Can Open Market Operations Save Puerto Rico?

With Puerto Rico’s continuing fiscal strains, some commentators have suggested that one avenue to give Puerto Rico breathing room would be the purchase of Puerto Rican municipal debt as part of Open Market Operations by the Federal Reserve.  The most prominent proponent of this plan is Rensselaer Tech Economics Professor Arturo Estrella.  His proposal can be found here.  The governance of Open Market Operations, which is the buying and selling of securities by the Federal Reserve System, is found in Section 14 of the Federal Reserve Act.

A threshold question is: does the debt of Puerto Rico qualify as allowable investments?  There are essentially three categories of allowable purchases under Section 14:  state/local government debt in the continental United States, foreign government (or agency) debt;  and U.S. Treasury or agency debt.  Professor Estrella spends considerable effort arguing that Puerto Rico is within the definition of “continental” United States and hence qualifies.  Unfortunately, his efforts are in vain as the Federal Reserve Act in Section 1 defines the “continental United States” to mean “the States of the United States and the District of Columbia” which obviously excludes territories like Puerto Rico.

How does Professor Estrella attempt to overcome the very clear language of the Federal Reserve Act?  He argues that “the preponderance of regulatory language in Federal Reserve regulations shows that Puerto Rico is treated in the same way as a state…”  The good professor offers plenty of examples, such as the Truth in Lending Act, carried out by the Fed’s Regulation Z.  What he fails to mention is that the cited regulations are not carried out pursuant to the Federal Reserve Act.  For instance, the Truth in Lending Act actually defines Puerto Rico as a state, which explains why Regulation Z as implemented does so.  Congress regularly chooses different definitions of the same words for different statutes, and it does so intentionally.  That, however, does not allow an agency to pick and choose.  The definitions contained in a statute govern the regulations promulgated under that statute only.

Estrella also argues that since the Fed treats Puerto Rico as part of the New York Federal Reserve District, then it must be a state since Section 2 of the Federal Reserve Act established a procedure of allocating states to reserve bank districts.  The essence of Estrella’s argument is that since the Fed treats Puerto Rico as a state in some contexts, then it must be classified as a state for purposes of Section 14.  Such a view implies that an agency, like the Fed, can simply rewrite statutes at its whim.  Such a view is, of course, incorrect.  Only Congress can write statutes and while agencies can “fill in the blanks,” they cannot rewrite clear statutory language.

Interestingly enough, Professor Estrella also argues that Puerto Rico might qualify as a “foreign government,” since the International Banking Act of 1978 defines, for its purposes, Puerto Rican banks as “foreign banks,” although it does not include Puerto Rico under its definition of “foreign country.”  One can debate the contradictory nature of the definitions of the 1978 Act, but they clearly do not apply to Section 14 of the Federal Reserve Act.  Lastly, I believe it is obvious–and I do not know of anyone who has argued the contrary–that Puerto Rico is not part of the federal government or one of its agencies.

In summary, any plain reading of the Federal Reserve Act, along with the traditional practices of statutory interpretation, would conclude that the Federal Reserve cannot purchase Puerto Rican government debt as part of open market operations.

Even if the Fed were allowed to do so, would buying debt fix Puerto Rico’s problems?

Let us assume, for the sake of argument, that Puerto Rico qualifies as part of the continental United States.  Section 14(2) limits any municipal purchases to maturities of less than six months at the time of purchase.  While I have not been able to find a distribution of maturities for Puerto Rican debt, reports appear to indicate much longer maturities.  Perhaps longer debt could be swapped out for six month, but such might leave Puerto Rico even more vulnerable as it would have to come to market far more often.  Just as Bear Stearn’s reliance on overnight debt was part of its undoing, shortening the maturity of Puerto Rico would likely make a bad situation worse.

Perhaps most binding of all is that Section 14 is dependent upon “anticipation of the collection of taxes or in anticipation of the receipt of assured revenues…”  In plain English, that means that lending is limited to debt that the Fed has determined there is revenue forthcoming.  As Puerto Rico’s governor stated that the debt “could not be paid,” it is hard to see how the Fed could stay within the clear language and intent of Section 14 while purchasing Puerto Rico’s debt.

Let me be clear: I do not have answers to Puerto Rico’s debt crisis.  What I do know, however, is that having the Federal Reserve purchase Puerto Rico’s debt as part of open market operations is not legal.  And if it was, it would likely be unworkable.

By Mark A. Calabria

Can Open Market Operations Save Puerto Rico?