Why Congress Should Let Puerto Rico Declare Bankruptcy

On Monday, Puerto Rican Governor Alejandro Padilla announced that the island’s seventy-two-billion-dollar debt load was, on its current terms, “not payable.”Photograph by Ricardo Arduengo/AP Photo

It hasn’t exactly been a quiet week in the world’s debt markets. Not only has Greece defaulted on a loan from the International Monetary Fund but on Monday Puerto Rico’s governor, Alejandro Padilla, announced that the island’s seventy-two-billion-dollar debt load was, on its current terms, “not payable,” and warned that, in the absence of debt relief, Puerto Rico could enter a “death spiral.” Padilla was essentially calling on Puerto Rico’s creditors—which include not only hedge funds but also municipal-bond funds that have been busy buying up the island’s debt—to restructure its obligations. It was a reasonable and, in terms of what’s best for the Puerto Rican economy, eminently sensible request. But it’s still unclear if it will have any effect.

Puerto Rico’s dilemma boils down to a couple of simple facts: its debt is enormous relative to the size of its economy, and, as I wrote recently in the magazine, that economy has been stuck in recession for almost a decade. While the U.S. territory has made some progress in trimming public spending, and is running a primary surplus (its budget balance without including interest payments) of eight hundred and fifty million dollars, its interest and amortization costs amount to $2.8 billion, which leave it with a deficit that dwarfs the economy’s growth rate. That means the island’s debt load, relative to G.D.P., is getting bigger every day, effectively forcing Puerto Rico to borrow money to pay off past borrowings, which of course leaves it further in debt and makes it harder to get out.

So what should Puerto Rico do? In the long run, the island’s economy needs real structural reforms, as a report, released Monday, that was commissioned by the current government and co-authored by the former World Bank chief economist Anne Krueger, makes clear. These reforms, many of which would require action by the U.S. Congress, could include things like trimming the minimum wage, exempting Puerto Rico from federal laws that reduce the island’s competitiveness, and restructuring the island’s notoriously inefficient electric utility. But these changes aren’t going to help in the short run. And while there is room for Puerto Rico to raise taxes or make further cuts in government spending, forcing the island into more austerity is exactly the wrong strategy to pursue at the moment, since that would only drive the economy further into recession and make the debt load even harder to pay off. Federal assistance could help, but on Monday the Obama Administration ruled out any kind of bailout.

The only real option, then, is precisely what Padilla talked about on Monday: a restructuring of Puerto Rico’s debt. The simplest, and most likely, solution would be for bondholders to exchange their current bonds for ones with longer maturity periods and lower interest rates. This is hardly a radical concept: companies in distress regularly restructure their debt payments. But it would be better still if Puerto Rico had a more dramatic choice available—namely, the ability to declare bankruptcy.

The challenge Padilla faces in getting creditors to come to the table, after all, is that his leverage with them is limited. First, the commonwealth’s constitution has a provision that so-called “general obligation bonds” must be repaid. More important, there is no legal provision in the U.S. that would allow Puerto Rico to declare bankruptcy. Cities can do so, but states cannot, and though Puerto Rico isn’t a state, it’s similarly barred from the process. Paradoxically, this prohibition was traditionally framed as a way to protect states from being forced into bankruptcy by their creditors. But the practical result is that when a place like Puerto Rico finds itself staggering beneath a pile of debt, it has no way to use the legal system to shrink it. The island could, of course, simply stop paying its debts, but that would create a legal morass that could take years to resolve, and would also, presumably, cut it off from further borrowing.

This is a problem that Congress can solve. As David Skeel, a corporate-law professor at the University of Pennsylvania, argued in an article for the Weekly Standard in 2010, Congress has the constitutional authority to pass a law letting states—or, in Puerto Rico’s case, territories—declare bankruptcy. Of course, the mere mention of bankruptcy for governments (whether Greece or Puerto Rico) inevitably brings cries that it’s just a way for feckless governments to escape the consequences of their fiscal mismanagement. But America has always had relatively lenient bankruptcy laws, because we’ve recognized that there is a limit to how much you can expect people to toil in the future in order to pay off the bad decisions of the past. That’s as true—and, in fact, might be truer—of states and countries as it is of corporations and individuals. In any case, bankruptcy is hardly an easy process, as Detroit has discovered. On the contrary, it typically forces businesses and governments to make painful choices. This, arguably, is an unsung benefit of letting governments declare bankruptcy: it gives them the political cover to institute reforms that are otherwise very hard to sell to the public.

There will, of course, be those who say simply that Puerto Rico borrowed the money, so it should find a way to pay it back, even if that means slashing social-welfare spending to the bone and leaving the economy stuck in the doldrums for years to come. But debt crises are never just the responsibility of the borrower; the lenders bear some of the responsibility, as well. In a capitalist system, after all, it’s the job of lenders to evaluate risk, and to be cautious about letting borrowers accumulate more debt than they can reasonably be expected to pay back. When lenders fail to do that job well—as is the case with all the people who blithely lent money to Puerto Rico—then they should bear some of the cost of writing down the debt. That’s the basic principle of bankruptcy: sacrifice has to be shared. It would be nice, if surprising, for Congress to make that possible for Puerto Rico.