Default without Capital Account: The Economics of Municipal Bankruptcy1

By Moberg, Lotta; Wagner, Richard E. | Public Finance and Management, January 1, 2014 | Go to article overview

Default without Capital Account: The Economics of Municipal Bankruptcy1


Moberg, Lotta, Wagner, Richard E., Public Finance and Management


ABSTRACT

This paper analyzes the concept of municipal bankruptcy in a comparative framework with commercial bankruptcy. Cities are corporate bodies that continue to exist despite the ever changing identities of the residents. The common designation of cities as municipal corporations suggests an affinity between them and commercial corporations that would offer a bridge between commercial and municipal bankruptcy. Despite this apparent affinity, however, there are significant institutional differences between the two forms of corporation that prevents construction of such a bridge. Commercial bankruptcy allows both creditors and debtors to resolve problems that emerge in consequence of a debt default, and to do so in a generally beneficial manner given the fact of insolvency. By contrast, municipal bankruptcy is a process that benefits some city creditors at the expense of others.

1. INTRODUCTION

These days, news media are full of reporting on governmental financial crises. The specter of default and bankruptcy looms across all levels of government, from small towns to large nations. Commercial corporations enter bankruptcy regularly and it is easy to understand how insolvency and bank- ruptcy can arise.2 Companies borrow in the anticipation that the added revenue that capital infusion makes possible will exceed the expense of retiring the debt. In a turbulent world, however, commercial plans sometimes do not work out as their creators anticipated, and the corporation may end up unable to redeem its debt. While bankruptcy may not be the best way for the corporation to move forward in the commercial world, it is a viable option all the same. A plan can be worked out to restructure the enterprise and unprofitable parts of it can be eliminated. Creditors can be assured of a process that is orderly even if disappointingly unprofitable.

Municipalities are in many ways like commercial enterprises. Cities have a formal similarity to hotels, with paying residents, services, transportation, and public and private spaces (McCallum, 1970; Foldvary, 1994; Wagner 2007, 2012c). Because of their similar structure, cities are often described as munic- ipal corporations. Like their commercial cousins, municipal corporations also experience financial crises. In the United States, they have their own form of bankruptcy provision, denoted as Chapter 9, to complement Chapters 7 and 11 that pertain to bankruptcy by commercial corporations. The resemblance be- tween municipal and commercial corporations thus allows for treating munici- pal bankruptcy as a special case of commercial bankruptcy. Those similarities, however, are superficial. Once one looks beneath that surface, the institutional differences between municipal and commercial corporations render dubious any facile extension of commercial bankruptcy to municipal corporations. Municipalities are but cousins to commercial corporations. With commercial corporations, there typically exists an active market for shares of ownership and there is at any moment a market value for the corporation. In contrast, there is no direct market for ownership shares of municipalities, so no market value can be established for them.

Commercial bankruptcy is often described as a means of giving everyone in the corporate nexus a fresh start once it becomes clear that they will other- wise be unable to escape their insolvency. For municipal corporations, howev- er, insolvency is often, though not invariably, a product of intentional political conduct. As we will see, municipal bankruptcy therefore leaves unaddressed the institutional sources of fiscal crisis. Municipal bankruptcy offers not so much a fresh start as it creates a fresh source of taxation by imposing a special tax on municipal creditors.

While economic action always follows a universal logic of seeking gain and avoiding loss, the substantive force of that logic plays out differently un- der different institutional arrangements. …

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