Puerto Rico is on its way to one of the largest debt defaults in history, right up there with Greece and Argentina. If you want to know what's happening in Puerto Rico, Anne Krueger is where you must start.
At 81, the former chief economist for the IMF has written, with two co-authors, a brief but incisive paper that has become the playbook for both the Commonwealth of Puerto Rico and its creditors. In an earlier piece in the Huffington Post, published on April 14, 2015, I cautioned that Puerto Rico's bondholders were going to have some sleepless nights.
Just 10 weeks later, the island's governor, Alejandro García Padilla, announced that the Commonwealth was unable to pay its debts, and would try to negotiate a "restructuring" with the bondholders. The Krueger report shows that their worry should not be about whether their bonds will be paid in full and on time -- her analysis shows that is simply not possible -- but rather how big are the concessions they will have to make. Equally important, she outlines the policy errors that are leading to default. Finally, she suggests a way out, using some of the pro-growth strategies of supply side economics. I will summarize the gist of her analysis.
The market has lost confidence in Puerto Rico's ability to repay debt. This kind of prophecy tends to be self-fulfilling. First lenders demand super premium interest rates, making debt service more burdensome. Default becomes more likely, and lenders shut off the spigots entirely. This loss of confidence has been driven by economic stagnation, even contraction, and persistent deficits in public finances. These deficits have been worse than investors expected: in part because public finances have been opaque, and in part because budgets were based on wildly optimistic economic assumptions.
Moreover the economic stagnation, or contraction, is not merely a result of an economic cycle but of major long term problems that make the island uncompetitive. The government of Puerto Rico has created many of these problems with its own misguided policies, but the Federal government has made a bad situation worse. "The single most telling statistic... is that only 40 percent of the population -- versus 63 percent on the U.S. mainland -- is employed or looking for work." Krueger attributes this to a Federal minimum wage which is far higher than unskilled labor earns in competing Caribbean islands, aggravated by local regulations on overtime, paid vacations, and dismissals which are more costly and onerous than on the U.S. mainland.
An overly generous welfare system undermines the incentive to take jobs at all: "One estimate shows that a household of three that is eligible for food stamps, AFDC, Medicaid, and utility subsidies could receive $1743 a month." That amount is actually higher than the median family income on the island.
Energy costs, another key economic input, are also exceedingly high, several times mainland prices. The government's electric utility, PREPA, is inefficient, overstaffed, and technologically antiquated. The Federal government's Jones Act makes things worse by requiring that all oil imports be conducted with U.S. vessels and crews. Indeed, that Act applies to all shipments to and from U.S. ports and drives transport costs generally to uncompetitive levels. Local regulation of rates and licensing for ground transportation adds to the problem.
Turning to government finances, Krueger finds that "the overall deficit is larger than recognized, its true size obscured by incomplete accounting." Public sector debt has risen every year since 2000, reaching 100 percent of GNP in 2014. One attempt after another has failed to balance the budget, which is based on extremely optimistic revenue projections (on average revenues have been only 85 percent of projected levels). Falling revenues don't drive lower spending: instead the agencies simply fail to pay their suppliers, who are required to wait longer and longer to collect.
Lax verification of payrolls aggravates the problem; and deficient accounting masks it. Consolidated reports are dense, hard to penetrate, and not timely (the most recent is for fiscal year 2013). Information on the Treasury's General Fund operations is timely but "greatly understates the true deficit and the challenge ahead." It reports on a cash basis (that is, it doesn't count purchases the government has made but not yet paid for as spending) and excludes some 150 government agencies (whose deficits it nonetheless needs to fund with cash) as well as capital expenditures, which also deplete cash balances. It's as if, in budgeting for your household, you omitted credit card purchases, expenses incurred by your children, and the cost of buying a new car.
Taking these and like items into account makes the cash situation far more problematic than is generally understood. Similar cash deficits flow from the three big state enterprises (the monopolies for electric power, water and sewers, and highways and transportation), as well as from the Employee Retirement System for government employees (which has no liquid assets at all) and the Teachers Retirement System (which will likely run out of money in a year or two). With all of this cash depletion combined, the government will need to raise nearly 5 percent of GNP to keep operating in 2016 -- a near impossibility in a zero growth economy with no access to new borrowing. Even this bleak picture can get worse if a fully blown fiscal crisis pushes the economy into a sharper retraction.
Is there a way out? The report suggests there is, but it must be both comprehensive and ambitious. The Federal Government, the bondholders, and the government of Puerto Rico must all make difficult decisions. The solution must begin with a revival of growth. The key is supply side reforms. The Commonwealth can fix local labor regulations, and eliminate obstacles to doing business. It can bring energy costs down by opening competition for electric generation to new and more efficient suppliers. The Federal Government needs to make welfare payments consistent with local market conditions, suspend the Federal minimum wage, and exempt Puerto Rico from the Jones Act.
A major fiscal adjustment is required. Revenue measures should be as growth friendly as possible, and might include VAT/Sales tax and property tax overhauls. Expense measures should include right sizing of education services (PR has more teachers per student than the wealthiest counties on the mainland), a means test for tuition at the University of PR, and elimination of Medicaid benefits in excess of Federal standards. After several years, supply side reforms ought to result in 2.5 percent growth, which will drive increased revenue collections.
But even after a major fiscal effort, and a resumption of growth, a large residual financing gap will remain. A comprehensive discussion would benefit from the orderly processes of Chapter 9 of the U.S. bankruptcy code, which Congress should extend to Puerto Rico's public enterprises. Bondholders will suffer if the Commonwealth cannot provide essential services, if there is a breakdown of order, or if the economy collapses in the wake of a crisis. They will need to relieve the island of a meaningful proportion of the interest and principal coming due in the next six or seven years. To agree to do that, they will want to be sure that the Commonwealth government is committed to politically difficult structural reforms, and that the Federal government will grant Puerto Rico the required exemptions from regulations that raise costs and stifle growth.
Supply side reforms will not be a panacea for decades of bad policy decisions, but they are an essential part of the solution.