Only courts can save developed countries from disorderly collapse of welfare states — by developing the legal framework for their ordered dissolution and bankruptcy

Imagine a private company whose strategy is to borrow from people and repay them much later with the money resulting from certain productive activities. Also, imagine that the organization somehow succeeds in increasing the borrowing to the point where its projected receipts from the productive activities in question are almost certainly not going to be remotely sufficient to fulfil the obligations it has assumed. Even if the contracts under which the money is borrowed do not contain explicit financial covenants, such behavior seems to be in stark violation of the implied covenant of good faith recognized in the common law jurisdictions and the express statutory obligations for contracting parties to act in good faith usually contained. This obligation is clearly violated in our thought experiment because when someone lends money to an organization, she certainly believes — and the borrower knows that she believes — that the borrower will not take steps that obviously make the repayment of the loan essentially impossible. Obviously, in our thought experiment, the situation in which the imaginary company finds itself in is not rectifiable and it would be eventually pronounced bankrupt by a court.

There are not many private organizations who behave like that but the same cannot be said about modern developed states. Over the time frame in which they have operated entitlement programs like pay-as-you-go (PAYG) pension systems and single-payer or co-payment based healthcare, governments in such states have been doing an equivalent of what the hypothetical company did: they have been massively increasing payments to the growing number of current beneficiaries, and making promises to more and more current employees in exchange for taking money from them.

At present, we have reached a point where entitlement programs are perhaps the biggest problem facing most developed societies at present, even if few members of these societies realize the whole extent of the trouble. It is not just that those programs are essentially bankrupt, and may lead to spectacular government defaults and massive social unrest that could propel collectivist populism. These programs also deeply hamper the domains that they are supposed to improve.

PAYG pension systems in all likelihood have already resulted in massive underinvestment. A good illustration of this is the rate of return that they offer to the recipients on the money that were taken from them over the years preceding retirement. As Jeremy Siegel recently calculated for The Wall Street Journal, his accumulated pension contributions will increase by the factor of 2.55 if he lives to the age of 90. However, if his contributions had been invested into an index fund, instead, his total contributions would have been multiplied almost by seven by the same time.

In addition to causing damage in similar ways, healthcare entitlements have a highly detrimental effect on the medical industry. Single-payer systems lead to long waiting times while systems where government pays a large part of the medical expenses, like in the US, lead to huge administrative burden and breakdown of price mechanisms. CATO Institute scholar and surgeon Jeffrey Singer recently provided a sobering account of this process launched by the expanding Medicare.

The reasons for doing something about the runaway entitlement programs, and fast, do not end there. In developed country after developed country, welfare states are essentially bankrupt. For the sake of brevity, let us focus on the example of the United States. According to the calculations of a respected expert, Laurence Kotlikoff, the scale of the pension and healthcare promises which are not covered by the projected revenues is a staggering $222 trillion, or almost thirteen times the US nominal GDP. The magnitude of the problem is such that it is impossible to tax its way out of it. Of course, the Federal Reserve may just print money and drastically lower the real burden of these obligations but this would be a default in all but name.

As the recent financial and political turmoil in Greece demonstrated, an unsustainable pattern of government debt accumulation may run into a halt in a dramatic fashion, through the financial markets refusing to further accommodate government bond issuance. At the same time, in many developed countries there is a worrying trend of ascending xenophobic populism with authoritarian undertones. Donald Trump in the US, National Front in France and Law and Justice in Poland are just the most prominent examples of this, and they have burst into the political scene, even though the respective countries have not been facing all-out socioeconomic crises. One can only imagine what could transpire in case of a sudden involuntary collapse of welfare states. The whole liberal democratic order on which the modern life in the developed countries is built may then be under a serious threat from the panicked voters.

However, there is a very big difficulty in trying to resolve the issue through normal political mechanisms. Entitlement programs are very popular among voters, even those who are generally skeptical about large-scale government involvement in the economy. It is clear that politicians craving for getting reelected are probably not going to address the issue, until it is too late to do it. It may, however, be objected that the political situation in developed societies is grim for any reform. The main problem is that entitlement programs remain very popular, and there is scarcely any understanding of what a ticking time bomb they represent. For instance, according to the polling done by Pew Research Center in 2013, 69% of respondents voiced support to keeping the Social Security and Medicare benefits as they are as opposed to reducing deficits. Just 23% expressed an opposing opinion.

However, even though it is probably impossible to reform entitlements through normal political mechanisms, there is another way which is rarely considered. In principle, courts, especially in common law jurisdictions can call the massive violations of the entitlement obligations by governments and dismantle welfare states not unlike in the case of the hypothetical company with which we started.

The initial implausibility of this course of action stems from the prevalence in one way or another of the notion of sovereign immunity of states. In common law, for example, this principle has the status of a well-established doctrine. However, is this doctrine as unassailable as it seems at first sight?

It will suffice for our purpose to consider the example of the US. In one of the key cases on the matter, In re Ayres, the US Supreme Court (the SCOTUS) gave the following justification to the principle of sovereign immunity:

The very object and purpose of the Eleventh Amendment were to prevent the indignity of subjecting a state to the coercive process of judicial tribunals at the instance of private parties. It was thought to be neither becoming nor convenient that the several states of the union, invested with that large residuum of sovereignty which had not been delegated to the United States, should be summoned as defendants to answer to complaints of private persons…

Although the case concerned a state and not the national government, it is evident from the quote that the justification of the sovereign immunity for the states is analogous to that for the US as a whole.

Judging by the more recent US court decisions on the matter, this seems to remain the key justification for the doctrine of sovereign immunity in the US but it is even more important that something similar to this reasoning is probably going to be reproduced by a court in any common law jurisdiction or even beyond.

The key underlying idea seems to be that in the modern democracy, the voters taken together are essentially the owners of the state, and ultimate decisions regarding their property can only be made through voting.

A simple issue raised by economists in the public choice tradition casts a strong doubt on the idea that voters can be considered as effective owners of the state. The probability for any single voter to cast the decisive vote in a national election is, for practical purposes, indistinguishable from zero.

It can be argued, of course, that the situation is similar with many publicly traded corporations that can have hundreds of thousands of small shareholders. However, voters, unlike shareholders in large publicly traded corporations, cannot exercise a right of exit through selling their shares.

If the idea that the totality of voters are the owners of the state is rejected, the only alternative owners that remain are the members of the bodies that actually can effectively make fundamental decisions about the expenses, revenues and property of government — members of parliaments. As bankruptcy involves removing the current owners from the control of the troubled enterprise, the bankruptcy of a nation state with respect to its entitlement obligations should involve courts replacing the parliamentarians with special administrators with regard to all matters involving expenditures, revenues and property of the state, until the issue of entitlement programs has been resolved.

The volume of this essay does not permit to address the way courts should resolve this issue but there are two key elements. A cut-off age should be established below which entitlement obligations will be pronounced invalid. If, for instance, people who are now 45 years old are told that they have to save for their retirement, twenty years of savings opportunities will probably be sufficient in the vast majority of cases. This approach is better in any case than continuing with the PAYG approach until the system undergoes a sudden bust.

Future beneficiaries who are above the cut-off age and the current beneficiaries should be provided with special accounts on which they will be receiving the proceeds from the gradual sale of government properties. The graduate sale approach is more reasonable because even though, on paper, governments own property with a very high estimated value, this does not mean that all or a large part of this property can be sold at once at its estimated market value.

It may be argued that the review of the sovereign immunity doctrine suggested here is too much of a change of approach for common law courts but it would arguably be at least not more radical than what the SCOTUS did in the 1930s, when it largely reversed its longstanding practice of pronouncing government restrictions of economic freedom as unconstitutional. For instance, before 1937, the SCOTUS repeatedly nullified minimum wage legislation invoking the US Constitution’s due process defense from the 14th amendment. But in West Coast Hotel Co. v. Parish, the court explicitly reversed course with the following justification:

We think that the question which was not deemed to be open in the Morehead case is open and is necessarily presented here. The Supreme Court of Washington has upheld the minimum wage statute of that State. It has decided that the statute is a reasonable exercise of the police power of the State. In reaching that conclusion, the state court has invoked principles long established by this Court in the application of the Fourteenth Amendment. The state court has refused to regard the decision in the Adkins case as determinative, and has pointed to our decisions both before and since that case as justifying its position. We are of the opinion that this ruling of the state court demands on our part a reexamination of the Adkins case. The importance of the question, in which many States having similar laws are concerned, the close division by which the decision in the Adkins case was reached, and the economic conditions which have supervened, and in the light of which the reasonableness of the exercise of the protective power of the State must be considered, make it not only appropriate, but we think imperative, that, in deciding the present case, the subject should receive fresh consideration.

The key reason for overriding of the established precedent seems to have been the change in economic conditions. While it can be argued that minimum wage legislation in times of economic crisis is probably even less justified than normally, the case for abandoning the sovereign immunity with respect to the essentially bankrupt welfare states, given the changed demographics and the real threat of populist dictatorship that a disorderly collapse of welfare states poses, seems to be far more solid than what sufficed in 1937.

It seems, therefore, that if courts and legal academics become willing to abandon the unfortunate myth that the voters effectively own the state, this may pave the way for resolving perhaps the biggest political issue of our time.

Show your support

Clapping shows how much you appreciated Daniil Gorbatenko’s story.