America’s own Greece- Puerto Rico

While much attention has been focused on the Greek drama, out-of-control debt is rearing its ugly head closer to home. The small island of Puerto Rico is in a bad way; the lyrics may be different but the melody is the same.

The governor of Puerto Rico dropped the bombshell last month that there is no way the island can pay its $72 billion in public debt. He pledged to begin developing a debt restructuring plan.

Since the financial meltdown of 2008, debt is like a canker spreading across the globe. The Greek analogy may be overused, but in one respect it is relevant. Greece and Puerto Rico are among many governments with too much debt and not enough economic growth to generate the tax revenues needed to cover it.

Short of a federal bailout, the island will be unable to repay its debt between now and the Second Coming. To paraphrase Margaret Thatcher: “Puerto Rico has run out of other people’s money”.

Puerto Rico is by far the most indebted American territory or state, owing $20,400 per capita. Since 2005, the island’s economy has shrunk by about 10 percent. Its unemployment rate is above 12 percent; more than double the national average. Since government benefits are more lucrative than a minimum wage job, just 40 percent of the adult population is working or looking for work. The U.S. labor participation rate is 63 percent.

Moreover, high labor costs have proven onerous for many businesses. Generous overtime provisions, excessive paid vacation benefits and job security regulations that are more costly than on the mainland all magnify employment costs and kill the demand for labor. The island’s population has also declined from 3.8 to 3.5 million since 2005 as Puerto Ricans leave for Florida and other parts of the U.S.

Until 2006, Puerto Rico’s economy was kept afloat by tax incentives for American pharmaceutical, textile, electronic and other firms that manufactured there. When the tax breaks disappeared in 2006, it contributed to the loss of 80,000 jobs. Puerto Rico’s economy has been in free fall ever since. The weak economy drives the middle class to the U.S., the shrinking population results in a smaller tax base and the beat goes on.

Puerto Rico’s bonds, unlike those of states or municipalities, are exempt from federal, state, or municipal taxes everywhere in the United States. Thanks to this competitive advantage, they were quite attractive to bond funds and investors in the highest tax brackets. More than 180 municipal bond funds have at least 5 percent of their portfolios in Puerto Rican bonds. Many hedge funds and distressed debt buyers stepped in to buy Puerto Rico’s bonds at deep discounts as the island’s economy worsened and its credit rating dropped below investment grade in early 2014.

Unlike municipalities, states and Puerto Rico are barred from seeking bankruptcy protection. The Governor has appealed to Washington to change the law so the island can seek bankruptcy protection, buy time to restructure debts and get its fiscal house in order.

Chapter 9 of the bankruptcy code allows a company or municipality to get new financing from markets while continuing to function as debts are restructured or written down. The importance of orderly debt restructuring was in evidence during the recent bankruptcy process that helped Detroit to restructure its $18 billion in debt.

Without allowing Puerto Rico access to the partial remedy of bankruptcy, the island has no chance of pulling out of its death spiral. Like Greece, Puerto Rico is stuck in a vicious cycle and badly needs structural reforms to set the economy on a sustainable path. The challenge is to grow the economy while at the same time fixing its public finances.

There is one lesson to be learned from Greece: Expect Puerto Rico’s fiscal crisis to get worse if debt restructuring and the implementation of reforms to make the island economically competitive are delayed.

Originally Published: August 1, 2015

Greece’s failed economy should be lesson for U.S.

Since the European Union (EU) was created, no member has skated as close to insolvency as Greece. The country teeters on the brink once again, drowning in debt. The crisis confronts the EU with its worst dilemma since the creation of the euro.

The Greek crisis also holds important lessons for the United States. We have our own debt problems, with the ratio of public debt to GDP climbing 40 percentage points to 105 percent since 2008. It would be far better to get our fiscal house in order and make structural reforms today, when there’s time to craft trade-offs rather than under duress when creditors are in danger of losing faith.

The immediate causes of the Greek crisis are clear. In 1992, members of the European Commission signed the Maastricht treaty which formed a more comprehensive EU, including a common currency . The Euro was launched in 1999.

Greece didn’t initially meet the fiscal criteria for joining the currency union. But in May 2000, the European Commission declared that the Greek fiscal deficit, including interest, was only 1.6 percent of GDP, inflation was only 2 percent; and the country met all the Maastricht requirements except for its government debt, a shortcoming that was hardly unique among member states.

Greece joined the euro zone in 2001 and when the markets opened, yields on Greek bonds fell to an all­ time low. The newfound perception of Greek debt as safe could most likely be attributed to investors believing that, by joining the euro zone, Greece had acquired an implicit European guarantee on its debt.

This enabled Greece to borrow money at very cheap interest rates. It borrowed plenty and embarked on an expansionary fiscal policy. This rapid growth in borrowing and spending was similar to the cheap credit that fueled the American housing bubble. One symbol of Greek extravagance was the 2004 Olympic Games, which cost almost three times the original estimate.

In the wake of the 2008 global financial crisis, the Greek economy slowed as tourism and shipping suffered from the decline in global trade. After a deep and prolonged recession, the economy has contracted by more than one quarter and unemployment now exceeds 25 percent. Today Greece’s debt is 180 percent of its GDP and will never be repaid without generating tax revenue from major economic growth.

To make matters worse, the Greek government misled the international community about its debt. When a new government took power in 2009, it announced that the deficit that has been projected to be around 5 percent would actually be about 12.7 percent.

Greece had been understating its deficits for years, raising alarms about the integrity of the country’s finances. The previous government had apparently been cooking the books, which shattered any faith that international investors might have had in the Greek economy and government.

Suddenly Greece was shut out of the financial markets. By the spring of 2010, it was veering toward bankruptcy. Two of the three international credit rating agencies cut ratings on Greek bonds to junk status and warned that further downgrades were likely.

The International Monetary Fund, European Central Bank, and European Commission issued the first of two bailouts for Greece, which would eventually total about 240 billion euros ($264 billion). Now, Greece is back in the soup and needs another $86 billion euros ($94 billion).

The lenders extended the bailout package in exchange for the Greek government agreeing to implement deep budget cuts, steep tax increases, and labor and pension reforms to make Greece a more attractive place to do business. But many believe these austerity measures alone will only quicken the shrinking of the Greek economy without providing debt relief.

If the United States is to avoid being in similar straits someday, we must learn some important lessons about borrowing to consume, living beyond our means and failing to invest in the productive capacity of our economy.

Originally Published: July 25, 2015