I wouldn’t say I know much about economies, but I do know they are cyclical in nature. There are booms and there are busts. They go up, then they go down, only to come back up again later. Or so they say.
In recent years, as the Puerto Rican economy has continually found ways to shock and worry most of us living on the island, my standard response any time someone brought up this depressing subject would inevitably be a variation of “it’s gonna be ok, things will get better soon enough”. I had no idea why the economy kept doing poorly, but I had this blind belief that things were going to get better eventually, just as they always did. In my mind, it was simply a matter of patience. Because of this, I never really bothered to understand the ugly details of what was going on.
But, recently, I’ve begun to get worried things might not be so simple. Why? Let’s see, we’ve got:
1. 10 years of recession and counting (the average US recession lasts only 10 months).
2. A government which can barely cover its operating expenses, yet is staring at a humongous debt pile.
3. A scarcity of employment opportunities sparking an unprecedented mass migration to the US, and
4. A Fiscal Control Board who will get to make major decisions even though a) nobody voted for them, and b) no one knows whose interests they’re really here to defend.
Given these developments, I’ve started to truly wonder if things are ever going to “get better” again or not. And so, I decided to roll up my sleeves and finally get to the bottom of what’s really going on.
Now, trying to understand how the Puerto Rican economy works can be frustrating af, mainly because:
1) Everyone has an opinion, yet few people actually know what they’re talking about.
2) Those who do know often fail miserably when trying to explain it in simple terms (this includes most books I tried to read).
However, after a few weeks of research, I was able to finally understand many things I didn’t quite get before.
Don’t worry, this is not a post about the debt crisis or the fiscal control board, there’s been plenty written about that already. Rather, it’s an attempt at explaining the basics of how our economy works, which in my opinion is just as important, if not more. I will try to explain it the way I wished somebody had explained it to me when I first started learning about all of this. It’s a long post, but it’s also an important issue.
With that said, let’s start by discussing what an economy is truly all about.
The Importance of Trade
Let’s start with the very obvious: Humans have needs. In order to survive and be happy, humans need food, shelter, and a whole bunch of other things. In an ideal world, each individual person would produce for himself anything he needed. If we were all capable of growing our own food, sowing our own clothes, and building our own homes and cars, etc., life would probably be much simpler. Unfortunately, that’s not the case. The reality is most of us cannot produce on our own all the things we need to survive and be happy. So how do we get the things we want but can’t make ourselves? Well, we trade.
Now, in order to be able to trade for all the things we want but can’t produce on our own, we must first have something of value to exchange in return. In most modern economies, this “something of value” is usually money, and the way to acquire money is also through trading. For example, when you go to work, you trade your skills and knowledge for money.
Because of this, we can say trading serves two main purposes, it allows us to earn income, and it allows us to consume, or exchange that income for things we need. All participants in an economy are constantly performing these two types of trades, either earning income or consuming. One type of trade leads to the other, as we earn income in order to consume, and we consume in order to survive and be happy, after which we need to once again earn income. This is the cycle of economic activity.
Another important aspect of trading is this: trades only happen when both parties benefit. In other words, whenever a trade takes place, it’s because both parties believe that what they gained is more valuable than what they gave in return, otherwise they wouldn’t trade. Specifically, the value created for each side is the difference between the value of what they are getting minus the value of what they gave in return. What allows this to happen is the fact that the concept of “value” is completely relative and subjective (one man’s garbage is another man’s treasure), and usually depends on people’s wants and needs in that particular moment.
In a typical market economy like Puerto Rico, there are two key participants making trades: Individuals and Companies. Individuals are people like you and me, while Companies are organizations formed and controlled by one or more Individual in order to trade on a larger scale. Putting all this together, an economy is just the continuous flow of trades taking place between Individuals and Companies, both of whom alternate between earning income and consuming.
When you hear people talking about economic growth, what they’re really talking about is an increase in the amount and value of the trades taking place, while a recession is a decrease in the amount and value of trades. Increasing trade activity benefits all participants because, the larger the amount of trade activity, the more opportunities to earn income and to consume there will be for everyone. Increased trading activity means more jobs and greater income, which is why it should be maximized.
So far we have learned that trading is the way we humans get the things we want but can’t produce, that an economy is just the continuous flow of trades between Individuals and Companies alternating between earning income and consuming, that trades occur only when they benefit both sides, and that in order to have a healthy economy we need to maximize the amount of trading activity.
I know what you’re thinking: “Enough about trades, I thought this post was about the economy of Puerto Rico”. Yes, it is. And to understand the economy of Puerto Rico, we need to understand who the main traders are.
Circular economic flow
In order to better understand it, I think it’s useful to visualize this whole trading activity as a big ‘circular economic flow’.
In this circular flow, products and services are being exchanged for money, which in turn gets exchanged for other products and services, all in a circular motion. As we saw before, these trades are performed by individuals and companies, which alternate between consuming and earning income.
So, who are the main traders in this circular flow? If we focus exclusively on the trade flow that happens within the borders of Puerto Rico, we can identify three main traders: Locally Owned Companies, Foreign Owned Companies, and the Government. Let’s take a look at the types of trades made by each of these, beginning with the locally owned companies.
Locally owned companies are just what they sound like, all commercial establishments that are owned by PR residents. This includes local restaurants, retail stores, dentist offices, law firms, and many others. These companies earn income by selling products and services to local consumers. As with individuals, companies must also consume. However, rather than buying food or clothes, companies consume by paying their employees, suppliers, owners, and taxes, since these are the necessary expenses the company must incur in order to operate. These employees, suppliers, owners, and the government (who receives the taxes) will then use that income in order to consume and make further trades within the economy. As seen by the black arrows, the money that flows into the company in exchange for their products and services later flows back to the economy in one of these four ways.
This is all good except for one detail: in Puerto Rico most local companies have to import most supplies from foreign companies in order to operate (red arrow). Because these suppliers are not PR residents, they usually use that income to consume elsewhere. This means the money received by these foreign suppliers does not flow back into the economy, which is not a good thing. We will come back to this point later.
Let’s now add our second mayor trader in the local economy, the foreign owned companies.
These are your Walgreens and Wal-Marts, McDonald’s and Burger Kings. Mainly US owned businesses. They work exactly the same way as the locally owned companies, earning income through sales of products and services to locals, and consuming by paying their employees, local suppliers, owners, and taxes. Similar to the locally owned companies, these foreign owned companies also import many of their needed supplies, which is money that does not flow back into the economy. On top of that, because these companies are owned by foreigners, the distributions made by the Company to their owners also leave the economy, also called repatriated profits.
Our third key player is the government. Let’s add that in as well.
The government works similarly to a company in that it also performs the two types of trades mentioned above, earning income and consuming. It earns income by collecting taxes and tariffs in exchange for providing essential public services (police, firefighters, public hospitals and schools, etc.). It then consumes by paying its employees and local suppliers who provide all the aforementioned services, while also spending in infrastructure projects. All of these expenses flow back into the economy. However, some of their consumption expenses are payments to foreign suppliers as well as payments to foreign debt holders, which is money that does not flow back into the economy.
As we can see, of the money that flows through our economy as part of the local trading activity, a lot of it leaks out in the way of payments to foreign suppliers, repatriated profits, and external debt payments. This is troublesome for two main reasons. First, because of the multiplier effect, for every $1 that leaks out of the economy, usually $2 or $3 of potential trading activity is lost. Second, if we think about the economy as an inflatable pool that leaks water, unless you find a way to replenish that lost flow, you will end up with an empty pool. Similarly, these outflows of money are a constant threat of seriously shrinking our economy. Thankfully, we have found ways to pour water back in, but as we will see soon, the way we replenish our economic pool is not the most ideal or sustainable. Let’s look at both of these issues one by one, starting with the multiplier effect.
Multiplier Effect
The multiplier effect is simply the accumulated impact that $1 can have on the economy as it gets traded multiple times. This effect can teach us about the importance not only of having more locally owned businesses, but also more local suppliers.
To better understand the impact of the multiplier effect, let’s look at what happens when $100 gets spent in a foreign owned company with foreign suppliers, compared to what happens when that same $100 gets spent in a foreign company with local suppliers, and finally in a local company with local suppliers.
Spending money in a foreign owned company with foreign suppliers looks a little like this.
When the foreign company receives the $100 in exchange for providing a product or service, that money will get distributed between the owner, supplier, and the employee (I have purposely left out the taxes paid to the government for simplification purposes). In this example, since it is a foreign company with foreign suppliers, only the $10 paid to the employee will get re-spent within the local economy, as it is assumed that both the owner and the supplier will take their money and spend it outside of PR. Assuming the employee spends his money in another local company, his $10 will then get distributed between the owner, supplier, and the employee of that second company, who would continue the cycle a few additional times.
Now let’s see what happens with that money if it’s spent in a foreign owned company which has local suppliers.
As we see above, this means that, in addition to the money paid to the employee, the money paid to the local supplier will also most likely be re-spent within the local economy, creating more economic activity and more opportunity. However, the owner’s portion, which in many cases is a very substantial amount, will leak out and not flow back into the economy.
Finally, let’s see what happens when those same $100 get spent in a locally owned company with local suppliers.
In this case, the $100 gets distributed to local owners, suppliers, and employees, who will then all re-spend their earned income within the local economy, creating more trades and more economic activity. More economic activity means more businesses operating, which means more jobs. When more money gets spent in local companies, and when those companies buy from local suppliers, the full potential of the local economic activity gets realized.
Losing water
To recap, there are serious leaks in Puerto Rico’s economic flow, and the impact of these outflows is augmented by the lost multiplier effect. As mentioned above, the second big problem is that we essentially have an inflatable pool losing water and, unless we pour water back in somehow, the pool will eventually empty out. Clearly, there needs to be an inflow that compensates for the outflow just described, or else the economy would completely collapse in short order. Thankfully, there is.
The first two sources of inflow we will discuss are local export companies and foreign export companies. Let’s go ahead and add them in.
1. Local export companies are similar to the locally owned companies described above, with the main difference being that they sell their products abroad instead of locally. Although the sales happen outside of Puerto Rico, the money then flows back to our economy in the way of salaries, local suppliers, owner’s profits, and taxes, essentially increasing the circular flow. These companies have a huge potential market (the rest of the world), and they do not compete directly with other local companies. Also, because these companies have local owners, they are much less likely to relocate out of Puerto Rico as they usually grow deep roots within the local community. Unfortunately, Puerto Rico has very few companies that export their products to outside markets. Some of these include companies like Bacardi and Destilería Serrallés, among a few others. Many believe that the reason we don’t have more local companies exporting is because of the historical focus by the local government on incentivizing the growth of foreign export companies, which is the second source of inflow we will discuss.
2. Foreign export companies are simply exporting companies that are foreign owned. Ever since the 1950s, Puerto Rico has been a tax haven for foreign export companies who, by relocating here and taking advantage of certain tax laws, can pay much lower taxes than they would elsewhere. The fact that they are exporting means their sales do not depend on the local market. However, the fact that they are foreign owned means their earnings are repatriated and have little effect on Puerto Rico’s economic flow. Also, most of the suppliers of these companies are foreign based as well. The impact that these companies do have on the economic flow comes mainly through the wages they pay to local employees and the taxes that they pay to the PR government. This is all good, as they are not taking anything away from the economy and are simply contributing in the way of taxes and wages. In fact, because of these net benefits, Puerto Rico’s economic growth plan for the past 60+ years has been predicated on getting more and more of these companies to relocate here. The problem with these companies comes in two flavors, the first being that, since most of these companies are huge multinationals with few ties to Puerto Rico, they usually will not hesitate to relocate once the advantageous tax laws change, as clearly happened once the 936 tax laws were modified. Second, and maybe more importantly, there is a huge problem when all the attention and effort of the government is placed in attracting these firms at the expense of finding ways to encourage and support the development of local exporters, which are much more valuable to the economy in the long run.
Despite the government’s best efforts, the inflows received thanks to these foreign export companies does not come even close to matching the outflows of money previously described. Instead, in order ‘re-fill the pool’, our economy depends on three other sources of inflow: tourism, federal agency spending, and last but not least, net federal transfers.
- Tourism: The tourism industry represents a big source of inflow for Puerto Rico. Given our location in the Caribbean, there is also a big potential for growth. However, the fact that so many hotels here are US owned limits the multiplier effect of every dollar spent.
- Federal Agency spending: These are federal agencies that operate in the island, and who’s entire operating costs are paid by the federal government. That means that wages and other operating expenses later flow into the economy, representing a net benefit for Puerto Rico.
- Net federal transfers: Ah, the famous federal transfers, better known as the federal funds. Essentially, these break down into two categories, earned transfers and granted transfers. Within the earned transfers you’ve got Medicare and Social Security, among others, and they’re called earned because individuals have to contribute to these programs before being able to benefit from them. However, it is important to emphasize that the numbers I will be showing shortly are the net transfers, which already take into consideration the money that was paid by PR residents and deducts it from what comes in. So for example, if Puerto Ricans pay the same as is coming in, the net transfer is 0. Historically, the amounts coming in are much larger, resulting in positive net transfers. On the other hand, the granted transfers are programs like food stamps, Pell grants, and other benefits received by local residents by virtue of being US citizens. As we will see, these federal transfers play a huge role in keeping the local economy afloat.
Putting it all together
It’s now time to see the whole picture, tying together the different parts we have described so far. Below I’ve summarized the impact of both outflows and inflows in dollar amounts. Because Puerto Rico’s national statistics are seriously distorted by the impact of the foreign export companies, some of the numbers are my best approximation after closely studying the numbers and making adjustments to exclude that impact.
As you can see in the left graph, money leaves the economy mainly through imports ($12B), repatriated profits ($11B), external debt payments to non-residents ($2B), transportation ($2B), and other outflows ($2B). On the other hand, money flows into the economy through net federal transfers ($17B), local exports ($5B), tourism ($4B), federal agency spending ($2B), and other inflows ($1B). Both inflows and outflows closely match for fiscal year 2015, totaling approximately $29B each.
What do these numbers tell us? First, $29B left the local economy in 2015 between all sources of outflows. To put that into perspective, total economic activity as measured by economists was around $65B, so around 40% of that leaked out. That is a huge amount, and it highlights the problem of having so many foreign owned companies and foreign suppliers, also called absentee capitalism. So should we boycott all the foreign businesses and just buy local? Well, it’s not that simple. Remember what we talked about regarding each trade only happening if it adds value to both parties? Well, the reason these US firms are successful here is because they offer more value to consumers than their competitors. Nobody forces you to buy at Wal-Mart, but people do because they know they’ll get a better deal there than elsewhere. In other words, they’re successful here for a reason, and PR consumers benefit greatly from the products and services they receive in exchange for their money. That doesn’t mean that the current situation is ideal either. If we can somehow get local entrepreneurs to establish businesses that can successfully compete with their US counterparts on both quality and price, the local economy as a whole would benefit greatly from every additional dollar spent on the local businesses vis-à-vis the US business.
Another big takeaway is how big a role net federal transfers play in plugging the hole left by the outflows of money. In fact, when adding both net federal transfers and federal agency spending, we see that close to 70% of inflows in 2015 were in some shape or form a federal transfer or expenditure. 70%! Think about what that means for a second.
The truth of the matter is that most businesses in Puerto Rico (except those who export) depend on the local economic flow, and this local economic flow owes 70% of its annual refill to net federal transfers and federal agency spending. The question we need to be asking ourselves, is this an ideal situation for us? How do we move away from this dependence? We can do this by finding new sources of inflows so that these federal transfers stop being the main drivers of economic flow. This includes promoting the tourism industry and, most importantly, incentivizing local entrepreneurs to increase exports on a global level. Also, we need to increase the participation of local entrepreneurs in the economy, so we don’t continue to lose 40% of our economic activity every year in the way of imports and repatriated profits. For that, we need our government to stop focusing on incentivizing foreign companies to operate here (as with the proposed 245a bill) and instead find ways to incentivize local business both from an import substitution and a global exporting perspective.
Is there any silver lining? Well, the current system does provide a safety net for those at the bottom, and that’s a huge reason why we don’t see the type of debilitating poverty we see in other countries around Latin America. That’s a good thing, and we can’t lose sight of that. It also guarantees a certain level of economic activity from which we all benefit, helping the PR economy achieve something resembling a first-world country economy. That’s also a good thing. However, it is also true that the high level of US assistance has zapped the energy out of our workforce, helping to explain our alarmingly low labor participation rates and consistently high unemployment rates. Many people just don’t think it worth the effort to go out and look for a job when they can get by with these government assistance programs.
I think it’s fair to say that US dependence has put a ceiling over PR’s economic potential, but it has also put a floor underneath it. Until things change significantly, its unlikely things get much better, but also unlikely that things get much worse (just look at some countries in the Caribbean and Latin America if you want to know how much worse things can get). However, a lot more needs to be done if we ever plan on re-igniting strong, sustainable, economic growth.
-JS
Sources
Dietz, James. 2003. Puerto Rico: Negotiating Development and Change. Boulder: Lynne Rienner.
Puerto Rico Planning Board. 2015. Statistical Appendix, Economic Report to the Governor. San Juan: Commonwealth of Puerto Rico, Office of the Governor.
_______. 2015. Balance of Payments. San Juan: Commonwealth of Puerto Rico, Office of the Governor.
Susan M. Collins, Barry P. Bosworth, and Miguel A. Soto-Class, editors. 2006. The Economy of Puerto Rico: Restoring Growth. Brookings Institution.
Machlup, Fritz. 1965. International Trade and the National Income Multiplier. Princeton University
