Even before Hurricane Maria struck Puerto Rico, the island was suffering from a financial crisis brought about by a debt burden of over $70 billion. For some context, California has the largest debt of any U.S. state at $146 billion. That works out to $3,720 per Californian, about a month's rent in a mid-sized apartment in San Francisco (kidding - that would be an efficiency). Puerto Rico's debt is $20,500 per person.
For more context, the median household income in California is over $61,000. In Puerto Rico it is – pre-hurricane – a little less than $20,000. A family of four in Puerto Rico making the median income could pay every penny they make to the government for four years straight and not retire their portion of the debt. That's what we call a non-payable debt.
John Maynard Keynes modernized an old parable by saying, “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” While creditors can make life in Puerto Rico difficult -- and they have been -- the problem is ultimately theirs. They are not going to get their money back.
This is why I was excited to hear President Trump, in the wake of Hurricane Maria, throw his support behind the inevitable outcome everyone involved is hoping to forestall. Of Puerto Rico, the president stated:
"They owe a lot of money to your friends on Wall Street and we're going to have to wipe that out," Trump said during an interview with Fox News. "You can say goodbye to that."
“I don’t know if it’s Goldman Sachs but you can wave goodbye to that.”
In other words, if Puerto Rico owes you money, you're not going to get that back. As a candidate, Donald Trump was lambasted for multiple instances of filing bankruptcy. Yet, of all politicians, he seems the most in touch with the vague morality of Keynes' adage. Money is lent with the expectation that it will be paid back, but there is risk involved. That risk is -- at least in theory -- represented by the rate of interest charged.
We all understand why credit cards have a high rate of interest while a home mortgage is very low. The former is unsecured; there is nothing backing it up and so it is a pretty high risk. Your home makes for pretty compelling collateral, at least during normal economic times, and is a much lower risk.
In his book Debt: The First 5,000 Years, David Graeber doesn't describe the morality of debt as vague but rather as confusing:
If one looks at the history of debt then, what one discovers is profound moral confusion. Its most obvious manifestation is that, most everywhere, one finds that the majority of human beings hold simultaneously that (1) paying back money one has borrowed is a simple matter of morality, and (2) anyone in the habit of lending money is evil.
This is why many can look at the unpayable debt that Puerto Rico has and believe that (1) it must be paid off, and (2) who are the loan-sharking, bottom-feeders who dared loan Puerto Rico that much money?
Interestingly, the answer to that second question is: you. As CNN Money recently reported in a piece titled "Who owns Puerto Rico's mountain of debt?":
In reality, most of that money is owed to everyday investors. Less than 25% of Puerto Rican debt is held by hedge funds, according to estimates by Cate Long, founder of research firm Puerto Rico Clearinghouse.
The rest of the debt is owned by individuals and mutual funds that are held by mom-and-pop investors.
"For the most part, Main Street America owns this debt," Long said. "It's not as though these are vultures circling around the island."
So what were you thinking, you loan-sharking, bottom feeder?
You probably didn't know that Puerto Rico owes you money or – more importantly now that you do – that you're losing part of your savings because of it. With the Federal Reserve driving interest rates so low in an effort to create economic growth, your pension fund or retirement account can't get a decent return with low or even medium risk investments. Not only AAA government bonds but even corporate bonds weren't paying much interest. The crisis is that, your pension fund – which is desperately insolvent – needs a fairly aggressive annual return just to keep its head above water. If you're funding your own retirement, you've likely been enticed into riskier plays as well.
In the business, this is called "chasing yield", the need to search for investments that pay some rate of return. When the Federal Reserve purchases every seemingly safe asset – from treasury bonds to home mortgages to quality commercial paper – it doesn't leave a lot of options left for everyone else. That means a lot of dollars competing for not enough investment opportunities. This drives down the cost of borrowing. Thus we find your pension fund falling all over itself to lend to a tragically bankrupt Puerto Rico just because they can get a 5% rate of interest.
There's something more here with the confusing morality of debt that is, perhaps, unique to the present time: the expectation of a rescue. That rescue can come in the form of an insurance payoff or, as many are advocating (and many are counting on), a government bailout. Will this happen?
Take the insurance payoff first. In the 2008 financial crisis, the largest bailout went to American International Group (AIG). Selling insurance is what got AIG in trouble. To simplify what happened, imagine an insurance company that sold policies for payout in the event of an apocalypse (go ahead and laugh, but what would you call a doomsday bunker if not that?) They collect regular fees for this insurance, a portion of which they pay out in executive compensation packages. One day the apocalypse happens, you go to collect your payout (or occupy your bunker) and discover, darn, things are so bad that the insurance company went out of business. Kinda hard to sort that one out in the middle of the apocalypse.
In the words of our favorite economist, Tomas Sedlacek, it's like having air bags that work perfectly all the time except for car crashes. Many of the investors in Puerto Rican debt have those loans insured against default. That meant they didn't worry about whether the loan would get paid back – who cares, I'm insured against loss – and the insurance companies were glad to sell the policies because, well, they get paid to sell insurance. And if they default, as AIG demonstrated, everything goes to hell and it's kinda hard to sort that one out.
If this all sounds crazy, understand that Illinois, a state that has been paying its bills in I.O.U's for years, a state whose debt is rated "junk", a state with perpetual budget crisis and no real hope of structurally resolving the situation, can still borrow money over long terms at less than 5% interest, so long as it is insured. I'm sorry, but that is insane. To look out a decade or more and have any faith in Illinois having the capacity to pay its debts is crazy. Yet, with the competition for your investment dollar so fierce, they need only pay you what AAA securities could have gotten a decade ago. That's nonsense.
This brings us to the other rescue option: a government bailout. It's interesting to me – in a Jonathan Haidt, The Righteous Mind, kind of way – how the notion of a bailout causes all kinds of consternation. For some, a bailout is a moral imperative; we have to free Puerto Rico of its debts (so that it can begin borrowing again) because people are suffering.
For others, it's a bailout of Wall Street and the worst kind of moral hazard. There is such emotion around this that, after President Trump made his statement on "wiping out" Puerto Rico's debt, White House Budget Director Mike Mulvaney had to "clarify" the president's statement with the following:
“We are not going to pay off those debts,” Mulvaney said. “We are not going to bail out those bond holders.”
That's interesting, only the president didn't say bail out. The president said wipe out. As in, eliminate. As in, the losses go to those who lent the money, not the taxpayer via the government.
As I said earlier, our favorite economist here at Strong Towns is Tomas Sedlacek. He speaks at length about interest rates and debt in a 2013 speech he gave in Berlin called "From Economics to Humanomics." I recommend listening to this entire talk (keep in mind that English is not his native language and, like many brilliant people, his mind sometimes wanders as he speaks, especially in a foreign tongue), but I've set the time stamp here to the discussion on interest rates.
Sedlacek states that, today, interest rates are a proxy for trust. Those we trust more have low interest rates while those we trust less have higher interest rates. Markets are supposed to use interest rates to reflect risk, yet with so many dollars chasing so few available investment opportunities, can we really say that? Sedlacek argues that we can't. If we could, the insolvency of Greece (and now Puerto Rico) would be business as usual, something long accounted for in the rate of interest. It wasn't accounted for because we can't do it.
That's because we're irrational humans, a fact economists find easier to ignore. In that speech, Sedlacek paraphrases Aristotle's warnings against using interest by saying that interest rates are too "spooky" to understand. That's not spooky as in ghosts and goblins; it's spooky as in the results will sneak up on us because we – even someone as wise as Aristotle – don't understand how to properly use them.
And if you disagree with that, if you think we humans are good at using interest rates to calculate risk, explain how Puerto Rico ran up $70 billion in debt at single digit rates of interest.
It should be hard for insolvent governments to take on more debt. The fact that it is not should be a huge indicator to everyone that this system is not working, that the feedback loops that are supposed to prevent disaster are broken. This should be terrifying, especially to economists. Instead, it's an affirmation. We're all confident in the future of America. It's kinda Orwellian.
I'm with the president on this one; I think Puerto Rico should be allowed to declare bankruptcy and its debt should be restructured in a way that is serviceable. They need to be given a chance. That being said, there needs to be strict limits on the accumulation of municipal debt. No city, state or territory should be able to obligate future generations in the ways they currently do. Either limits or, if we're going to trust the market to set interest rates, we need to give up on the notion that a centralized agency can properly calibrate rates for the entire economy.
The Strong Towns Strength Test, Question #10, gives a guideline for imposing your own local limit on debt: Does the city government spend no more than 10% of its locally-generated revenue on debt service? You need to be able to say "yes" to this or your city needs to take steps to reduce its financial fragility. There won't be a bailout.
(Top image from Wikimedia.)