For David Skeel of Penn Law School, Detroit’s bankruptcy filing is a reminder that Congress ought to pass a bankruptcy law for state governments:

If a major city is willing to file for bankruptcy, it is certainly possible that a state in dire financial distress might do the same if there were no good alternative. To be sure, the situation in Detroit was unusual. Mayor Dave Bing and the Detroit city council were not the ones who decided to file for bankruptcy. The initial recommendation was made by Kevyn Orr, a bankruptcy lawyer who was brought in to run Detroit under a controversial Michigan law that permits the governor to appoint an emergency manager when a city is deeply distressed. But the ultimate decision to permit Detroit to file for bankruptcy rested with the governor, Rick Snyder. In June 2011, Snyder had said (much as the California and New York officials did) that he would never permit Detroit to file for bankruptcy. But given Detroit’s predicament, he quite properly changed his mind. Snyder’s willingness to face the flack suggests that a governor also might be willing to file for state bankruptcy if the state’s financial condition were sufficiently dire.

Detroit’s bankruptcy filing also undercuts claims that enacting a state bankruptcy framework would cripple the state bond markets. Similar claims were made about municipal bankruptcy when the predecessor to Chapter 9 was enacted in the 1930s, but none of the dire predictions came true. Only if bond markets are incapable of distinguishing between profligate cities or states and fiscally responsible ones would the mere enactment of a state bankruptcy law roil the markets for every state, not just the troubled ones. The market’s reaction to the Detroit filing suggests the bond markets know the difference. Although a few pundits warned of disaster, there was very little change in municipal bond prices, even the day after Detroit’s filing.

E.J. McMahon of the Manhattan Institute made the case against state bankruptcy in 2011, arguing that state officials had the tools they need to address unsustainable cost structures and that state bankruptcy would cause collateral damage:

For constitutional reasons, any federal law enabling state bankruptcy would have to be voluntary, meaning states would have to invite federal judges to play tough with their unions. But if Gov. Jerry Brown and the California legislature are unwilling to rewrite their collective bargaining rules—signed into law by Mr. Brown himself, 33 years ago—why assume they would plead with a federal judge to do it for them?

It’s more likely that a state like California would pursue bankruptcy if powerful unions and other budget-dependent interest groups saw this as a way to deflect some of the pain to bondholders. California is one of the states that constitutionally guarantees its general obligation debt, and whose bondholders are now seemingly untouchable. That could change with a bankruptcy option.

Such an option would certainly rattle the bond market—which bankruptcy proponents see as a good thing. Yet this ignores the potential for collateral damage and disruption. While bond spreads might get wider for the most troubled states, the enactment of a state bankruptcy law is likely to raise the cost of borrowing for all municipal issuers.

McMahon is not alone in his concerns. A February 2011 Knowledge@Whartonarticle offers a balanced account of the issue. I think I’m with Skeel, but there are strong arguments on the other side.

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