Late last year, David Skeel, a law professor in Philadelphia, made an unusual proposal in a magazine on what was once a dull, purely hypothetical topic. Nothing could have prepared him for what came next.
The response, he says, was like "throwing a match on dry timber." A slew of e-mails flooded his inbox and his phone started ringing with calls from the staff of U.S. legislators.
Everyone wanted to know more about his idea – in a nutshell, that American states face such serious financial trouble ahead that there should be a way for them to declare bankruptcy.
It's a notion that is getting serious attention from U.S. lawmakers, part of a broader trend that has turned state finances into one of the hottest issues in politics.
Governors and unions are clashing in states from Wisconsin to New Jersey over how to tackle current and future shortfalls. In Washington, D.C., there was a congressional hearing last month specifically on the topic of state bankruptcy.
The heightened attention is the product of political calculation but also deepening concern about cash-strapped states. Some experts like Prof. Skeel, who teaches at the University of Pennsylvania, argue that it's better to prepare for the unthinkable by giving states an ordered way to restructure their debts.
But it's unclear if such an option would really help – and other experts counter that the woes facing states are being vastly overstated.
States face a double predicament. The Great Recession left yawning holes in budgets as revenues collapsed. In the coming years, pension and benefit payments owing to public employees born during the baby boom years (1946 to 1964) will swell, presenting states and cities with another fiscal ordeal.
One study by the not-for-profit Pew Center on the States estimated a $1-trillion (U.S.) gap between what states have set aside for pensions and what needs to be saved to meet such longer-term obligations; other experts say the figure is even higher.
It's not all bad news. Federal Reserve chairman Ben Bernanke said last week that if the U.S. economy continues to improve as forecast, "states and localities may start to get a little breathing space."
State tax revenues continued to rebound in the latter half of 2010, noted researchers at the State University of New York, even if they haven't yet recovered the ground lost in the recession.
The financial maladies of states, while serious, aren't life-threatening in the immediate term, say experts. Creating a mechanism for bankruptcy is a medicine that is worse than the disease, some add (unlike cities, there is no bankruptcy law for states, which are sovereign entities in the United States).
Having a procedure for "state bankruptcy would not be helpful to anybody," says Alicia Munnell, who heads the Centre for Retirement Research at Boston College. "It would make it impossible for states to raise money. People would lose confidence completely in a state's ability to pay back loans."
Prof. Munnell says that the current hue and cry about the cost of pensions for public employees has distorted their importance. According to a recent study from the centre, such expenses ate up only about 3.8 per cent of state and local budgets in 2008, although that figure will have to rise in the coming decades.
"There are real issues that need to be solved and it requires hard work," she says. But "to politicize it the way it's being politicized is not helpful."
At last month's congressional hearing, one expert warned that financial markets would react poorly to a bankruptcy code for states. Such a move represents an "extreme remedy," testified Matt Fabian, managing director at Municipal Market Advisors. "Even an unused bankruptcy law would amplify headline risk."
In other words, investors would panic at the first hint of trouble, driving borrowing costs higher, especially for places like California and Illinois.
American states have a long history of somehow muddling through periods of financial stress.
The last time a state failed to pay its debt was in 1933, when Arkansas found itself overwhelmed by its interest payments. More recently, California's treasurer has said that the only thing that would prevent the state from repaying its debts is "thermonuclear war."
To address the longer-term problems faced by states, you need a "rifle, not a shotgun," says James Spiotto, a bankruptcy expert and partner at law firm Chapman and Cutler in Chicago. Bankruptcy is too blunt an instrument, he says; instead, he advocates the creation of a pension funding authority, a panel which could arbitrate disputes between states and employee unions.
Prof. Skeel says that he believes there's a good chance U.S. legislators will move ahead to introduce a bill on state bankruptcy, although its prospects for becoming law would be uncertain. He considers having a bankruptcy law a better plan than resorting to a default or asking for a bailout from the federal government.
"Here is something in case the unthinkable happens," Prof. Skeel says. "Here's a last-resort option that requires everybody to contribute and share the sacrifice."