Unlikely Lessons for the Eurozone

Puerto Rico will continue to use the dollar. Now, the Commonwealth has a a legal framework for debt restructuring. The governments in the Eurozone ought to follow this example. A column by Barry Eichengreen.

Barry Eichengreen
«Europe must create a debt restructuring mechanism and be prepared to use it.»

Europe has a long history of looking to other monetary unions, notably that of the United States, for lessons about how to improve the functioning of its Single Currency. Today, with the tenth anniversary of the Greek crisis approaching, it does so more than ever.

A problem with this comparison is that we lack much relevant information about the operation of the U.S. economic and monetary union, such as export and import data for the 50 individual states. One exception is the subject of a classic 1962 book by the American economist James Ingram, who analyzed the monetary union between Puerto Rico and the Continental U.S. Ingram was motivated by the creation of the European Economic Community five years earlier and by the possibility that the Community might one day develop into a monetary union. He focused on this case because Puerto Rico, as a U.S. territory rather than a state, and as an island, gathered its own import and export data.

A remarkable aspect of Ingram’s book was the extent to which it anticipated modern conclusions about what makes for a smoothly functioning monetary union. Ingram emphasized similarities and differences in the economic shocks hitting the island and the U.S. mainland. He pointed to the transfer of resources from the Continental U.S. through the federal government budget. He highlighted the high level of labor mobility between Puerto Rico and the 50 U.S. states.

Asymmetric shock

Today Puerto Rico is back in the news, and not in a good way. In 2017, the island was devastated by Hurricane Maria. Thousands lost their lives, and 80 per cent of the power grid collapsed. For cognoscenti of the theory of monetary unions, this was the mother of all asymmetric shocks.

In response to the storm, the U.S. government provided assistance, but on a wholly inadequate scale. The lasting image from the aftermath of the hurricane is of Donald Trump throwing paper towels into a desperate crowd. Even now, Trump is talking of diverting funds from Puerto Rico’s reconstruction to building his wall on the U.S.-Mexico border.

The aftermath of Hurricane Maria prompted discussions of whether the island, like any economy suffering distinctive economic shocks, would be better off with its own currency. Those discussions were entirely academic, of course, since Puerto Rico isn’t going to get its own currency. Doing so would require independence, for which there is no prospect, nor even any appetite on the island. The most Puerto Rico can hope for its statehood. In which case it will still be part of the U.S. monetary union and still use the dollar.

Lousy fiscal position

Greece is in the same position. So long as it remains an EU member, it will be part of the European Monetary Union and use the euro. And leaving the EU is something for which there is similarly no appetite in government circles in Athens.

So what are the real lessons from Puerto Rico for Europe and the euro? They are three.

First, it is critically important to limit pre-existing vulnerabilities and avoid self-inflicted damage in order to build resilience against asymmetric shocks. Puerto Rico’s fiscal position had already deteriorated severely before the hurricane. Its governor had acknowledged that the Commonwealth’s debt was unsustainable. Its government had been encouraged to issue debt, and investors had been encouraged to hold it, by U.S. laws giving the bonds tax-exempt status. This is not unlike how European governments are encouraged to issue debt and banks are encouraged to hold it by regulations freeing them from holding capital to back those investments.

Fatal outmigration

Puerto Rico’s heavy debts left the government with zero room for maneuver. When the economy then stagnated, this eliminated the possibility that it might grow out from under the debt. The hurricane was just the straw that broke the camel’s back.

The implications for Italy are obvious. The Italian government’s debt load is crushing. The economy is stagnating. If it suffers a natural or man-made disaster, the country will have no fiscal room for maneuver.

Second, labor mobility, long highlighted as a precondition for a smoothly functioning euro area, hurts as much as it helps. When an economy experiences a negative shock, residents look for better prospects elsewhere. The adversely affected economy may then be substantially depopulated. With fewer taxpayers, the government will be unable to raise the revenues needed to service its debts. Public services will be cut, and the resulting hardships will only encourage more outmigration.

Congress has intervened

Puerto Rico has a long history of emigration. The Jones-Shafroth Act of 1917 granted U.S. citizenship to the residents of the island, and migration to the Continental U.S. picked up with the advent of low-cost air travel. But out-migration accelerated in the mid-2000s when the economy stagnated. Puerto Rico had seen outmigration of 1 per cent of its population annually for more than a decade before Hurricane Maria struck, after which migration picked up with a vengeance. The migrants were disproportionately young and economically active, which not only depressed tax revenues but also accelerated the ageing of the population.

Similarly, Greece saw large-scale emigration to Northern Europe, as did Spain and Portugal to Latin America, during the euro crisis. As in Puerto Rico, it was disproportionately the young and economically active who moved. From the point of view of debt sustainability, this high level of labor mobility was no blessing.

From this flows the third and final lesson. Europe must create a debt restructuring mechanism and be prepared to use it. Outmigration that results in depopulation can render inherited debts untenable. To avoid dragging down growth, those debts must be restructured. This is something the U.S. Congress acknowledged when, in 2016, it enacted a new law, called PROMESA, giving Puerto Rico a legal framework for debt restructuring, and when it created a Fiscal Control Board to oversee the process.

Vulture funds unhappy

That oversight board is currently under attack in the courts by vulture funds unhappy with the debt restructuring terms on offer. But no one with Puerto Rico’s interests at heart – not the Congress and not the courts – doubts that a deep restructuring is coming.

Last November, ten EU finance ministers, mainly from Northern Europe, authored a joint position paper calling for unsustainable Eurozone public debts to be restructured. Talks are underway about how to empower the European Stability Mechanism, the Eurozone bailout fund, to organize this process. Talk is well and good, but it is not enough. Puerto Rico’s experience suggests that European leaders need to move urgently from talk to action.