## Monday, June 29, 2015

### Puerto Rico and Greece: a comparison of two defaults

Excessive pensions and similar expenses are always the main problem

The center-left populist government of Puerto Rico just announced that the islands (one big plus many small ones) won't be able to repay their $70+ billion public debt. These announcements just happen to come at the same time when Greece is expected to go bankrupt (tomorrow in the evening). It's tempting to compare these two economies. I think that there are some huge differences as well as some amazingly accurate similarities – both of which are being heavily underestimated. Let us look at those. First, just to be sure, Greece is a country in Southwestern Europe (in the Balkans), very close to Asia and Africa, and it's been considered the weakest link of the European Union and the Eurozone for many years. On the other hand, Puerto Rico is an island East from Cuba that has been governed by the U.S. federal government since the 1930s but it is not officially incorporated as a state. We may say that Puerto Rico is the weakest link of the U.S. – and the U.S. dollar zone. To summarize, these two defaulting entities have totally analogous relationships to their larger umbrella territories or currency areas. I believe that many Americans who tell the Europeans that Europe "should" bail Greece out again totally fail to realize that their relationship with Puerto Rico is totally analogous. If it's right for Europe to bailout Greece again, the U.S. government should surely bailout Puerto Rico as well, shouldn't it? One could argue that Puerto Rico is politically "closer" to the government in D.C. than Greece's solidarity distance from Berlin, Helsinki, Bratislava, or even Brussels. Puerto Rico's main leader "is" Obama in some sense – but the Greeks' main leader is neither Merkel or Hollande nor Tusk or Juncker. Second, the population of Greece is over 11 million while Puerto Rico has 3.5 million, i.e. 3 times smaller population – mostly composed of Spanish speakers. Clearly, the absolute size of Greece and Puerto Rico isn't similar. The government debt per capita (including babies) is$20,000 in Puerto Rico and over $30,000 in Greece – Greece "wins" but the difference isn't quite "qualitative". However, the GDP per capita is totally analogous again. At their best moments, both Greece and Puerto Rico had GDP per capita close to$27,000 a year. Again, they're almost like siblings. The average pensions are analogous once again. I believe that they're around $1,000 a month in Puerto Rico and €882 in Greece according to the most recent statistics. Those numbers are virtually the same and they are extremely excessive – comparable to the average salary in many relatively healthy countries such as my homeland. While the GDP per capita is about the same, only the Puerto Rican figure is realistic. Puerto Rico is an extremely competitive economy that actually has a significant trade surplus (imports$45 billion, exports $65 billions). According to many surveys, it's actually the most competitive – and most prosperous – country (or quasi-country) of Latin America. It's better than that. Puerto Rico is the wealthiest Spanish-speaking country in the world because it marginally beats Spain, too. It's still not enough to beat any of the 50 regular states in the U.S., however. 2/5 of Puerto Ricans are beneath the poverty line etc. Greece is an uncompetitive economy. The imports are$50 billion but the exports are just $30 billion a year – a huge trade deficit. Note that the absolute Greek exports are just 50% of the Puerto Rican exports even though Greece is a 3.5 times larger nation. A large part – about 1/2 – of the Greek GDP per capita is composed of production that is only competitive domestically and the reason of its domestic competitiveness is the existence of lots of consumers among pensioners and public employees who were largely funded from the borrowed money. This demand simply has to drop dramatically once Greece balances its budgets (and it will be forced to) so the GDP will have to drop as well, albeit by a smaller amount. Puerto Rico is an island so you might say that it's natural for its trade to be larger. But I think that this logic is actually flawed. There exists no reason why islands should be more open economies. It's harder for them to do trade with others which is why there are pressures for them to become more self-sufficient. I believe that Greece's low trade figures are due to their ideological opposition to trade and capitalism in general – opposition that has grown in recent 40 years. In the competitiveness, the two entities differ dramatically. But the default always boils down to the same general cause: too much spending relatively to the tax revenue for too long periods of time. Puerto Rico tried to struggle with the deficits but it was apparently not enough. Mismanagement and fallacious excuses The most widespread excuses are the same, too. People love to yell that the "austerity" (lowering of the pensions etc.) reduces the domestic demand and therefore the growth rate, too. But as a recipe what to do, this claim is absolutely ludicrous. It is indeed true that the domestic demand is lowered if people aren't fed with the borrowed money. But both of these steps are still absolutely necessary to return the government's finances on the right track. And if this return doesn't succeed, it is always because the "austerity" wasn't sufficiently vigorous! It's trivial to see that a country simply always can get rid of the debt problems as long as the annual payments needed to keep the real debt constant are lower than 100% of the GDP. I don't propose such an extreme measure. But simply eliminate the pensions (and public wages that are making loss) completely and lower the wages so that the country may competitively export what it's producing and increase the exports. The domestic demand may always be replaced by the foreigners – by exports. You may see that with sufficiently lowered revenues, the country starts to repay the debt. In the real world, one can't eliminate the state pensions completely etc. But there exists some compromise that is still enough. Whenever the countries don't get rid of the debt problem, it's because they underestimate how much they have to "fasten their belts" to return on the right track. There is never any other reason. Yes, if you save$1 on pensioners, you will also reduce the domestic demand and it will lower your tax revenue perhaps by $0.50 because of the lowered GDP. But the point is that the latter figure is smaller than the former. It is inevitably smaller because at least a part of the pensioner's consumption may be replaced by other consumers, perhaps the foreign ones. What it means is that if you want to improve your budget balance by$1, you must actually lower the spending for pensioners by $2 rather than$1. But there always is a number. The number is higher than the naively or optimistically calculated one but it is finite.

Needless to say, sufficiently populist governments don't want to think about the right value of this number at all. They – especially the Greek ones – simply place high pensions above everything else. Well, if you place high pensions above your country's economic survival, your country almost certainly won't economically survive.

For animals, people as well as countries, the survival simply has to be a top priority and comfortable pensions, however attractive or "needed for dignity" they may be presented to be, simply always have to be considered less important than the survival, than the ability of the country's to tame and then reduce its debt burden.

Populists, Keynesians, and other economics cranks aren't even able to determine the correct sign of this number – the required reduction of pensions and similar expenses. They yell – and make their gullible stupid listeners believe – that you may improve your debt problems if you increase the pensions etc. By doing so, one increases the domestic consumption which accelerates the GDP and with a higher GDP, it becomes easier to repay a fixed amount of debt, they claim.

But everyone who actually believes such a claim is a complete idiot. The extra $1 you pay to pensioners will increase the GDP but by less than$1 (and certainly the increase of the tax revenues will be less than \$1) so the overall contribution of this operation is negative – it contributes to the deterioration (and quite often, spiraling out of control) of the country's debt problems because you still had to pay the whole dollar! All the "scholarly" warriors against "austerity" completely overlook the most important term in the equation, the original extra dollar that the government had to pay!

Parable of the broken window

This error is analogous (and perhaps completely isomorphic) to the errors of the people who incorrectly solve Frédéric Bastiat's 1850 parable of the broken window. These people say that it helps the economy to break the windows in the shop (owned by a shopkeeper) because the glazier produces and earns 6 francs for repairing the window. He has some expenses so from the 6-franc revenue, he can make a 4-franc profit and he pays his newly earned extra money to the seller of coffee (or for something else), and that guy does something else with those 4 francs, and so on – so the result is that everyone is earning more money and living a more prosperous life.

If you're a dimwit, you may be persuaded by this Keynesian argument. But almost a century before Keynesians became popular (and 30 years before Keynes' parents dared to conceive the bastard), Bastiat already knew the obvious reason why Keynesians are dimwits (and why nations haven't started to kickstart their economies by breaking all their windows). The Keynesian dimwits forgot to consider the first and most important term in the equation – the money that the shopkeeper had to pay for repairing the window! (This term is analogous to the extra wasted dollars for the higher pensions.)

The shopkeeper has paid 6 francs to repair the broken window – which was an unnecessary expense whose forced existence doesn't make the buyer any happier. (I avoided complicated terms such as "opportunity costs".) If he could have avoided this frustrating payment, he could have bought something else – e.g. coffee – for the same 6 francs. Note that in the broken window scenario, the glazier has only bought coffee for 4 francs because he had expenses. But if the window weren't broken, someone else (namely the shopkeeper) would have bought the coffee (or other things, or some mixture) for 6 francs, a higher amount. So it's obviously better for the whole working nation or the economy if the windows are not being uselessly broken. The difference for the economy – how much it's better if the window is not broken – is exactly those 2 francs, the glazier's expenses while repairing the window. Common sense.

The correct message is that due to the interconnections in the economy, the damages for the "whole economy" are smaller than what the shopkeeper has to pay to repair the window (he pays more than what the expenses are). But they are still positive. If you unnecessarily break a window, it's still damaging for the economy. In the same way, if a highly indebted country increases the pensions further, it inevitably makes its debt problems more serious. The deterioration of the debt problem is smaller than the increased money going to pensions but it has the same sign.

I believe that an intelligent 10-year-old schoolkid may understand these mechanisms and calculations – an important template of economic thought (and even 6-year-old kids know that it can't be good for the nation if someone keeps on breaking all the windows) – but the Keynesians are dimwits who simply can't match an intelligent 10-year-old schoolkid.