Where Puerto Rico Went Wrong
Long-term reform is needed.
Stop me if you've heard this one before: A government, run by a succession of politicians, spent frivolously for decades and repeatedly ignored all the warning signs of looming fiscal disaster, and now that it has arrived, is begging for a bailout. No, I'm not talking about Greece. This time, it's Puerto Rico. And the Republican-controlled Congress is seriously considering a bailout.
Even Washington's out-of-touch cronies recognize that a simple cash bailout would be too politically toxic. But they've come up with an alternative that may have some appeal but also has very problematic features: bankruptcy.
It's not hard to see where Puerto Rico went wrong. About one-third of its working population works for the government. Its bloated workforce accounts for more than two-thirds of the budget, while onerous labor laws and regulations strangle the economy and prevent it from keeping pace with the growth of government. Compared to the island's lower standard of living, generous federal welfare benefits also contribute to an extremely low 50 percent participation rate in the labor force. That, along with the high shipping costs imposed by the Jones Act, are problems that Congress can help solve, but the rest is up to Puerto Rico itself.
The appeal of bankruptcy is that, in theory, it lets municipalities get out of the bad contracts that are causing the financial problems, such as excessive pension promises. Puerto Rico, like the District of Columbia, is not granted access to Chapter 9 bankruptcy under federal law. Hence, the call to change the law.
However, bankruptcy is never the silver bullet people make it out to be. For better or worse, the absence of bankruptcy authority is the legal framework under which creditors purchased bonds and lent the territory the more than $70 billion in debt it's accumulated. To retroactively change the rules and allow Puerto Rico and its public-sector corporations shed their obligations would be to undermine the rule of law.
Treasury Secretary Lew recently urged Congress to pair a control board or other fiscal oversight mechanism with an "orderly process to restructure its debts." But the commonwealth can already negotiate with creditors to restructure debt, and in at least one instance has already done so when the Puerto Rican Electric Power Authority—one of the island's biggest debtors—negotiated down its debt by reaching a deal with bondholders.
What Lew is asking for is the ability to unilaterally rewrite terms and stiff creditors by leaving them with pennies on the dollar. Moreover, politics usually still dominates the process as we saw in Detroit, where the creditors' priorities were ignored to serve powerful interest groups. This is why a strong and principled control board is so important. But can we trust today's Congress to really play that role?
Unfortunately, in case of failure, the consequences could be long lasting. Puerto Rico's investors already know that they made a bad investment and won't get repaid. But by changing the rules of the game, they may be scared to invest in Puerto Rico for years to come, too.
To be sure, as my colleague Maurice McTigue rightly points out, it's the creditors that facilitated Puerto Rico's bad debt habits by lending to a profligate spender without a good revenue source. Many were retail investors wooed to buy bonds because of the tax exemption and probably had no clue about Puerto Rico's fiscal state.
There's also the matter of incentives. Right now, they're biased toward fiscal irresponsibility on the part of the government. Lew's policy may only sharpen the bias against fiscal stewardship and undermine the likelihood of seeing real fiscal reforms. Indeed, the ability to substitute the dismissal of contractually agreed upon debt obligations for budget cuts is more temptation than politicians can resist and undermines incentives to fix what really ails Puerto Rico.
From the taxpayer's point of view, there's no denying that allowing bankruptcy is better than a bailout. However, the only real path forward for Puerto Rico is to finally address its fiscal mismanagement while unleashing its economy through pro-growth reforms. Bankruptcy poorly executed may slow down that process and lead to more fiscal craziness. If that's the case, taxpayers may have to foot the bill for a bailout after all.
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