Puerto Rico has now firmly established itself as America's analogue to Greece. To get back to fiscal sanity, Puerto Rico is going to need some combination of debt forgiveness, political reform, and privatization. Congress may be in a position to help, but it will have to face down powerful special interests to do so.
After missing relatively small bond payments last August and this January, Puerto Rico's public sector defaulted on at least $367 million of principal due May 1. As a consolation, investors did receive $9 million in interest from the defaulting entity, Puerto Rico's Government Development Bank.
The fact that Puerto Rico even has a Government Development Bank should raise an eyebrow. State-owned banks are not a major feature of the mainland US economy, perhaps because failures of state banks contributed to a number of state bond defaults in the 1840s. Since the US didn't take over Puerto Rico until 1898, the island was not around to learn that lesson. The GDB is one of over fifty public corporations dominating Puerto Rico's economy. Others control the island's electricity, water, and sewer services.
Public corporations date back to the 1940s and largely owe their existence to the efforts of Rexford Tugwell. "Red Rex" was a Columbia University economist who was sold on the virtues of the Soviet way when he visited Stalin's Russia in 1927. He went on to play a leading role in implementing Roosevelt's New Deal. In 1941, FDR appointed Tugwell as Puerto Rico's governor, where he applied a similar state-led economic model. While much of the New Deal was unwound on the mainland, Puerto Rico's public corporations persisted on the strength of borrowed funds.
Puerto Rico's 1917 congressionally-imposed constitution limited Puerto Rico's central government and municipal debt to 7 percent of assessed property values. It also mandated a balanced budget. These limits did not apply to public corporation debt, and these entities started borrowing liberally.
A new constitution ratified in 1952 as amended in 1961 relaxed constitutional limits on Puerto Rico central government and municipal borrowing. A major cause of this relaxation was a mistranslation of balanced budget language in the 1952 constitution. While the English version instructs the legislature to balance revenues and expenditures, the Spanish translation of revenues was closer to "resources". The Puerto Rico government interpreted "resources" broadly, even including bond proceeds. It thus became possible to "balance" the budget with borrowed funds.
By the early 1980s, public sector debt had reached 82 percent of GNP—not far below today's level of about 100 percent. Puerto Rico muddled along with high debt levels until recently, when a long-lasting recession, out-migration, a string of unbalanced budgets, and loss of bond market access triggered the current crisis.
So what now? Detroit, San Bernardino, Stockton, and Vallejo were able to reduce their debt burdens by using Chapter 9 of the federal bankruptcy code. But that option is not available in Puerto Rico. The Commonwealth passed its own version of Chapter 9 in 2014, but its implementation has been held up by litigation which recently advanced to the Supreme Court. Puerto Rico then asked Congress to extend Chapter 9 to the island, but House and Senate bills making this change went nowhere in 2015.
Now that Puerto Rico's crisis has deepened, House Republican leadership and the Obama Treasury Department have reached a broad agreement on what needs to be done. The plan, embodied in HR 4900, combines a new legal process for debt restructuring with a federal oversight board to help Puerto Rico balance its budget.
Oversight boards are undemocratic, but they succeeded in New York and Washington, DC. As I discussed in a recent paper for the Mercatus Center at George Mason University focusing on the historical causes and potential solutions for the crisis, this formula also proved effective in Newfoundland—which was transformed from an insolvent British Colony to a debt-free province of Canada by an appointed government.
With Puerto Rico's population shrinking, many government facilities could be consolidated. Although some schools have been shut, the Commonwealth has resisted closing prisons. Puerto Rico has maintained the same number of correctional facilities in recent years despite a substantial drop in prison population. It has a large number of unused cells and more guards per inmate than any of the 50 states. Puerto Rico's elected government, susceptible to the influence of correctional officer unions, may be unable to make the necessary cuts. Unelected technocrats staffing an oversight board should be more effective.
The more controversial portion of the bill has been the restructuring authority. The proposed legislation creates a process in which bondholders negotiate with Puerto Rico public sector debt issuers restructuring terms (such as delayed principal and interest payments, or write-downs of bond value). If a restructuring agreement is approved by a certain percentage of bondholders and approved by the oversight authority, courts can impose the deal on all bondholders.
There are several factors beyond the scope of my Mercatus research that merit discussion. The possibility of debt restricting has horrified hedge funds, several of whom bought Puerto Rico's debt at fire sale prices and intend to use litigation to secure maximum payouts. This is the route Paul Singer successfully pursued with defaulted Argentina debt. The House bill, if enacted, shuts down that avenue: Litigious hedge funds would get the same payout as widows living on municipal bond interest in retirement, which is not a good way of justifying the hefty fees they charge their clients.
The fund managers have reacted by trying to derail the legislation. The Center for Individual Freedom—which serves as a useful stand-in for these hedge funds—has been running issue ads on cable news networks, Washington DC broadcast stations, and in committee member districts blasting the proposed bill as a federal bailout. The ads mislead viewers into thinking that U.S. taxpayer dollars will be given to Puerto Rico, ginning up constituents and generating calls. Because CFIF is a dark money group we don't know how much the ads cost, but it is likely to be several million dollars.
Many libertarians are mistakenly supporting the hedge funds' cause: arguing against restructuring legislation because it changes the terms of an agreement between bondholders and Puerto Rico governments in the middle of the game, undermining the sanctity of contract. But, as Murray Rothbard argued in 1992, orthodox libertarians should reject government bond agreements because these obligations are satisfied by coercively extracting money from taxpayers. Rothbard concluded that the only appropriate solution was repudiation of government debt, a view shared by Jeff Hummel and Wendy McElroy. While less pure libertarians may not wish to go that far, these scholars help us to recognize that government contracts should not be considered sacrosanct.
The current House bill is the right way forward for Puerto Rico. Ignore the dark money ads and move forward with the combination of federal oversight and debt relief.
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