How Puerto Rico's Oversight Board Can Emulate the Success of Others

Earlier this year President Obama signed a bill to help Puerto Rico, after a decade of government profligacy and recession, deal with its fiscal and economic morass. The legislation created a path for the island to manage its excessive government spending as well as reform its moribund economy.

A key feature of the legislative fix is the creation of a fiscal oversight board--appointed by the president from a list picked by Congress--that would essentially take over the fiscal decision-making from the island's government for the near-term; making necessary reforms that its elected government has resisted doing. The hope is that without the pressures of electoral politics, the temptation to make irresponsible fiscal choices to curry favor with special interests will be non-existent.

A history of fiscal oversight boards in the U.S. in the last forty years has shown that these are most successful when the board eschews the quick fixes generally advocated for by special interests and instead makes genuine tax, spending, and regulatory reforms that poise the economy for stronger long-term economic growth. This is precisely what the Puerto Rico board should concern itself with as well.

A Review of Previous Fiscal Oversight Boards

Washington, DC

Perhaps the most prominent, and most successful, use of a fiscal oversight board occurred in the nation's capital in the mid-1990s. The city faced a budget shortfall of $700 million, which amounted to nearly a quarter of its entire budget, and the option for bankruptcy proceedings available to U.S. cities was off the table, just as it is for Puerto Rico. In an attempt to fix the problem Congress in 1995 established a five-member oversight board and charged it with the seemingly impossible task of balancing the budget in four years.

The board was a rousing success and the District achieved a balanced budget by 1997, keeping it balanced for the ensuing four years, when it ceded budgetary power back to the elected government. The city has maintained a balanced budget for another two decades, thanks primarily to the sound fiscal and structural reforms that were put in place under the board - the type of reforms that the board in Puerto Rico also can and should put in place. Additionally, the implicit understanding that the board could resume control if Washington ever fails to meet its pension or payroll obligations again was a powerful tool to enforce responsible fiscal decision making.

Besides eliminating billions of dollars of dubious spending the DC board also asserted the right to examine all regulatory actions by the city and to set aside those that did not pass a basic cost-benefit test. This helped engender a much more business-friendly environment in the District.

The focus of the board was never to erase debt; instead, it was to leave the District with a long-term path to access to the credit markets and prosperity. By any objective measure it has succeeded: In the aftermath of the oversight board the city's economy has exploded, in part due to the expansion of the federal government in the post 9-11 world. However, a more important ingredient of the robust economic expansion is that businesses and families have relocated from the suburbs to the city, drawn in by a more reasonable tax environment and city services on par with those in neighboring communities.

Perhaps the most telling manifestation of the board's success is the fact that the politicians in 1995 who saw their power of the purse usurped by the oversight board ultimately praised its implementation. In a speech shortly before he died Marion Barry acknowledged that the board's actions effectively saved the city, as he felt he had no political maneuvering room to make tough fiscal decisions. By distancing himself from the board he still maintained his popular support and could still pursue changes to benefit his constituents--as long as they didn't cost anything.

The office of DC Auditor is an office tasked with overseeing the District's budget and providing it advice, and it is currently run by Kathy Patterson, who was a member of the City Council when Congress implemented the oversight board. Earlier this year Patterson said that despite the robust fiscal health of the city at present she would welcome a fiscal-oversight-board resumption for a short period of time to help impose greater spending discipline.

New York City

The state of New York has a history of utilizing fiscal oversight boards, with the first instance coming in 1975. As a recession gripped the nation, New York City nevertheless tried to maintain extensive welfare and pension programs. When these policies created a budget gap, the city tried to borrow to close it. Before long, New York's debts were becoming toxic, and the city found itself mired deeply in financial crisis, unable to meet its obligations, and teetering on the brink of bankruptcy.

Unable to convince Congress to provide a bailout, the state legislature created the New York State Financial Control Board, and empowered it to take charge of the city's finances. The board could reject the city's budget, issue bonds, and comment on proposed collective bargaining agreements.

While not as swift or efficient as the DC board, New York's control board achieved its goals by 1986, when the city once again had a balanced budget and had repaid its debts, which was viewed by nearly everyone as a necessary step to assure continued access to financial markets. This was achieved through the enactment of sound fiscal and structural reforms. Since then, New York State has returned to the concept of control boards a number of times to rescue various counties and municipalities from insolvency, with each board specially tailored to the individual circumstances of the local government in question, and with generally positive results.

Today, the New York State Financial Control Board functions only in an advisory capacity, with New York City required to submit an annual financial plan before the beginning of each fiscal year for board review. The city is kept in line by the knowledge that the board can reassume control if the city defaults on any of its financial commitments or incurs an operating debt of more than $100 million within a single year. Like in Washington, DC, this threat of resumed control provides an incentive to the city's elected officials not to make fiscally irresponsible decisions, even when they appeal to the popular urges of the electorate.

Philadelphia

In 1991, financial mismanagement by Philadelphia Mayor W. Wilson Goode drove the city to verge of bankruptcy and caused the political process in the legislature to grind to a halt. Electoral pressure from labor unions prevented any compromise on pension funds and the State Senate had lost all confidence in the mayor, so much so that it refused to agree to any solution that allowed him to maintain fiscal control.

These factors drove the creation of the Pennsylvania Intergovernmental Cooperation Authority (PICA) as the last hope to save Philadelphia from bankruptcy. Unlike most fiscal control boards, PICA was not only given the power to approve budgets, but was also permitted to levy taxes to make up budget shortfalls as well as withhold state funds from Philadelphia to ensure that fiscal goals were met.

The board succeeded in restoring the city to solvency by issuing long-term bonds to pay for short term expenses. The board could accomplish this despite the city's bad credit rating because the state endowed PICA with all the proper incentives for responsible financial management. People unwilling to lend to a city known for fiscal recklessness were confident that PICA, divorced from the pressures of electoral politics, would prove a sound investment, and they were proven right.

In the intervening years, the city's fiscal situation has turned around and the city has had no problem maintaining a balanced budget. The control board will remain in place and need to approve all city budgets until all of the long term obligations it created are paid off as well, which will occur in 2023.

Miami

In 1996, a federal investigation into fraud and corruption led to the arrest of several Miami officials, and uncovered a fiscal situation that was perilous to the city's future. The city faced a projected shortfall of $68 million, about a quarter of its budget, and was so low on cash reserves that it was in danger of failing to meet payroll obligations. The city was declared to be in financial emergency, and within two months, Florida's Governor Lawton Chiles had appointed an oversight board to deal with the crisis.

Under the board, the city made drastic changes to its finances. After the board vetoed the first proposed budget, the city entered a hiring freeze, made significant spending cuts, and renegotiated union contracts. The city also stopped using the general fund to subsidize garbage and fire services, relying instead on user fees to pay for them.

As a result of these reforms, Miami successfully balanced its budget for five years straight, and turned its deficits into a narrow surplus by 2001, at which point the financial oversight board was dissolved.

It's worth noting that Miami's mayor at the time, Joe Carollo, was strongly supportive of the difficult choices that needed to be made in order to balance the budget. Nevertheless, while his actions were effective, they were not politically popular and he lost his reelection bid in 1997. This story illustrates the difficulty elected officials have in exercising fiscal responsibility, and the value financial control boards offer in operating independent of political concerns.

Detroit

Few cities have suffered from financial mismanagement as much as Detroit, which stands in stark contrast to the successes noted above. In Detroit, an emergency manager reporting to a politically motivated governor ran roughshod over investors and creditors and, as a result, the city continues to face financial distress and lack access to growth capital. It serves as a reminder of how oversight boards can fail to achieve their goals if they favor quick fixes and Band-Aids over sound economic and structural reforms.

Detroit's problems had myriad causes: The decline of the automobile manufacturing industry, as well as significant demographic changes, resulted in a steady erosion in employment and the tax base that continued virtually unimpeded since the 1970s. The city was loath to adjust its public workforce commensurate to the reduced population--in part because their workers represented the bulk of all white-collar employment in the community--and the city's debt ballooned. The great recession and steep decline in the fortunes of the big auto companies created a bigger hole in the budget that could not be filled, and the city was left with a debt of $18 billion.

While Detroit--unlike Puerto Rico and Washington, DC--could avail itself of a Chapter 9 Bankruptcy, which it did in 2013, bankruptcy law requires the state government to acquiesce before a municipality does so. Michigan agreed to the bankruptcy, but it concomitantly established an advisory board and an emergency manager for the city as well. They were given the authority to develop and approve the city's budgets, work with individual agencies on cost saving measures, and draft city-wide initiatives to allow for better financial management.

Thus far the outcome of Detroit's bankruptcy and the work of the oversight board has been disappointing; the local economy continues to struggle as the city lacks access to the capital markets and thus can't properly invest in essential services, let alone the growth initiatives needed to restore the city's economy.

A key difference between Detroit's oversight board and the others that have been discussed is that Detroit's was established as part of a broader Chapter 9 process and engaged in substantial debt restructuring. Specifically, the haircut imposed on the city's bonds--which exceeded the reductions imposed on the city's pension participants, whose claims are inferior to bondholders in bankruptcy law--has made it impossible for the city to return to the bond market without the explicit backing of the state government. Some go farther and assert that the debt reductions reduced the pressures to do fundamental economic reforms.

Puerto Rico's future

Fiscal oversight boards are by their nature a last-resort tool to fix a fiscally bereft government out of other options. They may be far from a perfect instrument to fix an ailing government but when they focus on the underlying ailments of the particular jurisdiction's fiscal woes, instead of the usual political advocacy, they have a proven track record of returning governments to solvency and giving the economy a chance to recover.

The key to their success is a focus on reforms designed to bring long-run prosperity to the economy: right-sizing government, improving the tax and regulatory climate, and helping the government return to capital markets in a timely way. The experience in Detroit illustrates the grave consequences that can result for municipalities and their residents when oversight Boards veer from this model and instead take the route of focusing on debt restructuring and in doing so destroy the jurisdiction's access to the capital markets.

We have reason to be optimistic that we will be able to tell a positive story about Puerto Rico in a few years. The island's economy has some inherent advantages that should allow it to grow and prosper if investors and the labor force do not have to worry about its government's future. Fixing the public pension, providing a stable fiscal regulatory environment, reforming--or possibly jettisoning or privatizing --some of the government-owned corporations, and reassuring investors that they can return to the Island with confidence that contracts and the rule of law are enforced would give Puerto Rico a shot in the arm and a rejuvenated economy.