This is a post from the State Bar of Michigan's official blog. The post is the original content of University of Indiana School of Law Professor Gerard Magliocca.
Not that this would ever happen in Michigan, but Prof. Magliocca guest blogs at Balkinization on the constitutional implications of a state going into default, in "Too Big To Fail" States".
He says we better get ready, especially for a default by a big state:
The prospect that a state like California might default or need a bailout raises two interesting constitutional questions. The first is whether Congress can attach conditions to a bailout that would require a state to undertake substantial reforms of its constitution. I think the answer is yes. Under South Dakota v. Dole, Congress has broad authority to place strings on the receipt of federal money so long as there is some relationship or germaneness between the money and the terms. After all, the state is always free not to take the funds.
The much harder question is what happens if a state threatens to default unless it gets a bailout. In the case of a small state, this is not much of a threat. A default there would not cause any systemic problems. If California or another large state defaults, however, that's a different story. These states may be "too big to fail." What's worse, they know this. It is clear that Congress cannot just order a state not to default--that would run afoul of New York v. United States and the Tenth Amendment. Thus, if California comes to Congress for a bailout, the state is the one with the leverage. ("Give us a bailout on generous terms or else.") In effect, this would create the possibility of a "reverse unfunded mandate"--the federal government picking up the tab for a profligate state.
What can be done to address this issue? One possibility, I suppose, is that Congress could declare that a state in default is not "a republican form of government" under the Guarantee Clause and then order them not to default. That's a pretty heavy lift though, especially since states that defaulted in the past were never considered "not republican." The other thought is that Congress could threaten to withhold other federal spending from a renegade state. Would this be constitutional? I'm not sure. There's a difference between saying to a state, "Here's a gift with some conditions. Take it or leave it" and saying "Here's a gift. Take it or else we are going to kick you in the teeth." Nevertheless, that might be the only way to make a default so costly for the state that it would have to accept a bailout under stringent terms.
One reason we got into trouble in 2008 is that there were no default rules (or analysis) in place when "too big to fail" financial institutions started to fail. We'd better not make the same error when it comes to state governments.