There is a problem that Illinois faces. There is no actual right for a state to go bankrupt. That does not mean that no state has simply defaulted and never paid. A state hasn’t defaulted since Arkansas in 1933 during the Great Depression. However, that was also not the first state to simply not pay. The Sovereign Debt Crisis of the 1840 was just such a situation.
In 1841 and 1842, eight states and the Territory of Florida all defaulted on their sovereign debts. Traditional histories of the default crisis have stressed the causal role of the depression that began with the Panic of 1837, unexpected revenue shortfalls from canal and bank investments as a result of the depression, and an unwillingness of states to raise tax rates. However, these stylized facts do not fit the experience of states at all very well.
The majority of state debts in default in 1842 were contracted after the Panic of 1837; and most states did not expect canal investments to return substantial revenues by 1841 and did not experience unexpected shortfalls in those revenues. Finally, most states were willing to raise tax rates substantially and did. The relationship between land sales and land values explains much of the timing of state borrowing and the default experience of western and southern states.
Pennsylvania and Maryland defaulted because they postponed the imposition of a state property until it was too late. The United States was the emerging market for Europe and these defaults ruined its credit for decades to come. The Bank of England still has some State debts that were never made good. The Panic of 1837, which had been caused by an over-expansion of banks, caused farmers, planters and merchants to lose their enterprises. This led to a economic contraction that further reduced bank deposits causing bank failures as the depression then settled into the states from which it sprang. States issued bonds to try to bail out the banks and many states ended in default. They did not declare bankruptcy, but instead, simply refused to honor their outstanding bond issues.
When states behave badly, their borrowing costs rise. The United States was the emerging market and interest rates rose in the aftermath of the state defaults. In fact, the historical high in United States call money rates took place in 1899 reaching almost 200%.
Currently, interest rates for the financially troubled state of Illinois are now three times as high as that of California. So interest rates rise as the risk of default mounts. But the Illinois crisis is something new. Its constitution forbid diminishing state employee pensions. So the public pensions are sucking in all the available money resulting in taxes rising, property values falling, and public services being cannibalized to pay pension.
Now there is a curious admixture thanks to the “New Deal” and socialism, which complicates matters even much more. The federal government relies on the states to carry out some programs, such as Medicaid. Therefore, is a state cannot fund itself, then it cannot carry out a federal program. The average person will look to the federal government as defaulting. If investors and state governments begin to look to Washington arguing they have an implicit duty to come to the rescue of states, then how is the crisis resolved? States would naturally be tempted to just hand the bill to the feds. Bond holders will be storming Washington to be bailed out of their state bonds. If Washington is on the hook for the states’ problems, then how is the legal crisis resolved? The feds would naturally want control over state finances, however, that would be a violation of the Constitution and the separation of sovereignty.
Illinois could mandate that the state public pension be reinvested only in state government bonds. That would comply with their constitution. Then at some future point, Illinois could simply just default since it could not file for bankruptcy. You can see that there is a real messy dilemma brewing on the horizon. The best advise – get rid of public debt and stay with blue-chip corporate debt – nothing public.