the same as unfunded pensions, it would impose enough losses to ensure that the state regained its financial solvency, and it would condition debt relief on significant reforms. Ideally, the process would be available long before a state technically became insolvent but after it was willing to make significant reforms. Unfortunately, political resistance and unrealistically exuberant projections may prevent a state from taking advantage of any solution before insolvency.