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NAPOLITANO: When the government goes bankrupt

Profligate public debt is always passed to taxpayers

What happens when the government goes bankrupt? This question is one that sounds like a hypothetical exercise in a law school classroom from just a few years ago, where it might have been met with some derision. But today, it is a realistic and terrifying inquiry that many who have financial relationships with governments in America will need to make, and it will be answered with the gnashing of teeth.

Earlier this week, a federal judge accepted the bankruptcy petition of Stockton, Calif., a city of about 300,000 residents northeast of San Francisco, over the objections of those who had loaned money to the city. The lenders — called bondholders — and their insurers saw this coming when the city stopped paying interest on their loans — called bonds. In this connection, a bond is a loan made to a municipality, which pays the lender tax-free interest and returns the principal when it is due. Institutional lenders usually obtain insurance, which guarantees the repayment but puts the insurance carrier on the hook.

The due dates of many of these bonds have come and gone, and the bondholders and their insurers want Stockton to repay the loans. But the city lacks the money with which to make the repayments. It borrowed money from the bondholders during good financial times, when its real estate-generated tax receipts were greater than today, and when its advisers predicted no foreseeable end to the flow of cash to the city. The expected cash flow, the natural inclination of those in government to want to give away other people's money, and the self-serving manipulations of those in power who rewarded their friends and themselves with rich pensions combined to cause the city to make generous pension commitments to its employees.

It is politically easier to offer generous pension payments to municipal employees in the future than it is to raise their salaries today. The promise to pay a pension to qualifying retirees upon their entry into the retirement system, just like the promise to repay bondholders the money they loaned, is a legally enforceable contract.

So, confronted with an obligation to repay more than $200 million in loans to bondholders and more than $900 million to the California pension system for its current and former employees, and confounded by a reduction in real estate tax revenue so serious that Stockton cannot afford to pay either the bondholders or the pension system, let alone both, the city that overborrowed, overspent and overpromised has sought the protection of a federal bankruptcy court.

Bankruptcy in America is a strange bird. It permits debtors to be relieved of their financial obligations by paying less, often far less, than they owe. It compels creditors to accept less, often far less, than they are due. It is generally an orderly and mechanical process presided over by a neutral judge without a jury. Its goal is to get the creditors something, leave the debtors with something, and let all parties go home in peace and resume their livelihoods.

It rarely happens to the government. That's because the government, which has no competition, creates no wealth, doesn't produce anything of value and needn't attract clients, has a monopoly on the use of force with which it can extract what it needs to pay for its mistakes in the form of higher taxes. These extractions, of course, are not voluntary transactions as when you buy gas for your car or food for your table. They are mafia-style transactions: Pay us more, or else.

There must be a limit even to the Stockton taxpayers' willingness to part with their wealth in the form of taxes — hence the filing for bankruptcy. The Stockton case presents a rare opportunity for a federal judge to interfere with the contractual obligations of a municipal government and actually modify or even nullify them.

It also presents a confluence of a culture in California of high taxes and generous — often non-contributory — pensions for even short-term government employees and a federal system that when it faces a shortfall simply goes to its banker — the Federal Reserve — and asks it to print more cash. Stockton cannot legally print cash the way the Fed can.How does this affect the rest of us? Currently, state and local governments owe about $4 trillion in pension benefits that they do not have to current and former employees, and they know they cannot politically acquire it by raising taxes. This affects all 50 states. So the odds are that the states and the similarly situated Stocktons in America will go to the Obama administration and ask for free cash. The president will, no doubt, find it for them. That "found" cash will be borrowed from the Federal Reserve and, like all of the federal government's debts to the Fed, will never be repaid. Countless generations of American taxpayers will make enormous and endless interest payments on it.

Does that sound too apocalyptic for you? Well, consider this: The federal government is still paying interest on the $30 billion it borrowed to wage World War I nearly 100 years ago. So, to the feds, mortgaging your children's future to save the Stocktons of the country from the consequences of their own profligate ways is a no-brainer.Should Americans yet unborn pay for all of this? Is this what you elected the government to do? What will it take to keep the government within the confines of the Constitution?

Andrew P. Napolitano, a former judge of the Superior Court of New Jersey, is the senior judicial analyst at the Fox News Channel. Judge Napolitano has written seven books on the U.S. Constitution. The most recent is "Theodore and Woodrow: How Two American Presidents Destroyed Constitutional Freedom."

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