Puerto Rico's real problem

As the Puerto Rican economic and debt crisis deepens, one has to be struck by the partial solutions being advanced for its resolution. The Obama administration and Democratic senators put much faith in affording Puerto Rico with Chapter 9 bankruptcy protection akin to that currently enjoyed by all U.S. municipalities. For their part, Republican members of Congress put much store on the imposition of a mid-1990s New York City-style financial control board that would exert the budget discipline that the island has been so sorely lacking.

Yet neither of these proposals addresses the island's core issue, which is that it has been stuck in an economic slump over the past decade. Sadly, that slump now shows every sign of picking up pace.

As Greece's recent dismal economic experience attests, a declining economy tends to seriously exacerbate an economy's debt problem. The smaller the economy becomes, the less able it becomes to repay its debt. Puerto Rico would seem to be no exception to this rule, since a large part of its current inability to service its $72 billion debt mountain is the fact that its economy today is some 15 percent smaller than it was in 2005. Over the same period, the island has lost 10 percent of its population, with the exodus to the mainland picking up pace sharply in 2015 as Puerto Rico's financial crisis has deepened.

The reasons for Puerto Rico's economic slump are not difficult to identify. Manufacturing tax preferences for the island legislated by Congress, which had earlier encouraged investment and economic growth, were completely phased out by 2005. Over the same period, the island's public finances were grossly mismanaged. It also did not help that the U.S. military presence on the island was scaled down and that the island was subject to the same minimum-wage requirement as was the mainland. That minimum-wage requirement is reflected in a labor participation ratio of around 45 percent, which is more than 20 percentage points below the corresponding ratio on the mainland.

Against this background, it is difficult to see how either the imposition of a control board or the affording of Puerto Rico with Chapter 9 bankruptcy protection would in and of themselves place the island on a higher growth path. Indeed, one would expect that by imposing budget austerity on the island at the same time that it is locked in a monetary union with the United States that precludes it from following an independent monetary or exchange rate policy, its economic slump would deepen as it did in Greece. Similarly, while bankruptcy protection might spare the island from the debt-related legal free-for-all that would almost certainly otherwise occur in its absence, it is difficult to see how that protection in and of itself extricates the island from its current downward economic spiral.

Rather, it would seem that sorting out Puerto Rico's present economic and financial mess would require a comprehensive approach that emphasized policies to spur economic growth. A fiscal control board together with bankruptcy protection might certainly be helpful in that endeavor by exerting budget discipline and by avoiding a debt-related free-for-all in the courts. However, if Puerto Rico is truly to succeed, it would also need far-reaching structural economic reforms to get its economy growing again. As emphasized by the recent Krueger report, such reforms should include congressional action to modify Puerto Rico's minimum wage to make its economy more competitive, as well as amending the Jones Act to reduce the island's transport costs. Congress would also do well to reinstate manufacturing tax preferences for the island to encourage economic growth and investment.

As the litigation already started by bond insurers and the recent falling apart of the Puerto Rican electricity utility's debt restructuring deal remind us, the clock is ticking for Puerto Rico. Hopefully, House Speaker Paul Ryan (R-Wis.), who is promising to come up with a solution for the Puerto Rican crisis by the end of March, is hearing that clock. More important yet, hopefully, in coming up with a solution for the island, he will attach the highest priority to those measures that have the best chance of putting the island back on an economic growth path that might make it better able to repay its debts.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

By Desmond Lachman

Puerto Rico's real problem