Should Puerto Rico Default?
Donald Trump caused a stir this week by suggesting that Puerto Rico's massive $73 billion public debt should be "wiped out." Puerto Rico narrowly avoided default with an interest payment this summer but the debt is a huge long-term problem for the island. While the cost of this burden is plain, talk of default is considered beyond the pale. Indeed, the White House immediately "walked back" the President's remark. “I wouldn’t take it word for word with that,” said OMB director Mick Mulvaney. What Trump meant, according to the summary in the New York Times, was that "the administration would be focusing its efforts on helping Puerto Rico rebuild from storm damage," while "the commonwealth would continue to proceed through the debt restructuring process it was undertaking before the storm." I.e., the debt problem needs to be solved, but not by forgiveness or default.
Trump implied that large investment banks like Goldman Sachs will need to take a haircut and, indeed, Goldman and other investment banks and hedge funds own about $17 billion of Puerto Rico's debt (one hedge fund, the Baupost Group, holds $1 billion all by itself). The rest is held by a variety of mutual funds and other institutional and individual investors (most Puerto Rican bonds are rated as "junk," so US pension funds cannot hold them.) In other words, all sorts of investors would be hurt by default (and have already been hurt -- Puerto Rican debt already trades at a 50% discount and prices fell even further to 37 cents on the dollar after Trump's statement.)
Of course, the interest payments have to be made by someone, i.e., Puerto Rican taxpayers (and, indirectly, taxpayers in the rest of the US via billions in disaster relief and other payments). Should taxpayers foot the bill for the bad investment decisions of investment banks, mutual funds, and other market participants?
I discussed the general case of sovereign default in two previous articles about the US national debt (here and here). I pointed out that there is nothing magical about government debt; it's a loan from investors to the government borrower and, like other loans, carries some risk of default. Investors weigh this risk, along with the expected yield, in comparing various investments. You buy the bond, you take the risk.
Private and corporate borrowers often default; that's what the bankruptcy code is for. Debts are restructured and even forgiven under various circumstances. Most people argue that government debt, especially US Treasury Bills, must always be paid because default would send a bad signal to the market, potentially wrecking the US economy. To this I say hogwash. As I wrote in 2016:
[T]he idea that the US can never restructure or even repudiate the national debt -- that US Treasuries must always be treated as a unique and magical "risk-free" investment -- is wildly speculative at best, preposterous at worst. Every other borrowing entity -- individuals, business firms, and governments -- has the option of renegotiating interest payments and even defaulting on loans. It is hardly an extraordinary event, even for sovereign borrowing -- that's why lenders charge a risk premium beyond the return they require to compensate for time preference. There is lots of evidence on private, corporate, and sovereign defaults, and the results are hardly catastrophic. Depending on the circumstances, the benefits of reducing debt can exceed the costs of harming the borrower's reputation and thus increasing the costs of future borrowing. Anyone who has been through a personal or corporate bankruptcy knows this.
My US states defaulted on their debt in the 1840s and many ended up in better financial shape than before. As I noted in 2013, government borrowers, like corporate borrowers, can also pay down debt by selling assets. Puerto Rico has a lot to sell, with a large number of state-owned enterprises including the island's electricity, water, sewer, and garbage collection providers. And how about some of those beautiful public beaches? Privatization would raise a lot of funds.
Neither default nor asset sales are perfect solutions to Puerto Rico's debt crisis, but what is? Radical restructuring, even full default, may be the least bad option. For libertarians, default carries the added bonus that it would presumably increase the government's future borrowing costs, potentially constraining government spending. Forcing Puerto Rican taxpayers to bear the continual burden of interest payments, or asking US taxpayers on the mainland to foot the bill, is hardly an obvious choice. I feel bad for lenders who would lose for default, but that risk is part of what they signed up for.