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When Congress overhauled the country’s bankruptcy law in 1984, it added a new section — Chapter 9 — to address municipal bankruptcies. States, however, were not included. Separate from philosophical considerations of state sovereignty, the Constitution (Article I, Section 10) is explicit: “No State shall … pass any … Law impairing the Obligation of Contracts.” The 1984 law explicitly treats Washington, DC and Puerto Rico on par with states for the purposes of bankruptcy law.
So now that Puerto Rico is insolvent, the island’s government is turning to the federal government for help. It passed a law restructuring its $73 billion in debts (it also owes $40 billion in pension obligations), but its creditors successfully sued in federal court to have the law overturned. Recently the US Supreme Court agreed to hear Puerto Rico’s appeal. Meanwhile, Democratic senators have introduced legislation to extend Chapter 9 protection to the island.
Republicans have so far resisted that call, labeling the move a “bailout.” This is hyperbole — creditors, not taxpayers, would take the hit — but the Republicans are correct on the merits. The island’s lenders took measured risks on the basis of the law as it was written; a retroactive rewrite would be both morally wrong and counterproductive. Just as importantly, what got Puerto Rico into trouble was profligacy, and Chapter 9 protection would do nothing to foster reforms. Absent changes to the island’s unsustainable spending and bloated public sector, it would only be a matter of time before Puerto Rico became insolvent again.
If the condition of Puerto Rico’s finances sounds familiar, perhaps that’s because a number of Democrat-dominated states are in the same situation. For years, we have been warned about unsustainable spending and pension obligations in California, New York, Illinois, Connecticut, New Jersey, and others. Not only are these states the biggest debtors, they are also losing population and growing older. Absent spending reform, it is only a matter of time before one or more of them goes bankrupt too.
And then, who will pay the price? Creditors? Pensioners? State employees? Or will it be taxpayers?
So the situation in Puerto Rico bears watching. It can serve as a template for how these claims are resolved — for good, or for ill.