The Greece of the Caribbean?

There was a time when it might have been said that Puerto Rico, in the midst of a wrenching debt crisis, was returning to its Latin roots. After all, Latin American governments were once world leaders in over-indebtedness. But the United States’ public debt now stands at over 100% of its GDP, and Detroit has just gone through bankruptcy. Perhaps Puerto Rico is, at last, becoming more American.

Or perhaps it is becoming more European, given the resemblance of its debt problems to those of Greece. After the adoption of the euro, Greece was able to borrow at interest rates not much higher than those paid by northern European countries, even though its fiscal policy was worlds apart from that of Germany or Finland. The result was massive debt accumulation to fund current expenditure, not investment.

Puerto Rico – a US territory – was also allowed to borrow too much for too long. Its government bonds are tax-exempt everywhere in the US, and hence particularly attractive to US investors, who, despite the increasingly perilous state of the island’s finances, have gorged on them. So, Bloomberg reports, Puerto Rico has more debt – over $70 billion – than any US state government except California and New York, while its economy is smaller than that of Kansas.

Another similarity has to do with relative prices. Once it gave up the drachma, Greece was no longer able to devalue in order to cut the value of domestic wages in terms of foreign currency, and thus spur exports. With competitiveness lagging, the trade deficit soared, and so did unemployment.

Puerto Rico’s predicament is similar, but again with a twist that makes it more serious. The island uses the US dollar, and the US Congress imposed on Puerto Rico the federal minimum wage, even though its per capita income is – as Anne Krueger has pointed out – about half that of the poorest US state. Puerto Ricans’ freedom to move to the mainland was not enough to keep unemployment from becoming a secular problem: around 11% before the 2008 financial crisis, a 17% peak in 2010, and above 12% recently.

As in Greece, there is plenty of blame to go around. Critics point to weak budget institutions, muddled accounting, and rampant fiscal populism among island politicians. Proud Puerto Ricans retort that US banks and hedge funds were complicit by happily loading up on island debt. Both sides are right.

Puerto Rico and its leaders can learn three important lessons from Greece. First, it is no use pretending that debt reduction can be avoided. And when the time comes, action must be sufficiently bold to do away with the debt overhang and encourage private investment.

The European Union dithered for years before acknowledging that private loans to Greece should be written down. Then it negotiated an insufficient haircut and ended up dithering again – resorting to accounting tricks to avoid writing down European public-sector loans. The story would have been very different if the need for substantial debt reduction had been accepted upfront.

The same holds for Puerto Rico, except that – yet again – the situation is more complicated, owing to the vagaries of US law. Puerto Rico cannot declare bankruptcy under Chapter 9 (neither can any of the 50 states). In 1984, Congress adopted an amendment that also denied Puerto Rico’s municipalities and public corporations access to Chapter 9 bankruptcy protection.

Puerto Rico recently tried to enact legislation modeled on Chapter 9 that would allow for an orderly restructuring of the debt of public corporations and municipalities. But creditors have challenged the move in court, with the US Supreme Court set to issue a ruling by the end of June.

So exactly how debt reduction will happen in Puerto Rico remains unclear. But whether it will happen is in little doubt; when it does, it better be large.

The second lesson is that policymakers must put fiscal policy on a sustainable path, while recognizing that austerity alone is not the answer. Puerto Rico’s economy had been shrinking before the fiscal crisis, and the spending cuts and tax increases since it erupted have only made matters worse. The island risks sharing Greece’s fate, with the debt-to-GDP ratio continuing to rise as austerity deepens the recession.

In exchange for help, congressional Republicans are threatening to impose on Puerto Rico a fiscal control board similar to the one established in 1995 in response to the fiscal crisis in Washington, DC. Bad idea. Not only would such a board smack of colonialism and be politically untenable; the scheme would also lack the flexibility needed to avoid a depression in Puerto Rico, while reassuring everyone, including investors, that fiscal policy will remain prudent in the future.

A much better solution is a rule of fiscal responsibility like those adopted in countries as different as New Zealand, Sweden, Colombia, and Chile. The idea is to keep expenditure below what the government can raise in taxes in the long run (thereby ensuring sustainability), while allowing deficits whenever the economy is operating below potential and tax revenue is abnormally low (thereby guaranteeing flexibility and contributing to macroeconomic stabilization).

In Chile, the rule allowed the government to pay back debt gradually and eventually turn itself into a net creditor, while at the same time reducing the volatility of public investment and output. There is no reason why a similar arrangement could not work in Puerto Rico.

The third lesson from Greece is that macro tinkering is not enough; highly indebted countries also need a credible growth strategy. Puerto Rico is no exception.

For a long time, the island’s economy grew on the basis of corporate tax incentives. But, beginning in 1996, the US Congress did away with those tax breaks, without producing any blueprint for development. On the contrary, Puerto Rico is stuck with an early-twentieth-century law that forces all trade with the mainland to be conducted with expensive US ships, increasing transport costs and undermining economic competitiveness.

All that must change. Puerto Rico will not pay its debts – not even what is left after debt reduction – unless its economy grows. US creditors and lawmakers must accept that reality, and act accordingly.