Puerto Rico and Wall Street’s 21st Century Debt Peonage Imperialism

February 2014

Puerto Rico and Wall Street’s 21st Century Debt Peonage Imperialism

Victor M. Rodriguez, Professor, California State University, Long Beach

    Puerto Rico is usually thought of as a tourism destination or is usually invisible in the U.S. media. In recent times, its fiscal and economic crisis has led to inaccurate comparisons with Detroit or Greece whose fiscal crisis have attracted much media attention. As usual, the mainstream press looks at the illness without looking at the root causes. And the comparisons are usually risky because they tend to ignore history and the nuances of each case. Unfortunately for Puerto Rico, its fuzzy political relationship with the United States is always described with euphemisms (“Commonwealth”) in order to avoid the undeniable truth: Puerto Rico is a colonial possession of the United States in the 21st century. The colonial model that was developed after World War II is entering a stage of complete collapse and the colonial government has few alternatives to repair the economic crisis. But the United States, like an alcoholic has always been in denial of the fact that a democratic nation has colonies. But in Puerto Rico the wall of denials is cracking and threatening to impact the U.S economy and national security. 

History
    One outcome of the “splendid little war” of 1898, the Cuban-American-Spanish war was the transfer of Puerto Rico, Cuba and the Philippines as part of the Treaty of Paris. No representatives from these nations were present in the treaty process. Spain “ceded” Puerto Rico to the United States. Puerto Rico then became an “unincorporated territory of the United States “or to use the phrase of Justice Edward Douglas White in his Downes v. Bidwell decision in 1901 “Porto Rico was not a foreign country, since it was owned by the United States, it was foreign to the United States in a domestic sense, because the island had not been incorporated into the United States but was merely appurtenant thereto as a possession.” In other words, it belongs to but it is not part of the United States (this court also decided the 1896 Plessy v. Ferguson “Separate but Equal” Decision). Its residents after 1917 became citizens of the United States under the Jones Act (their Puerto Rican citizenship was eliminated) but the statutory nature of the citizenship has created a second class citizenship status for Puerto Ricans. In another decision the Supreme Court in Balzac v. Porto Rico (1922) said that the bill of rights does not pertain to Puerto Ricans. They do not pay Federal Income taxes but they can be drafted in times of war. They also cannot vote for the commander in chief, the president of the United States. Because of the statutory nature of its citizenship a Puerto Rican born in the island cannot be president of the United States (although this has not been firmly decided by the Supreme Court where a Puerto Rican woman, Sonia Sotomayor now serves). If islanders want to increase the level of their citizenship they must travel to the United States mainland and participate in the electoral process there. Close to 5 million Puerto Ricans live in the mainland already while only 3.6 million live in the island proper.
    The awkward status of the island is the outcome of misgivings U.S. congress had in incorporating a nation where a majority of the population was considered non-white. Most of the territories conquered by the United States (with the exception of the Philippines and Cuba) became territories (the track toward possible statehood) and their final entry was finally determined by their racial demography. New Mexico, for example, although the Mexican American War ended in 1848 did not become a state until 1912, while California became a state in 1850. The determinant factor in the different time of admission for both is that by 1850 whites were the dominant group in California. New Mexico, on the other hand had, while it still had a significant Mexican American population by 1912 the white population (and their control of the economy) had become sufficiently large to allay some of the congressional fears. The cases of Hawaii and Alaska occurred after World War II when the racial issue while still pertinent was less determinant in the process because there was a significantly large white population in both territories. To not grant statehood would have created two large populations of white second class citizens.
    Puerto Rico, on the other hand by the end of the Spanish American War already had a population of one million inhabitants, so changing the racial demography of the island would have been a massive process of ethnic cleansing. The bringing of white settlers and the promotion of the massive emigration of Puerto Ricans would have been too controversial.  However, population control efforts were carried out in Puerto Rico by the colonial government coupled with the promotion of emigration and the recruitment of workers for sugar plantations of Hawaii and the agricultural fields in the Northeast of the United States. These early immigrants are the pioneers who created the Puerto Rican communities that persist today in the United States. By 1930, more than 52,000 resided in the U.S. But the process of emigration was not sufficient to diminish the population significantly since the birth rate was quite high. In fact, the population of Puerto Rico has always shown natural growth in each of the decennial census the U.S. Bureau of the Census has carried out in the island. But recently, a new population phenomena is taking place in Puerto Rico.

Declining Population
    For the first time since 1898 the population of Puerto Rico has suffered a decline. According to the U.S. Census Bureau the island’s population has declined from 2010 (last decennial census) through 2013. An analysis performed by the Center of Puerto Rican Studies (2014) indicates that the population of Puerto Rico declined from 3,721,208 in 2010 to 3,615,086 in 2013. A decline rate of 1 per cent per year while at the same time the natural growth of the population has declined 13 per cent between 2012 and 2013. It is estimated also that 500,000 Puerto Ricans have emigrated in the last decade. Just in the state of Florida an estimated 900,000 Puerto Reside. In fact, in the 2012 elections President Obama received the electoral votes of this states thanks to the Puerto Rican vote which nationally voted 83 per cent for Democrats.
    But the emigration is having other consequences in the island. The island’s population is becoming older which together with the fiscal crisis that it is facing are creating a climate of uncertainty among its population. While there is a small flow of immigrants to the island their demographic characteristics compound the problem. The median age of the population of return migrants is 33 years and the median age of those who leave is 29 years so the median age of the island population will likely increase from the present 38.2 years. As the dependency ratio increases (ratio between the young and the old population) it will mean a smaller working class to maintain the increasingly growing retired elderly population. This is becoming a core problem which has resulted in some drastic reforms by the colonial government of the public pension systems of teachers and public workers. Both system have an actuarial deficit of $45 billion according to the government. Teachers engaged in limited strikes and protests because of the dramatic reduction in their pensions. This reduction in benefits has also induced many teachers to emigrate.  
    But despite the myths that abound in the media there is not a massive “brain drain” occurring in the emigration flow. In fact, most of the emigrants are less educated than the non-emigrant population according to a study covering 2000-2011 by Kurt Birson of the Center for Puerto Rican Studies of Hunter College, CUNY. While there are a significant number of professionals among the emigrants, only 15 per cent hold a bachelor’s degree and 5 per cent a graduate degree, a slightly smaller representation than the non-emigrant population. The emigrants are however younger and made up of more blue-collar workers than their counterparts who stayed in the island. Given the state of the U.S. economy where low wage jobs are being produced in greater proportion than in previous decades the less educated emigrants are finding themselves stuck in low wage jobs and competing with foreign immigrant workers. But the anecdotal narratives carried by mainstream newspapers in the U.S. exacerbate and inflate the perception that most of those leaving are highly educated teachers, engineers, physicians etc. Already, the public school system has closed many elementary schools because of the decline in the birth rate. 

The Fiscal Debt of Puerto Rico
    In the meantime, as a result of the failure of the colonial system to provide the momentum for the economic development of the island, the colonial government, especially since the 1970s began to rely on debt to pay for basic public services and to pay for previous debt. Since last February 4, 2014, Standard & Poor’s, Moody’s and Fitch have downgraded its debt to junk status, brushing aside a series of austerity measures taken by the new governor which were considered necessary but only helped to avoid a further lowering of the credit rating. Also, despite the announced radical measures by the governor of Puerto Rico’s Governor Alejandro Garcia Padilla to reduce appropriations by $170 million and plans to have a balanced budget for 2015, Standard & Poor surmised that the government may have to return to the market to cover a 2015 deficit. This is a chaotic situation given that the public debt of Puerto Rico is $70 billion dollars or 102 per cent of the island’s GNP the highest of any state in the U.S. The debt income ratio is 83 per cent (Villamil, 2014) almost 14 times the same measure as New York, California or Illinois. The island is paying close to $3.7 billion a year to service the debt. To compound the situation the population is declining, the labor participation rate has declined to 41.3 per cent (one of the lowest in the world). In addition, the unemployment rate is 15.4 per cent, highest than any state of the U.S.

Colonialism and the Failure of Economic Development

The Achilles heel of any effort to heal Puerto Rico’s financial crisis is its inability to expand its economic growth in a self-sustaining way. While according to the governor there is an increase in revenues that may help the island avoid a deficit in 2015, the reality is that Puerto Rico decades ago chose a growth and not a developmental path that was limited by its colonial status. Puerto Rico cannot issue its own currency, because of cabotage laws enacted by Congress in 1920 Puerto Rican trade has to utilize the U.S. merchant marine, the most expensive and likely the most inefficient in the world. It is also unable to protect its local production because it does not have the power to raise tariffs. Its poultry sector, its agriculture, housing construction and even its once thriving banking sector are also in a crisis. Three major banks were liquidated by the FDIC. Puerto Rico also cannot enter into trade agreements with its neighbors directly it has to use the United States government as an intermediary. In fact, contrary to the experience of Detroit, Puerto Rico cannot go into bankruptcy. To add insult to injury, Puerto Rico’s constitution requires the government to pay general obligation bond holders before it fulfills other regular governmental obligations. In other words, services to the citizenry could be further cut to pay for its fiscal debt. At this point, with the reduction of the island’s credit rating even if they wanted they could not afford the higher interest rates that the markets have imposed. For many years Puerto Rico bonds did pretty well in the market offering higher interest rates than those bonds issues by states and municipalities in the U.S. The constitutional clause and the backing of the colonial government made these bonds very profitable to its buyers. For example California was paid 2.375 for its bonds while Puerto Rican bonds earned between 8 and 10% (2013). Now that bonds have been reduced to a junk status this source of income is almost closed to Puerto Rico. Finally, raising taxes in an already regressive tax system will only further accelerate the depressed economy. Puerto Rico’s economy, while the U.S. economy is enjoying a modest recovery, is in it eight recessionary year. Its GNP has been reduced by 15 per cent in real terms.  


The Genealogy of the Crisis

Puerto Rico’s colonial governments have relied upon tax exemption benefits to muster economic growth since the failure of a modest import substitution effort in the 1940s. This effort was modeled on similar efforts in Latin America to develop industries that had some linkages to the local economy and that would reduce the dependency on imports. The intellectual template for this effort was the “Chardon Plan,” Carlos Chardon was the first Puerto Rican chancellor of the University of Puerto Rico (1931-35). In 1935 he developed the framework for what was to become the Puerto Rico Reconstruction Administration (PRRA) created by the Roosevelt administration to help solve some of Puerto Rico’s economic problems. The local government provided some resources and had the support of a progressive colonial administration under Governor Rexford G. Tugwell (1941-46) who was appointed governor of the island by President Franklin Delano Roosevelt. With government financing, publicly owned industries were created (like the Tennessee Valley Authority), enterprises like a glass bottle plant, a cement plant, a box carton plant and other agencies with the purpose of decreasing the reliance on imports, provide some resources for local industrial development and provide local employment. Most of the publicly owned initiatives were labor intensive. Unfortunately, management problems and political problems led to the eventual privatization of these enterprises. Politicians both in Puerto Rico and the U.S. had complained calling this a socialist experiment a complaint that resonated among conservative sectors in the U.S.

The first effort after World War II to improve the economy was called “Operation Bootstrap” which was a misnomer because Puerto Rico was not pulling itself by the bootstraps instead it was relying on U.S. corporate investment in labor intensive light industry. Initially these enterprises provided significant local employment. However, because the colonial government provided generous tax incentives to these corporations it also reduced the tax revenues for basic services. While the tax incentives attracted corporate investment that increased employment the fiscal situation of the island remained under control. From 1950 to 1970 the model had some success in attracting U.S. capital because since U.S. workers had not been allowed to strike during World War II U.S. capital had accumulated huge profits during the war. Then after the war, since the traditional economic rivals of the United States, Japan and Germany had their industrial base demolished the U.S. became the dominant economic power.

This unique combination of factors created a niche that helped Puerto Rico achieve some economic growth, however, no development. The income per capita in in the U.S. 1950 was $1,935 (Dietz, 2003) or six times larger than Puerto Rico’s. As the industrialization program developed under these conditions it achieved some success, by 1960 income per capita in the island had reached $723 and by 1970 it had doubled to $1,857. During a short period there was a convergence between the local economy and the U.S. For example, during the first two decades 1950-1970s the U.S. per capita gross domestic product (GDP) as a multiple of the island’s income was only four in 1960 ($2,915) and then in 1970 it was only 2.7 times ($5,050) greater than Puerto Rico’s (Dietz, 2003). The income convergence between the U.S. and Puerto Rico began to slow after 1970, and through 1990s remained virtually unchanged. But while in absolute terms there were increases in income, the position of the economy of the island relative to the United States remained static, the convergence ended. One factor that stabilized local income was the federal transfers to the island that began in 1975 when food stamps were approved for Puerto Rican residents. This infusion of money helped the commercial sector and brought many out of deep poverty. But in addition to the federal transfers one factor that aided in the reduction of poverty and the unemployment rate was the massive emigration of Puerto Ricans. The industrialization process included the overt and deliberate promotion of emigration to the United States as an escape valve. During the 1940s and 1950s Nationalist activism created fear of political disruption in Puerto Rico and the United States. In 1950s there was a Nationalist insurrection and in 1954 nationalists engaged in armed action against congress.

The next phase of the Puerto Rican economy was primarily based on the changes in the Federal IRS code which created the 936 code in 1976 which allowed U.S. corporations to repatriate profits in Puerto Rico without paying federal taxes (in the form of a tax credit). The purpose of this tax code was to help “possessions” to bring external capital investment to increase employment and economic growth. Some amendments were made to the law in subsequent years which allowed corporations to also get tax credits from passive investment and intangibles like intellectual property of patents. In sum, a very generous tax scheme which resulted in the expansion of drug and pharmaceutical industries, medical instruments, high technology. Unfortunately, the contribution to employment in the island became expensive since in the late 80s the cost of creating one job was $70,000 in lost federal revenues for a job that paid $26,471 in wages in the pharmaceutical industry.

The local government, in order to avail itself of some income from the tax exempt industries instituted a “tollgate tax” of 10 per cent for any repatriated profits. This money was to be invested in the local banks which provided a financial incentive to banks and increased the availability of loans and in some way promoted the consumerism which continues unabated even today. For many years, personal consumption in the island benefitted from this significant source of funds which were available to the banking sector. Puerto Ricans enjoyed very reasonable interests for consumer expenditures leading to one of the highest ratio of cars per 1,000 inhabitants in the world. These low interests which also extended to the mortgage market may also well be responsible for the real estate housing bubble that ensued.  

Because of the concern that the 1976 936 IRS code was too expensive for the U.S. Treasury and because it was not providing the level of employment that had been expected the Clinton administration in 1995 signed legislation which phased out the 936 code which was to end in 2005. Corporations would have to opt for other sections of the tax code so they could protect their profits. Some incorporated as “controlled foreign corporations” (CFC’s) which allowed the enterprises to receive tax benefits under the 901 IRS code which allowed corporations to get tax credits for their investment in foreign countries. Puerto Rico was considered a foreign country for tax purposes so many investors chose this avenue to protect their investment. Ironically, despite the fear that only tax incentives could provide the island with economic growth, the partial decline in the role of manufacturing in Puerto Rico predates the elimination of the 936 tax exemptions. Manufacturing, like in the United States already had begun to decline as a percentage of the island’s economy. In fact, from 1995 through 2000 employment grew in construction, trade and services and began to provide a greater proportion of the employment than manufacturing. These are also sectors of the economy with a greater role of local capital. The explanation for this is that since the 1970s Puerto Rico began to receive federal transfers like food stamps and other programs which maintained the consuming power of the population and reduced poverty.

However, most of the external investment has resulted in the elimination of local capital and in a reduction in the tax revenues for government services. Also, as Dietz has indicated in previous work (1986) the Puerto Rican economic developmental model focused on growth but not on development. Puerto Rico was the model (which initially was showcased for other Latin American countries) for what in other countries, particularly Mexico are called “maquiladoras” which are basically assembly plants. The core problem of this model is that it creates an enclave with no forward or backward linkages to the local economy. The manufacturing plants are basically assembly plants that avail themselves of cheaper labor and then export their products. Since they use very few local inputs, their contribution to the local economy is relatively small since most of the inputs are also imported. These external inputs also negatively affects the trade balance.
The other weakness of this model is that, even in the pharmaceutical and drug companies, which pay the highest salaries, they manufacture their products, also with external inputs, and then export them to the U.S. creating a “crisscross” process. Pharmaceutical products are exported directly to the U.S. and then exported back to the Puerto Rican consumers increasing prices for local consumers. Logically, there should be a direct sourcing of those products to local pharmacies and other commercial consumers but that is not the practice.

In order to obtain some revenue from these newly incorporated “controlled foreign corporations” the colonial government instituted Law 154 to tax these corporations at a rate of 4 per cent, in an industry that has become addicted to low taxes this measure has not been received well. In 2012 the government received $1.8 billion dollars from this measure. A local economist Argeo Quiñones has argued that instead of this tax the government should legislate to increase the backward linkages of these enterprises. In other words to provide incentives so that they buy a higher percentage of their industrial inputs to infuse more money into the economy and further increase employment. Also, he suggests that pharmaceutical and drug companies should be forced to sell their products in the island to reduce the cost of drugs and other pharmaceutical products in the island.     
Because of the reliance on local tax exemptions, “controlled foreign corporations” are not subject to federal taxes and at times they sell their intellectual rights (like Microsoft USA) to their local foreign owned subsidiary (since Puerto Rico is foreign for tax purposes) and are able to save billions of dollar in the sales in the U.S. market. The Congress Committee on Homeland Security and Governmental Affairs (October 12, 2012), chaired by Senator Max Baucus found that: “In 2011, this corporate sleight of hand enabled Microsoft USA to shift 47 cent of every dollar in U.S. sales totaling $6 billion, to its Puerto Rican subsidiary, dodging payments of U.S. taxes on nearly half of its U.S. sales income.”         
The façade that attempts to hide Puerto Rico colonial status, the doublespeak that politicians engage in and the fiscal maneuvers that local and foreign corporations engage in to avoid paying taxes is accompanied by a high level of corruption at the highest levels of government. During the administration of former governor Pedro Roselló (2005-2009) close to 40 members of his administration were indicted for corruption, including the secretary of the department of education. This culture is reflected in the decline in labor participation rate and the paucity in tax collections. Recently, the local government reported that only half of income from the sales tax that had been implemented to augment revenue for government services and that was flowing into COFINA, (its Spanish acronym) Puerto Rico Sales Tax Financing Corporation, were received by the government. Although they were being collected by businesses, half of the businesses did not send the collections to the government. For years the government has had a serious problem in being able to get the tax revenue that is necessary to run the government and to provide incentives for the development of the economy.
Also, the informal economy has grown to such an extent that some measure it as close to 30 per cent of the GNP, so despite the fact that income has fallen personal disposable income from 2007-2011 increased 0.7% The difference lies in federal transfers, which now not only include food stamps but Social Security, and also the underground drug economy. Federal transfers alone have increased from 6 per cent of personal income in the 1970s to 22 per cent today (Villamil, 2014). According to Estudios Técnicos , an important local economic planning and consulting firm, Puerto Rico is a transshipment point for drugs into the United States that brought in $5 billion in drug trafficking activity in Puerto Rico in 2011.This is 10 per cent of the island’s gross domestic product (GDP). While 7 per cent of the U.S. bound cocaine trafficking came through the Caribbean in 2011, 14 per cent came along this route in 2013. In tandem with the corruption, 8 year recession, lower labor participation rate crime, particularly murders, most related to the drug trafficking activity has reached dramatic levels. According to the World Bank in 2010 Puerto Rico’s per capita murder rate was higher than Mexico and 500 per cent higher than the U.S. mainland rate (Villamil, 2014). 

The Eternal Status Issue

Politics in Puerto Rico, given its uncertain political relationship with the U.S. have always in one way or another revolved around the political status. The three main political parties represent each of the three formal positions: the governing Popular Democratic Party (PPD) represents the “Commonwealth”; the New Progressive Party represents statehood and Pro Independence Party represent independence. In the 1950s the first elected Governor of Puerto Rico, Luis Muñoz Marin and his Popular Democratic Party passed legislation like the “muzzle law” to suppress pro-independence dissent which was at its height during the 1940s-50s. They also contributed to the dismantling of the Central General de Trabajadores (CGT) the most power trade union federation in the nation which had a large number of socialist and pro-independence leaders. In a referendum in 1952 the PPD submitted Law 600 and a constitution which had been agreed with the United States (whether there were negotiations is matter of debate) for an improvement in the political relationship with the United States. A constitutional convention was organized and a constitution was drafted but it had to be approved by Congress. Some of the most progressive aspects of that draft were vetoed by congress. Only 54.7 per cent of the electorate participated, the lowest in any referendum over the status in the island. The United States then informed that Puerto Rico had exercised self-determination and the island was removed from the UN purview. A few years later the PPD wanted some cosmetic changes to the newly approved “status” in 1959 when the Fernós-Murray Bill was introduced in Congress. This bill like many other bills attempting some changes in the relationship have died in congress, the last effort was the Young Bill in 1998 which died in the Senate. Since 1952, Puerto Ricans have voted in non-binding referenda in 1967, 1993, 1998, in all the elections the “Commonwealth” has been chosen as the preferred option for Puerto Rico (always with some improvements) but congress has ignored the results. In 1998, as a protest because of the efforts of the New Progressive Status to not include the “Commonwealth” as an option, the vote was inconclusive. Most voters from pro-commonwealth to independence supporters voted for “none of the above “which received 53.7 per cent of the vote. But since 1967 the pro-statehood has increased in its support, although this has waned in the last decade.  

Recently, in 2012 the regular election included a referendum on Puerto Rico’s status. The referendum had two parts, one in which people had to choose whether they were satisfied with the present “territorial status” status, given the long term efforts to improve it the results of this vote were not a surprise. 54 per cent of the voters chose that they were not satisfied with the present colonial status. In the second part of the referendum people were given three choices but the present status of “commonwealth’ was not included. The purpose was to disperse the pro-commonwealth vote and highlight the pro-statehood vote. However, in protest for the language of the ballot the PPD asked its supporters to leave the ballots blank. In this round, while statehood received the highest percentage of the votes 44.4 per cent it is the lowest pro-statehood vote since 1998 and 1993. When the blank votes are added to the rest 54.7 per cent of voter rejected statehood. What is interesting is the high percentage of votes for the “Free Association” alternative (24.2%) which are the left of the PPD voters who reject the colonial status of the island. But in sum, these results have confused the issue for congress and while the Obama administration approved funding for another plebiscite and another bill is in Congress to ask voter “Yes or No” on statehood no reasonable observer expects any clear result from these efforts. 

  Until Puerto Ricans are assured a clear path toward a status that allows them to have more control over their political and economic destiny, Puerto Rico will continue to fester and hundreds of thousands of island residents will vote with their feet against living under the oppressive conditions of its colonial status. Any plebiscite that is carried out in the island (or a constitutional assembly as the left proposes) is destined for failure unless Puerto Ricans are granted the power to decide their destiny and protect their economy. That can only happen under independence. Just like other colonies were able to have a transition period where economic and political adjustments could be made (including a decolonization fund to reconstruct the economy) many islanders will choose the underground economy. This will have dire consequences for all, Puerto Rico and the United States. 

Selected References

 
1.    James Dietz. Puerto Rico: Negotiating Development and Change. Boulder, CO: Lynne Rienner, 2003
2.    Emilio Pantojas Garcia. “The Puerto Rico Status Question: Can The Stalemate Be Broken?” Caribbean Journal of International & Diplomacy. Vol. 1, No. 2 June 2013: pp. 41-52.
3.    Jose R. Villamil. “Why Puerto Rico’s Economy Matters for U.S. Security.” Washington, D.C.: Center for Strategic & International Studies, January 2014.