Wall Street Journal Editorial Board

Puerto Rico is playing brinkmanship with creditors by threatening a default that could reverberate through financial markets and the refugee state of Florida. Congress may need to save the island from itself, if only to minimize the collateral damage.

On Wednesday Puerto Rico Governor Alejandro Garcia Padilla signed legislation authorizing him to declare a moratorium on the commonwealth’s $72 billion debt. This would trigger a default as soon as May when a $422 million payment on Government Development Bank debt comes due. Puerto Rico and its public agencies owe another $2 billion in July.

The moratorium upends negotiations with creditors and throws a wrench—perhaps deliberately—into Congressional deliberations over how to help the island manage the crisis. In a better world, Puerto Rico’s 18 public debt issuers, 20 some creditor committees and government unions would agree to a restructuring without federal intervention. But creditors possess competing claims, bond covenants conflict, and public agencies have intermingled funds. And Puerto Rico appears unwilling to act in good faith when left to its own devices.

Lo, last May Puerto Rico tripled its alternative minimum tax on corporations that transfer property from outside the commonwealth—in effect, a protective tariff. The tax’s lone target, Wal-Mart, sued. Puerto Rico claimed U.S. federal courts lack jurisdiction over its tax laws and that Wal-Mart had to pay before it could sue. That’s extortion.

Last week federal Judge José Antonio Fusté issued a scathing rebuke striking down the tax as a violation of the U.S. Constitution’s Commerce Clause. The tax, he wrote, was “a legislative money grab, pure and simple, funding the personal account of Puerto Rico’s insolvent Treasury from the presumably deeper pockets of large multistate corporations and their local affiliates.”

Puerto Rican politicians are unrepentant. “The judge just took away $100 million from the people of Puerto Rico and gave it to Wal-Mart,” the governor complained. “Now I have to look for that money somewhere else.” Caveat creditor.

The PR government has already shorted creditors to pay public unions. After issuing $600 Christmas bonuses to public workers that totaled $120 million in December, the government clawed back $174 million in tax revenue dedicated to repaying public agency creditors so that it could make payments to general obligation bondholders (which now may get shorted too).

On Monday a group of hedge funds sued the insolvent Government Development Bank (GDB), which they claim has selectively allowed public agencies and municipalities to withdraw funds. The debt moratorium also creates a “bridge bank” for government agencies to recover their deposits if the GDB goes into receivership.

While Puerto Rico’s moratorium will likely be ruled unconstitutional, Congress needs to act quickly to impose order and due process. Article IV of the Constitution gives Congress the “Power to dispose of and make all needful Rules and Regulations” for territories. Congress can exercise its muscular powers to require fiscal, government and economic reform.

The House Natural Resources Committee, which has jurisdiction over U.S. territories, has proposed an oversight board and restructuring process. Any federal control board—which ideally would be jointly appointed by the President and Congress with Puerto Rican officials in an advisory role—needs to be able to audit the government’s books, subpoena information as well as reject budgets and labor contracts.

Federal overseers should also be in charge of crafting a debt readjustment and fiscal rehabilitation plan that covers general obligation and public agency bonds, labor contracts as well as public-worker pensions. Enabling contracts to be impaired ex post facto is rarely good policy, but the alternative is now a haphazard default dictated by Puerto Rican politicians.

A federal judge like Mr. Fusté would be best situated to mediate negotiations, determine creditor classes, resolve claim priorities and rule on whether the readjustment plan is fair and equitable to creditors. The board should continue to oversee the government’s finances for at least a decade.

Puerto Rico needs above all to restore economic growth, which will require an attitude and policy makeover by the island’s politicians. Washington could perhaps help would-be reformers eliminate laws that discourage work and investment—for example, onerous job protection and benefits—by providing financial incentives.

Puerto Rico needs above all to restore economic growth, which will require an attitude and policy makeover by the island’s politicians. Washington could perhaps help would-be reformers eliminate laws that discourage work and investment—for example, onerous job protection and benefits—by providing financial incentives.

President Obama has said he’s committed to working with Congress to assist Puerto Rico, and we hope he means it for a change.

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