Naperville, Illinois, August 3, 2015 --  

Both hopeful Cubans and distraught Puerto Ricans have distorted ideas about their economic future.

When the U.S. Embassy reopened in Havana last month after over a half century's absence, it fueled the highest hopes that Cubans have seen in decades. Cubans throughout the island are expecting great things from the end of estrangement with their big, rich American neighbor. Thoughts of and end to the embargo and foreign investment that once seemed impossible, now appear to be looming on the horizon.

Contrast this optimism with the stunning despair in nearby Puerto Rico, which yesterday entered into partial default.¹ Fueled by a 12.6 percent unemployment rate², it is in the midst of a second great wave of emigration to America, its population declining by 170,000 in the four years ending in July of 2014.³

The dichotomy between the moods of Puerto Rico and Cuba are especially striking because the two have much in common. Both were wealthy trade colonies of Spain which drew mass European immigration. Both rebelled against Spanish rule when a Puerto Rican poet described the two islands as “two wings of the same bird.” Americans ended this rule during the Spanish American War in 1898.

But the paths of the two islands began to diverge. Cuba regained its independence, and its revolution shifted its economy toward a Soviet model and eventually to ruin. Puerto Rico sought to become a specialized manufacturing zone for the American economy. This worked very well for Puerto Rico for a long time -- by the early 2000s, it had the highest per capita income of any territory in Latin America.

But Puerto Rico's manufacturing success was driven partly by tax breaks, many of which expired in 2008.⁴ In that same year, the economic crisis severely battered manufacturers across all parts of America.

While manufacturing remains a the biggest sector of the Puerto Rican economy, it has continued to decline. The expired tax breaks are certainly a factor, but the decline may have been inevitable -- tax incentives were probably just keeping economically weak factories running a bit longer than they otherwise would have.

Today, Puerto Rico's relative affluence and special relationship with the United States offers both benefits and challenges. America's federal minimum wage applies to Puerto Rico as well, where wages are much lower than on the American mainland. Hikes in the minimum wage since 2007 changed it from $5.15 to $7.25 per hour. This is the equivalent of $18.85 on the mainland, once you account for differences in household income. Many low-skilled Puerto Ricans who have lost manufacturing jobs have not been able to find other work at those wages.

The island's status as an American territory also drives up local costs. The sugar plantations of a century ago are gone, and most food is now imported. Imported food and other goods cost even more than on the American mainland. The high local costs are an impediment to new businesses, which must pay far more to set up shop than in other parts of Latin America.

But there's an even bigger economic consequence of Puerto Rico's relationship with America. All Puerto Ricans are eligible for American passports, so many with high skills simply leave for better opportunities in the mainland -- much like the best and brightest of small towns across America. This emigration has accelerated with a slumping local economy.

This has left the government of the Commonwealth of Puerto Rico in a debt spiral. Tax revenues are hit both by people leaving the island and by lower local employment rates. The number of people seeking government benefits continues to grow, and the debts run up during the good times become an ever greater burden on the economically active people who remain.

While this may sound terrible, it's important to remember that life for most people in Puerto Rico is still far, far better than life for most people in Cuba. The territory still has the highest per capita income in Latin America. Even Puerto Rico's poor have access to consumer goods, the internet, new cars, and a wide variety of imported foods that regular folks in Cuba can only dream of. The economy may be slumping, but it is slumping relative to a very high starting point.

What Puerto Rico and Cuba have in common is a need to move to a new economic model -- in Cuba away from a Soviet-style centrally planned system and in Puerto Rico away from an outdated manufacturing-based system. For Cuba, the main obstacle is a government that refuses to let a modern market-based economy take hold. Remove this obstacle and the country will be in a position to start growth. Unless the Cuban people know something about the fragility of the regime that the rest of us do not, their economic optimism is probably unwarranted.

Fortunately, extreme pessimism about Puerto Rican economy is equally unwarranted. Yes, the island's public debts are probably not payable, and will need to be re-negotiated with creditors or eliminated through a special bankruptcy law requiring an act by the U.S. Congress. But the island has lots of long-term advantages. Its tropical climate and American legal system should be a major boon for tourists and retirees. Who on earth thought it was a good idea to take a tropical paradise and turn it into a manufacturing center?

Sooner or later, reality will temper unrealistic expectations on both islands. With luck, the Cuban people will one day enjoy a hint of the prosperity enjoyed by their Puerto Rican brothers, making the “two wings of the same bird” ring true once again. But this will take time. Meanwhile, Puerto Rico's relative prosperity, no matter how bad things look today, won't be disappearing any time soon.

Related Web Columns:

Barely Rattling Along, February 23, 2015

Surfing Like It's 1999, February 27, 2015

The Never-Ending Party, October 16, 2012

Invading the Next Frontier
The Coming Boom in Cuban Real Estate ,September 28, 2004

Vamos Federales! December 15, 1998

America Libre, March 24, 1998

Notes: Notes:

1. The Wall Street Journal , Puerto Rico Defaults on Most of $58 Million Debt Payment, August 3, 2015

2. Bureau of Labor Statistics, Economy at a Glance: Puerto Rico, July 31, 2015

3. US Census Bureau, Annual Estimates of the Resident Population by Single Year of Age and Sex for the United States, States, and Puerto Rico Commonwealth: April 1, 2010 to July 1, 2014, as posted, August 3, 2015 (Estimated population on July 1, 2014: 3,548,397. Estimated population on July 1, 2010: 3,721,527)

4. Caribbean Business, Manufacturing at a Crossroads, August 4, 2015