Standard & Poor's has downgraded the debt of Puerto Rico's government to junk status, as Reuters's Ryan McCarthy reports. That may be overdue: Puerto Rico's debt has been trading at junk prices since September, and it appears that in order to sell further bonds, Puerto Rico will have to promise to pay 10 percent interest. That's a major problem for investors, because Puerto Rico bonds, exempt from federal, state and local taxes, are widely held by bond funds. Puerto Rico's government is a commonwealth, which is better described in the Spanish term estado liberado asociado -- associated free state -- it is a possession of the United States, and Puerto Ricans are U.S. citizens by virtue of an act of Congress passed in 1917. Only a tiny percentage of Puerto Ricans favor independence, but Puerto Rican voters are closely divided between two island parties, the Popular Democrats, who favor the current status arrangement with some modifications, and the New Progressives, who favor statehood.
Why is the government of Puerto Rico in such trouble? The short answer is that it has been spending more than it has been taking in. Employment is low (1.2 million in an island of 3.4 million) and one-quarter of jobs are in the public sector. The federal minimum wage law applies to Puerto Rico, which probably eliminates or moves underground many low-wage jobs. The longer answer is that Puerto Rico's post-World War II transformation from a sugar producer to a manufacturer was stimulated by federal tax law, particularly Section 936, which gave a tax preference for income from manufacturing plants in Puerto Rico; the pharmaceutical industry was a particular beneficiary. However, in the 1990s, the Clinton administration and Congresses both Democratic and Republican moved to phase out Section 936, and Puerto Rico's economy has sagged. In the past decade, it has suffered population loss as thousands of Puerto Ricans have moved to the mainland, especially Florida -- the first big outmigration since the huge surge of migration to New York City from 1949 to 1961.
To say that Puerto Rico's economy has not recovered from the 2007-09 recession is an understatement. Its economic product is 16 percent below 2004 levels, and except for a brief period in 2012, economic activity has declined since 2007, as Reuters's Felix Salmon shows. Salmon compares Puerto Rico to those other tourist destinations Greece and Portugal, which have low education levels and are also unable to devalue their currency. Puerto Rico is already being partially bailed out by the federal government, because it passed an excise tax on U.S. companies manufacturing on the island: Since this is deductible on federal corporate taxes, it effectively transfers money from the U.S. to the Puerto Rico treasury.
But that is not enough to solve Puerto Rico’s fiscal problems, especially as population and economic activity seem fated to decline. Salmon’s suggestion to the Puerto Rico government: “Start having quiet conversations in Washington about a piece of legislation that would give the island the legal freedom and ability to restructure its debts in a clean, one-and-done manner.” But this would be politically difficult. Puerto Rican Gov. Alejandro García Padilla is a Popular Democrat, its non-voting (except in committee) member of Congress — the title is Resident Commissioner— Pedro Pierluisi is a New Progressive. The two parties are intensely competitive (no governor has been reelected since 1996) and they seem unlikely to cooperate, and even if they did, they would have to deal with a Republican House and a Democratic Senate and administration.
Here's another suggestion: Congress should pass a law providing a bankruptcy procedure -- pretty much along the lines of Salmon's suggestion -- which would apply to the states and to the U.S. territories (the U.S. Virgin Islands, American Samoa and the Commonwealth of the Northern Mariana Islands are in dreadful fiscal shape too). This is the policy advocated by University of Pennsylvania Law School professor David Skeel, one of the nation's leading experts on bankruptcy, in the book he co-edited, When States Go Broke: The Origins, Context and Solutions for the American States in Fiscal Crisis. There is no law providing for state bankruptcies. Puerto Rico needs one now and Illinois may soon.
By the way, I will be on the panel in a conference at the American Enterprise Institute on Feb. 18 with Skeel, my AEI colleagues Alex Pollock and Andrew Biggs and John Mousseau of Cumberland Advisors. The subject is “The Detroit bankruptcy: Conflicts and implications.” Perhaps Puerto Rico will enter into the discussion.