WHILE Europe’s debt crisis seems to have stabilised, the vigilantes of the bond market have found a new target on the other side of the Atlantic. Puerto Rican paper has sold off sharply in recent months as investors have lost confidence in the cash-strapped island’s ability to meet its obligations, and its government is perilously close to losing market access entirely. Many of the roots of Puerto Rico’s current woes lie in its peculiar status within the United States as an overseas territory. Its residents are American citizens who use the dollar and are subject to federal law. However, because it is not a state they do not pay federal income tax on their local earnings and cannot vote for president or Congress. Interest payments on its debt are also exempt from taxation by America’s 50 states, making Puerto Rican bonds artificially attractive to rich investors in high-tax jurisdictions. That enabled the island to borrow more money at lower rates than its economic fundamentals could justify. The island’s dire financial condition—and resulting speculation as to whether a federal bailout may be forthcoming—has refocused attention on its status. Can Puerto Rico become the 51st state?

The United States won control of Puerto Rico in 1898 following the Spanish-American War. It granted citizenship to the island’s residents in 1917—which conveniently allowed 20,000 of them to be drafted into service in the first world war the following year. Although boricuas, as Puerto Ricans call themselves in homage to the indigenous name for the territory, set up their own government in 1952, their legal relationship with the federal government remained the same. Since then, they have held four non-binding referendums regarding their status. In 1967 and 1993 they voted to remain a commonwealth, and in 1998 a majority chose “none of the above”, owing to disagreements over the technical definitions of the various options. Only in 2012 did statehood advocates finally come out on top: in a ballot with two separate questions, a majority voted both in favour of changing the island’s status and for becoming a state if a change did occur. Critics argued that the referendum’s design was rigged to produce a pro-statehood outcome, since even people who voted against a change in status were still asked to select a preferred arrangement other than the current one.

Regardless of the referendum, Puerto Rico is unlikely to become a state any time soon. Because the island remains a territory, the decision is ultimately out of boricuas’ hands. Only the federal Congress, to which the island appoints a non-voting “resident commissioner”, can grant statehood, which it has not done since it admitted Hawaii in 1959. Until the most recent referendum, Puerto Ricans had never voted in favour of statehood, so Congress had no reason to act. That obstacle has now been removed, but coming on the heels of a government shutdown and a brush with debt default, the legislature is highly unlikely to prioritise a Puerto Rican statehood bill.

Even if Congress were to break out of its current gridlock, the Republican Party would surely use every tactic at its disposal to block a statehood bill. Exit polls showed that last year Barack Obama won 83% of the presidential vote among Puerto Ricans living on the mainland. Adding two Democratic-leaning senators, five representatives and seven presidential electoral votes would be a political nightmare for the GOP. Now that statehood advocates have won a referendum at home, they will need to focus their efforts on supporting Democratic legislative candidates in 2014 to have any hope of success.

Puerto Rico: Greece in the Caribbean
America can learn from Europe’s Aegean follies
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Puerto Rico

Greece in the Caribbean

Stuck with a real debt crisis in its back yard, America can learn from Europe’s Aegean follies

Oct 26th 2013 |From the print edition

IT WILL not be long till Congress and the White House start squabbling again about the budget in Washington, DC. But before they create another artificial debt crisis, Barack Obama and his Republican opponents ought to pay some attention to a real one 1,500 miles to their south-east.

Puerto Rico, an American territory, risks a Greek-style bust. With $70 billion of debt outstanding, the equivalent of 70% of its GDP, it is more indebted than any of America’s 50 states. (Puerto Rico is not technically a state, but its bonds are treated as if it were.) Yields on its bonds have soared as high as 10%, as investors fret it may be heading for a default.

In this section

• Subterranean capitalist blues
• Europe’s other debt crisis
• The great decompression
• Greece in the Caribbean
• Canada doesn’t get any sexier than this

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Related topics

• Taxes
• Public finance
• United States
• Puerto Rico
• Europe

Like Greece, Puerto Rico is a chronically uncompetitive place locked in a currency union with a richer, more productive neighbour. The island’s economy is also dominated by a vast, inefficient near-Athenian public sector. And, as with Greece, there are fears that a chaotic default could precipitate a far bigger crisis by driving away investors, and pushing up borrowing costs in America’s near-$4-trillion market for state and local bonds. Yet the Hellenic comparison is also helpful: it should show the Americans what not to do.

For decades Puerto Rico has been sustained by federal subsidies. Its people, far poorer than the American average, get lots of transfers, from pensions to food stamps. Until 2006 the economy was buoyed by tax incentives for American firms that manufactured there. As drug companies took advantage, the territory became a vast medicinal maquiladora.

This tax break disappeared in 2006, and Puerto Rico’s economy has shrunk virtually every year since. It has been able to keep on borrowing, thanks to another subsidy: interest on Puerto Rican debt is exempt from state, local and federal taxes in America, making it artificially attractive to investors.

Some Puerto Rican bonds that are just dyin’ to meet you

No growth and heavy debt are a toxic combination. In 2010 Puerto Rico’s previous governor tried—and failed—to boost the economy with tax cuts. The current one, Alejandro Padilla, has raised taxes sharply, and hopes for a balanced budget in 2016 (see article). Puerto Rican officials insist their country is solvent. And with some heroic assumptions about future growth and rising tax revenue, you can get the numbers to add up.

This is where Greece’s experience warrants study. It suggests that austerity alone is no route to solvency in a chronically uncompetitive economy. Puerto Rico’s priority should be structural reforms to boost growth, from breaking up monopolies to reducing red tape. The island scores 41st in the World Bank’s Doing Business index, whereas America is fourth. Labour costs are too high, not least because the federal minimum wage, which applies in Puerto Rico, is almost as much as the average wage. Politicians in Washington must help, not least by getting rid of crazy rules that force all cargo between the island and American ports to be carried on American ships.

The second lesson from Greece is that if debt does need to be restructured, it is best to do it sooner rather than later. Greece waited far too long. America’s Congress is unlikely to provide official loans to pay off private bondholders, as the Europeans did for Greece. But America’s policymakers could, and should, ensure that a Puerto Rican debt restructuring is orderly. The federal government could provide interim finance to assist the restructuring, much as the IMF does elsewhere. Even the legal details of Greece’s bond swap could be a model.

None of this would be easy even if policymakers in San Juan and Washington were bold and far-sighted. But the former are pussyfooting, and the latter are not even paying attention. Expect Puerto Rico’s debt crisis to get worse.