What to do with bankrupt states?

Let them go bankrupt, David Skeel writes in The Weekly Standard.

The financial mess that spendthrift states have gotten themselves into is well known. California—recently dubbed the “Lindsay Lohan of states” in the Wall Street Journal—has a deficit that could reach $25.4 billion next year, and Illinois’s deficit for the 2011 fiscal year may be in the neighborhood of $15 billion.

There is little evidence that either state has a recipe for bringing down its runaway expenses, a large portion of which are wages and benefits owed to public employees. This means we can expect a major push for federal funds to prop up insolvent state governments in 2011, unless some miraculous alternative emerges to save the day. This is where bankruptcy comes in.

We have long done this for municipalities.

We now have more than 70 years of experience with a special chapter of the bankruptcy code, which permits cities and other municipal entities to file for bankruptcy. For decades, this chapter did not get a great deal of use. But since the successful 1994 filing for bankruptcy by Orange County, California, after the county’s bets on derivatives contracts went bad, municipal bankruptcy has become increasingly common. Vallejo, California, is currently in bankruptcy, and Harrisburg, Pennsylvania, is mulling it over. The experience of these municipal bankruptcies shows how bankruptcy-for-states might work, what its limitations are, and why we need it now.

Municipal bankruptcy dates back to the last epic financial crisis, the Great Depression of the 1930s. According to testimony in a 1934 congressional hearing, 2,019 cities and other governmental entities had defaulted on their debt at that time.

Forbes has an interactive map showing how states are doing with debt.