A new Rhode Island state law places bondholders before other creditors in the case of bankruptcies of municipalities.
The town of Central Falls declared bankruptcy recently, but its bondholders are scheduled to be paid in full. The pensions of retired city workers will suffer a cut of one third.
Why did Rhode Island take this unusual and politically-costly approach? A Rhode Island official explained it as follows: “We do not want bondholders to think this state was not a good place to put their money.” He also noted that without this law, Rhode Island municipalities will have to pay higher interest rates for its borrowing.
How is it that such economic rationality trumped politics in Rhode Island? Why could we not have had such rationality during the federal debt limit debate?
Municipalities in states borrow in highly competitive markets. They must compete against 49 other states. If the state’s investment climate is inferior to others, they cannot attract lenders. If you wanted to buy municipal bonds, would you buy from Rhode Island or California?
The federal government faces less competition, and the competition it faces is weak (such as European and Japanese sovereign debt). Our federal government believes it can sell its debt not matter how badly it misbehaves.
The recent Standard and Poor downgrade may change this way of thinking.