Friday, July 1, 2016

Default Day in Puerto Rico

The fateful date of July 1st has finally arrived, and the crisis in Puerto Rico is arriving on schedule. In spite of efforts in Congress to ease the pain, the US territory of Puerto Rico has announced that it will default on more than $1 billion in bond payments today.

In the short-run, this is likely to cause some degree of chaos in the financial markets. However, there is a silver lining here. Puerto Rico's default today was predictable, and the only way it could have been avoided was if the US government formally bailed the island out--establishing a dangerous precedent that many US states (looking at you, Illinois) would probably try to take advantage of in the near future. Given that this was the only real alternative, default is the preferable outcome.

The real question is what will happen next. Congress successfully passed a bill called PROMESA (Puerto Rico Oversight, Management, and Economic Stability Act) that should reduce some of the short-term chaos. But it looks like it will fall shy of a more radical bankruptcy solution that we argued for two months ago (the last time Puerto Rico defaulted on its debt payments).

In essence, the bill prevents the island from being sued over its debts, and establishes a federal oversight board that is empowered to restructure the nation's debts and reform its economy. Most of this is helpful. Establishing a single body to settle Puerto Rico's debt negotiation with creditors will lead to less turmoil, and debt restructuring is going to be a necessary step for the island to get back on its feet. Unfortunately the last part of the board's mandate, to institute economic reforms, should give us pause. Time will tell exactly what this entails, but it certainly sounds like Puerto Rico is going to be forced to institute economic austerity measures by an undemocratic external player. In other words, it sounds very similar to what happened to Greece in its dealings with international lenders.

The Austerity Debate?
In case you're new to the subject, austerity generally refers to a package of economic programs designed to reduce budget deficits. This can be done through increasing taxes, reducing government spending, or a combination of the two. Notably, programs that emphasize reducing government spending have typically produced better results over time than those that attempt to reduce deficits primarily through increased taxes. Austerity measures also tend to include some beneficial free market reforms into the economy.

Before we go further, we should hasten to point out that the debate on the merits of austerity programs is deeply silly on its face. People will frame this debate in terms of pro-austerity or anti-austerity, as if they are just two competing ideas. In reality, austerity is the (almost) inevitable result of consistently running large budget deficits until the government becomes completely broke. And you may not be surprised to learn that the same people that support budget deficits, also tend to oppose austerity measures (sometimes in the very same article!). I would like to suggest this is not a serious position. It is the government-equivalent of saying you love binge drinking but are strongly anti-hangover. While it may be true that you both love being drunk and hate hangovers, these are clearly irreconcilable positions. When it comes to alcohol, suffering a hangover is the consequence of drinking too much. When it comes to economics, implementing austerity is the consequence of spending too much, for too long. This much we know.

Problems with Undemocratic Austerity
So austerity can be necessary and it can produce desirable economic reforms from a libertarian perspective--for instance, one of the controversies in the PROMESA bill is that it will allow a reduction in the minimum wage in Puerto Rico. But in spite of these possible benefits, I don't think economic austerity is the best outcome for Puerto Rico.

The reason is that the austerity program will most likely be implemented in an undemocratic fashion. This may appear to be a minor point, but it matters. Of course, I have no delusions about the chances for a democracy to get a complicated economic decision right. I have even less faith in Puerto Rico doing so in the midst of a crisis. That said, the prospect of having an external unelected body decide on major economic reforms, even if they are the "right" reforms, is not going to be received well, by Puerto Ricans or anyone else. This reality should be particularly obvious in light of the recent Brexit vote.

Economists and politicians are prone to thinking solely about policy solutions. And to be sure, policies do matter. But the process that produces those policies matters just as much. If good, long-term policies get implemented without any kind of democratic support, it is our contention that they will ultimately fail to achieve the desired result. They could also raise political unrest at a time when domestic tensions are already very high.

Due to these concerns, there is a better option than austerity. Ideally, Puerto Rico should be empowered to declare outright bankruptcy, and radically write-off most or all of its public debt to creditors. Upon writing off most of its debt, the territory will instantly lose the ability to borrow money in the future at decent interest rates. Thus, from that point on, Puerto Rico will have no choice but to maintain a balanced budget and dramatically reduce government spending to do so.

As a result, this path ends up with an outcome that looks similar to austerity. But there is a key difference. This solution has a chance of being sold to the public as a worthwhile trade-off: the benefit is the ability to write-off years of bad budgetary decisions, offset by the (perceived) cost that they will need to have a far smaller government. In reality, this is a win-win situation. The only losers are the creditors, who took a risk on Puerto Rico that didn't pay off. That is how it should be.

It's not likely that this solution will emerge triumphant based on the PROMESA bill that was passed. Still, we should have a rooting interest that the oversight board ultimately supports expansive debt relief rather than just minor restructuring. If they fail to do so, chances are we'll back here some months hence covering Puerto Rico's next default, and we'll still be proposing the same solution.

No comments:

Post a Comment