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