When the Government Goes Bankrupt

Thursday, April 4, 2013
By Paul Martin

by Andrew P. Napolitano

What happens when the government goes bankrupt? This question is one that sounds like a hypothetical exercise in a law school classroom from just a few years ago, where it might have been met with some derision. But today, it is a realistic and terrifying inquiry that many who have financial relationships with governments in America will need to make, and it will be answered with the gnashing of teeth.

Earlier this week, a federal judge accepted the bankruptcy petition of Stockton, Calif., a city of about 300,000 residents northeast of San Francisco, over the objections of those who had loaned money to the city. The lenders – called bondholders – and their insurers saw this coming when the city stopped paying interest on their loans – called bonds. In this connection, a bond is a loan made to a municipality, which pays the lender tax-free interest and returns the principal when it is due. Institutional lenders usually obtain insurance, which guarantees the repayment but puts the insurance carrier on the hook.

The due dates of many of these bonds have come and gone, and the bondholders and their insurers want Stockton to repay the loans. But the city lacks the money with which to make the repayments. It borrowed money from the bondholders during good financial times, when its real estate-generated tax receipts were greater than today, and when its advisers predicted no foreseeable end to the flow of cash to the city. The expected flow of that cash, the natural inclination of those in government to want to give away other people’s money, and the self-serving manipulations of those in power who rewarded their friends and themselves with rich pensions combined to cause the city to make generous pension commitments to its employees.

It is politically easier to offer generous pension payments to municipal employees in the future than it is to raise their salaries today. The promise to pay a pension to qualifying retirees upon their entry into the retirement system, just like the promise to repay bondholders the money they loaned, is a legally enforceable contract.

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