January 28, 2016

January 28, 2016 | Commentary on Issues, Economy, Economic Analysis

Obama's Misguided Solution to the Keynesian Crisis in Puerto Rico

Treasury Secretary Jack Lew has sent a letter to the U.S. House of Representatives to update Congress on the Puerto Rican “debt crisis.”

Lew is referring to the fact that Puerto Rico has buried itself under a mountain of debt that it’s struggling to repay. Aided by a special tax status, the island’s total debt doubled in the 1980s and 1990s, and has tripled since 2000.

To the Obama administration, this situation is merely a government-financing problem, one that should be solved by changing the rules of the game and increasing government oversight.

The administration does not want to admit it, but what’s really in crisis here is the notion that governments can create prosperity by endlessly borrowing and spending. That’s how Puerto Rico got itself into this mess.

These kinds of policies are typically referred to as Keynesian, but that’s being a bit unfair to John M. Keynes.

Keynes only suggested deficit spending during economic downturns. Economists and politicians have twisted the original idea, and now governments borrow and spend even during prosperous times.

Puerto Rico has been a test case for this strategy, and the results are spectacularly bad. It turns out government borrowing cannot go on ad infinitum, and constantly expanding government’s role in the economy tends to destroy prosperity.

A quick rundown for what happened on the island starts in 1942, when Puerto Rico created the Government Development Bank (GDB). The GDB is a “fiscal agent…financial advisor, and primary lender to the Commonwealth, its political subdivisions, and its public corporations.”

By the 1970s, the GDB had created a host of subsidiaries, such as “the Puerto Rico (PR) Municipal Finance Agency, PR Development Fund, [and the] PR Housing Finance Authority.”

The expansion continued, and the Commonwealth created even more government entities, such as the Puerto Rico Electric Power Authority (PREPA) and the Puerto Rican Highways and Transportation Authority (PRHTA).

As of 2014, the GDB had roughly $9 billion in outstanding loans, and virtually all of that debt was held by government agencies. The PRHTA alone accounts for nearly 25% of the GDB’s total loans, and almost all of the GDB’s roughly $6 billion in deposits are government funds.

Almost half of PREPA’s 2014 accounts receivables are from government clients, and some of PREPA’s largest public customers are not even making payments on what they owe.

Unsurprisingly, PREPA is a model of government inefficiency. It’s in financial trouble even though it takes in more revenue and sells less electricity than comparable power companies inside of the U.S.

After all of this excessive government involvement, the whole Puerto Rican economy is floundering. If we rank Puerto Rico against the 50 U.S. states, we find that from 2003 to 2013 the commonwealth’s gross state product (GSP) ranks dead last.
Using BLS and Census data, the island’s GSP growth (adjusted for inflation) during that period was negative 13.2%. Over roughly the same period, its growth in nonfarm payroll employment would also put Puerto Rico dead last.

The island was, however, in the top 10 for the number of government employees per 10,000 residents, and in the top three for the highest percentage of total revenue spent on debt service. (One researcher recently recommended requiring government employees to collect their paychecks in person because so many of them don’t bother to show up for work.)

As of 2010, the Puerto Rican government had issued bonds totaling 90% of its GSP. The financially troubled state of Illinois, by comparison, had issued bonds amounting to only 4% of GSP.

Puerto Rico’s official debt total is now $72 billion, more than 100% of its economic output. The Commonwealth owes approximately $18 billion in principal and interest payments (over the next five years) on its existing debts, more than a third of its projected revenues.

Even worse, these figures do not include another $35 billion in unfunded pension (and other) liabilities. There’s no way the island’s economy can generate enough to pay for all of this debt without some major economic reforms.

As my colleagues Salim Furth and Rachel Greszler recently pointed out using another measure of economic output, gross national product (GNP), 
"Puerto Rico is not experiencing a temporary recession; it is in economic decline. Puerto Rico’s real GNP has declined in seven of the past eight years, with only a slight increase in 2012. Real GNP in Puerto Rico fell 13 percent from its peak from 2006 to 2014. During this period, despite its own recession, GNP increased in the U.S. by almost 11 percent."
Puerto Rico’s population has declined by more than 7% over the past decade, and its labor force participation (LFP) rate (as of 2013) fell to only about 50%. The drop in LFP is hardly shocking given the island’s relatively high minimum wage, strict labor laws and generous welfare and disability benefits."

A recent government audit showed that Puerto Rican residents – who typically speak Spanish – qualified for disability because they had trouble speaking English. Nearly 40% of the population receives food stamps compared to less than 15% in the U.S. (There have also been several recently discovered disability and Medicare fraud schemes in Puerto Rico.)

Rather than focus on these structural problems, the Obama administration wants to intercede in the island’s debt renegotiations.

Lew’s recent letter repeats the administration’s call for “an orderly process to restructure its [Puerto Rico’s] debts,” and claims that “only Congress can enact the legislative measures necessary to fully resolve this problem.”
All of this is code for asking Congress to change the U.S. bankruptcy code in the middle of ongoing negotiations, a terrible precedent to say the least.

Currently, Puerto Rico and Washington, D.C., are explicitly excluded from using Chapter 9 of the U.S. bankruptcy code, the option available to U.S. cities provided that their home state allows it.

It is factually incorrect that removing this exclusion, so that Puerto Rico can use Chapter 9, is the only way to ensure an orderly restructuring of the island’s debt. The island’s government has been negotiating with debtholders for months, and a formal legal structure for receivership already exists.

Existing debtholders lent Puerto Rico money with an explicit set of rights to renegotiate and/or restructure that debt. Altering this legal framework right now would be a blatant violation of the rule of law and could make the situation in Puerto Rico even harder to solve.

The U.S. government should not lend a helping hand to either side in these negotiations: Puerto Rico borrowed the money; let the island and its creditors work it out.

Besides, given the federal government’s own fiscal mess, it’s hard to argue that Washington should even be handing out minimal advice to Puerto Rico. The Congressional Budget Office projects that net interest on the U.S. debt (see page 13) will be more than half of all discretionary outlays before the end of the 10-year budget window.

But if Congress insists on getting involved, lawmakers should start with the following improvements. First, pare back Washington-imposed regulations that increase costs and reduce businesses’ ability to compete.

Such regulations include the maritime Jones Act and the federal minimum wage. Then, Congress should grant Puerto Rico more flexibility to administer federal welfare benefits so that individuals can no longer earn more on welfare than they can by working.

Over the long-term, Congress should remove the special tax treatment for Puerto Rican municipal bonds. Those special considerations made it easier for the island to accumulate its $72 billion in debt in the first place.

What Puerto Rico needs most of all is strong leaders willing to make tough choices and to reduce the government’s involvement in the island’s economy.

Norbert Michel is The Heritage Foundation’s research fellow in financial regulations.

This piece originally appeared in Forbes. Read the original and more at http://www.forbes.com/sites/norbertmichel/2016/01/25/obamas-misguided-solution-to-the-keynesian-crisis-in-puerto-rico/#4345e98033e7

 

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

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