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Monday, June 24, 2019

Puerto Rico: The Crisis We Ignored

America has never suffered through a fiscal crisis. So long as our politicians keep their heads tucked away under their armpits, refusing to realize that it will happen here too, they will go into that crisis totally unprepared. If at least they decided to learn from such crises elsewhere, we would be better prepared when the day comes.


A lot has been written about Greece and other European countries that were hurled into a debt crisis a decade ago. Less attention has been given to the debt meltdown we had in our own backyard: Puerto Rico. Their crisis is highly relevant to U.S. states and what they have to look forward to if they don't get their fiscal house in order. 

I covered the Puerto Rican crisis four years ago. Here is a reprint of two articles on the debt crisis that America ignored.

--- Lessons from the Puerto Rican Debt Crisis ---

1. From Panic to Austerity

A debt crisis is not just a theoretical construct. It is a reality, unfolding before our very eyes. For now, it is confined to two relatively small economies, Greece and Puerto Rico, and one should always be cautious with drawing parallels between those and the U.S. economy. That, however, does not mean that the comparison is completely irrelevant. On the contrary, there are some basic similarities deserving of our attention, especially on what happens when a government sits out its chance to deal with the debt before the IMF and global investors hurl our country into the shadow realm of fiscal panic and crippling austerity.

Let us start with the Puerto Rican debt crisis. From Fox News
Puerto Rico's governor believes the U.S. territory will not be able to pay back its $72 billion public debt, a spokesman told the Associated Press late Sunday. Gov. Alejandro Garcia Padilla's spokesman, Jesus Manuel Ortiz, confirmed that the island's government is seeking to defer payments while negotiating with creditors. He confirmed comments by Garcia that appeared in a report in The New York Times published late Sunday, less than a day before Garcia is scheduled to deliver a public address amid debate on a $9.8 billion budget that calls for $674 million in cuts and sets aside $1.5 billion to help pay off the debt. 
The debt that the Puerto Rican government has accumulated is equivalent to 69.8 percent of GDP. This is a low ratio to run into a debt crisis, indicating that the ratio between the debt-related payment obligations and the ability of the Puerto Rican taxpayers to honor those obligations has simply become overwhelming.

With a GDP per capita of only $28,500 it does not take a lot of taxes to create a burden on the average Puerto Rican taxpayer.

Fox News again:
Puerto Rico's bonds were popular with U.S. mutual funds because they were tax-free, but hedge funds and distressed-debt buyers have been stepping in to buy up the debt as the island's economy worsened and its credit rating dropped. Puerto Rico's constitution dictates that the debt has to be paid before any other financial obligation is met. 
This constitutional obligation is more or less redundant; a country (or, as in this case, territory) that does not honor its debt payments - period - will suffer deeply at the hands of international credit rating institutions as well as global investors. 

Currently [as of June 2015] Puerto Rico's credit rating is in the vicinity of CCC+ with a negative outlook. This is a smidge higher than Greece, which is rated at CCC with a stable outlook.

There are other similarities with Greece. Puerto Rico is in a currency union with a much larger economy. Will the Federal Reserve and the U.S. government come to the rescue of Puerto Rico like the European Central Bank and the EU have tried repeatedly to save Greece from its own debt problems? 

The question is more than academic. Fox News explains:

Puerto Rico's central government could run out of cash as soon as July, possibly leading to a government shutdown ... Pierluisi, the Resident Commissioner of Puerto Rico, is the island's non-voting representative to the U.S. House. Puerto Rico's situation has drawn comparisons to Greece ... Puerto Rico's governor recently confirmed that he had considered having his government seek permission from the U.S. Congress to declare bankruptcy amid a nearly decade-long economic slump. 
A bankruptcy would have the same effect as the Greek debt writedown in 2012: it would lower the nominal debt (some reports say Puerto Rico would seek a 50-percent reduction) and reduce the debt-to-GDP ratio. However, it would not do anything to address the underlying cause of the debt crisis: just as in Greece, the problem in Puerto Rico is structural over-spending by government.

Another parallel to Greece is the call for austerity policies. The Greek economy has been subjected to at least five austerity packages, all of which were sold as the anti-debt remedy. None of the packages worked, as evidenced by the acute situation in Greece. Now there are calls for austerity measures in Puerto Rico:

Puerto Rico's governor, following a damning report by former IMF staffers about the U.S. Commonwealth's financial stability, faces tough decisions on  brutal reforms and possible debt restructuring to relieve the island's $73 billion debt burden. Governor Alejandro Garcia Padilla said on Monday that over the next week, leaders would host meetings and briefings and tell citizens the steps the Commonwealth is taking to address Puerto Rico's problems. ... Citizens of the commonwealth could face tough measures such as fewer teachers, higher property taxes and suspension of the minimum wage, if Puerto Rico follows the [IMF] report's recommendations of debt restructuring and austerity measures. 
The Fox News story quoted above also mentions austerity measures:
Garcia has taken several measures to help generate more government revenue, including signing legislation raising the sales tax to 11.5 percent and creating a 4 percent tax on professional services. The sales tax increase goes into effect Wednesday and the new services tax on Oct. 1, to be followed by a transition to a value-added tax by April 1.
Neither drastic spending cuts nor panic-driven tax increases will have any lasting effect on the debt crisis. That is an experience from Europe in general, and Greece in particular, that governments here in the New World should have learned from. Austerity has done nothing to get Greece out of debt hell. 

Nevertheless, the fact that the government in San Juan is faced with demands for austerity from the IMF (and according to some websites international creditors) is a very important signal for other heavily indebted countries to pick up on. Basically, the United States should learn three things from the Greek and Puerto Rican experiences:

1. Once your debt becomes a problem in the view of international investors, events soon spin out of government's control;

2. When the crisis gets to the point where the IMF and global creditors demand austerity, the wiggle room is basically gone;
3. When a country goes into fiscal panic, it enters a downward macroeconomic spiral the bottom of which is perennial economic stagnation and a life in the grim, dark reality of industrial poverty.

It is high time for Congress and the U.S. president to become proactive on the national debt. If they don't, events in the near future will show us what a crushing price tag that comes with deficit punting. 

2. An American Outlook

From Greece to Puerto Rico, we have a thing or two to learn from international economic events, especially in terms of what can happen to a country when its government debt causes a crisis. 

The Greek lesson is that you can have a debt crisis if you choose the wrong kind of balanced-budget requirement. The Puerto Rican lesson is that you will have a debt crisis if you choose to not have any balanced-budget requirement at all. 

Since the United States currently does not have a meaningful balanced-budget requirement on its books - let alone its constitution - it is a very safe bet that we will hit a debt crisis in the next few years. The big question is not when it will happen, but what it will look like when it strikes. Puerto Rico's debt crisis offers a good opportunity to put some numbers on what inevitably is coming our way.

Puerto Rico's government debt became a crisis-level problem at just over 73 percent of GDP. The interest rate at the time of the crisis was five percent (and some change). Their credit fell to junk status (marginally worse than Greece) and the governmetn in San Juan had to scramble together a counter strategy. Their response consisted, in a nutshell, of traditional austerity measures:
  • In May 2015, the legislature approved a budget that cut spending by $674 million;
  • Sales and use taxes go up from 7 to 11.5 percent, and will be replaced by a much-worse form of taxation, namely a value-added tax;
  • The budget also set aside $1.5 billion to pay off debt, more than 15 percent of the total budget.
This is the point that is of particular U.S. interest. The Puerto Rican response to the debt crisis is not one of measured policies, but is best characterized as fiscal panic. A crisis has escalated to the situation where government has practically no time at all to come up with an exceptional response. The outcome is almost inevitably a slew of quick-fix measures, not because they are constitute the best response but because they have the appearance of being the best response.

It is more than likely that fiscal panic that will strike one day here in the United States. There is also a fair chance that when the crisis strikes, Congress will be pushed to make some quick pay-offs on the debt, just to please its most aggressive creditors. While extremely harsh under today's conditions, it should therefore come as no surprise to anyone if Congress had to set aside 15 percent of the federal budget to pay down the debt. 

To put numbers on this: in 2016, when the federal government is expected to spend $4 trillion for the first time in history, the 15-percent debt reduction payment would amount to $600 billion.

That is a lot of money. It equals almost the entire defense budget. It is $15 billion more than the cost of Medicare, or almost twice what the federal government spends on Medicaid. Add spending cuts to that, equal to the ones proposed in Puerto Rico. Those cuts amount to 6.8 percent of the budget, which is $272 billion in the U.S. budget.

Together with the debt down payment, there is now $872 billion being taken away from other spending, either as direct debt payments or as panic-driven spending reductions. And we have not even counted interest rate payments on the debt.

The interest rate is the real dark horse in this race. In the forecast for 2016 by the Office of Management and Budget, it is assumed that interest rates will be around 3.3 percent. That is the rate that determines how much the U.S. government has to pay on its debt. 

Greece and Spain went into tailspin over their debt situations with interest rates at seven percent (and higher occasionally). Puerto Rico has hit the debt default line with the rate on its ten-year treasury bond at five percent.

U.S. interest rates are on the rise, and although there are some good reasons for this, including a somewhat tighter monetary policy and higher macroeconomic activity, there is also a bad reason. Our credit rating, while no longer in decline, has not improved since the downgrades a couple of years ago. In other words, our debt outlook has not improved notably despite a stronger economy and short-term reductions in the federal debt. This keeps interest rates higher than they otherwise would. 

In other words, all it takes is a cooling-off in the business cycle, with the debt surging again, and we will see interest rates jump - not decline as they did in the last recession. That is the point where we "go Puerto Rican". 

Suppose a U.S. debt crisis is triggered at a rate of five percent. That means it would be 50 percent higher than the 3.3 percent that the Office of Management and Budget has in their current forecasts. 

If the federal government pays five percent on all its debt in 2016, its total cost therefore rises from $283 billion to $429 billion. To pay for that increase we now have to cut another $146 billion out of regular spending programs and hand the money over to owners of the federal debt.

Let us tally up the total amount of spending cuts we need to do in order to “pay” for a debt crisis:
  • The 15 percent of the budget in debt down payment: $600 bn
  • Spending cuts to reduce the deficit: $272 bn
  • Spending cuts to pay for the higher interest rate: $146 bn
  • TOTAL: $1,018 bn
In other words, one trillion dollars in spending cuts. In one year.

The $100 billion in tax increases suddenly seem like peanuts in comparison. But that doesn’t really help, does it? A lot of spending programs are going to take a big beating.

But should we not redirect some of this into tax hikes instead? Is it not fair to split the austerity package in half between higher taxes and spending cuts?

To answer these questions, let us adjust the earlier numbers: 
  • The 15 percent of the budget in debt down payment: $600 bn
  • Spending cuts to reduce the deficit$272 bn
  • Spending cuts to pay for the higher interest rate: $146 bn
  • Previously announced tax increases: $100 bn
  • TOTAL:  $1,118 bn
Half of this total amount would be $559 billion – in one year.

Where would these new taxes come from? Here is a quick comparison between federal taxes as predicted for 2016 and an adjusted amount based on how much higher they would have to be if all of the $559 bn was raised through one of them:[i]

Table 1a

(Billions of dollars)                                       Actual                 Adjusted                        Increase
Corporate income taxes                                 433                              992                  129 percent
Individual income taxes                               1,610                          2,169                 34.7 percent
Excise taxes                                                        100                             659                  659 percent

Or, if we spread the tax burden evenly:

Table 2b

(Billions of dollars)                          Actual                                Share                New revenue
Corporate income taxes                         433                      20 percent                               546
Individual income taxes                      1,610                       75 percent                           2,030
Excise taxes                                               100                         5 percent                               128

Let us remember, again, that this represents statist-style austerity measures supposed to be enacted and implemented in one year alone. Leaving aside for a moment the political fallout, which would be enormous, the macroeconomic consequences are closing in on Greek dimensions. 

It is scary enough to imagine what this means for the Puerto Rican economy. It is even more frightening to imagine how fiscal-panic driven austerity could put the American economy into a tailspin. But worst of all is the picture of fiscal panic engulfing a Congress that could have taken decisive action way in advance - action that started with the passing of the right kind of balanced-budget amendment

[i] OMB Federal budget for FY2016; Supplementary table S4.

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