Thirty-one months ago I wrote this on my blog.
The economy of Puerto Rico is poised at a juncture that may very well prove to become a true turning point in its structure and long-term behavioral pattern. A number of events have come together to define a rare political context that, given the relative size and importance of the public sector in the economy of the Commonwealth and the limited diversity of the private productive structure, raises the likelihood of decisions and changes that may have lasting influence in economic psychology and behavior.
The Commonwealth has lost what were its comparative advantages during the period of industrialization. These included mostly free access to the US market, tax exemption for US corporations with operations in the island and relatively low wages. Low wage rates ceased to be an advantage due to the application of federal minima. Several refineries and a complex of petrochemical and downstream manufacturing industries located in the island during the 1960’s benefiting from an oil import quota of cheap foreign source petroleum. The price differential under which they were able to compete was obliterated during the 1970’s by increasing imported oil prices. The petrochemical industrial complex collapsed. Manufacturing regained strength under revised tax exemptions granted to US possession corporations in 1976. These tax exceptions have ended and starting in January 2006 the Commonwealth will lack federal stimulants to manufacturing investments in the island. This development accounts for the loss of 25,000 jobs since it became evident that the special tax treatment would be lost in the mid 1990’s. Access to the US market has been obtained by other jurisdictions as a result of treaties such as NAFTA and the global general crumbling down of trade walls.
High rates of growth are no longer typical of the Puerto Rican economy. In fact, growth has become a difficult goal to achieve. The productive sectors of the economy have retreated and in their place government (and underground activities) has had to step in to fill the gap. As a result, the economy’s center of gravity has shifted from production to consumption; from supply to demand. Even in spite of spectacular progress in per capita incomes and the development of a middle class, dependency indexes are worrisome. Insufficient capital accumulation and demographic realities constitute what has been a formidable obstacle. Participation rates are below 50 percent of the working age population; age-dependency ratios are increasing rapidly under the pressure of an aging population; family structure have changed dramatically as single mothers account for more than 50 percent of live births; approximately 50 percent of the resident population lies below federal poverty line standards.
As the private productive sectors have lost the capacity to create and sustain jobs at the required levels and rates, the public sector has taken the slack upon its back. Public expenditures in infrastructure, purchases of goods and services, and the employment of a close to a third of the labor force, have produced a gigantic dependence on government. Populist postures by politicians on all parties compounded by growth public service unions –stimulated for political purposes– have combined to generate serious difficulties. Dependence on non-recurrent revenues, disguised deficit spending and excessive public debt at central and municipal governments, as well as by public corporations, has undermined the credit position of several public corporations and most recently of the Commonwealth government. Dependence on the Government Development Bank for short-term financing has exhausted its capital base.
[U1] In spite of these troubling signs, aggregate demand remains strong. Federal transfer payments constitute a formidable component of disposable personal income sustaining personal consumption expenditures. Historically low interest rates and substantial subsidies in multiple forms, have kept the demand side of the housing market at very high levels. This is evidenced by prices and turnover time of new or existing units. Reflecting the inadequacies of public transportation, the automobile and other motor vehicles market still remains strong in spite of hefty excise taxes, high and increasing gasoline prices, and lackluster employment levels. It remains to be seen whether this strength is sustainable in the future. What is certain is that structural reforms are needed to change the existing dependency model.
The model that called for a social effort to raise the economy by its bootstraps through a strategy of industrialization financed by US capital, eventually gave rise to a mixed model of productive and dependent sectors. The productive sector gained in relative size as a result of attractive stimulants to foreign investment. However, even under rapid growth rates, the small starting base and the ever evolving external circumstances, forced constant evolution and restructuring. In the meantime, the dependent sector grew in size and political power. Government substituted the private sector as the principal source of employment. Expediency and shortsightedness resulted in inefficient, ineffective and unproductive structures that added little value to the economy, while consuming enormous amounts of very limited endogenously based resources. Federal transfer payments have become essential to minimum living standards and government operational feasibility. After decades of development along these lines and several crises, the limits of the dependency model have suddenly hit home with a key segment of the population, i.e., public sector employees.
Decades of meager, and even negative, savings discouraged by an inadequate tax system, stagnant private capital accumulation, inordinate growth of public sector employment, loss of relative competitive advantages in attracting external investments due to external and internal conditions have dynamically worked to divest the island of the needed agility to adapt to changes brought about by globalization and the crumbling walls of protectionism.
The ingredients necessary to maintain the rates of growth of real per capita income required to sustain rapid growth of production-based living standards eroded. Not surprisingly, the political dynamics became a formidable obstacle to policy changes that would have helped in adapting to the changing times. Irresponsible partisan behavior dominated public policy and the financial consequences have at long-last come home to roost.
The results of November 2004 general elections have brought an unexpected distribution of power. The incoming executive found the fiscal house in disorder. Creative accounting, put in place by past administrations, an eroding tax base, declining manufacturing employment, increasing dependence on government spending to supplement aggregate demand, accumulated public debt financing and a resulting downgrading of Commonwealth credit quality by Standard & Poor’s and Moody’s Investor Service, combined with external forces that include high oil prices have produced unavoidable measures on spending and revenue requirements.
The resulting divided government has been unable to tackle the needed budgetary actions. In March 2006 the crisis came to a head. For the first time in the Commonwealth’s history the central government was forced to shut down under a cash flow insufficiency and a last warning from Moody’s Investor Services and Standard & Poor’s credit rating agencies. The shutdown lasted for ten days of dramatic events.
Structural fiscal reform is a necessity, not just a recommended approach. Public investment is on the balance whenever credit worthiness is questioned. And it has been. The political system, however, acts more like a constraint than a facilitator of the needed policy changes. Thus, instead of the supply driven structure necessary to sustain real growth and to raise living standards for prolonged and sustainable periods into the future, a demand driven economy has taken root.
Not unlike the phenomenon seen in other jurisdictions, fueled by the liquidity stemming from government spending and illicit drugs transshipment and consumption, a dynamic and rapidly growing underground sector developed in Puerto Rico during the second half of the XX Century. The interrelated dynamics of these and other forces has sustained thriving import, distribution, wholesale and retail sectors. Cash flows are considerably more substantial than those one would expected from an economy devoid of a relatively large underground component.
The above constitutes an incomplete sketch of salient features that characterize the current underlining network of socio-economic relationships in Puerto Rico. A profound crisis appears to be the minimum required stimulus to break the vicious circle of the dependency model now in place.
The current predicament
The consequences of the aforementioned trends are numerous. However, I would like to address the effect that flows have on stocks. Income, for instance is a flow. It has a time dimension. Wealth is a stock. It has no dimension. The effects that flow trends have had on Puerto Rico´s stocks of assets have made us poorer. Let us mentioned some outstanding stocks impacted by the flow trends mentioned previously.
Populism and fiscal irresponsibility have had a negative effect on flows destined to sustain retirement funds. The government retirement fund is bankrupt.
Tax policies have stimulated excessive consumption by punishing savings. Consumers have adjusted to this reality. Personal debt has reached precarious levels in relation to personal assets.
Tax policies have stimulated speculation in the real estate market. Inflation in property prices has become fuel to a vicious circle that feeds upon itself. Thus, real assets have reached market valuations that are not in line with their productive potential. To make things worse, the recent publication of a draft land use map precipitated a burst on the land price bubble. Land values have collapsed in the areas designated by the plan draft to be protected in perpetuity. Land prices in areas already developed have not responded in the opposite direction due to the cost associated with construction in those already built, and usually deteriorated, areas. Demand is not there and legislated stimuli has been stymied through regulation.
Corruption and mismanagement of private financial assets also has been made public. Two examples come to mind because of their scale: the health plans administered by labor unions in the Education Department and in the Aqueducts and Sewers Authority. The actuarial deficit of the Commonwealth retirement system has reached $15 billion of unfunded liabilities. The political cost of layoffs in light of very limited opportunities in the private sector is predictable.
Intangible assets have also suffered debasement. Politically motivated attacks on the governmental institutions have had a negative effect on confidence indispensable to attract capital at competitive cost. Confidence has been shaken on the Commonwealth’s government to comply with its obligations under contracts or law. Although intangible these assets are invaluable. They are the basis of a capitalist system. A fissure on the perception of the capital markets that the full faith and credit of the Commonwealth is of prime rate would be catastrophic. Such scenario was unthinkable. It is no longer unthinkable now.
Thus, the examples mentioned point to a deflation in the value of island held assets, a depletion of financial stocks under government administration, and rapidly increasing personal and public liabilities. It is an understatement to say that the economy of Puerto Rico is highly leveraged. A stern warning from Moody’s Investor Services and Standard and Poor’s credit rating agencies that further downgrading of the Commonwealth’s debt would be inevitable if fiscal discipline is not attained.
A Medium-term View
Unfortunately, the roots and the underlying logic of the current predicament as well as the long-term trends that set conditions in the short-term are political in essence. Thus, the medium-term must be defined in terms of the electoral cycle. The next three and a half years promise to be a period of turbulence. Badly needed initiatives will become even more difficult to launch. Fiscal reform and restructuring of the tax system promise to be unfeasible.
Paradoxically, the difficulties involved in any structural change and the unlikely success of any such initiative should not be the source of major instability in certain markets in the island. For instance, even in the face of record gasoline prices, consumption will likely decrease in less than proportional quantities in light of the relative inelasticity of demand.
At any rate, if the shock is limited to one year, the initial adjustment will vanish in the out years. The wage bill [U2] will prove to be even more resilient. More than 80 percent of government expenditures are due to the wage bill. Voluntary reduction in public service employment faces huge obstacles. Attrition takes time. Substantial early retirement is costly and will be faced by the dire financial condition of the retirement systems.
A Long-term ScenarioLong-term is meant to be understood as a period extending beyond the next general elections. In our opinion, it is likely that the unsustainable fiscal structure now in place will be the subject of major changes. This is so because the present conditions are simply not feasible to sustain. If they were, living standards would decline, emigration of the most productive segments of the social structure will surely occur and the island would accelerate towards conditions typical of inner cities as they are abandoned by the middle class and become concentrations of the disadvantaged left behind. Puerto Rico has lived through this in the past. As of now, this is not politically acceptable. The dynamics of social change would, hopefully, provide enough energy to avoid this scenario.
The key unknown still remains, i.e., how can the island restructure its economy from a consumption driven to a production driven system? If this restructuring is not achieved, real growth rates will remain close to those barely required by population growth and price inflation. In real terms, though, growth and living standards would remain lacking.
In ConclusionThe economy of Puerto Rico is undergoing a structural change. The basic policy instrument on which the Commonwealth has rested as a competitive advantage to attract non-resident capital to grow its manufacturing sector will vanish at year end. Populist fiscal policies, abused for electoral gain, have reached a critical point. The relative size of government is no longer sustainable without painful tax measures. A mixed electoral outcome has brought about a divided government with one party dominating the legislative and another governorship.
Under the gun of the credit rating agencies, a political battle royal has unfolded taking the budgetary process hostage. As a result of fiscally responsible, albeit politically risky, cost cutting measures the Governor has brought home the message that things cannot go on as usual. Public employees have been jolted by the sudden realization that government jobs do no longer offer immunity to the laws of economics. A slow growth regime has taken hold of the productive sectors of the economy. The demand side remains strong under the influence of a relatively large cash flow stemming from entitlements and a very large service sector. Underground economic activities add to the pool of cash fueling consumption expenditures. Local tax policies provide a high degree of incentive to development, construction and purchase of housing. Land use patterns and the resulting absence of adequate mass transit have stimulated the dependence on the automobile as means of transportation. Thus, the demand for automobiles, parts, fuel and other related goods and services is relatively inelastic, even in the medium term. In the long term, adjustments are conceivable but will require major structural changes in urban design, the tax structure, and huge investments in infrastructure. All constitute politically difficult changes to achieve.
It is certain, that Puerto Rico will go through years of political turmoil and economic adjustment. As the current political crisis deepens, necessary policy adjustments will become even more difficult to achieve. Current tax policy is markedly biased against earned income, saving and investment. It is inefficient, ineffective and unjust. It has become a burden on the productive sector and has ceased to provide enough revenues to sustain government operations in the absence of restructuring.
Manufacturing will continue to be the value added exporting engine of Puerto Rico’s economy. However, under competitive pressures, its potential as a job creating sector will continue to diminish. Government has reached its limits as an employer of last resort. It is no longer able to absorb an increasing labor force that exceeds demand. The psychological impact of this reality cannot be minimized. The resulting behavior of key sectors of the electorate may generate a new political dynamics. In a non-linear world, this new dynamics may shake the tree and force those now sharing power to change course. If this occurs, the present fiscal crisis may prove to be beneficial after all.