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It is said that those who do not learn from history are doomed to repeat it. Sadly, this seems to be the case with respect to the Puerto Rican government and its Oversight Board in their handling of the Puerto Rican economic crisis. By not drawing the right lessons from Greece’s recent failed attempt at fiscal austerity within a monetary union, the Puerto Rican government is all too likely to exacerbate rather than to cure the island’s current economic crisis.

Greek Parallels

In essence, Puerto Rico’s macro-economic challenge today is very similar to that of Greece in 2010. As was the case in Greece, Puerto Rico’s public finances have become seriously compromised in large measure due to years of economic mismanagement. This has led to a large public deficit, an excessive public debt to GNP ratio, and a very large amount of unfunded pension liabilities. Similarly, as was the case in Greece, Puerto Rico is now having to address these public finance imbalances within a currency straitjacket. Whereas Greece is part of the Euro bloc, Puerto Rico is tied to the US dollar which means that it does not have a currency of its own.

Large budget deficit reductions are very difficult to make in a monetary union. This is because the government lacks the normal monetary policy instruments to offset the contractionary impacts of tax hikes and public spending cuts on the economy. Not having its own central bank, it cannot lower interest rates to cushion the blow of budget belt-tightening. Similarly not having a currency of its own it cannot resort to currency depreciation to boost its exports and reduce its imports.

There are reasons to think that Puerto Rico’s challenge of rebalancing its economy today without monetary policy instruments is even more daunting than was that which Greece faced in 2010. Whereas Greece started its adjustment process with its macro-economy in reasonably good health, Puerto Rico is starting its adjustment process with its economy mired in a ten-year slump. Over the past decade, the Puerto Rican economy has shrunk by 10 percent while more than 10 percent of its population has migrated to the mainland. At the same time its unemployment rate remains over 12 percent and barely 40 percent of its population participates in the labor market. The island shows little sign of exiting this economic slump anytime soon.

Greece’s Experience

Greece’s recent very unfortunate experience with excessive budget belt-tightening within a Euro straitjacket offers a cautionary tale for Puerto Rico. Since 2010, mainly as a result of an attempt to reduce the budget deficit by more than 10 percent of GDP, Greece is now experiencing a deep economic depression. Indeed, Greece’s loss of output over the last eight years exceeds that experienced by the United States in the 1930s. Greek GDP has declined by around one quarter, unemployment has risen to 25 percent, and youth unemployment has risen to over 50 percent. It is disturbing that the Greek economy is yet to show any real signs of economic recovery.

To its credit, the IMF has drawn the following three lessons from its Greek experience that might be pertinent to Puerto Rico’s current economic challenge:

The negative impact of major budget tightening on an economy in a monetary union can be very large. Indeed, the IMF now estimates that the fiscal multipliers in a monetary union could be as high as 1.7. This means that, assuming that everything else stays the same, budget tightening measures amounting to 1 percent of GDP can lead to a 1.7 percent decline in GDP relative to where it would otherwise have been.

Structural economic reform is of the essence for an economy trying to make a large budget deficit reduction effort in a monetary union. Those reforms are necessary to make the economy a more attractive place in which to invest and thereby to provide a much needed offset to the contractionary effect on the economy of budget belt-tightening. Greece’s disastrous economic performance in recent years owes much to having engaged in draconian budget belt tightening without at the same time reforming its highly uncompetitive economy in general and its rigid labor market in particular.

It is counterproductive to delay the restructuring of an economy’s debt if that economy’s debt is judged to be unsustainable particularly if that economy is in a monetary union. Not restructuring the debt in a timely fashion can lead to demands for the economy to make a larger than desirable fiscal effort. That in turn can result in a sharp drop in the economy’s output that can have the effect of both reducing tax revenue collection and raising the debt to GDP ratio. The IMF now acknowledges that it was a mistake not to have insisted on a Greek debt restructuring at the start of the IMF’s Greek financial support program in 2010.

Puerto Rico’s economic outlook

Puerto Rico’s economic prospects do not appear to be at all favorable considering that its government and Oversight Board appear to be making each of the three basic mistakes that Greece made in the handling of its economic crisis:

a. Like the Greek government before it, the Puerto Rican government is being required by its Oversight Board to do more budget adjustment than is advisable within a US dollar straitjacket. This is especially the case at a time that its economy is still declining. According to the island’s recent fiscal plan, which was approved by its Oversight Board, over the next few years Puerto Rico is planning on budget tightening amounting to around 6 percent of GNP. Assuming that Puerto Rico’s fiscal multiplier is around 1.5, its GNP could decline by a further 9 percent as a direct result of those budget measures.

b. In much the same way as Greece engaged in drastic budget belt-tightening without structural economic reform, Puerto now seems to be doing the same. Under the tutelage of its Oversight Board, most of the Puerto Rican government’s policy efforts are directed at budget deficit reduction with very little being done to reform the Puerto Rican economy in a manner that might make it more competitive.

The lack of reform is all too evident in the island’s highly uncompetitive labor market where labor participation is below 40 percent. In particular, little is being done to adopt the following three basic labor market reforms that were suggested by the Krueger Report:

The introduction of measures to reduce Puerto Rico’s currently high minimum wage in relation to the level of its local income.

The reform of federal welfare payments to make them consistent with local labor market conditions rather than with US mainland conditions.

The streamlining of labor laws to reduce the island’s employment costs and to make the island’s labor market more flexible.

c. As was the case in Greece, Puerto Rico is failing to face up to its debt problem in a timely way. Even though there is widespread recognition that the island is insolvent, it is yet to restructure its public debt mountain or to address its chronic pension situation.

Concluding Remarks

Puerto Rico appears to be repeating Greece’s policy mistakes. It is doing so by committing itself to drastic fiscal policy austerity in a monetary union without at the same time undertaking serious economic reform. If Greece’s experience with such a policy mix is anything by which to go, unless there is a major change in policy direction Puerto Ricans should brace themselves for several years more years of a slumping economy.

The social and economic consequences of sticking to a policy of budget austerity without at the same time reforming the economy should not be underestimated. Puerto Rico is already poorer than any of the 50 states in the United States and it has an unemployment rate of over 12 percent. In addition, it is already losing around 2 percent of its population each year to migration.

It would seem that if Puerto Rico is avoid a deepening economic depression, it must change policy course and come up with a comprehensive plan focused on promoting rapid economic growth. Such a plan might be centered on a more reasonable pace of budget reduction, serious economic reforms especially to its labor market, and a major reduction in its debt burden. Needless to add, the island could also benefit from substantive Congressional support in the form of the repeal of the Jones Act and the restoration of at least some of the tax advantages that the island previously enjoyed.