Capitalism without bankruptcy is like religion without hell, the saying goes. The grain of truth here is that we depend on markets for error-correction; “people are fallible, but competition selects”, as Adam Smith well noted.

But many who fail in the marketplace seek a way out via politics. This includes bail-outs, as well-documented in the recent book, Financing Failure, by Independent Institute Research Fellow, Vern McKinley. The roster of federal bailouts has grown significantly with the addition of marquee names from Detroit and Wall Street.

Unlike hell, bankruptcy usually involves reorganization and can be an opportunity. But the Washington stimulus of 2009 also bailed out state and local governments around the country. This is too bad. Much needed reorganization can come from within (usually via austerity measures) or it can be imposed by a bankruptcy court. Bail-outs (as in the 2009 federal stimulus), on the other hand, send the unfortunate signal that these measures can be avoided or at least mitigated.

The choices facing city leaders are further skewed by the cumbersome bankruptcy process. The case of Stockton, California is a prime example. Forbes Magazine named Stockton the “most miserable city” in the U.S last year and on May 19th, PBS’s News Hour reported that Stockton has continued in its downward spiral, bordering on bankruptcy. The Los Angeles Times reported (March 1): Stockton “... is the first city to resort to a recently enacted California law designed to slow a municipal bankruptcy filing. Under AB 506, all involved parties, including those who hold debt in the form of bonds and employee unions whose paychecks and benefits depend on city revenue, sit down to work out deals with a neutral evaluator, most likely a retired bankruptcy judge.” The federal bankruptcy laws need streamlining. It remains to be seen whether the new California law is a useful substitute.

The City of Stockton embarked on the path to its current state when it involved itself in too many unpromising but expensive revitalization projects. This was when times were good.

Private and voluntary institutions are the real alternative to politics as usual. Some of these were described in The Voluntary City. Charter schools, home-schooling and school choice are alternatives to conventional government school boards and school districts. The recently highlighted Khan Academy is an example of schooling via new arrangements and new technologies.

Another possibility involves pay-for-success bonds, which have been used in the UK and Australia (the White House has recently allocated funds for pilot projects). Bonds are sold on the condition that bondholders are repaid if the particular social program involved succeeds (via clear scoring methods agreed to in advance). Two things happen: first, private sector funds are made available for social services programs; second, program managers have incentives to succeed if they expect to tap the bond markets ever again.

Local governments must consolidate their functions. There are precedents from which they can learn that will stimulate independent recovery rather than federal dependence.

Image Copyright Zoomer via Flickr