Puerto Rico is a Prisoner of the U.S. Monetary Union

Imagine that you are Greek. (If you have a taste for fine beverages, you might perhaps imagine you are this fellow). When your economy slows or crashes, you have no resort to traditional monetary policy tools to prop it up. Many of the key rules that affect your economy are set by distant bureaucrats over whom your influence is indirect. Still, you have levers of control. You can threaten to leave the monetary union (though, again, if you are this fellow, leaving is not really in your nature), with all the attendant chaos that would cause. This credible threat forces your fellow EU countries to protect you, in order to protect themselves. Your trade neighbors, too, want urgently for your economy to recover, because theirs depends in good measure on yours. And all Europe knows you hold a veto over major EU actions requiring unanimous consent; log-rolling gives you opportunities to force your fellows to use fiscal policy — taxing and spending measures — to give your citizens some relief.

Now imagine instead you are Puerto Rican. You can even be a wise Latina, if you like, for the good it will do you. You were conquered by the United States in the 19th Century. You have nowhere to go. No logs to roll, no votes to trade. You don’t even have geographic neighbors with deeply imbedded trade ties to you, as you are, of course, on an island.

When your economy crashes in 2006 (due in part to withdrawal of U.S. tax incentives for manufacturing), your only option is to borrow money in the hopes of spending your way out. In the long run, of course, the debts will come due. But think. Suppose you have debts no honest man can pay. Your tax-exempt bonds sit in the center of the nest-eggs of many tax-sensitive mainland investors, maybe even whole banks. Finally, a lever: you can maybe become too in debt to fail. In the meanwhile, of course, your smartest and most mobile neighbors will notice the looming mountain of debt, with the certain austerity and tax increases it will have to bring. If you risk driving them away, economic recovery may never come. A hard and cruel option, but what other choices are there?

Puerto Rico’s dilemma, in short, is a dilemma of stupid design. We engineered the monetary, fiscal, and political institutions that tie Puerto Rico to the rest of the U.S. in such a way that it was almost inevitable that a sharp local downturn would cripple the island’s economy.

In the short run, bankruptcy and extinguishment of Puerto Rico’s debts is the right move, and certainly the only move that comes close to satisfying the moral obligation we owe as the literal authors of its woes. Bankruptcy in effect will pay for Puerto Rico’s (inadequate) fiscal stimulus by taxing its creditors. This is a foolish way to pay for fiscal stimulus, among other reasons because it means Puerto Rico will probably never be able to repeat the trick. Also, because many of the government’s creditors are exactly the struggling middle-class residents it needs for its economy to ever recover. More generally, it’s usually more efficient to spread the risks of economic downturns as widely as possible across the economy, both to lower marginal rates and to diversify exposure to downturns.

I would vote, then, for a bailout of Puerto Rico, or at least a compensation fund for retail investors who hold its debts. Vulture funds that bought up its debts are a harder question, though perhaps one could argue that feeding vultures this time will help assure a higher resale price for initial creditors later, which should help to keep PR’s long-term interest rates a bit lower.

The bigger picture, though, is that the current institutional arrangements are ridiculous and perhaps unsustainable. Monetary and fiscal policy are not the only cures for recessions; other institutions can help to act counter-cyclically. These require some creativity — read Yair Listokin for some great recent work. We can build in all kinds of automatic triggers to allow greater flexibility for local economic hardships.

But Puerto Rico’s lack of any political influence at all, even in the form of good trade partners, saps any impetus for creative thinking. It is not exactly coincidence that the economic fortunes of African-americans in the South changed sharply after the Voting Rights Act.

Let them vote, or let them go.