Lessons on Handling the Puerto Rico Crisis

Lessons on Handling the Puerto Rico Crisis

Puerto Rico's debt crisis — the subject of House hearings later this month — represents a failure of the island's unique commonwealth governing model. It's not a country, not a state, and not a territory. Instead, Puerto Rico is a combination of all three: a largely self-governing island with heavy economic and political dependence on a great power.

North America has seen this movie before, but it played in a remote area long ago, so most of us didn't catch it. For those of us watching the new version, here's a spoiler alert: Puerto Rico needs a break from the party politics that led it to fiscal ruin, followed by a path to statehood. To understand why, look north rather than south, to Newfoundland — the autonomous British colony that required a bailout in 1932 and in 1949 became a Canadian province.

Like Puerto Rico today, Newfoundland had a long colonial history, followed by a period of increasing self-government without independence. In 1832, the colony was granted an elected parliament, and after 1855, executive authority was shared by locally elected officials, ushering in a system called "responsible government."

The elected government ran up substantial debt for railroad construction, barely avoiding a default in the 1890s. During World War I, the colony's economy boomed amid increased demand for its main export, cod fish. Due to the war, European competitors were unable to maintain their cod production, enabling Newfoundland to increase shipments and raise prices.

By 1920, the boom ended, but government spending remained at high levels. Between 1920 and 1932, annual deficits averaged 20 percent and Newfoundland's public debt almost doubled. This fiscal mismanagement left the government unable to cope with the effects of the Great Depression — just as the highly indebted Puerto Rico government is now unable to cope with its own long-running recession.

At the end of 1932, default became inevitable, but it was averted by a joint British-Canadian loan. In order to obtain the emergency loan, the Newfoundland government agreed to abide by the findings of a newly formed royal commission. That body, known as the Amulree Commission, recommended that Newfoundland "be given a rest from party politics for a period of years." Newfoundland's elected government was replaced with a team of appointees selected by London.

This unelected government presided from 1934 to 1949. When its work was finished, Newfoundland was debt-free and even had a significant cash surplus. In 1949, Newfoundland was admitted to Canada as a full-fledged province, ending its experiment with a unique form of government.

Unfortunately, Canadian provinces' fiscal model has a serious flaw relative to that employed by U.S. states. While almost all states have some sort of constitutional balanced-budget requirement, provinces do not. Although state balanced-budget requirements have loopholes, they do limit debt accumulation to some degree. Thus, no U.S. state has debt burdens approaching those of most Canadian provinces.

After joining the Canadian federation with an elected government, Newfoundland returned to its spendthrift ways. In the 54 fiscal years between 1949 and 2003, the province recorded 51 deficits and only three surpluses. The government faced renewed fiscal crises in the early 1990s and early 2000s, after which higher oil prices and some degree of spending restraint brought improved fiscal conditions.

Newfoundland's history is instructive for Puerto Rico in two ways: First, Puerto Rico's commonwealth governing model — like Newfoundland's "responsible government" — is ineffective at balancing revenues and expenditures. By being tied to the United States, Puerto Rico has had access to unusually deep capital markets and substantial federal subsidies, reducing pressure to keep spending in line.

Thus, a federal bailout of Puerto Rico should be accompanied by a "rest" from Puerto Rico's party politics. An appointed control board, free of worries about political patronage, should be able to adjust the island's spending while restructuring its debt. As I discuss in a forthcoming Mercatus Center study, Puerto Rico's government is riddled with wasteful spending such as overstaffing in its Medicaid program and an excess of correctional facilities given a declining prison population.

But equally important is what happens after an appointed control board finishes its work. A return to the commonwealth's failed governing model would be a recipe for another financial crisis down the road. Instead, Puerto Rico requires a path to statehood and a state constitution that enforces fiscal discipline.

Marc Joffe is the principal consultant at Public Sector Credit Solutions and a former senior director at Moody's Analytics. He's the author of a forthcoming Mercatus Center at George Mason University study on the origins of Puerto Rico's fiscal crisis.

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