Puerto Rico cannot pay its debts. The question now before us is not how it will go about making good on its financial obligations but how it will go about not making good on them.
A number of factors have contributed to this sorry state of affairs. Puerto Rico’s government spends too much relative to its income, and the commonwealth is plagued by familiar problems: dysfunctional tax and regulatory policies imposed by Congress, excessive pension and benefits promises offered to government employees as a cowardly way to keep compensation increases off the books; a political environment dominated by public-sector unions, which threw out Luis Fortuño, the last governor to make a halfway serious attempt at fiscal reform; an economy hampered by relatively low work-force participation, with the concomitant loss of private-sector production; an electorate susceptible to gimmicky non-solutions that promise real results without real reform; brain drain as its most skilled, energetic, and entrepreneurial residents leave as quickly as they can for better economic opportunities elsewhere in the United States.
This is a tragedy in that Puerto Rico had long been the great example that democratic and constitutional governance, the rule of law, property rights, and a strong currency work as well in the Caribbean as they do anywhere else, and that free trade isn’t just for Manchester. Puerto Rico is a dire warning about what happens when government is comprehensively colonized by government employees — when it stops working for the people and starts working for itself.
Puerto Ricans are American citizens, and Puerto Rico’s bonds, reduced to junk status though they may be, are held mainly by American financial institutions ranging from pension funds to insurance companies. A bailout cannot be countenanced, but neither can Washington play the role of economic Pontius Pilate and wash its collective hands of this matter. It may be that Puerto Rico should be an independent commonwealth, but it isn’t one.
What to do?
One possibility that has been floated is extending Chapter 9 bankruptcy provisions to Puerto Rico, which would require an act of Congress. Democrats are in the main happy to proceed down that avenue; Republicans, particularly the conservatives, hesitate. There is good reason for that hesitation: Chapter 9 is not designed for commonwealths, dependent or independent; it is a set of bankruptcy provisions for municipalities. It has been used to entities that are economically larger than Puerto Rico, with Orange County, Calif., notable among them. New York City narrowly avoided bankruptcy in 1975 with the help of a state and federal bailout, and Chapter 9 was subsequently amended, taking its current form. Most recently, it was used to reorganize the obligations of the bankrupt city of Detroit.
In the long term — which may not be all that long in coming — we probably a new chapter in the bankruptcy code.
Supporters of the Chapter 9 expansion argue that this would simply extend to Puerto Rico a legal instrument that is available to the 50 states. But that is not exactly true: Chapter 9 is available to municipalities and municipal agencies within states; there is, in fact, no body of bankruptcy law dealing with the insolvency of states themselves, a fact that is very likely going to be of acute interest to California, Illinois, and other states in the future. Almost half of the states do not extend Chapter 9 options to their municipalities; 16 do so with tight restrictions, and only a dozen have blanket authorization. Whatever the best approach for dealing with the Puerto Rico situation is, it probably isn’t Chapter 9.
And it is far from clear that Congress has the power to use Chapter 9 to manage Puerto Rico’s current crisis in any case: Extending Chapter 9 would constitute a clear ex post facto impairment of the property rights of Puerto Rico’s creditors, and as such is a constitutional no-no, not that such constitutional niceties carry much weight in the Obama era. The island’s creditors have made it clear that they are disinclined to go along with a Chapter 9 approach, in that the steep haircuts imposed on bondholders in the Stockton, Calif., and Detroit bankruptcies are fresh on their minds, not to mention the losses imposed on creditors in the Obama administration’s illegal bailout of General Motors. They will fight, instead, for a conventional receivership arrangement, seeking to secure their rights under conventional contract law.
In the long term — which may not be all that long in coming — the lamentable fact is that the United States probably needs a new chapter in its bankruptcy code, one covering states, territories, and other purportedly sovereign entities within the United States. The way that state courts have shielded pension promises from reform by bankruptcy law, on the implausible grounds that their constitutions make these benefits sacrosanct, needs special attention. This project will raise wide-ranging constitutional questions, and even an intelligently designed approach for the orderly resolution of future fiscal crises does little or nothing for the question of the here and now.
There is no replacement for real reform: Before anything else can be done, Puerto Rico simply must adopt a new set of fiscal policies that put its public finances on sustainable footing, and Congress and the Obama administration should use any and all means at their disposal to force that issue. That is going to mean imposing substantial reductions in public spending, with reductions in government pensions and retirement benefits figuring prominently. The commonwealth’s creditors are going to take losses, too, but they should be allowed to negotiate terms with the benefits of the law under which they lent.
The reality of state finances mean that what happens in Puerto Rico is more than a tropical storm — it will be a precedent. We should be careful to set the right one.