One argument for state regulation of local government financial management (e.g. limits on debt issuance, limits on expenditure growth, etc.) is the plausibility of negative fiscal externalities. That municipal bankruptcies might spillover and contaminate other local governments is a popular example, so much so that it even got its own plotline in the show Parks and Recreation. The argument is that bankruptcy will cause investors to look more suspiciously at, and accordingly demand higher risk premiums from, the municipal bond market that will drive up the borrowing cost for other local governments.
Public Administration Review has a new research article by Lang Yang (George Washington University) titled “Negative Externality of Fiscal Problems: Dissecting the Contagion Effect of Municipal Bankruptcy.” The paper revisits one of the more extreme cases of municipal bankruptcy, Jefferson County (AL) in 2011, and attempts to determine the presence of these contagion effects. She provides a helpful taxonomy for types of contagion effects that are either “general” or “case specific” that can be operationalized as hypothesis. These are summarized in her Table 1:
Using a difference-in-differences regression at other local governments in Alabama she finds no evidence for the general contagion effects: Being in Alabama, or geographically closer to Jefferson County, had no adverse effects on municipal borrowing costs. Importantly, this may be because Jefferson County’s bankruptcy cause was not driven by local or regional economic factors, but rather “mismanagement of a large infrastructure projects and use of unconventional financial instruments” (page 2). However, this is also important because she finds some evidence that borrowing costs declining for other local governments, as she does some additional investigation (see page 8 and Table 6) to show that it seems investors with a preference for Alabama simply reallocated their loanable funds to other local municipalities.
Yang does find evidence of case specific contagion factors, however, in that she finds that other local governments that similarly shared a “full faith and credit” commitment were reevaluated by local investors to the tune of 6 or 7 basis points on their borrowing costs. That is, local governments trying to borrow general obligation debt without the backing of committed taxes had been revealed as potentially unsecured credit in a bankruptcy proceeding.
It is a thoughtful paper with important implications for the motivation of state policy over local governments, particularly with respect to bankruptcy protection.