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Here Comes Puerto Rico's Default

Walter Russell Mead

First San Bernardino, then Detroit. Illinois cities and towns from Chicago on down in trouble. Now this, via the WSJ:

Investors are bracing for Puerto Rico to miss about $58 million in bond payments in coming days, as the U.S. commonwealth attempts to restructure $72 billion of debt.

Saturday’s deadline could mark the first skipped payment to bondholders since Gov. Alejandro Garcia Padilla last month said that the island’s debts were unsustainable and urged negotiations with creditors. Because Saturday is a weekend, payment can be made Monday, a spokeswoman for Puerto Rico said.

Public Finance Corp., a financing unit for Puerto Rico’s government, this month notified holders of appropriation bonds, typically those backed by funds set aside by the legislature, that it hadn’t transferred money to a trustee to pay the debt due at the beginning of August. The corporation said the legislature never actually appropriated the funds. The missed transfer led some ratings firms to say the island was highly likely to default.

The Puerto Rico meltdown is going to be brutal: Many of the bonds are held by Puerto Rican retirees, either directly or as part of pension fund portfolios. Moreover, the island is a typical example of blue model governance, with a bloated state that doesn’t perform effectively, public sector unions out of control, and lots of poor people who depend on a government that doesn’t serve them very well. And on top of all this, there are no bankruptcy provisions that would enable an orderly restructuring.

Ultimately, bankrupt blue cities and states and their pension funds will troop to Washington with their hands out, begging for bailouts. Already we’ve seen a leading New Jersey state Democrat call for a $1 trillion federal bailout fund for pensions. The political pressures around the issue will be intense. Some (mostly Republicans) won’t want to give a single dime to the improvident fools and crooks who created this mess. Others (mostly Democrats) will insist on no-fault bailouts, arguing that social justice demands nothing less than an infinite willingness to pour money down ratholes, so long as those ratholes are Democrat-run.

What the country needs is something in between: relief for reform. Cities, counties, and states (or, as in the case of Puerto Rico, commonwealths) who can’t manage their debts anymore can qualify for limited help—but only if they undergo serious, life-changing reform. That may well mean the end of public unions, drastic changes in governance, haircuts all around, tax reforms, and other substantive changes. Forward-looking people in Congress should be thinking now about the legislation that would be needed to set up a framework of some kind to handle these cases. The legal issues are complex; courts have been upholding, for example, the inviolability of employee pensions under state constitutional provisions. It’s hard to see how federal bailouts would let those pensions go unchallenged.

It’s going to be difficult and it’s going to be painful, but there are three things the federal government needs to do.

First, it needs to figure out how ‘relief for reform’ could be applied and administered so that the inevitable pain of the coming blue meltdown is managed in an orderly and reasonably fair way, resolving issues as quickly as possible.

Second, it needs to take proactive measures that would keep this mess from getting worse. Bringing public pension systems under the same tight regulatory oversight now used for private pension plans is a good place to start. But given the role that federal tax exemptions play in the municipal bond market, there is something to be said for making eligibility to issue tax-exempt bonds conditional. State and local governments that want federal tax-exempt bonds might need to demonstrate the sustainability of their budget policies and debt burdens. This should not be a tool for micromanaging state and local governments (one can see liberals leaping to impose identity politics mandates, unreasonable wage policies, renewable energy mandates, and every other kind of impractical burden on local governments through a mechanism like this). Rather, it should focus as tightly as possible on economic fundamentals, and nothing else.

Third, the federal government needs to get its own house in order. Programs like Medicare are as fiscally unsustainable as any fly-by-night Illinois pension Ponzi scam; if the feds keep behaving recklessly they won’t be able to bail anybody out.

The United States faces some serious issues as the 2016 election cycle begins; the blue model meltdown is bigger and in its way more toxic than anything that happened at Chernobyl. Reporters and voters should be asking candidates what they plan to do about it.

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