Greek lessons for Puerto Rico

One has to be encouraged by the fact that at least the U.S. Treasury appears to have learned something from Greece's economic crisis. Rather than pretending that Puerto Rico is solvent, the Treasury now recognizes that an early and orderly debt restructuring would be in the long-term interest of both the island and the collective of Puerto Rico's creditors.


Similarly, rather than leaving the island to its own devices, the Treasury is proposing that, in exchange for bankruptcy protection, Puerto Rico agrees to an oversight board that would assure the full implementation of its fiscal commitments. If adopted soon by Congress, these proposed policies could spare Puerto Rico from Greece's tragic economic fate and enable creditors to get repaid a higher proportion of their loans than would otherwise be the case.

While there are certainly many differences between Puerto Rico and Greece, there are a number of striking similarities. Those similarities suggest that Congress would do well to look at Greece's experience when framing a policy response to the island's deep economic troubles, which are now reflected in a 45 percent domestic poverty rate and in an ever-increasing number of Puerto Ricans leaving the island for the mainland.

Over the past decade, like Greece before it, Puerto Rico took advantage of favorable financial market conditions (in Puerto Rico's case, created by ample Federal Reserve liquidity and by highly generous tax exemptions on interest on its bonds) to borrow very heavily in the capital market. Like Greece too, Puerto Rico made poor use of that borrowing. It did so by allowing major public finance imbalances to build up and by delaying real structural economic reforms that might have galvanized its ailing economy.

Like Greece, Puerto Rico's economy has been in a prolonged slump (owing to mismanagement and Congress withdrawing generous manufacturing tax preferences). Perhaps most important of all, though, similar to Greece, Puerto Rico does not have a currency of its own. As a result, like Greece, Puerto Rico too cannot use interest rate or exchange rate policy as an offset to the contractionary effects of budget tightening on aggregate demand.

In a rare moment of candor, the International Monetary Fund (IMF) recently owned up to two very costly mistakes that it had made in the handling of the Greek economic crisis which contributed importantly to Greece now experiencing an economic depression on the scale of that experienced by the United States in the 1930s. The first mistake was not to recognize in 2010 that Greece was suffering from a solvency, rather than a liquidity, crisis. This led the IMF down the path of demanding from Greece an excessive amount of budget austerity within a euro straitjacket that precluded currency devaluation. The second mistake was that it grossly underestimated the size of Greece's fiscal multipliers or the degree to which budget tightening could have a deleterious impact on the Greek economy. This mistake caused the IMF to be consistently too optimistic in its Greek economic growth forecasts.

The collapse of the Greek economy has had devastating social consequences for the Greek population. It also has hardly been good for Greece's bondholders. In the end, as Greece's capacity to pay was highly diminished by its shrinking economy, Greece's bondholders were forced in 2012 to accept a 75 percent write-down in the present value of their loans in what was the largest sovereign debt default on record.

It is against this background that one has to applaud the U.S. Treasury for seeking an early and orderly restructuring of Puerto Rico's debt, which has now reached over 100 percent of the island's gross national product. To that end, the Treasury is proposing that Congress extend to U.S. territories, like Puerto Rico, Chapter 9 bankruptcy procedures that would allow the island to restructure its 18 different bond issues in an orderly way. The overriding objective of Treasury's proposal is to provide a legal framework for this to be done in an equitable and orderly manner and to avoid the legal free-for-all that would otherwise result and which, if Greece's experience offers any precedent, would be to the detriment of both the island and the creditors as a group.

One also has to applaud the Treasury for linking proposed bankruptcy protection for the island to serious fiscal reform and stronger fiscal governance. To that end, the Treasury is proposing an oversight board that would force Puerto Rico to implement those fiscal reforms necessary to put the island on a better growth path that would be in the interest of both the island and its creditors.

Judging by Greece's catastrophic experience over the last few years, Congress would seem to have a clear choice in its dealings with Puerto Rico. It could continue to sit on its hand and watch the island's economic slump deepen and its population increasingly migrate to the mainland. Alternatively, it could embrace the Treasury's bankruptcy-cum-oversight board proposal that would give the island a fighting chance to turn around its economy. One has to hope that Congress makes the right choice.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.