Lessons from Puerto Rico Bankruptcy

Puerto RicoA couple of weeks ago, Puerto Rico (PR) effectively declared bankruptcy. Although I am no expert on the PR economy, based on my limited research, the mess down there seems to illustrate how too much government causes problems for an economy. We can all learn some lessons from this.

What are the problems?

Over the years, the PR government incurred many budget deficits and piled up a crushing load of debt. A year or two ago PR declared the debt simply unpayable.

The PR government is now such a bad credit risk that no one is willing to lend them further money. PR cannot afford to pay its debt service, pension obligations, and planned spending on things like schools and social services. Hence bankruptcy.

In addition, economic growth and living standards have declined over the past decade or so, causing economic hardship, population drain, and further exacerbating the government’s financial woes.

Why are problems happening?

PR is a US territory that follows some US policies, but not all. Although the PR economy is fairly open in some ways, both the US and PR governments have implemented some questionable policies.

Below is a summary of the issues that have led to government bankruptcy and a weak economy:

  • Fiscal mismanagement: The government has irresponsibly run up debt and deficits. Spending has not been controlled. The tax code is riddled with exemptions and collects less than it should. The government workforce is bloated, representing 24% of the total workforce, compared to about 15% for the US. Interest income on PR debt is totally tax-free, a borrowing advantage that likely enabled the government to over-borrow.
  • Tax subsidy eliminated: A federal tax subsidy was established in the 1970s to encourage US companies to set up operations in PR. This gave PR an advantage, but the subsidy was terminated in 2005, removing the advantage.
  • Minimum wage: PR follows the US federal minimum wage, which increased from $5.15 per hour in 2006 to $7.25 in 2009, a 41% increase. Minimum wage tends to create unemployment (see here for further explanation). In PR, the forced unemployment is even greater than usual, because $7.25 is high compared to average income on the island. The higher that minimum wage is compared to the average income, the more unemployment it will create. If minimum wage is set high enough that it applies to 50% of the workforce, that will price more people out of work than if it applies to only 5% of the workforce. To illustrate this point the opposite way, no one will be priced out of the labor market if minimum wage is only $0.01 per hour.
  • Fewer people working: The labor force participation rate (i.e., the percentage of working-age people employed or actively looking for a job) is only 41% in PR. Compared to 63% in the US, this means that many fewer people are working in PR. Lowering the minimum wage would likely help get people back to work. So would reducing the benefits of government programs. They are overly generous compared to work, and therefore weaken the incentive to work.
  • Population drain: Population growth has slowed over the past twenty years or so, and has even declined about 10% over the past decade because people are leaving the island. This is bad for the economy and tax collections. Worse, it is likely the more enterprising residents that are leaving.

The people are harmed 

All the problems listed above impact the residents of PR negatively. A shrinking economy harms jobs and incomes. The PR unemployment rate in April was 11.5%, about 2.5 times higher than the US rate of 4.4%. PR data is less widely available, but median household income has dropped for at least the past couple of years.

Unexpected cuts in government services and benefits are also unpleasant.

Lessons for others

Other countries should be able to learn some lessons about good government from the PR situation:

  • Governments need budget discipline. Government should not grow faster than the private economy.
  • Governments should face problems promptly, instead of continually avoiding the hard decisions until absolutely forced to act. The PR government kept borrowing ever-more money instead of undertaking the hard work of economic reforms. The pain was postponed, but now is greater than it needed to be. Politicians and voters must accept that economic reality cannot be avoided.
  • Work is beneficial for the individual, the overall economy, and government finances. Therefore, the benefits of government programs should be properly scaled to minimize the disincentive to work. Minimum wage should either be eliminated or at least allowed to scale to local wages so it creates less unemployment.
  • It is the nature of government to implement one-size-fits-all solutions. For example, applying the same federal minimum wage in PR as in Boston. One-size-fits-all often does not work well. It’s one reason why government interference in the economy often leads to worse economic results. It also illustrates why setting policy at the local government level rather than the national level is often more effective.
  • Countries and companies that become heavily dependent on government spending or government directives are setting themselves up for future turmoil and disruption. I’m referring to the tax subsidy that benefited PR for decades but was then yanked away. Government is prone to capriciously handing out rewards, then withdrawing them later. These decisions are usually influenced more by politics than by economics. The overall economy will produce better results if we allow economic motives – rather than political motives – to select winners and losers.
  • People will flee weak economies when survival and prosperity are a struggle. This further weakens the economy. It’s often the more talented and ambitious people that leave, an even bigger blow. Therefore, it makes good sense to make the economy strong and attractive to businesses, workers, and consumers, so they all want to stay.

    I encourage you to enter comments or questions below. Two rules: 1) be reasonably polite, 2) address the issue and avoid personal attacks.

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