Time to Restructure Debts of Chicago and Illinois is Now

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Both the State of Illinois and the City of Chicago are in dire fiscal straits. Taxes keep rising, while staggering amounts of red ink are projected as far as the eye can see.

The city and the state should act now to restructure their liabilities and put the fiscal mess behind them. This can be accomplished by utilizing Chapter 9 and other tools Congress just gave Puerto Rico. The process would entail about two years of unpleasant headlines, but the city and the state will rebound far sooner and less painfully than if they stay on their current paths.

Illinois has the worst credit rating of any U.S. state. Republican Governor Bruce Rauner was elected in 2014 with a mandate to get the state's financial house in order, but he and the Democrat-controlled legislature are at an impasse. Illinois is overdue on about $8 billion owed to healthcare providers and other vendors. If spending growth follows its 10-year average, the State projects a cumulative deficit of $17.5 billion over the next three years alone.

Chicago is in even worse shape and is rated "junk" by Moody's. The city recently increased its real estate taxes by a stunning 63% – yet massive deficits are still projected indefinitely.

Pension liabilities are an important component in the budgetary travails of both governments. The state's net pension liability is $109 billion, and Chicago's is $34 billion. Funds that should have gone to the pension plans have been diverted for years.

Because the state's financial resources are over-stretched, it is less able to lend a hand to the city. Indeed, Governor Rauner has encouraged legislation that would empower Chicago to file for Chapter 9. From the state's standpoint, this is perfectly rational. Why should the state send Chicago money to avoid default when Chicago can extract concessions from its creditors by threatening Chapter 9?

There are only three ways to restore Chicago and Illinois to financial soundness – increase taxes, decrease expenditures, and/or restructure liabilities. All three are unappetizing, but it's critical that public officials act decisively to identify and implement an orderly solution before a disorderly crisis wreaks havoc.

Further tax increases do not provide a viable solution. In the short run tax increases can partly bridge the deficits, but even this benefit will prove pyrrhic. Recent tax increases have already made the state and the city less competitive venues.

As for expenditures, there's still fat that can be cut from the budget, but it's difficult to see this making more than a dent. The elephant in the room is, of course, the pension liabilities, but the unions have already been cooperative in reforming the pension plans, so there might not be a lot more benefit to squeeze from this area.

This leaves comprehensive financial restructuring. Simply put, the city and the state can deal with their problems either the long-drawn-out way or the swift and decisive way. The drawn-out way entails years of over-taxation, suppressed economic activity, stopgap budget measures, shortchanged services and infrastructure, and incremental reforms – delaying but unlikely avoiding a financial restructuring. The decisive way is to confront the fiscal crisis now and fix the mess once and for all through an orderly restructuring.

Detroit is instructive. It struggled for years to deal with its fiscal problems, borrowing more and more. When Detroit finally resorted to Chapter 9, the case lasted only 17 months.

While Chapter 9 presents a straightforward path for Chicago, Chapter 9 as presently written does not apply to the states. Congress could amend the law to give Illinois the option of utilizing Chapter 9, which is akin to what Congress just did for the Commonwealth of Puerto Rico.

Ideally the city or the state would have an opportunity to work things out with their creditors without having to resort to Chapter 9. The legislation enacted by Congress for Puerto Rico (PROMESA) stays all bondholders from suing Puerto Rico upon a default, without Puerto Rico even entering bankruptcy. This allows Puerto Rico to take a "time out" on paying its bondholders. During this period, Puerto Rico can attempt to negotiate a restructuring with its bondholders. If that fails, Puerto Rico can still enter bankruptcy. Presumably Congress would be willing to give such a stay to Chicago and Illinois as well.

State and local governments should absolutely strive to fulfill their commitments. But once a financial mess of the first order is at hand, as is the case with Chicago and Illinois, it can be far better to act decisively by restructuring rather than prolonging the pain.

If given the tools by Congress, Chicago and Illinois will be able to address their overwhelming financial burdens swiftly and decisively. This will be far better for residents, taxpayers, pensioners, and creditors than drawing out the agony for years and praying that something works.

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