> I think you've missed the point behind why bankruptcy is bad. It's bad because it directly harms the people living in that state, which is something you didn't addressed at all in your post. It's hyper-focused on taxation and economic performance. It's callous.
Taxation and economic performance are essentially the 2 core predictors for any political entity's prosperity. This is true of any nation in the world, from Germany, Denmark, Belgium, France, the Netherlands, Sweden, Finland, Estonia, etc. The core thesis is that we want States to be as prosperous, if not more prosperous than those countries. There's no way to get there without digging ourselves out of the fiscal hole — or if you believe in it, MMT. And unless we totally swap out the governing decision-makers responsible for digging States into the fiscal hole in the first place, this will keep happening again and again. It's the same reason bailing out big banks and corporations is also bad.
> States pay first responders - medics, firefighters, police, teachers - fund projects, and invest in their communities. State governments themselves employ huge amounts of people. They fund homeless shelters and food banks and all sorts of public services. It would be incredibly harmful to these communities to have their support systems that they depend on removed. Not to mention not being able to pay first responders during a crisis. Hows that for a moral hazard?
Going into bankruptcy doesn't change any of this, it just means that they get to keep the funds that they borrowed in order to pay for all of those things without having to pay back bond-holders. The bond-holders lose. Then the next thing that happens is that the credit rating falls, and they would have to pay higher interest rates on future bonds. This is definitely painful in the short-term, but institutional investors will continue to have some appetite for higher-yield bonds for near-term projects. In the long-term, credit ratings can change if the people of a State elect better leaders, and the State can take out lower interest-rate bonds. California had a BBB credit rating in 2003, and through strong leadership and good policy, raised their credit rating up to an A+ rating in 2006.
Additionally, States can also raise revenue by raising taxes. State taxes are awfully low. Those services, while good and important, aren't free — and their societies need to pay for them through sustainable taxation. The marginal income tax rate in the US is lower than it was in a lot of the 20th century — Illinois, California, New York, etc can all raise taxes to fill in that void. In most European countries, the middle class income tax rate is what pays for most programs, and is far higher than the middle class tax rate in the US. Another avenue that States can look into.
> I also do not see how your post addresses the fact that blue states are overwhelmingly net contributors in federal taxes, and how red states are overwhelmingly net takers. It seems like it warps your view of price discovery, since the government has for decades guaranteed the bond prices of red states. The consistent federal allocation of tax money towards the everyday failure of red states totally discredits your theory weeding out "institutional rot" during a crisis, and of optimal taxation.
Yes, fiscally irresponsible Red states should also declare bankruptcy, and all of this applies to them as well. 2 things can be true at the same time: we should ensure that there is a mechanism to weed out long-run institutional corruption/rot in both Red and Blue states, and we should also reduce transfer payments from net contributors to net takers. If there is a net contributor that ends up having to go through bankruptcy restructuring they should be able to use their surplus to weather the short-run fallout.