Establishing a Puerto Rico Financial Stability and Economic Growth Authority

Main Points¹

1. Puerto Rico faces a serious and immediate debt crisis—scheduled payments have been missed, the government is forced to resort to emergency liquidity measures, and arrears to suppliers are building up.
2. Given recent economic outcomes and likely immediate prospects, it is clear that the government and its various agencies borrowed too much. At the same time, creditors must have been aware of the risks—Puerto Rico's economy has struggled over more than a decade and bond yields have long reflected the elevated risk of default.
3. The question now is how to put Puerto Rico back on the path to prosperity. A return to broad-based growth will permit rising living standards at the same time as ensuring the best possible outcomes for existing bondholders.
4. Puerto Rico needs a new set of economic policies—oriented towards boosting growth through reducing the cost of doing business and investing in productive opportunities.
5. One reaction is to demand further austerity, for example in the form of wage reductions and healthcare cuts. But residents of Puerto Rico are also US citizens and they vote with their feet—the population has fallen from 3.9 million to 3.5 million in recent years as talented and energetic people have moved to Florida, Texas, and other parts of the mainland.
6. The situation is complicated by the fact that much of Puerto Rico's $70 billion debt was issued by government corporations.² Federal law allows such municipal debt to be restructured under Chapter 9 of the bankruptcy code in all 50 states but not in Puerto Rico, which is the largest US territory. A protracted series of confusing legal battles and selective defaults looms. The cost of essential infrastructure services—electricity, water, sewer, transportation—will go up while quality declines.
7. The more that creditors demand lower living standards and higher taxes, the more the tax base (i.e., people) will simply leave the island—and bondholders will only experience greater loss.
8. Disorganized public corporation default will also make it hard for any part of the private credit system to function. As private credit becomes harder to obtain, the real economy will decline further.
9. Leading voices—including at the Hoover Institution—have long argued in favor of using established court-run process when large financial firms fail.³ The same logic applies here: a judge can rely on precedent and ensure fairness across creditor classes, based on seniority and the precise terms under which loans were obtained.
10. A judge—for example, responsible for administering a broad restructuring authority—can remove any doubt that actual insolvency in fact exists, while also ensuring that credit remains available during a restructuring. A well-designed restructuring authority can also forestall disruptive litigation and prevent holdouts by a few creditors.
11. For a sustained economic recovery, Puerto Rico needs private sector investment, and this requires three steps.
    1. First, bureaucratic hurdles to job creation should be eliminated, including by using state-of-the-art technology to make government more transparent.
    2. Second, the cost of essential inputs for industry needs to fall. Electricity on Puerto Rico is significantly more expensive than in Florida, in part because of underinvestment. More broadly, there are pressing needs for public investment to improve infrastructure and this includes great opportunities for private sector participation – but none of this will happen until the debt overhang is removed.
    3. Third, Puerto Rico needs better fiscal management. The island's idiosyncratic tax and expenditure system—and the lack of effective local fiscal control—has become part of the longer-term problem. Puerto Rico should, over time, become more like one of the 50 states in its fiscal relationship with the federal government. If Congress is willing to commit to that path, a reasonable quid pro quo would be strong fiscal rules—and a powerful monitoring body.
12. With congressional support and pro-growth policies, Puerto Rico can attract talented Americans (and legal immigrants) to move to the island, to start companies, and to work hard. Higher education in Puerto Rico remains strong—but over 80,000 people leave to live and work elsewhere every year (while only 20,000 move in).
13. In part this is because the healthcare system in Puerto Rico is badly frayed. The federal government provides significantly more support to every state healthcare system through Medicaid and Medicare, despite the fact that Puerto Ricans pay the same federal payroll taxes that fund much of the Medicare program.
14. And hard-working low-income Puerto Ricans are eligible for more robust support, including through the earned income tax credit (EITC)—a program supported by leading conservatives, such as Speaker of the House of Representatives Paul Ryan—but only if they move to one of the 50 states.
15. Puerto Rico does not need a bailout. It needs to reduce the cost of doing business, encourage investment, and attract people to work (and pay tax). It also needs to move away from an unsustainable fiscal deal vis-á-vis the federal government—and towards the same kind of arrangement that is available to all 50 states.

Lessons from International Experience

Puerto Rico's current situation is unusual for the United States, but there are definite recent parallels with the experience of countries around the world.

Governments borrow when times are good—or when investors are willing to bet on an improvement in economic conditions. Some of this borrowing may be directly onto the government's balance sheet, but it is also quite common to take on debt through various quasi-government agencies that have an explicit or implicit guarantee.

During a boom, investors are typically willing to ignore or play down the potential risks—and there is not enough thinking about what exactly will happen in a downside scenario.

As credit conditions tighten and expectations become more pessimistic, bond yields go up—reflecting the additional risks. As this happens, it is quite common for a different kind of investor to become involved, e.g., hedge funds. The risks of default are clearly higher but some investors still feel that the additional return justifies buying the debt.

At this stage, there is usually an active secondary market for debt—as investors who like risk buy up debt at a deep discount. Some investors may also take the view that they are acquiring more senior claims—or claims that will have advantageous treatment in the event of a restructuring.

When a country loses access to debt markets and is generally regarded as having unsustainable fiscal policies, some form of crisis ensues.

The main issue then becomes: How much will the existing debt be restructured? At the country-level there is a long-standing problem because there is no agreed mechanism (or court-run process) to determine a fair amount of debt reduction. As a result, there is reliance in the first instance on voluntary debt swaps (e.g., reducing the present value of payments but not always lowering principal). If this approach does not work, the International Monetary Fund often becomes involved—and the extent and nature of IMF support becomes part of the conversation with creditors.

IMF support comes with strings attached, including detailed monitoring of fiscal flows (and related monetary developments). However, IMF programs work only when there is substantial local buy-in. Imposing austerity from outside is never a good idea.

The viability of any IMF program (and related international assistance) always depends on getting debt payments down to a sustainable level. In this context, it is best if the payments can be made contingent on outcomes, i.e., if the economy recovers, then bondholders receive more.

A sovereign debt restructuring mechanism (SDRM) has been proposed in the past—and was given serious consideration by the George W. Bush administration. Unfortunately, we do not currently have an SDRM at the international level—and this makes debt restructuring more time consuming and harder to implement. In particular, some investors decide to hold out for full repayment and this can greatly complicate a return to capital markets for the government.

Compared with international experiences, Puerto Rico has the potential advantage that a restructuring mechanism could be put in place. Municipal bankruptcy (within the United States) is one obvious precedent, but a broader process—to include all debt—may also be considered.

In any such process, not all creditors will be treated alike—depending on the precise nature of the commitment to pay them (seniority of claim, broadly defined). The point is to have a fair, transparent, and politically legitimate process to decide on these payments. Running such a process through a judge (and the court system) has a great deal of appeal in the United States.

All such debt restructurings are contentious and no one ends up completely happy. But creditors were taking on well-documented risks when they lent to Puerto Rico. And the federal government has long made it clear that it does not stand behind the obligations of states or state-backed municipal lenders.

The reaction of debt markets to developments in Puerto Rico so far has been muted—and this is further confirmation that investors understand the risks with this kind of lending are quite differentiated across borrowers.

The biggest danger for Puerto Rico is that there will be no comprehensive debt restructuring. Without further congressional action, the terms on some loans will be changed, but only partially and likely not enough to return the territory to fiscal sustainability.

One potential historical parallel is Latin America during the 1980s. Following a debt crisis that began in 1982, there was a long period of stagnation—until the US Treasury helped to facilitate a restructuring at the end of the decade.

Puerto Rico could easily experience a lost decade of growth. And outcomes (in terms of economic aggregates in Puerto Rico) could even be dramatic because residents can move to the 50 states. In modern times we have never experienced this particular dimension of a debt crisis—the relatively easy exit of a population.⁴

International experience teaches us that economic recoveries are possible, even from apparently dire circumstances. Puerto Rico does not have its own currency, so recovery through devaluation is not an option. And reducing wages in Puerto Rico would induce more people to leave—this should be regarded as an important constraint on policy.

But international experience also suggests there is a sensible way forward if Congress and the government of Puerto Rico are willing to support: significant debt restructuring in a court-run process; improvement in fiscal management, including with external oversight; a reduction in the cost of doing business; and an investment-led recovery.

Notes

1. Simon Johnson is Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; senior fellow, Peterson Institute for International Economics; and cofounder of BaselineScenario.com. He is also a member of the Federal Deposit Insurance Corporation's Systemic Resolution Advisory Committee, the Office of Financial Research's Financial Research Advisory Committee, and the independent Systemic Risk Council (created by Sheila Bair). All the views expressed here are his alone. Underlined text indicates links to supplementary material. For important disclosures, see baselinescenario.com/about/.

2. There are various estimates of the precise debt outstanding for which the government of Puerto Rico is responsible; $70 billion is a reasonable baseline number to use for gross public debt.

3. There is a debate about whether bankruptcy can be used to deal with the largest financial firms, because of potential systemic risk spillover effects – i.e., the failure of one firm causes other firms to fail. These concerns do not seem to apply in the case of Puerto Rico's debt.

4. Some euro area countries now experience substantial out-migration, including for young and educated people. But it is harder to move within the euro area—for cultural and linguistic reasons—than it is to move from Puerto Rico to Florida, Texas, or other states.