Puerto Rico, wealth redistribution and a needed control board

The Puerto Rico debt mess now has arrived on Congress’s agenda, a sure sign that some perceive gains from politicizing it. “Politicizing it” means using the issue to transfer wealth to favored constituencies. Since the commonwealth must restructure its massive $73 billion debt — Puerto Rico is the third-largest issuer of municipal bonds in the U.S. — the competition is on to see which groups will be left to endure more fiscal pain than others.

{mosads}That is the issue to be decided by Congress. Because federal legislation enacted in 1984 prevented Puerto Rico and its various municipal agencies and bureaus from using Chapter 9 bankruptcy, a retroactive reversal of that policy will carry serious implications for the entire municipal bond market: Who will believe such promises again? The proscription of Chapter 9 bankruptcy has created efficient incentives for public officials because they have political time horizons — the next election — shorter than the economic horizons shaping business decisions. Municipal debt crises would have adverse effects down the road, but those would be borne by future officeholders rather than those currently incurring too much debt. Accordingly, the prohibition on municipal bankruptcy imposes a useful constraint in the here and now.

It is no surprise that Puerto Rico officials are desperate for retroactive access to Chapter 9; that would make negotiations with creditors far easier. At the same time, it would weaken pressures for needed policy reforms, as a summary review of the recent bankruptcy for Detroit — often described as “successful” — demonstrates. Pension costs were the single largest outlay in the city budget, but the bankruptcy in effect reinstated pension obligations in full while bondholders received less than 10 percent of what was owed them. City officials were able to avoid the adoption of almost all major cost efficiencies, such as those recommended for the Department of Transportation. Not one of Detroit’s 28 agencies was closed. Infrastructure planning has not been adjusted to reflect a population decline of almost two-thirds. And so on.

In short, a retroactive resort to Chapter 9 will penalize those not responsible for the fiscal problems confronting Puerto Rico, will weaken commonwealth incentives to adopt fiscal and governance reforms, and will increase future borrowing costs for the municipal bond market writ large.

And so we return to the theme of how the Puerto Rico fiscal pain will be distributed. The main contestants are bondholders and other creditors, commonwealth taxpayers, the beneficiaries of public spending programs and quasi-public delivery of services, and public employees. These appropriate policy goals must be kept in mind — finding a path forward for Puerto Rico while:

• Preserving sound longer-term incentives for fiscal discipline; 
• Preserving political accountability for fiscal choices; and
• Preserving the commonwealth’s ability to make ongoing investments in needed infrastructure.

A retroactive resort to Chapter 9 would “solve” the immediate debt crisis while politicizing the process of allocating the pain; can anyone believe that local politicians would not have powerful incentives to protect local interests at the expense of everyone else? It also would create perverse incentives both for Puerto Rico fiscal decision-making moving forward, and for the entire municipal bond market. Moreover, Puerto Rico’s borrowing needs over the not-distant future are substantial. Large investments in electric-generating equipment and infrastructure are needed to satisfy new environmental requirements now being finalized by the Environmental Protection Agency (EPA), and to move away from the use of expensive oil. The Puerto Rico Aqueduct and Sewer Agency — the debt of which already is below investment grade — has investment needs over the next few years of well over $1 billion, of which about $400 million alone is needed to satisfy consent decrees with the EPA. And so on. The need to finance such capital investment efficiently is inconsistent with the incentives created by a retroactive Chapter 9.

In a world of bad options, a temporary takeover of the commonwealth’s fiscal policies by a control board (or fiscal authority) appointed by Congress would be an approach vastly superior to a retroactive Chapter 9 bankruptcy. Such a control board was the basic approach used to extricate New York City from fiscal disaster in the 1970s, and was used also to reform fiscal policies in the District of Columbia in the 1990s. In short, neither New York City nor D.C. needed access to Chapter 9 to solve its problems. In the Puerto Rico context, such a control board would have the power to:

• Renegotiate labor contracts, revise work rules and restructure pension obligations;
• Impose discipline on commonwealth spending, reducing aggregate outlays and specific line items as needed to sustainable levels;
• Improve and modernize the tax collection system so as to increase the revenues paid by the legally-authorized tax base and also increasing the fairness inherent in the treatment of all taxpayers; and
• Improve the collection of fees paid for services provided by such commonwealth agencies as the Puerto Rico Electric Power Authority.

Such actions by a control board implementing a reform plan over several years would satisfy the policy goals noted above, with the possible exception of the preservation of political accountability. But Chapter 9 bankruptcy would fail in this dimension as well, and the same is true for any approach in which local policymakers do not adopt reforms that put the commonwealth on a sound fiscal path over the long run. Local policymakers are incapable politically of doing so. That no easy option is available is obvious, but a control board offers a path forward without the perverse incentives and adverse effects that Chapter 9 would create. These are the realities that Congress should keep in mind.

Zycher is the John G. Searle scholar at the American Enterprise Institute.