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I'd like to welcome Vinton Buccola do knowledge at work man he is a professor
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of legal studies and business ethics here and he's written an interesting paper about excessive state debt and a
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new approach to this problem there's a worry a concern that some state debt around the world I guess could end up in
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default creating lots of problems for investors and capital markets and Vince I'd like to leave it to you to explain
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what this paper is about and what some of the findings were sure thanks Steven so this paper or this position brief is
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based on a paper published in the Duke Law Journal it takes up the problem of state over borrowing and I mean here
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states of the United States Illinois California and so on and the paper really has to conclusions for
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policymakers one of them is negative or sort of pessimistic and one of them is maybe more optimistic so I'll just take
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this one at a time i'll stop the the pessimistic findings so in the aftermath
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of the financial crisis a number of policymakers politicians and scholars saw in the leverage or over-leveraged of
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a number of american states like Illinois New Jersey California some of the same moral hazard or too big to fail
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thinking that was part of the cause any way of the financial crisis in Wall Street the idea is that the institution
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note can over borrow knowing that if things get bad enough there's a federal
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back stop there and therefore lenders are more willing to extend and overextend credit so these thinkers in
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most prominent was probably my colleague and friend at the law school here at Penn David Skeel proposed a bankruptcy
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mechanism a new law that would allow states in addition to cities and towns which can already file for bankruptcy
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this would allow states to file and they thought this might relieve turn off the
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spigot by allowing there to be a mechanism that would give creditors a haircut the idea would be to forestall a
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federal bailout so the negative conclusion of my paper is that the bankruptcy mechanism won't
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work to reduce state borrowing and the basic problem is an old very old legal doctrine called sovereign immunity this
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doctrine dates at least into the 19th century and the idea is that because the American states are thought of as
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sovereigns they can reject any claims on to pay debts they can simply walk away from them so in other words they don't
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need a bankruptcy mechanism and the way this works is that if someone Sue's a
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state for a debt say on a bond the state can decline to be sued so there's no
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remedy and the upshot is that states can already walk away from deaths if they want to they don't need bankruptcy
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mechanism and they won't opt in to one unless they're given sweeteners let me
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ask you what are what were the main conclusions of your research as you looked into this but also as a preface
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to that is there a history of states defaulting has it happened in what have been the results yeah so the earliest
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state defaults were in the 19th century a wave of financial panics caused state defaults in the 1840s 1870s after the
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Civil War the most recent state default was Arkansas is during the Depression I think it was 1933 but I might be wrong
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on the exact date so yeah there is you know I think people tend to think that the states are risk-free and they're not
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they haven't historically been and and the the law is solid in the sense that
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there's no legal repercussions there are obviously reputational consequences to
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default but but not legal so what were your main takeaways from your research sure I think there they really are
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twofold one is that a kind of any kind of ex post mechanism a kind of illegal mechanism that tries to work on
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borrowing after the fact after things have done bad is not going to work and the second takeaway relates to an idea I
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develop in the paper called tax credit borrowing which is a way to get around the this problem of sovereign immunity
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that I'm that I mentioned and the tax credit borrowing may have um more hope or more promise than a
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bankruptcy mechanism and what is that exactly sure so the idea of tax credit borrowing is that you that a state
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borrows just like it or not I would think of a bond the prompt the state problems is to pay a coupon annually
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however periodically they want but instead of promising an outlay of cash the state promises a tax credit some
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credit that can be applied against a tax bill owed to the state and the idea this
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really is just to circumvent that sovereign immunity doctrine I was mentioning under the settled law
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sovereign immunity only applies to a state as a defendant in court it does not apply to a state as a plaintiff in
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court so the logic of tax credit borrowing is that the owner of the bond say or the obligation can assert the
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right to decrease taxes and if the state doesn't like that or wants to default
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will say the state must sue rather than be sued and by toggling the plaintiff defendant distinction as sort of trivial
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as that sounds maybe to a non-lawyer you get a radically different result that's
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interesting so a company obviously would have to have substantial business interest in that state in a substantial
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tax obligation in order for that to to make sense is that often who's investing
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is in it sort of big investors with institutions in New York and so forth um you know it with municipal and state
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that there actually are a lot of individuals or owners so the way I really foresee Tax Credit barn working
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is that the tax credit would coupon say would just be sort of an option on for the holder so in the ordinary run of
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business the taxpayer that I'm sorry the holder of the obligation just gets paid
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as an ordinary bond but the taxpayer or the holders one would have an option to use it as an offset against a tax bill
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so it would only come into play if a state was let's say teetering financially and wanting to default in
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this way so is the other thing I'm wondering is would that would that be a sweetener for states to be able to to to
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get a lower interest rates or is that federal back app already providing something
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equivalent yeah so I the short answer is I think it would allow states to borrow
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more cheaply it's a way of creating a lower risk state instrument there are 22
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observations that one is we're not sure how much of over barling really is attributable to moral hazard that's too
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big to fail idea i think actually tax credit borrowing would help researchers like myself get a better purchase on how
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much of over borrowing is really caused by that sort of moral hazard and how much is due to other political failures
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you know and then the last thing I'd add about the text credit borrowing is not
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not just about allowing states to borrow at cheaper interest rates there are a lot of constituents what you might say
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creditors of states who are not bondholders I'm thinking employees with retirement plans and so on who could
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really use a little safety I would probably be willing to give up a little juice for for our consider for for the
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safety of a return down the line I think their tax credit borrowing is you know I
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introduce it in this paper as a mechanism to reduce the over borrowing incentive at the state level but I think
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it has other potential uses so states could see this as a way to lower their financial costs I'm if they if they so
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chose I think that's right yeah sorry interesting as you looked into this where their conclusions or findings that
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surprised you yeah 11 rise is an historical I thought that I was coming up with this mechanism out of sort of
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scratch but as I conducted research I found out that the state of Virginia I guess the Commonwealth of Virginia
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actually used tax credit borrowing in the aftermath of the Civil War in the 1870s so some lawyers in Richmond were
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smart enough to figure this out and in fact Virginia tried to repudiate these tax credits and they were upheld in the
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courts so that was a big surprise we have some precedent yeah that's right what are some of the other practical
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implications for this that maybe have them covered just yet so I think for for investors and for employees at the
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state level it's important to know this is not this is not unique or new from my
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work but it's important to know that states can walk away from their obligations a lot of general obligation
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bonds and according to some constitutions state pension obligations are said to be backed by the state's
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Full Faith and Credit it's a common language and a lot of people assume that
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means it's impossible for the state to default you should know it's not impossible and states have done it
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before they will probably do it again okay so that would be one of the misperceptions that the public may have
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about these kinds of things that because it hasn't happened since the 30s that
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that it's unlikely to happen and it does it does seem like an unlikely thing and
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yet if you can provide a guarantee against it and at the same time incentivize States to perhaps lower
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their borrowing closet that that's an interesting thing and how much might Lauren cause be lowered is it a quarter
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percent an eight percent anyway to any way to judge that you know I'm not sure
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and I'm probably would not be the best at figuring this out I think the case is
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that the better the financial situation of a given state the less this tax credit borrowing mechanism matters so if
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there's a prudent highly solvent state it's not going to change borrowing costs
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at all but then again I'm we're not so concerned about that states motive on so
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it's more an issue as a state is under increasingly dire financial situation
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this the tax credit bar will have a bigger impact I don't know how to quantify that any states around right
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now that are in that position Illinois okay Illinois Illinois is not doing is not doing well its Supreme Court has in
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the past couple of years issued rulings that make it look difficult to restructure pension obligations there
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which are a major driver of costs and the city of Chicago is in financial trouble as well if you're trying to
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understand the fiscal picture at state and municipal levels you often in some ways need to look at
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together because states can offload some of their own obligations to the to their
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own municipalities or if municipalities are doing badly the state can back them up if both of state and its major
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municipalities major cities are simultaneously on the rocks financially that's a bad picture all right what what
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else about this whole idea would be interesting to know that we haven't talked about or have we covered it ah
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we've covered this research okay I'm what what I'm doing now is watching
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watching what's happening in Puerto Rico it's not a state but in and so the
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sovereign immunity doctrine i mentioned doesn't apply there but it'll be
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interesting to see what happens there there's some question whether puerto ricans going to be a warm-up for
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illinois we'll have to see and presumably they could offer some sort of a coupon that was in effect a tax break
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for let's say certain investors that that had enough business there that they
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be able to offset the tax obligation i think that's right okay well thanks for
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coming in thank for an interesting stuff you [Music]