America’s Greece
The world is watching the situation in Greece closely, in the wake of the nation’s default last night on a $1.7 billion loan payment to the International Monetary Fund. European creditors continue to demand tax hikes and spending cuts, while Greek leaders threaten to put tough stipulations to a referendum this Sunday.
But America has a Greece-like problem too. Its name is Puerto Rico.
Puerto Rico is $72 billion in debt. When interest, pension obligations, the deficit and health care program shortfalls are added to the calculation, the number rises by nearly $100 billion more. For each person in the Puerto Rican workforce, there is $168,471 of debt.
Within one day of Gov. Garcia Padilla’s remark that the $72 billion was “not payable,” the price of some bonds decreased 12 percent, while the stock prices of bond insurers who secured the debt were down 23 percent. Policymakers in Washington and on the island are wrestling with how best to move forward. The good thing is that it appears the strategies used in the past are being left behind.
The Puerto Rican government commissioned a study to be conducted by Anne Krueger, a former World Bank chief economist, to analyze the commonwealth’s financial problems. The so-called Krueger Report, released June 29, outlined several key origins of the crisis, which actually caused the island’s economy to contract 1 percent per annum over the last decade. This is noteworthy because the commonwealth is suffering neither from civil strife nor a deep financial crisis.
The study cites a decline in investment by island residents, spurred by a sharp fall in home prices. Individuals and small businesses had less wealth to be pumped into the economy. The U.S. recession from 2007 to 2009 also contributed, as the states are the island’s largest trading partner. Puerto Rico’s inability to recover along with the U.S. mainland suggests structural problems.
The larger problem may be employment and labor costs, which thankfully seem to have possible solutions. Only 40 percent of the adult population (compared to 63 percent in the states) is employed. One reason is that the federal minimum wage represents 77 percent of Puerto Rico’s per capita income, whereas it is only 28 percent on the mainland. This suggests that the minimum wage is severely limiting employers’ ability to hire. Employers also do not hire because of strict regulation of overtime, vacation pay and dismissal.
What’s more, workers face bad incentives, as the public welfare system provides excessively generous benefits. Krueger writes:
One estimate shows that a household of three eligible for food stamps, AFDC, Medicaid and utilities subsidies could receive $1,743 per month–as compared to a minimum wage earner’s take-home earnings of $1,159
When safety nets exceed feasible wages, perverse incentives cause people to act in their own self-interest. Public policy must cut benefits to the unemployed to encourage them to work; at the same time, wage restrictions must be reevaluated to encourage employers to hire people.
A key contributor to the size of Puerto Rico’s deficit is public policy that makes municipal debt tax-exempt in the United States. Most economists would actually agree that, all things being equal, this is usually a sensible policy, as it prevents income from being taxed twice. But double taxation is a hallmark of the U.S. tax code, and the tax-exempt status, by creating incentives for investors to allocate resources to municipal debt, also makes it much easier for local governments to borrow.
It’s reasonable to ask whether, to stop the situation from getting any worse, the tax code should be changed so that new Puerto Rican bonds are not tax-exempt. That change shouldn’t be applied to current bonds, or the incentive would be for investors to dump them, raising the interest the commonwealth would have to pay and sinking it even further into the hole. Over the longer term, the United States should seek to stop taxing income both when it is earned and when it is saved.
Another contributor to Puerto Rico’s problems is the Jones Act, a 1920 law passed after World War One to protect against German U-boats. The law requires any trade between two U.S. ports to be conducted by American flagged vessels operated by U.S. citizens. Today, the law effectively protects shipping interests, but hurts both American consumers and producers of goods both on and off the island.
Because of the law, Puerto Rican goods cost more and Puerto Ricans pay more for goods made in the states, all other things being equal. The law makes electricity, a basic input of production, extremely expensive, because the commonwealth has to rely entirely on the states or other countries for oil. Congress should repeal this outdated legislation.
Puerto Rican public corporations are both troubled and large in number. The electric power authority owes about $9 billion in debt, $417 million of which is due this week. Legislators tried to assist these corporations with a law intended to skirt rules governing debt reconstruction. A federal court found the law violated the U.S. bankruptcy code, as Puerto Rican public corporations—unlike those in the states–are not able to use Chapter 9.
Democrats in Washington are pushing to expand Chapter 9 to Puerto Rico, which essentially would allow these companies to declare bankruptcy and restructure debts on their terms. Republicans argue that such an exception would infringe on investors’ rights. The White House has been rather silent, other than to say there will not be a federal bailout. While it is a good thing that Chapter 9 legislation likely will not pass, long-term reforms are needed. The Krueger Report suggests the government facilitate “a voluntary exchange of existing bonds for new ones with a longer/lower debt service profile.”
Finally, Puerto Rico got caught in a vicious circle. For years, the commonwealth borrowed to balance the budget, taking on more and more debt and constantly raising the budget deficit. It’s the same strategy Greece used to pay off their debts until European creditors cut off the spigot, forcing them to default the IMF loans. The U.S. federal government has its own history of borrowing to pay the national debt, which today is more than $18 trillion.
Like in Greece, it appears elected officials and the population at-large remain hesitant to raise taxes and/or cut discretionary spending, but progress has been made. Unlike in Greece, the commonwealth is not seeking new loans to pay off old ones.
The island uses our dollar, trades with our states and has borrowed our dollars without repaying them. Free markets and real solutions must be used to prevent Puerto Rico from becoming America’s Greece.
