Puerto Rico:  A Big Default—What Next?

Rexford Tugwell, sometimes known as “Rex the Red” for his admiration of the 1930s Soviet Union and his fervent belief in central planning, was made Governor of Puerto Rico by President Franklin Roosevelt in 1941.  Among the results of his theories was the Government Development Bank of Puerto Rico, a bank designed as “an arm of the state,” which is a central element in the complicated inner workings of the Puerto Rican government’s massive insolvency.

The bank has just defaulted on $367 million of bonds, the first, but unless there is Congressional action, not the last, massive default by the Puerto Rican government and its agencies on their debt.  The Government Development Bank was judged insolvent in an examination last year, but the finding was kept secret.  The governor of Puerto Rico has declared a “moratorium” on the bank’s debt, which means a default.  A broke New York City in 1975 also defaulted and called it a “moratorium.”

Adding together the Puerto Rican government’s explicit debt of about $71 billion and its unfunded pension liabilities of about $44 billion, amounts to $115 billion.  This is six times the $18 billion in bonds and pension debt of the City of Detroit, which holds the high honor of being the largest municipal bankruptcy ever.

Puerto Rico’s government-centric political economy goes back to Rex the Red, but its budget problems are also of long standing.  In this century, the government has run a deficit every year, borrowed to pay current expenses, and then borrowed more to service previous debt until the lenders belatedly ceased lending and the music stopped.  Its debt and its real GDP definitively parted company in 2001 and have grown continuously further apart, as shown Graph 1.

As its debt skyrocketed, the credit ratings of its bonds fell and then crashed.  See Graph 2.

Graph 1

Graph 2

Where do we go from here?  Addressing the deep, complicated, and contentious problems requires three steps:

1. The creation of an emergency financial control board to assume oversight and control of the financial operations of the government of Puerto Rico, which has displayed incompetence in fiscal management (or mismanagement) is a central aspect of the solution. This control board can be modeled on those successfully employed to address the insolvencies and financial mismanagement in Washington, DC in the 1990s, in New York City in the 1970s, and in numerous other places.  More recently, the City of Detroit got an Emergency Manager along the same lines.

Such a board would be and must be quite powerful.  The sine qua non for financial reform is to establish independent, credible authority over all books and records; to determine the true extent of the insolvency of the many indebted government entities—in particular to get on top of the real condition of the Government Development Bank; and to develop fiscal, accounting, control and structural reforms which will lead to future balanced budgets and control of the level of debt.

Needed reforms cited by Puerto Rican economist Sergio Marxuach in congressional testimony include “increase tax revenues by improving enforcement efforts, closing down ineffective tax loopholes, and modernizing its property tax system; crackdown on government corruption; significantly improve its Byzantine and unduly opaque financial reporting; reform an unnecessarily complicated permitting and licensing system that stifles innovation; … lower energy and other costs of doing business.” A good list of projects.

Does all this take power and responsibility away from the Puerto Rican government?  Of course it does, it needs to, and it can be done.  Under the Constitution, Congress has complete jurisdiction over territories like Puerto Rico.  Just as in Washington D.C. and New York City, when the problems are straightened out, financial management will revert to the normal local government.

2.  Pollock’s Law of Finance states that “Loans which cannot be repaid, will not be repaid.” Naturally, this law applies to the $115 billion owed by the Puerto Rican government, which is on its way to some form of restructuring and reorganization of debts.  It seems clear that this should be done in a controlled, orderly and equitable process, which takes into account the various levels of seniority and standing among the many different classes of creditors.

The pending House bill puts the Oversight Board in the middle of the analysis and negotiations of competing claims. If the reorganization cannot be voluntarily agreed upon, the process can move to the federal court, where the plan of reorganization would come from the Oversight Board.

Three objections have been made to this approach.  One, with heavy advertising, claims that it is a “bailout.”  Since no taxpayer money is planned to go to creditors, this is simply wrong and ridiculous.  Bondholders taking losses is the opposite of a bailout.

A second is that bondholders may be disadvantaged versus pension claims, and this may affect the whole municipal bond market.  Indeed, in the Detroit bankruptcy, the general obligation bonds got 74 cents on the dollar, while the general city employee pensions got 82 cents— an important haircut, but a smaller one.  The political force of pension claims in insolvencies is a credit fact that all investors must take into account.  If the national municipal bond market internalizes and prices the risks of unfunded pensions, thereby bringing more discipline on the borrowers, that seems like progress to me.

A third objection is that the bill’s approach would set a precedent for financially struggling states like Illinois, which they might follow.  In my judgment, there is zero probability that Illinois or any other state would volunteer to have a financial control board imposed on it.  Even leaving aside the fact that Puerto Rico is not a state, this argument is vacuous.

3.  Of fundamental importance is that in the medium term, Puerto Rico must develop a sustainable economy—that is, a market economy to replace its historical government-centric one. Various ideas have been proposed relevant to this essential goal, and much more work is required.  This is the most challenging of all the elements of the problem.  Steps 1 and 2 must be done first, but Step 3 must be achieved for ongoing success.

One thoughtful investor in municipal bonds, reflecting on Puerto Rico, Illinois and other troubled political entities, concluded, “We don’t trust governments.”  That made me think of how there have been more than 180 defaults and restructurings of sovereign debt in the last 100 years, and how further back, a number of American states defaulted on their debts, and even repudiated them.  So I wrote him, “I think that’s wise.”

Nonetheless, the immediate requirement to deal with the Puerto Rican debt crisis is a federal government action.

Reader Discussion

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.

on May 11, 2016 at 14:30:38 pm

Why is this Caribbean island a U.S. territory, anyway?

read full comment
Image of Mark Pulliam
Mark Pulliam
on May 11, 2016 at 14:57:05 pm

From reading the Puerto Rico Constitution it looks like it suffers from at least two of the same general problems as the US Constitution.

First, there isn't effective oversight of the government. The proposal discussed in the blog post recognizes the problems of corruptions, but doesn't address causes. Problems deep in the architecture of a constitution lead to operational problems. What tends to happen in cases like PR is that quick fix work-arounds are applied, but the deeper architectural problems are not addressed. The quick fixes are faster and cheaper to implement, and the constitutional corrections are slow and difficult, so the quick fixes tend to be applied instead of the constitutional corrections.

Because the architectural problems are not addressed the problems continue. They continue in a different form because of the quick fixes, but they do continue. Over time as quick fixes are applied to address multiple problems, the quick fixes start to take a life of their own and start to become unmanageable. They introduce their own opportunities for governmental issues.

Any constitutional government would benefit from non-partisan elective methods, and from the use of the secret ballot in editing policy decisions, especially in the part of government responsible for preventing the enactment of bad laws. In the US Constitution that would be the Senate. Same with the PR Constitution.

The elected officers need to be dutiful only to the people who elect them, not to political parties or other interests. An improved election process can separate the politicians from interference by non-elective groups. Remove the interference and provide better oversight against corruption and a lot of governmental issues will go away overnight. First, establish political protections so elected officers are not subject to abuses (false accusations) by political players so the officers do not need the protection of parties.

Publicized voting creates opportunities for manipulation by giving punishment or rewards for voting for or against an act. The votes of US Representatives and Senators are published, which creates many opportunities for punishment and reward. In such a system the carrot and stick heavily influence the voting of policy makers and the people with the biggest sticks and the most carrots (the "one percenters" and the party establishment) have the most influence. With a secret ballot the carrots and sticks would become only shadows and policy makers could vote their consciences.

With these kinds of architectural reforms Puerto Rico would stand a chance at long term stability and prosperity. Quick fix "reforms" would produce short term improvements, but long term problems will remain.

Expect pro-statist progressives to propose the same kinds of things, except they will propose stronger populism in the reforms, and those kinds of reforms would only make things even worse over the long run. Populism has a funny way of giving the people with the biggest sticks and most carrots more control of government, not less.

Adding oversight and removing opportunities for corruption will fix the problems in Puerto Rico but only as long as the reforms go deep enough into the architecture.

read full comment
Image of Scott Amorian
Scott Amorian
on May 12, 2016 at 19:38:30 pm

This problem did not just spring from the head of Zeus. The graph shows a break down in fiscal responsibility since the beginning of this century. As a taxpayer, I see absolutely no reason to pay $250, my prorated share, for PR's either mismanagement or corrupt management, summing to the existing debt, $71 Bn. It is beyond obvious that fiscal managers, decades ago, concluded they and their buddies could live high and Uncle Sam would have to bail them out. Vote for me and I will raise your pay and retirement without raising any fiscal pain, tax.


The bond holders must take a hair cut. The government employees must take a hair cut. The retired government workers must take a hair cut. And the fiscal bosses must have a brick placed on their check, cut off completely, from any future pay outs.

This would send a message to the 6 - 7 states watching this moral hazard game. If we do not stop this, that green paper in your wallet will become just green paper. The federal debt is beyond paying in the next generation. We are transferring our national debt to Americans, yet conceived.

Government debt has grown to immoral proportions. This will destroy America long before climate change raises sea level.

read full comment
Image of R. L. Hails Sr. P. E. (ret.)
R. L. Hails Sr. P. E. (ret.)
on May 13, 2016 at 03:03:16 am

[…] be the last, writes Alex J. Pollock, a senior fellow at the R Street Institute, in a column at the Library of Law and Liberty. He notes that Puerto Rico’s Government Development Bank and “government-centric […]

read full comment
Image of Puerto Rico’s Debt Crisis Likely to Worsen | Certain Right
Puerto Rico’s Debt Crisis Likely to Worsen | Certain Right
on May 13, 2016 at 13:03:22 pm

Why is Puerto Rico a U.S. territory? It is an accident of the Spanish American War. Compounded by U.S. imperialism connected to the Panama Canal. (One 'resolution' to the problem is they threaten, or actually get their national independence.)

read full comment
Image of a2plusb2
on May 13, 2016 at 13:17:05 pm

Elsewhere I have seen two other "musts" mentioned.
* The U.S. minimum wage applies to Puerto Rico, even though Puerto Rico is only half as prosperous as Mississippi, our most impoverished state. The result is that about 50% of Puerto Ricans are formally unemployed. That must change.
* Puerto Rico particularly suffers from the Jones Act, which says that only US flagged, captained and crewed ships can travel between two U.S. ports. The Jones Act drives up costs a lot, and Puerto Rico's low cost situation can't compensate for that.

read full comment
Image of a2plusb2
on May 13, 2016 at 16:01:57 pm

In the late 1900s, world leaders became enthralled with Sea Power, thanks to a seminal book by Alfred Mahan. World leaders were convinced that sea power was essential to national destiny, economic and military power, etc. Sea powers need overseas naval bases. The Spanish American War was inspired in part by Mahan's theory. Spain held many overseas territories as a result of colonial/imperialist history, but had become a second-rate (maybe even third-rate) military power.

PR was seized by the US from Spain through victory in the Spanish American War.

We also briefly held Cuba, but quickly followed through on our stated goal of Cuban independence.

We also took the Philippines from Spain, which had been fighting a local insurrection since 1896. The American victory over Spain set the stage for a very nasty war (which we call the Philippines Insurrection) in which some 4000 American troops died fighting against guerrillas seeking immediate independence. We granted the Philippines independence shortly after WW2, the culmination of a long series of steps that gradually increased Philippine self government.

I for one do not know why we did not grant (or force) PR to accept independence. Maybe it was fear that PR would become a base for foreign naval powers in the Caribbean. Maybe a majority of its residents has never been keen on independence.

read full comment
Image of Brian in Michigan
Brian in Michigan
on May 14, 2016 at 10:45:46 am

"The political force of pension claims in insolvencies is a credit fact that all investors must take into account."

Pollock is suggesting that government pensioners shouldn't take their fair haircut. Government debt, issued by government workers on the back of taxpayers, is made with the "full faith and credit" of the PR government and its employees. It should be paid first, even if that drains pensions for existing and future government retirees, contrary to Pollock's suggestion. The "political force" is now null and void, because the politicians have bankrupted the territory. Making former and existing retirees take the bigger haircut, creates an incentive for government workers to ensure the government is well run. Breaking the rules for political reasons, creates a moral hazard and will make it worse for everyone else except for the government employees who drove the territory into its bankrupt condition.

read full comment
Image of MoreFreedom

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.