Tag Archives: Puerto Rico

Local governments reluctant to issue new debt despite low interest rates

The Wall Street Journal reports that despite historically low interest rates municipal governments and voters don’t have the appetite for new debt. Municipal bond issuances have dropped to 20-year lows (1.6 percent) as governments pass on infrastructure improvements. There are a few reasons for that: weak tax revenues, fewer federal dollars, and competing budgetary pressures. As the article notes,

“Many struggling legislatures and city halls are instead focusing on underfunded employee pensions and rising Medicaid costs. Some cash-strapped areas, such as Puerto Rico and the city of Chicago, face high annual debt payments.”

The pressures governments face due to rising employee benefits is likely to continue. The low interest rate environment has already had a negative effect on public pensions. In pursuit of higher yields, investors have taken on more investment risk leaving plans open to market volatility. At the same time investments in bonds have not yielded much. WSJ reporter Timothy Martin writes that public pension returns are, “expected to drop to the lowest levels ever recorded,” with a 20-year annualized return of 7.4 percent for 2016.

The end result of this slide is to put pressure on municipal and state budgets to make up the difference, sometimes with significant tradeoffs.

The key problem for pensions is “baked into the cake,” by use of improper discounting. Linking the present value of guaranteed liabilities to the expected return on risky investments produces a distortion in how benefits are measured and funded. Public sector pensions got away with it during the market boom years. But in this market and bond environment an arcane actuarial assumption over how to select discount rates shows its centrality to the fiscal stability of governments and the pension plans they provide.

Puerto Rico’s labor market woes

Puerto Rico – a U.S. territory – has $72 billion dollars in outstanding debt, which is dangerously high in a country with a Gross Domestic Product (GDP) of only $103.1 billion. The Puerto Rican government failed to pay creditors in August and this was viewed as a default by the credit rating agency Moody’s, which had already downgraded Puerto Rico’s bonds to junk status earlier this year. The Obama administration has proposed allowing Puerto Rico to declare bankruptcy, which would allow it to negotiate with creditors and eliminate some of its debt. Currently only municipalities – not states or territories – are allowed to declare bankruptcy under U.S. law. Several former Obama administration officials have come out in favor of the plan, including former Budget Director Peter Orszag and former Director of the National Economic Council Larry Summers. Others are warning that bankruptcy is not a cure-all and that more structural reforms need to take place. Many of these pundits have pointed out that Puerto Rico’s labor market is a mess and that people are leaving the country in droves. Since 2010 over 200,000 people have migrated from Puerto Rico, decreasing its population to just over 3.5 million. This steady loss of the tax base has increased the debt burden on those remaining and has made it harder for Puerto Rico to get out of debt.

To get a sense of Puerto Rico’s situation, the figure below shows the poverty rate of Puerto Rico along with that of three US states that will be used throughout this post as a means of comparison: California (wealthy state), Ohio (medium-wealth state), and Mississippi (low-wealth state). All the data are 1-year ACS data from American FactFinder.

puerto rico poverty

The poverty rate in Puerto Rico is very high compared to these states. Mississippi’s poverty rate is high by US standards and was approximately 22% in 2014, but Puerto Rico’s dwarfed it at over 45%. Assisting Puerto Rico with their immediate debt problem will do little to fix this issue.

A government requires taxes in order to provide services, and taxes are primarily collected from people who work in the regular economy via income taxes. A small labor force with relatively few employed workers makes it difficult for a county to raises taxes to provide services and pay off debt. Puerto Rico has a very low labor force participation (LFP) rate relative to mainland US states and a very low employment rate. The graphs below plot Puerto Rico’s LFP rate and employment rate along with the rates of California, Mississippi, and Ohio.

puerto rico labor force

puerto rico employ rate

As shown in the figures, Puerto Rico’s employment rate and LFP rate are far below the rates of the US states including one of the poorest states, Mississippi. In 2014 less than 45% of Puerto Rico’s 16 and over population was in the labor force and only about 35% of the 16 and over population was employed. In Mississippi the LFP rate was 58% while the employment rate was 52%. Additionally, the employment rate fell in Puerto Rico from 2010-14 while it rose in each of the other three states. So at a time when the labor market was improving on the mainland things were getting worse in Puerto Rico.

An educated labor force is an important input in the production process and it is especially important for generating innovation and entrepreneurship. The figure below shows the percent of people 25 and over in each area that have a bachelor’s degree or higher.

puerto rico gt 24 education attain

Puerto Rico has a relatively educated labor force compared to Mississippi, though it trails Ohio and California. The percentage also increased over this time period, though it appears to have stabilized after 2012 while continuing to grow in the other states.

Puerto Rico has nice beaches and weather, so a high percentage of educated people over the age of 25 may simply be due to a high percentage of educated retirees residing in Puerto Rico to take advantage of its geographic amenities. The next figure shows the percentage of 25 to 44 year olds with a bachelor’s degree or higher. I examined this age group to see if the somewhat surprising percentage of people with a bachelor’s degree or higher in Puerto Rico is being driven by educated older workers and retirees who are less likely to help reinvigorate the Puerto Rican economy going forward.

puerto rico 25to44 educ attain

As shown in the graph, Puerto Rico actually fares better when looking at the 25 – 44 age group, especially from 2010-12. In 2012 Puerto Rico had a higher percentage of educated people in this age group than Ohio.

Since then, however, Puerto Rico’s percentage declined slightly while Ohio’s rose, along with Mississippi’s and California’s. The decline in Puerto Rico was driven by a decline in the percentage of people 35 to 44 with a bachelor’s or higher as shown in the next figure below.

puerto rico 35to44 educ attain

The percentage of 35 to 44 year olds with a bachelor’s or advanced degree fell from 32% in 2012 to 29.4% in 2014 while it rose in the other three states. This is evidence that educated people in their prime earning years left the territory during this period, most likely to work in the US where there are more opportunities and wages are higher. This “bright flight” is a bad sign for Puerto Rico’s economy.

One of the reforms that many believe will help Puerto Rico is an exemption from compliance with federal minimum wage laws. Workers in Puerto Rico are far less productive than in the US, and thus a $7.25 minimum wage has a large effect on employment. Businesses cannot afford to pay low-skill workers in Puerto Rico such a high wage because the workers simply do not produce enough value to justify it. The graph below shows the median individual yearly income in each area divided by the full time federal minimum wage income of $15,080.

puerto rico min wage ratio

As shown in the graph, Puerto Rico’s ratio was the highest by a substantial amount. The yearly income from earning the minimum wage was about 80% of the yearly median income in Puerto Rico over this period, while it was only about 40% in Mississippi and less in Ohio and California. By this measure, California’s minimum wage would need to be $23.82 – which is equal to $49,546 per year – to equal the ratio in Puerto Rico. California’s actual minimum wage is $9 and it’s scheduled to increase to $10 in 2016. I don’t think there’s a single economist who would argue that more than doubling the minimum wage in California would have no effect on employment.

The preceding figures do not paint a rosy picture of Puerto Rico: Its poverty rate is high and trending up, less than half of the people over 16 are in the labor force and only about a third are actually employed, educated people appear to be leaving the country, and the minimum wage is a severe hindrance on hiring. Any effort by the federal government to help Puerto Rico needs to take these problems into account. Ultimately the Puerto Rican government needs to be enabled and encouraged to institute reforms that will help grow Puerto Rico’s economy. Without fundamental reforms that increase economic opportunity in Puerto Rico people will continue to leave, further weakening the commonwealth’s economy and making additional defaults more likely.

 

 

Grants to Puerto Rico haven’t helped much

Greece’s monetary and fiscal issues have overshadowed a similar situation right in America’s own back yard: Puerto Rico. Puerto Rico’s governor recently called the commonwealth’s $72 billion in debt “unpayable” and this has made Puerto Rico’s bondholders more nervous than they already were. Puerto Rico’s bonds were previously downgraded to junk by the credit rating agencies and there is a lot of uncertainty surrounding Puerto Rico’s ability to honor its obligations to both bond holders and its own workers, as the commonwealth’s pension system is drastically underfunded.   A major default would likely impact residents of the mainland U.S., since according to Morningstar most of the debt is owned by U.S. mutual funds, hedge funds, and mainland Americans.

So how did Puerto Rico get into this situation? Like many other places, including Greece and several U.S. cities, the government of Puerto Rico routinely spent more than it collected in revenue and then borrowed to fill the gap as shown in the graph below from Puerto Rico’s Office of Management and Budget. Over a recent 13 year period (2000 – 2012) Puerto Rico ran a deficit each year and accrued $23 billion in debt.

Puerto rico govt spending

Puerto Rico has a lot in common with many struggling cities in the U.S. that followed a similar fiscal path, such as a high unemployment rate of 12.4%, a shrinking labor force, stagnant or declining median household income, population flight, and falling house prices. Only 46.1% of the population 16 and over was in the labor force in 2012 (compared to an average of nearly 64% in the US in 2012) and the population declined by 4.8% from 2010 to 2014. It is difficult to raise enough revenue to fund basic government services when less than half the population is employed and the most able-bodied workers are leaving the country.

Like other U.S. cities and states, Puerto Rico receives intergovernmental grants from the federal government. As I have explained before, these grants reduce the incentives for a local government to get its fiscal house in order and misallocate resources from relatively responsible, growing areas to less responsible, shrinking areas. As an example, since 1975 Puerto Rico has received nearly $2.7 billion in Community Development Block Grants (CDBG). San Juan, the capital of Puerto Rico, has received over $900 million. The graph below shows the total amount of CDBGs awarded to the major cities of Puerto Rico from 1975 – 2014.

Total CDBGs Puerto Rico

As shown in the graph San Juan has received the bulk of the grant dollars. The graph below shows the amount by year for various years between 1980 and 2014 for San Juan and Puerto Rico as a whole plotted on the left vertical axis (bar graphs). On the right vertical axis is the amount of CDBG dollars per capita (line graphs). San Juan is in orange and Puerto Rico is in blue.

CDBGs per capita, yr Puerto Rico

San Juan has consistently received more dollars per capita than the other areas of Puerto Rico. Both total dollars and dollars per capita have been declining since 1980, which is when the CDBG program was near its peak funding level. As part of the 2009 Recovery Act, San Juan received an additional $2.8 million dollars and Puerto Rico as a country received another $5.9 million on top of the $32 million already provided by the program (not shown on the graph).

It’s hard to look at all of this redistribution and not consider whether it did any good. After all, $2.7 billion later Puerto Rico’s economy is struggling and their fiscal situation looks grim. Grant dollars from programs like the CDBG program consistently fail to make a lasting impact on the recipient’s economy. There are structural problems holding Puerto Rico’s economy back, such as the Jones Act, which increases the costs of goods on the island by restricting intra-U.S.-shipping to U.S. ships, and the enforcement of the U.S. minimum wage, which is a significant cost to employers in a place where the median wage is much lower than on the mainland. Intergovernmental grants and transfers do nothing to solve these underlying structural problems. But despite this reality, millions of dollars are spent every year with no lasting benefit.

The “pension tapeworm” and Fiscal Federalism

In his annual report to shareholders, Warren Buffett cites the role that pension underfunding is playing in governments and markets:

“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made. During the next decade, you will read a lot of news –- bad news -– about public pension plans.”

He zones in on pension mathematics – “a mystery to most Americans” – as a possible reason for accelerating liabilities facing state and local governments including Puerto Rico, Detroit, New Jersey and Illinois. I might go further and state that pension mathematics remains a mystery to those with responsibility for, or interest in, these systems. It’s the number one reason why reforms have been halting and inadequate to meet the magnitude of the problem. But as has been mentioned on this blog before: the accounting will eventually catch up with the economics.

What that means is unrelenting pressure building in municipal budgets including major cities. MSN Money suggests the possibility of bankruptcy for Los Angeles, Chicago and New York City based on their growing health care and pension liabilities.

In the context of this recent news and open talk of big municipal bankruptcy, I found an interesting analysis by Paul E. Peterson and Daniel J. Nadler in “The Global Debt Crisis Haunting U.S. and European Federalism.”(Brookings Institution Press, 2014).

In their article, “Competitive Federalism Under Pressure,” they find a positive correlation between investors’ perception of default risk on state bonds and the unionization rate of the public sector workforce. While cautioning that there is much more at work influencing investors’ views, I think their findings are worth mentioning since one of the biggest obstacles to pension reform has been the reluctance of interested parties to confront the (actual) numbers.

More precisely, it leads to a situation like the one now being sorted out in federal bankruptcy court in Detroit. Pensioners have been told by Emergency Manager Kevyn Orr that if they are willing to enter into a “timely settlement” with the city and state, they may see their pensions reduced by less than the 10 to 30 percent now suggested. Meanwhile bondholders are looking at a haircut of up to 80 percent.

If this outcome holds for Detroit, then Peterson and Nadler’s findings help to illuminate the importance of collective bargaining rules on the structure of American federalism by changing the “rules of the game” in state and local finances. The big question for other cities and creditors: How will Detroit’s treatment of pensions versus bonds affect investors’ perception of credit risk in the municipal debt market?

But there are even bigger implications. It is the scenario of multiple (and major) municipal bankruptcies that might lead to federalism-altering policy interventions, Peterson and Nadler conclude their analysis with this observation:

[public sector] Collective bargaining has, “magnified the risk of state sovereign defaults, complicated the resolution of deficit problems that provoke such crises, heightened the likelihood of a federal intervention if such crises materializes, and set the conditions for a transformation of the country’s federal system.”

Does statehood trigger Leviathan? A case study of New Mexico and Arizona

I was recently asked to review, “The Fiscal Case Against Statehood: Accounting for Statehood in New Mexico and Arizona, by Dr. Stephanie Moussalli for EH.net (the Economic History Association).

I highly recommend the book for scholars of public choice, economic history and accounting/public finance.

As one who spends lots of time reading  state and local financial reports in the context of public choice, I was very impressed with Moussalli’s insights and tenacity. In her research she dives into the historical accounts of territorial New Mexico and Arizona to answer two questions.  Firstly, did statehood (which arrived in 1912) lead to a “Leviathan effect” causing government spending to grow. And secondly, as a result of statehood, did accounting improve?

The answer to these questions is yes. Statehood did trigger a Leviathan effect for these Southwestern states –  findings that have implications for current policy – in particular the sovereignty debates surrounding Puerto Rico and Quebec. And the accounts did improve as a result of statehood, an outcome that controls for the fact that this occurred during the height of the Progressive era and its drive for public accountability.

A provocative implication of her findings that cuts against the received wisdom:  Are the improved accounting techniques that come with statehood a necessary tool for more ambitious spending programs? Does accounting transparency come with a price?

What makes this an engaging study is Moussalli’s persistence and creativity in bringing light to a literature void. She stakes out new research territory, and brings a public choice-infused approach to what might otherwise be bland accounting records. She rightly sees in the historical ledgers the traces of the political and social choices of individuals; and the inescapable record of their decisions. In her words, “people say one thing and do another.” The accounts speak in a way that historical narrative does not.

For more read the review.

 

Credit Warnings, Debt Financing and Dipping into Cash Reserves

As 2013 comes to an end recent news brings attention to the structural budgetary problems and worsening fiscal picture facing several governments: New Jersey, New York City, Puerto Rico and Maryland.

First there was a warning from Moody’s for the Garden State. On Monday New Jersey’s credit outlook was changed to negative. The ratings agency cited rising public employee benefit costs and insufficient revenues. New Jersey is alongside Illinois for the state with the shortest time horizon until the system is Pay-As-You-Go. On a risk-free basis the gap between pension assets and liabilities is roughly $171 billion according to State Budget Solutions, leaving the system only 33 percent funded. This year the New Jersey contributed $1.7 billion to the system. But previous analysis suggests New Jersey will need to pay out $10 billion annually in a few years representing one-third of the current budget.

New Jersey isn’t alone. The biggest structural threat to government budgets is the unrecognized risk in employee pension plans and the purely unfunded status of health care benefits. Mayor Michael Bloomberg, in his final speech as New York City’s Mayor, pointed to the “labor-electoral complex” which prevents employee benefit reform as the single greatest threat to the city’s financial health. In 12 years the cost of employee benefits has increased 500 percent from $1.5 billion to $8.2 billion. Those costs are certain to grow presenting the next generation with a massive debt that will siphon money away from city services.

Public employee pensions and debt are also crippling Puerto Rico which has dipped into cash reserves to repay a $400 million short-term loan. The Wall Street Journal reports that the government planned to sell bonds, but retreated since the island’s bond values have, “plunged in value,” due to investor fears over economic malaise and the territory’s existing large debt load which stands at $87 billion, or $23,000 per resident.

This should serve as a warning to other states that continue to finance budget growth with debt while understating employee benefit costs. Maryland’s Spending Affordability Committee is recommending a 4 percent budget increase and a hike in the state’s debt limit from $75 million to 1.16 billion in 2014. Early estimates by the legislative fiscal office anticipate structural deficits of $300 million over the next two years – a situation that has plagued Maryland for well over a decade. The fiscal office has advised against increased debt, noting that over the last five years, GO bonds have been, “used as a source of replacement funding for transfers of cash” from dedicated funds projects such as the Chesapeake Bay Restoration Fund.

 

Puerto Rico Secretary of State on Government Reform

On my last post about government reform in Puerto Rico, a commenter pointed out that some of the trends indicating that the territory’s government is shrinking have reversed in the past year. Indeed, the number of government employees increased from 259,000 in December 2010 to 269,000 in December 2011. Likewise, government revenues ticked up in 2010 and 2011 after decreasing in 2008 and 2009.

I wanted to learn more about the reversal of the shrinking central government, so I spoke with Puerto Rico Secretary of State Kenneth McClintock about these trends. He explained, as the commenter pointed out, that the increase in government revenue is in large part due to an excise tax on foreign corporations that went into effect in 2011. This temporary tax is being used to finance broad-based tax reform and is gradually being phased out over the next five years when it will expire in 2016. McClintock explained that a six year plan for tax reform was one of the administration’s top priorities upon Governor Luis Fortuño taking office in 2008.

Reform measures have included cutting corporate tax rates from 39 percent to 30 percent and individual tax rates by 50 percent over the six year period. McClintock said, “Beginning in year one, everybody had more money in their pockets.” These reforms include a unique trigger. If Puerto Rico doesn’t achieve a balanced budget by the end of the six-year reform period, the final tax cuts will not go through. “We wanted to show people that good things happen with fiscal discipline,” McClintock continued.

Regarding the increase in government employees, McClintock said that part of the increase was due to stimulus funds from the American Recovery and Reinvestment Act and hiring by local governments. Additionally,  a negligible number of the initial cutbacks were deemed to be unsustainable and required refilling some positions that were eliminated in the initial round of cuts. Attrition policies are still in place, so longterm cuts should still be expected.

Initially, government job cuts raised Puerto Rico’s already high unemployment rate by about 1.2 percentage points. McClintock said that while hard data is not available on the individuals laid off from government jobs, anecdotally about half of them are now employed in the private sector. The layoffs included a $1 billion severance package which provided $5,000 for each laid off employee that they could use either to go to school or as seed money for a new business.

Of course, not everyone is as optimistic about the success of the territory’s reform efforts. As a blog produced by Center for the New Economy, a Puerto Rican think tank, reports, the tax reform program is not uncontroversial:

The control and reduction of government spending has stabilized the Commonwealth’s financial position.  Unfortunately, this stabilization is not cost free.  The implementation of this contractionary fiscal policy in the middle of a four year recession may have deepened and prolonged the economic recession in Puerto Rico.  Furthermore, the government’s pro-cyclical fiscal policy has been implemented at the same time that commercial banks in the island are undergoing a de-leveraging process that has significantly reduced the availability of credit.

As the article explains, some aspects of the tax reform plan may not point toward long run stability. The territory’s budget is increasingly reliant on federal funds with $1 of every $4 spent by the central government coming from federal transfer payments. Furthermore, debt service payments are increasing as a percent of Puerto Rico’s GDP.

While siginificant economic growth has yet to be seen coming out of the recession, economic indicators are looking better than when Governor Fortuño took office, despite about 12,500 government layoffs by the central government. Unemployment has fallen from 18 percent to under 16 percent and the Economic Activity Index reached positive territory in 2011 for the first time since early 2006. Some recent reforms will have staying power beyond Governor Fortuno’s term in office. The focus has been on improving Puerto Rico’s business climate relative to the states and neighboring countries by expanding trade and lowering taxes.

Reducing bureaucracy has also been a priority. “So far we have approved 11 of 13 reorganization plans to consolidate and eliminate agencies,” McClintock explained. He also said that many of the barriers to the renewable energy industry have been eliminated, leading the territory to become home to the largest wind and solar farms in the United States.

Puerto Rico is also pursuing an institutional change that could reduce long run spending. In August, Puerto Ricans will vote on an amendment to cut the number of legislators from 27 to 17 in the senate and 51 to 39 in the house of representatives. As research from Jowei Chen and Neil Malhotra demonstrates, state spending is likely to decrease with fewer state senators and with a higher ratio of representatives to senators.

Matt Mitchell and Nick Tuszynski covered their research in a literature review, and Matt estimates that these changes could be expected to reduce spending in Puerto Rico by about $77 per person yearly. The change to the legislature would take place ahead of the 2016 elections. McClintock said that this proposal is the result of “courageous legislators who are thinking from the people’s perspective rather than their own. It’s only natural that after cuts in the administration, people would expect cuts in the legislature as well.”

Many of the changes in Puerto Rico could be implemented in states looking to streamline government, particularly their tax reforms and triggers to provide incentives for voters to act as watchdogs to be sure that fiscal discipline is carried through.

Puerto Rico: What real reform looks like

As the Republican primary drags on, the candidates will face primaries in the U.S. island territories in the coming weeks. In Puerto Rico, 23 delegates are at stake. While Puerto Rico often doesn’t receive much coverage in U.S. news outlets, the case of government reform there provides a valuable case study that American governors seeking to reduce the size of state governments should note. Since taking office in 2009, Governor Luis Fortuño has led the territory in reducing the number of employees by nearly 16 percent.

Source: Bureau of Labor Statistics

While Puerto Rico has been hit hard by the economic recession and struggles with a current unemployment rate of 16 percent, Fortuño has made the difficult decisions necessary to preserve the territory’s ability to borrow money and to resume on-time payments to government suppliers and employees. In this Reason TV video, he explains that he had to borrow to meet payroll his first month in office, but succeeded in bringing its bond rating back from the brink of junk status.

In his work with government streamlining efforts in Puerto Rico, Mercatus’ Maurice McTigue stressed the importance of of shrinking the size of government relative to the economy. Any elected official can attest that the process of achieving these changing growth rates is painful, but Fortuño is in the process of leading just that sort of change:

Source: Government Development Bank of Puerto Rico

The lesson to draw from Puerto Rico is that an important reason to avoid unsustainable levels of government spending is to avoid the pain of cutbacks once a government gets to a point where spending cuts are no longer an option. In March, 2011, Standard & Poor’s raised Puerto Rico’s bond rating for the first time in 28 years, marking an objective change in confidence regarding the island’s economic prospects.

Hurricane Irene and Walmart’s staff meteorologist

A very interesting piece from NPR. Big-box retailers began their hurricane prep well before Hurricane Irene was predicted to make landfall. Home Depot’s Command Central, which looks, “much like NASA Mission Control during a shuttle launch” has been busy anticipating the storm’s effects along the East Cost. Walmart has its own staff meteorologist. This pre-hurricane prep – which actually begins before hurricane season – is why the shelves were stocked with emergency generators in Puerto Rico and available for customers when the electricity went out.

Economist Steven Horwitz studied the response of Walmart after Hurricane Katrina. His research – part of the Mercatus Center’s Hurricane Katrina project – shows that Walmart was able to respond more adeptly and quickly than FEMA and state emergency services, providing people with basic necessities including medicines (in some cases, local store managers gave supplies away to those in need). Not only are they on the ground and in the community, their very business is to respond to people’s needs and wants quickly and on a daily basis.

Since Katrina, FEMA has been studying ways to work more closely with the private sector. Interestingly, Horwitz found that the U.S. Coast Guard and local emergencies services were also able to respond more quickly than FEMA during Katrina for a similar reason: they are are decentralized and closer to the ground.

Here is Professor Horwitz discussing Walmart’s Katrina’ response: