C&B Notes

Where To For Puerto Rico?

New York Fed President William Dudley recently spoke in San Juan about Puerto Rico’s overwhelming fiscal challenges and how the territory should respond to them. Hard decisions on spending and borrowing that are insulated from political pressures are the clear first step, but other structural reforms will determine the island’s long-term fate.

As we all know, the Commonwealth of Puerto Rico has been through a very rough 10 years.  The economy has been in a long slump that could easily be called a depression.  Residents have endured a terrible drought, periodic blackouts and a fiscal crisis.  I don’t need to elaborate on all of the struggles Puerto Rico continues to face.  The Island has been suffering from a vicious cycle.  As employment declines, people move to the mainland to find jobs.  Accordingly, economic activity and tax revenues decline, forcing the government to raise taxes and cut spending, which further reduces employment and prompts still more residents to move.  At this point, the outlook for anyone who has been living here must be bleak, and it may be hard to imagine this situation turning around anytime soon.  And yet, history tells us that a turnaround, though not inevitable, is indeed achievable.

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Of course, not every city that has faced a fiscal crisis has the same track record.  Relative to cities that had similarly grim outlooks, New York City’s rebound has been much stronger.  In Detroit, there are hopeful signs, but it’s too soon to tell how things will turn out.  Both Washington, D.C. and Philadelphia experienced multiple decades of population declines leading up to their crises.  These population declines reversed in the 2000s.  Washington, D.C.’s population actually grew over 5 percent between 2000 and 2010, a rate even faster than that of New York City.  Cleveland’s fiscal reforms, on the other hand, were less comprehensive, and the city has never really turned itself around.  Its population in 2010 was less than half the level of 1960.

The different performances across cities reflect the complex interplay of native endowments, economic conditions and fiscal outcomes.  As in Puerto Rico, the fiscal woes of many of our largest cities have been closely related to long-term economic transformations — essentially, changes in the industrial specialization that occurred in those particular places. In the case of New York City, the transformation was from manufacturing to services, and it took a generation to complete.  The city’s management of that transition was far from perfect, and the fiscal crisis was the major manifestation of that failure.  The institutions set up to respond to the crisis were crucial to ensuring that fiscal policy didn’t continue to amplify the problems associated with the economic transition.  For a city to turn its circumstances around, it must navigate this economic transformation, identify what will define its comparative advantages going forward, and then build anew around those sources of strength.

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A successful fiscal reform first requires a regime in which local officials recognize and accept the reality of the changing economic situation, and set spending budgets accordingly.  This part is fairly straightforward, because it produces the simple policy dictum that borrowing — in all its forms — must be strictly limited.  Of course, knowing what to do and actually getting it done are different things, especially when politics are involved.  As a result, the record suggests that it can be extremely helpful to have some kind of independent fiscal monitor in place on an ongoing basis.  It’s important that this monitor be insulated from the direct influence of politics, giving it freedom to deliver objective analysis that may at times be very unpopular.  In Washington, D.C., this took the form of the Office of the Chief Financial Officer; in New York City it is the Independent Budget Office, which is modeled after the Congressional Budget Office.  These monitors have proven invaluable in keeping policymakers and the public informed on budgetary matters, and in providing apolitical expertise to assist in keeping budgets on a sustainable course.

The second major component is a successful completion of the economic transformation, which is a critical factor for reversing — rather than simply halting — a city’s decline, establishing a virtuous cycle of rising growth and strengthening fiscal outcomes.  New York City had the huge benefit of its comparative advantage in finance — an industry that was poised for sustained growth in the post-fiscal-crisis period of the 1980s through the 2000s.  Still, the city weathered a lot of shocks during that period, including the 9/11 terrorist attacks, the financial crisis and Hurricane Sandy.  It’s also worth pointing out that New York City is still prospering, even though employment in its finance sector has stagnated.  This illustrates the need for cities to continually look for new areas of growth, such as health care, technology, and leisure and hospitality services.

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First, it is important to reduce the cost of doing business on the Island as a way of encouraging business growth and increasing the demand for labor.  We have put forward many ideas to consider here, ranging from ones targeted at hiring — such as giving Puerto Rico more autonomy over setting its minimum wage policy — to more general ideas like streamlining regulation.  One thing that we’ve repeatedly emphasized is the need to find efficiencies in the Island’s energy industry.  Commercial customers on the Island pay roughly 20 cents per kilowatt hour for electricity — nearly double the mainland average. Island residents and businesses, as you are well aware, are also burdened with exceptionally high water utility bills.  It is also important to think hard about the supply of labor — the willingness of people to work, and the education and skills that they have to bring to the market. Labor supply is equally important, but less widely discussed than the demand side of the market. Labor force participation is lower at all ages in Puerto Rico than on the mainland.  This is a crucial impediment to growth, and addressing it requires innovative policy options.  One idea to address this problem would be to extend the Earned Income Tax Credit to Puerto Rico.  In addition, the structure of the Commonwealth’s tax system creates disincentives to work in the formal sector, and suggests that tax reform could produce a growth dividend as well as a more reliable source of revenue.  On top of the low labor force participation is the well known and deeply concerning high level of out-migration.  In addition to the lack of labor demand, it seems likely that quality-of-life concerns such as high crime rates are playing a role in these decisions.  This underscores the importance of basic public service delivery and is another example of the interplay between fiscal and economic outcomes.

Another important dimension of labor supply involves the skills that workers bring to the market.  Many of these skills are acquired while in school.  Our research indicates that test scores for school-age children on the Island are low, suggesting that there is an opportunity for improvement in the quality of public education.  One clear lesson from recent research in urban and regional economics is that the collective skills of the people living in an area are a critical ingredient for its growth prospects.  Improving the education available to residents can pay large dividends over time.

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