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Can US States Declare Their Debt Illegitimate?

July 18, 2012

In 2007, Rafael Correa was elected president of Ecuador.  At the time, Ecuador was in the same situation Greece is today: huge national debt bankrupting the country, creditors demanding drastic cutbacks on essential social services like healthcare.  Correa, though, unlike so many other national leaders, had the balls to stand up to the IMF and the big Wall Street banks.  He set up a national commission to investigate the debt and find out how much of it was illegitimate.

Illegitimate debt, also called odious debt, is a doctrine first developed by Alexander Sack in 1927, using the precedents of Mexico’s repudiation of debts incurred by Emperor Maximilian’s regime, and the denial by the United States of Cuban liability for debts incurred by the Spanish colonial regime.  In the more recent past, the doctrine of illegitimate debt was used by the United States to successfully argue that Iraq’s newly elected government should not be responsible for the debts incurred by Saddam Hussein.  According to the Center for International Sustainable Development Law, illegitimate or odious debts are “those that have been incurred against the interests of the population of a State, without its consent and with full awareness of the creditors.”  This can include loans incurred by a dictator in order to build mansions for himself or to buy weapons used to repress the people.  It can also include loans with usurious terms that were incurred by a corrupt governor in return for kickbacks.

In the case of Ecuador, the commission documented hundreds of allegations of irregularity, illegality, and illegitimacy in contracts of debt to predatory international lenders. The loans, according to the commission’s report, violated Ecuador’s domestic laws, US Securities and Exchange Commission regulations, and general principles of international law.

How is this relevant to the US?  Local governments in the US have been the victims for years of a massive bond-rigging scam.  This scam, participated in by nearly every big lender on Wall Street, was a conspiracy to manipulate down the interest rates paid on municipal bonds.  Three people working for GE Capital were recently indicted.  As Matt Taibbi wrote in his truly excellent article on the subject: “USA v. Carollo involved classic cartel activity: not just one corrupt bank, but many, all acting in careful concert against the public interest.”

State pension funds, meanwhile, invested in CDOs–assets backed by risky home loans, whose risk was routinely lied about by the investment firms who sold them and the ratings agencies who rated them.  They got creamed as a result.  Now many of the states are suing.

State governments in the US are going bankrupt.  The federal government, in its efforts to curb the national debt, is probably going to make things worse by cutting payments to states for social services–essentially, passing the buck.  One main reason for the state budget problems is that public employee pension payments are growing faster than revenues.  The Republicans will spin this to say that the public employees are a bunch of unnecessary overpaid union hacks.  The Democrats will spin this to say that it’s all because of the “bad economy” (something seen as controlled by nobody, like bad weather), which is forcing “us all” to make “tough choices”.

But how much of the problem is just due to plain old fraud?

I want to see an independent commission to determine just how much of the money lost by state and local governments this past decade was due to the people being scammed Wall Street firms, possibly with the collusion of corrupt government officials.

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