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What If A State Defaulted?

Nov 21, 2010 • Economic Debates, Government, Macroeconomic Measurement, Money and Monetary Policy • 701 Views    1 Comment

What would happen if a state defaulted on its debt? It is unlikely. It has not happened since 1933. But…what if?

In a fascinating simulation at The Economist’s Buttonwood Conference, an auspicious group of role players simulates a state debt crisis. As they debate the facts, unexpected events are announced that influence their discussion. (I really enjoyed watching the simulation for close to 1 hour.)

The facts: The fictitious state of New Jefferson is the 3rd largest state in the U.S. Economically diverse, it has considerable unemployment, underfunded pensions, and residents who prefer low taxes and high spending.  Its senior senator chairs the Senate Banking Committee.

The dilemma: A panel of “advisors” debates what the federal government should do. Should there be a bailout? If so, who? The Treasury? The Fed? Another way? In addition, exacerbating the crisis, periodic news flashes interrupt their deliberations. For example, as they speak, the advisors learn that if the state does not get $1.5 billion by Wednesday, it will default.

The roles include the (fictitious) Chairman of the Fed, the Secretary of the Treasury, and the White House Chief of Staff. All role players such as Robert Rubin, former Secretary of the Treasury, have actually had these types of positions. Predictably, their deliberations include insight and humor about relevant domestic and international implications.

When California really did ask the Obama administration for guarantees during 2009 in order to borrow more money, they said no. As a result, during July, 2009, California had to issue IOUs temporarily to pay some of its obligations.  And now, just this week, a Yahoo Finance article cited California’s delay of a $10 billion bond issue because of investor disinterest. 

The Economic Lesson

Can a state declare bankruptcy? According to a very good Slate.com “explainer” article the answer is no because of the state’s sovereign status. Without the bankruptcy option, what happens to the state’s financial obligations? You might enjoy looking at the Slate article. 

 

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