Wednesday, May 4, 2016

Let Puerto Rico Declare Bankruptcy

On Tuesday, the American territory of Puerto Rico defaulted on a $399 million bond principal payment that marks as the largest missed payment in its history. Although this event was partially expected, it's another bad sign for island's economic prospects. A larger $2 billion bond payment comes due at the beginning of July, and the governor of Puerto Rico has strongly suggested they will be defaulting on that and other payments as well if the US Congress doesn't act to create some kind of rescue plan for them. So now the pressure is on Congress come up with a solution or Treasury Secretary Jack Lew has said the US may be forced to sponsor a federal bailout of Puerto Rico's finances.

We'll get to the possible solutions in a minute, but first, it's important to understand just how bad the situation is. As it stands, Puerto Rico has approximately $72 billion in outstanding debt across all government agencies, and it also has $44 billion in unfunded government pension liabilities that aren't included in the initial number. This means a total net debt position of around $116 billion, which compares unfavorably with their current GDP of $103 billion (as of 2013). The details of how the island got here are beyond the scope of this post, but some of the basic contributing factors are as follows:

  • The federal minimum wage of $7.25 an hour applies to Puerto Rico.
    • This is a problem because the island's per capita income is considerably lower than mainland United States. Thus, in relative terms, the consequences of a $7.25 minimum wage in Puerto Rico are similar to what might happen if a $15 minimum wage was enforced in the US outside of major urban centers. These issues are then compounded by the fact that tourism is one of Puerto Rico's major draws, and the tourism industry relies on a lot of low-skilled and low-wage labor to exist. This has had the practical effect of making Puerto Rico's tourism offerings relatively more costly than that of other islands in the Caribbean.
  • Favorable tax treatment for Puerto Rican bonds mean that investors do not have to pay local, state, or federal income taxes on them.
    • This, in turn, means that there was artificially high demand for the island's debt, and Puerto Rico could get away with paying a lower-than-market interest rate. This happens because investors only care about their after-tax return. Thus, assuming for example a 25% tax rate, an interest rate of 6% on taxable bonds and 4.5% on tax-free bonds are equally desirable to investors. This gave the island an advantage, allowing them to borrow more at artificially low interest rates and put off making tough financial decisions for a few extra years.
  • A federal law has prohibited states and territories from declaring bankruptcy to restructure (i.e., get out of paying) some of their debt.
    • This again made Puerto Rican bonds an artificially attractive investment, since they are not legally allowed to not pay them back. Presumably, most investors have calculated that, if it gets bad enough, the federal government will probably decide to bail them out after all.
  • Puerto Rico is very poor by US standards.
So now that we know how we got here, it's worth contemplating some of the possible solutions. The leading options are as follows:
  • Force Puerto Rico to pay debts back in full (or on terms their creditors voluntarily agree to) and embark on an austerity program. Austerity could be implemented by an outside oversight body or the local government.
  • Have the Federal government explicitly bail out Puerto Rico.
  • Change the laws to allow Puerto Rico to declare bankruptcy just as municipalities like Detroit have been able to.
  • Technically, do nothing is also an option, but, in practice, it would eventually result in some combination of these options after the next default occurs. (Creditors will sue the island, and those will be the only remedies available.)

Before evaluating these ideas, we should note that any good solutions has three principle goals: 1) Help the Puerto Rican economy become sustainable again, 2) discourage flagrant government spending in the future, and 3) limit political unrest so the solution can last, and San Juan doesn't start to look like Seattle on May Day.

Some conservatives and libertarians are making the case for austerity. They argue that the government must honor its debts and shouldn't be allowed a free pass for irresponsible spending. Additionally, because the investors bought the debts in an environment where bankruptcy was not legally possible, they argue that allowing bankruptcy would be to undermine the rule of law. Thus, austerity is the major option.

To be sure, they make some good points here. But implicitly, they are assuming that the necessarily aggressive austerity program is politically possible. It's hard to imagine that's really the case. Austerity has become a dirty word in politics, and the governor of Puerto Rico has already started characterizing this issue as a pending humanitarian crisis. This does not bode well, particularly in an election year where Republicans are reluctantly running on a populist message and the leading Democrat openly celebrates voting for the financial and auto bailouts. Moreover, even if such a program could be passed, there's no reason to believe it would be sustainable. More likely, we'd have a situation like that in Greece. Austerity gets implemented, public revolts as economy declines, new party gets elected promising to end austerity, they back down and implement more austerity. Rinse. Repeat. But presumably that cycle eventually ends with another default anyway once the country has a sufficiently strong leader to tell international creditors no. Because it's unlikely austerity will be sustainable--rather simply kicking the can down the road--it should not be the go-to solution.

Government Bailout
Given how small these numbers appear in relation to the US national debt, this might initially seem like an attractive solution. Any political unrest is likely to be distributed across the US mainland, and wiping away Puerto Rico's debt would obviously go a long way to allowing a more sustainable economic path. However, this solution fails miserably when we consider the second criterion. This bailout will send exactly the wrong message to Puerto Rico and all other states and territories that are having financial issues. It tells them that there will be no consequences for excessive spending because Washington--nay, the American taxpayer in general--will be picking up the tab. The likely intermediate-term economic fallout from this would be considerable, as the US would be asked to bail out other insolvent states as well.

Additionally, at the very time that lenders should be getting more cautious about lending to heavily indebted governments, they will be encouraged to lend even more. This cannot end well.

All of which brings us to the least bad alternative. Puerto Rico needs to be allowed to go bankrupt and force its debt to be restructured. This will wipe out much of Puerto Rico's debt without placing the burden on the American taxpayer.

Instead, the burden is placed on the creditors. This is how it should be. But it's not because the creditors are evil, 1% hedge funds that deserve what's coming to them. Rather, this is the best solution because that is how bonds work. There's a reason that lenders get to earn an interest rate when they loan money (buy bonds) to Puerto Rico. Part of it is to compensate them for the time value of money; money is more valuable today than in the future so lenders must be paid extra in order to part with it. And the second thing the interest rate captures is the risk that Puerto Rico won't be able to pay them back. The more likely it is that an entity won't be able to pay somebody back, the higher the interest rate. This is a major reason subprime mortgages appeared attractive to lenders and investors in the financial crisis. Because the borrowers were very risky, they had to pay very high interest rates, thereby generating larger returns as long as they didn't default. (In practice, of course, many defaulted, wiping out any such returns.)

In other words, the risk that Puerto Rico would default, however unlikely it initially seemed and in spite of laws to the contrary, is already priced into the Puerto Rican bonds. That's why they have always paid a far higher interest rate than the US government--which is understandably deemed to be a far smaller credit risk. As of October of last year, Puerto Rico bonds were yielding 12.3% (tax-free) on a 10-year bond versus 2.16% for the US government for a similar duration. What else could possibly explain such a disparity?

So the creditors should be punished for making a bad bet, rather than having their losses absorbed by the taxpayer. What are the likely consequences?

Well, if the Congress makes it possible for other states and territories to also follow suit, many of them likely will. More creditors will lose their money, and it may result in something of an economic panic in the short-run as normally reliable state bonds become increasingly risky. Fair enough, but what about the longer run? After declaring bankruptcy, Puerto Rico (and any others) will no longer be able to borrow money easily. If they find any willing creditors at all, then they will be charged a very high interest rate as creditors are wary of getting wiped out again. This then means that Puerto Rico will have to have a balanced budget because running deficits will either be extremely costly or entirely impossible. And this solution will have to be sustainable because there's no alternative. Such policy won't be beholden to political whims; it will be enforced by the firm laws of economics.

In the short-run, this might also have a signalling effect for other states. Once investors realize bankruptcy is possible, interest rates there will rise as well and credit will become more scarce. Here again, the states will be compelled by market conditions to balance their budgets as well. This solution creates the most powerful disincentives possible to deter future budget crises.

All of this is why allowing bankruptcy is the best option for Puerto Rico and states in a similar position. Short-run pain is unavoidable when a problem like this has gone unchecked for so long. But to prevent these problems from happening in the future, we must avoid kicking the can down the road. The solution must create the proper incentives by punishing the people who knowingly accepted the risk in the first place, and allowing the people of Puerto Rico a chance for a balanced budget in the future. Allowing the island to declare bankruptcy is the only solution that can credibly achieve this outcome.

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