Getting Puerto Rico’s Fiscal Baseline Right

Developments in Puerto Rico are accelerating. The long-run fiscal plan is really a critical component of PROMESA—as it is intended to be a guide both for Puerto Rico’s annual budget and for any debt restructuring. I want to offer a few quick comments on the Ernst & Young report, and the most recent letter Puerto Rico’s oversight board sent the governor:

1) Puerto Rico probably isn’t going into (over?) its pension cliff and the health care cliff with a $1 billion primary fiscal surplus (the primary fiscal balance is the revenues minus non-debt expenditures). The Ernst and Young report suggests that spending is likely understated (unlike in past years, when the standard problem was that tax revenues were typically overstated). The oversight board seems to agree: "the Board has concluded that the Government’s FY17 expenditures could be understated by an amount ranging from $60 to $510 million, with a cumulative impact much greater over the next ten years. The Government’s liquidity projection is further understated by $300 million in FY17." The implication alas, is that when Puerto Rico loses $1 billion in pension financing (as its pension assets will soon be depleted) and $1.5 billion in health care financing (as the Affordable Care Act grant will soon run out), it will face substantial fiscal deficits even in the absence of any debt service. The fiscal math I walked through on Monday still I hope works, but the likely starting point is worse.*

2) The oversight board recommends lowering the nominal growth forecast for the next few years, and being more cautious in the medium-term. The implied real economic contraction is now over 3 percent in both 2018 and 2019. That I fear is the unfortunate reality: one clear lesson from Greece is not to imagine away near-term pain. I would though be interested in seeing more explicit treatment of how the magnitude of the proposed near-term fiscal adjustment is contributing to the fall in growth.

3) In standard macroeconomics, a fiscal consolidation only depresses short-term growth. The economy eventually bounces back to potential. I worry though that in Puerto Rico near-term consolidation will reduce long-run potential (hysteresis) for one simple reason: lots of Puerto Ricans will respond to the ongoing contraction by migrating off-island, permanently weakening Puerto Rico’s economy.

4) The enormous uncertainty around Puerto Rico’s future fiscal bargain with the federal government (Medical funding is the most significant aspect of this, but in my view the interaction between Puerto Rico’s system of tax and the federal corporate income tax is also part of the bargain) impedes any quick restructuring agreement. Any deal that Puerto Rico strikes with its creditors before its future Medicaid funding and corporate income tax treatment is settled leaves the downside risk with the residents of Puerto Rico.

One last point: The oversight board’s web site has become an essential source of information on Puerto Rico remarkably fast.

[*] Technical note. The COFINA trust fund (which collects sales tax before it goes to the budget) unambiguously has received funds in FY17, which would mean that the general government is in primary surplus if the rest of the budget balances. Ernst & Young’s analysis though suggest that the rest of the government is likely running a small deficit. And the FY17 deficit would come even though a substantial share of pension spending is being funded off budget by running down the pension system’s remaining assets.