Socio-Economic Environment of The Commonwealth of Puerto Rico: a Long-term View

A Long-term ViewOf the Socio-Economic Environment of The Commonwealth of Puerto Rico:Context for Planning and Decision Making

By

Elas R. Gutirrez, Ph.D.April 2008

TABLE OF CONTENTS 1 1.1 1.2 1.3 2 3 4 4.1 4.2 5 INTRODUCTION ............................................................................................ 1 The playing field as seen in August 2005 ....................................................1 Prevailing Trends .........................................................................................3 The current predicament ..............................................................................6 ALTERNATIVE FUTURES.............................................................................. 7 BUILDING SCENARIOS: A MANAGEMENT PLANNING TOOL .................... 7 THE MACROECONOMIC MODEL ................................................................. 8 The model structure .....................................................................................9 Productivity: the critical factor ....................................................................14

ALTERNATIVE SCENARIOS ....................................................................... 14 5.1.1 The Assumptions .................................................................................14 5.1.2 The Likely Long-term Response ..........................................................17 A Short-term View for the US Economy as seen in 2006...........................27 A Medium-term View for Puerto Ricos Economy ......................................27 Alternative Long-term Views for Puerto Ricos Economy ...........................28 SOME MARKET-SPECIFIC IMPLICATIONS................................................ 30 SPATIAL AND LAND USE IMPLICATIONS.................................................. 35 SYNTHESIS.................................................................................................. 35

5.2 5.3 5.4 6 7 8

APENDIX I .......................................................................................................... 40 FINAL DEMAND MODEL STRUCTURE ............................................................ 40 9 9.1 STRUCTURAL SPECIFICATION SYSTEM: XPLORAH_22 ......................... 41 Stochastic Equations .................................................................................41

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9.2

Identities.....................................................................................................42

APENDIX II ......................................................................................................... 44 ECONOMETRIC ESTIMATION RESULTS ......................................................... 44 10 STRUCTURAL COEFFICIENTS ................................................................ 45

APENDIX III ........................................................................................................ 94 ESTIMATES OF HOUSING UNITS BUILT WITHOUT PERMITS....................... 94 10.1.....................................................................................................................96 10.2.....................................................................................................................96

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LIST OF FIGURESFigure 1 Rate of Growth Real Gross Domestic Product Puerto Rico 1972 2006 ..4 Figure 2 Population Age Composition 1971 2005 and Forecasts 20025 ...........5 Figure 3 Financial Condition of Families 1996 - 2005 ...........................................6 Figure 4: Economic Cycles .................................................................................14 Figure 5: Rates of Change of Real Public Investment 1972-2007 and assumed 2008 - 2025..................................................................................................15

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LIST OF TABLESTable 1: Model Variables: Mnemonics and Descriptions ....................................12 Table 2 Endogenous Variables 2008 2025 Under Two Scenarios...................63 Table 3 Exogenous and Policy Variables 2008 - 2010........................................83 Table 4 Housing Units Built 1955 - 2004.............................................................95

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1 IntroductionThis paper describes in certain detail an econometric model designed to generate inputs within the Xplorah Spatial Decisions Support System. The paper also provides context to understand the current economic condition of Puerto Rico as a basis for planning and decision making at public and private organizations.1 The paper tackles the second objective in its initial sections. Then the paper goes into technical aspects that discuss specification and estimation of equations and structural coefficients.

1.1 The playing field as seen in August 2005The basic diagnosis on which the August 2005 report was based still stands. If anything, recent events have strengthened their validity. Thus, even running the risk of undue repetition, this report draws from the previous in certain sections to provide some background. The report then describes a long-term scenario deemed very likely given the current structure and predicaments of the economy and its social framework. As stated eighteen months ago, the economy of Puerto Rico is poised at a juncture that may very well prove to become a true turning point in its structure and long-term behavioral pattern. A number of events have come together to define a rare political context that, given the relative size and importance of the public sector in the economy of the Commonwealth and the limited diversity of the private productive structure, raises the likelihood of decisions and changes that may have lasting influence in economic psychology and behavior. The model that called for a social effort to raise the economy by its bootstraps through a strategy of industrialization financed by US capital, eventually gave rise to a mixed model of productive and dependent sectors. Puerto Ricos productive sector gained in relative size. High rates of growth took place, mainly in response to attractive stimulants to foreign investment and to the expansion of the US economy. However, even under rapid growth rates, the small starting base and the ever-evolving external circumstances, forced constant evolution and restructuring. In the meantime, the dependent sector grew in size and political power. Government substituted the private sector as the principal source of employment. Expediency and shortsightedness resulted in inefficient, ineffective, and unproductive structures that added little value to the economy, while consuming enormous amounts of very limited endogenously based resources. Federal transfer payments have become essential to minimum living standards and government operational feasibility. After decades of development along these lines and several crises, the limits of the dependency model have suddenly hit home with a key segment of the population, i.e., public sector employees. Decades of meager, and even negative, savings have dynamically worked to divest the island of the needed agility to adapt to changes brought about by globalization and the crumbling walls of protectionism. Obsolete fiscal policies have effectively discouraged savings through an inadequate tax system. This has resulted in stagnant private capital accumulation, inordinate growth of public sector expenditure and employment, and general loss of relative competitive advantages in attracting external productive capital. In short, Puerto Rico has lost much of its competitive capacity.A draft version of this paper was made available to Puerto Rico Planning Board personnel as part of training material in the Xplorah system implementation.1

The ingredients necessary to maintain the rates of growth of real per capita income required to sustain rapid growth of production-based living standards eroded. Not surprisingly, the political dynamics became a formidable obstacle to policy changes that would have helped in adapting to the changing times. Moreover, irresponsible partisan behavior dominated fiscal policy. The financial consequences have now come home to roost. The results of the November 2004 general elections brought an unexpected distribution of power. While the New Progressive Party (NPP) was able to attain majorities in the House of Representatives and Senate, the Popular Democratic Party (PDP) candidate for Governor prevailed with the support of a loose coalition of independent minded voters. The incoming executive found the fiscal house in disorder. Irresponsible creative accounting by past administrations, together with an eroding tax base, declining manufacturing employment, have resulted in a downgrading of Commonwealth credit rating by Standard & Poors and Moodys Investors Service. The credit evaluators eventually declared junk bond status for certain outstanding Commonwealth debt. The quality lose of Commonwealth risk has been the culminating episode of a process that accumulated a huge debt on flimsy legal grounds through the accumulation deficits. These deficits came about because of reliance on non-recurring revenues to cover recurrent expenditures. Anti-cyclical government intervention became the permanent modus operandi. To counter diminishing rates of growth of output, administrations have relied on government spending to supplement aggregate demand. Just like any addiction, the need for government expenditures grew exponentially. This dependence, combined with external shock and trends, that included unstable oil prices and intense foreign competition, have wrecked havoc on Puerto Ricos economy and government. Crises finally ensue and forced unavoidable cost-cutting measures. The political environment made the situation even worse. A divided government made management practically impossible. The resulting divided government has been unable to tackle the needed budgetary actions. The Governor vetoed the Joint Resolution containing the 2006 fiscal year budget sent by the NPP dominated legislature, after concluding that, contrary to the constitutional mandate, it was in deficit. The Governor submitted a package of revenue enhancing measures but they the legislature rejected them. The expenditure cutting measures include payroll reductions (without layoffs!). Not surprisingly, these have unleashed a choir of opposition from public sector labor organizations. Independently of is the result of the political battle that is now taking place, a structural imbalance between legislated expenditures and insufficient recurring revenues will force another crisis unless dealt with financially sound policies. Structural fiscal reform is a necessity more than a recommended approach. Public investment is on the balance whenever credit worthiness is questioned by the capital markets. And it has been. The political system acts however, more like a constraint than a facilitator on the needed policy changes. Thus, instead of the supply driven structure necessary to sustain real growth and to raise living standards for prolonged and sustainable periods into the future, a demand driven economy has taken root. A profound crisis appears to be the minimum required stimulus to break the vicious circle of the dependency model now in place. Not unlike the phenomenon seen in other jurisdictions, fueled by the liquidity stemming from government spending and illicit drugs transshipment and consumption, a dynamic

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and rapidly growing underground sector2 developed in Puerto Rico during the second half of the XX Century. The interrelated dynamics of these and other forces have sustained thriving import, distribution, wholesale and retail sectors. Cash flows are considerably more substantial than those one would expect from an economy devoid of a relatively large underground component. The above constitutes an incomplete sketch of salient features that characterize the current underlying network of socio-economic relationships in Puerto Rico. Both, public and corporate business long-term planning decision makers must be aware of them to assess risks adequately, even as opportunities are seized.

1.2 Prevailing TrendsThe Commonwealth has lost what were its comparative advantages during the period of industrialization. These included mostly free access to the US market, tax exemption for US corporations with operations in the island and relatively low wages. Low wage rates ceased to be an advantage due to the application of federal minima. Several oil refineries and a petrochemical downstream complex of manufacturing industries located on the island during the 1960s, benefiting from a US oil import quota granted to Puerto Rico for importation of foreign sourced petroleum. The price differential under which importing firms were able to compete was obliterated during the 1970s by suddenly increased imported oil prices. After the politically motivated oil shock, the important petrochemical industrial complex developed in Puerto Rico collapsed. The economy of the island has never fully recuperated from the restructuring experienced during the 1970s. The seriousness of the damage is reflected in the real growth performance since experienced. See Figure 1 below.

The underground economy, as a concept, includes activities that have the ultimate objective of simply avoiding taxes, but are otherwise legitimate. Tax avoidance, however, may be unlawful. Underground activities may also include those carried out by illegal aliens and otherwise legitimate activities organized with the purpose of money laundering. The wide interpretation of the term would also include criminal activities. On this category, the most salient are those linked to illegal drug importation, distribution, wholesale, retail and/or re-export to other markets, e.g., US and Europe. Activities closely linked to this segment of the criminal underground include the illegal importation, distribution and sale of arms. The abominable trade in human beings is also present in this geographic area. However, these activities are also found in other jurisdictions of the US, and should not to be identified as emblematic to Puerto Rico. The relative size of government and underground sectors of this economy, in contrast to the legitimate private sectors of commerce and production, constitute a social and economic problem that have not been adequately addressed and continues to grow.

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Figure 1 Rate of Growth Real Gross Domestic Product Puerto Rico 1972 2006Gross Domestic Product at constant 1954 prices per employee (% ch. a.r.) (Actual)10 8 6 4 2 0 -2 -4 1980 1990 2000 2010 2020

After the crisis of the 1970s, manufacturing regained strength. This was achieved in 1976 through revised US tax code. The revisions provided incentives granted by the US Congress to what were known as possession corporations. These tax incentives have now been terminated with disastrous effects. Starting in January 2006, the Commonwealth lacks for the first time federal stimulants for manufacturing investments in the island. This development accounts for the loss of more than 25,000 jobs since it became evident during the 1990s that the special tax treatment would be lost. Access to the US market has been obtained by other jurisdictions as a result of treaties such as NAFTA and the global general crumbling down of trade walls. High rates of growth are no longer typical of the Puerto Rican economy. In fact, growth has become a difficult goal to achieve. The productive sectors of the economy have retreated and in their place government (and underground activities) has had to step in to fill the gap. As a result, the economys center of gravity has shifted from production to consumption; from supply to demand. Even in spite of spectacular progress in per capita incomes and the development of a middle class, dependency indexes are worrisome. Insufficient capital accumulation and demographic realities constitute what has been a formidable obstacle. Participation rates are below 50 percent of the working age population; age-dependency ratios are increasing rapidly under the pressure of an aging population; family structure has changed dramatically as single mothers account for more than 50 percent of live births; approximately 50 percent of the resident population lies below federal poverty line standards. From the point of view of productive capacity and sustainable living standards, the most worrying trend is the age composition of the resident population of the island. Official projections forecasts that the juvenile dependent population (14 and under) will equal in number the working age population. The geriatric dependent cohorts (65 and over) will approach 1/5 of the total resident population by year 2025. Together, the juvenile and geriatric dependent cohorts will account for 37 percent of the population in 2025 if present net migration trends hold. If emigration of the population in working age brackets accelerates, the dependency rates would surely increase unless the pattern of emigration tilts toward complete families. In that case, the growth of the total population resident in the island will experience a stoppage. A zero growth condition would, in turn, generate an accelerated aging process. Figure 2 illustrates the numbers for these groups for the historical period 1970 2000, as well as the projected levels for 2000 2025.

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Figure 2 Population Age Composition 1971 2005 and Forecasts 200253000 2500 2000 1500 1000 500 0 75 80 85 90 95 00 05 10 15 20 25 3000 2500 2000 1500 1000 500 0

In thousands

Population 14 and less Populaton 15 through 64 Populaltion 65 and older

As the private productive sectors have lost the capacity to create and sustain jobs at the required level and rates, the public sector has taken the slack upon its back. Public expenditures in infrastructure, purchases of goods and services, and the employment of a close to a third of the labor force, have produced a gigantic dependence on government. Populist postures assumed by politicians of all parties, compounded by growth unions in the public sector stimulated by politicians with strictly electoral goals-have combined to generate rigidities and serious management difficulties. Reliance on non-recurrent revenues, disguised deficit spending and excessive public debt at central and municipal governments, as well as by public corporations, has undermined the credit position of several public corporations and most recently of the Commonwealth government. Reliance on, and abuse of, the Government Development Bank for shortterm financing exhausted its capital base. In spite of these troubling signs, aggregate demand, in its macroeconomic meaning, remains strong. Federal transfer payments constitute a formidable component of disposable personal income sustaining personal consumption expenditures. Historically low interest rates and substantial subsidies in multiple forms, have kept the demand side of the housing market at very high levels. This is evidenced by prices and turnover time of new or existing units. Reflecting the inadequacies of public transportation, the automobile and other motor vehicles market remains strong in spite of hefty excise taxes, high and increasing gasoline prices, and lackluster employment levels. It remains to be seen whether this strength is sustainable in the future. The intensity of the current recession is being felt in these two markets. The real estate market has shown clear signs of slowing down and, at the moment, is behaving as a buyers market. Anecdotal evidence and industry indicators point to longer absorption periods for sales and rentals. This is already influencing the rate of growth of prices. The automobile market has shown dramatic contraction in sales when compared to the previous two year period. Other signals of trouble are also evident. These include repossessions due to underperforming auto loans and delinquency rates. The record sales of the previous two years are sometimes brought up as partial explanation of the current contraction. However, when seen in a wider context and in conjunction with other indicators, one must conclude that the market is just reflecting a deep, long and wide contraction. A contraction that is not necessarily cyclical. At any rate, what is certain is that structural reforms are needed to change the existing dependency model and provide for growth at

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sufficient rates.

1.3 The current predicamentThe economy of Puerto Rico is highly leveraged. This is especially true for the government sector. Figure 3 illustrates the trajectory of three per capita indicators, i.e., consumer debt (Dc/P), public debt (D/P), and family financial assets (KFc/P). (Mortgage debt is not included.)Figure 3: Financial Condition of Families 1996 - 2005Per Capita Consumer, Public Debt and Family Financial Assets16,000

14,000

12,000

Million Dollars

10,000

8,000

6,000

4,000

2,000 1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

End of Fiscal Year Dc/P D/P KFc/P

A stern warning from Moodys Investor Services and from Standard & Poors credit rating agencies that further downgrading of the Commonwealths debt would be inevitable if fiscal discipline is not attained. This situation has tipped the balance of forces. In 2005, Governor Acevedo submitted to the Legislature a General Fund expenditures budget, explicitly exposing long disguised structural imbalances and complemented by short-term revenue raising measures. The House of Representatives refused to approve the budget resolution. Therefore, by constitutional provision, the budget approved by the previous Legislature remained in place. That budget was already deep in deficit. In 2006, the Governor submitted a new budget for legislative consideration. A fiscal reform package contemplating the implementation of a broad based consumption tax finally became unavoidable. A consumption tax was part of a comprehensive restructuring of the tax system recommended by a commission named by the Governor. The commission had been charged with the mission of proposing a new approach that would widen the tax base and provide relief to the salaried working class from the current asphyxiating tax system. The system is now generally perceived by taxpayers as unjust, inefficient and biased. The opposition controlled legislature declared the initiative dead on arrival. The revenue raising measures were rejected outright and a questionable expenditure resolution was voted by the majority. The budget resolution approved by the legislature exceeded the Treasury certified forecasted revenue estimate. The Governor vetoed the Joint Budget Resolution.3By constitutional mandate the ending fiscal years budget is automatically enacted in this eventuality. However, when confronted with actual revenues as of June 30 of each fiscal year, the current budget is in undisputable deficit. Thus, the Governor ordered expenditure cuts and a3

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2 Alternative FuturesHistory will eventually consist of what today is one of many possible futures. This is the basis of the reality of uncertainty. Exploring the future is a matter of discovering what is possible. Further, it implies identifying and assessing the likelihood of the possible. Imagination and knowledge of current structures provide the basis of such exploratory endeavor. Models are useful as instruments with which to explore how sensitive the systems they emulate are to assumptions regarding the behavior of exogenous variables. Exogenous variables are not determined within the model. Rather, they are determined by policy decisions or by forces not explained within the model. Variables whose values respond to policy decisions include: short term interest rates, government expenditures and investments, commodity prices subject to manipulation by cartels, growth paths of other countries economies, and many others. Several long-term scenarios have been defined and explored with a macroeconomic model. The scenarios differ in terms of the exogenous variables vector used. Certain variables are chosen to follow specific trajectories into the future for each scenario. The last year for which all necessary actual data are available in Puerto Rico is fiscal year 2005. Starting in 2006, the time horizon for these long-term scenarios projects to fiscal year 2025. This is a very long period. In fact, it is likely that during that spans of time the economy of Puerto Rico will experience structural changes. The model, however, assumes that the structure will remain stable. This is an important limitation that must be kept in mind as the outputs obtained from the model are analyzed and evaluated.

3 Building Scenarios: a management planning toolWhen trends are subject to external forces or to influences that infringe on the normal market dynamics, scenario building becomes a very useful tool for management. This is particularly true under conditions of ensuing structural change. Under such conditions, trends lose much of their value as past relationships readjust to the emerging structure. A couple of scenarios were drawn in our 2005 report to frame circumstances developing at that time within the likely bounds of possibilities. In our August 2005, this author explored a number of alternative scenarios. Among them, two medium-term scenarios were drawn.4 Scenario #1: Given the political realities, trends, resistance forces, and predictable conditions, a likely scenario in the medium term would include the following elements. The executive and the legislative branches come to an agreement that avoids layoffs and reduced workweek. The agreement includes symbolic expenditure cuts and several revenueenhancing measures. Among these, a special tax on financial institutions and an upward shift in reduced work week and salary cuts (initially on voluntary basis) in order to avoid actual layoffs. The political impasse brought about by a divided government congealed into a financial fiscal crisis. The sudden perception that government job security may be a thing of the past stirred a hornets nest. All interested parties cried foul. All were in favor of taxing someone else. No one was willing to step forth and volunteer any sacrifice. Trust is now a very scarce commodity in the island, while cynicism abounds. The present tens is used to place the reader in the future point in time when events have taken place and driven the economy to the described state of affairs in each scenario.4

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the rate on capital gains. The intention of considering a tax reform effort is jointly announced with the rating agencies attention as principal target. The real goal would be to gain time. Underground activities expand moderately. Scenario #2: The executive and the legislative branches are unable to come to an agreement and public employee layoffs take place. Wide-ranging protests are organized by labor unions. Legislative initiatives are bogged down. The possibility of considering a tax reform effort is scuttled and the Commonwealth credit rating is downgraded in December. Several municipal governments declare technical bankruptcy. The economy of the island goes into recession as total employment drops, construction activity slows down and sales only keep up with inflation. Underground activities expand rapidly. Eventually a combination of both scenarios actually took place.

The unsustainable fiscal equations now in place will have be the subject of major changes in the future. Present conditions are simply not sustainable. If, in spite of what fiscal responsibility demands, the conditions prevail, living standards would decline, emigration of the significant numbers of productive elements of the social structure will occur and the island would accelerate towards conditions typical of inner cities, as they are abandoned by the middle class and become concentrations of the disadvantaged left behind. Puerto Rico has lived through this in the past. One would hope that the dynamics of social change would provide enough energy to avoid this scenario. The political and partisan struggles have forced a distorted perception on island residents of what the long-term means. Long-term has come to be conveniently understood by some as a time beyond the next general elections. Of course, that is just foolhardiness. Thus, in exploring the future, one would raise the likelihood of action needed today to avoid the previously sketched long-term deterioration. Included in the necessary set of policy decisions would be a new tax structure. The new tax structure must include a general consumption tax, in the form of a value added tax (VAT), complementing a significantly reduced marginal income tax rate structure. Abandonment of the 6.6 percent general excise tax on imported consumption goods is a very likely event. This has, in fact, already began to take place with the approval of a sales tax and derogation of the excise tax. Less likely, but even more important, would be a realignment of valuation of real assets for tax purposes. This is a political taboo. However, it is inevitable in a longer-term horizon. The key unknown still remains, i.e., how can the island restructure its economy from a consumption driven to production driven system? If this restructuring is not achieved, real growth rates will remain close to those barely required by population growth and price inflation. In real terms, though, growth and living standards would remain lacking.

4 The Macroeconomic ModelAn econometric model with simulation capabilities has been applied as an instrument to

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help explore future long-term scenarios for the Puerto Rican economy.5 The public sector is directly or indirectly the largest employer and spender. Through decades of continued fiscal intervention seeking to stimulate aggregate demand and to absorb surplus labor, the economic structure has become excessively dependent on policy decisions and political priorities. Such a system is extremely difficult to model. The time series of macroeconomic and sector data tend to behave contrary to expectations drawn from economic theory. Moreover, the quality of macroeconomic and sector data has deteriorated. Therefore, specification difficulties are compounded by errors in variables that become impossible to cure. Some of the specification difficulties stem from the new composition and nature of production. Growths of the services sector, together with the development of symbolic activities that produce intangible products, make the measurement of production an increasingly difficult task. The new nature of production also stems from the way that production activities are organized. In the new era, decentralization of production and globalization of markets permits these activities to be overlooked by the government statisticians charged with the responsibility of monitoring them. Even counting heads has become a difficult and costly endeavor. Thus, population figures are now characterized by larger measurement error. Undercounting is now accepted in light of legal and illegal immigration. To complicate matters even more, in recent decades the informal sector of the economy has grown substantially. This fact generates yet another difficulty. By definition, this sector of the economy and the activities and transactions that take place are difficult to detect and record. Even when accounted for, underground activity measurements tend to be partial and biased. Thus, the quality of macroeconomic and sector series become even more suspect. Paradoxically, new and powerful computational, and model estimation capabilities, are increasingly restricted by lack of basic reliable data.

4.1 The model structurePuerto Ricos economy is extremely open and intensely intervened by government. Modeling such a system is a daunting task. Moreover, the quality of data has deteriorated steadily since the 1960s. The limitations of this analytical instrument have to be placed on the table from the start. The main function of the macroeconomic model used here is to forecast the vector of final demand. Final demand includes all components of consumption expenditures, investment, exports and imports. Thus, it excludes intermediate demand, i.e., that part of total production that is used by the economy to produce other products and services. The model forecasts GDP produced, and employment levels sustained, in five sectors of the economy, i.e., agriculture, manufacturing, services, construction and government. The model forecasts important variables determining land-use pressures. Thus, key variables of the housing market are explicitly dealt with within the models structure. The model forecasts new housing units built by the private and public sector. The dynamics of the housing market are incorporated through a stock-flow equation that determines5

The Final Demand macroeconomic model applied here has been designed to generate scenarios for the Spatial Decisions Support System (SDSS) known by the acronym Xplorah. The version used is a modification of the model specified and estimated as version System: Xplorah_22. System: Xplorah_22 generates a model in the EViews nomenclature Xplorah_Model_23.

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the housing stock. The diagram that follows indicates the relationship between the macroeconomic and input-output models incorporated in the Xplorah system. The arrows connect model modules indicating the direction of dependence between variables.

Chart 1: Xplorahs Economic Subsystem Interface

The model reacts to the influence of externally generated forces. This is achieved through a set of key variables. These variables permit limited simulation of external conditions such as US monetary and fiscal policies. For instance, short/term interest and mortgage rates and US federal transfer payments. Other key variables are the price of oil, the intensity and fluctuations of manufacturing activity and the real rate of growth of the US economy. Population and housing receive a special treatment due to their importance to land uses and special demand. Housing demand and supply are endogenous to the system. The version of the model discussed in this paper also treats population as endogenous, via an equation. Xplorah determines population through a separate model. Demographic change is a critical dimension determining the size and quality of the labor force, the composition of personal consumption expenditures, the savings potential, the demand for social services and numerous other key factors. That is precisely the reason that this model yields its more fruitful insights when integrated into the Xplorah EDSS. Table 1 lists all variables included in the New Model and the equation number for each endogenous variable. The model has 38 equations. Of this total, 26 are stochastic equations while the rest are identities. All equations are listed in the Appendix I. The

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structural coefficients are obtained through application of the method of weighted ThreeStage Least Squares (W3LS). The estimated coefficients, standard errors of estimate, calculated values for the t statistic, and probability that the calculated values are due to sheer chance appear listed in Table 2, Appendix II.

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Table 1: Model Variables: Mnemonics and DescriptionsIMPORR CNDR EXPORR POP CSR YDISPR CDR IFIXCPRR IFIXPLEPRR PRODUCTIVITY WEALTH_FAM FAMILIES IPDCONS NUVIVPRI GDP_AG GDP_SERV GDP_GOV GDP_MAN GDP_CONST EMP_AG EMP_CONST EMP_SERV EMP_MAN NFP CER CER_TOTAL IFIXCR IFIXPLER IR Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Endog Eq1 Eq2 Eq3 Eq4 Eq5 Eq6 Eq7 Eq8 Eq9 Eq10 Eq11 Eq12 Eq13 Eq14 Eq15 Eq16 Eq17 Eq18 Eq19 Eq20 Eq21 Eq22 Eq23 Eq24 Eq25 Eq26 Eq27 Eq28 Eq29 Real Imports deflated by imporindex_92 Real Consumption Expenditures Non-durables Real Exports deflated by Imporindex_92 Population Real Consumption Expenditures Services Real Disposable Personal Income Real Consumption Expenditures Durables Real Fixed Private Investment Real Fixed Private Investment Machinery Equipment Millions of GDP in 1992 prices per 1000 non-government employee Perceived Value of Families Wealth Number of Families Implicit Deflator Construction (1992=100) Number of New Private Housing Units Unadjusted for Unaccounted Gross Domestic Product Agriculture Gross Domestic Product Services Gross Domestic Product Government Gross Domestic Product Manufacturing Gross Domestic Product Construction and Mining Employment in Agriculture Employment in Construction Employment in Services Employment in Manufacturing Net Factor Payments to Foreing Residents Real Personal Consumption Expenditures deflated by imporindex_92 Real Personal plus Government Consumption Expenditures Real Fixed Domestic Investment Construction Real Fixed Domestic Investment Plant and Equipment Gross Domestic Investment, total

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IFIXR IFIXGR GDPR GNPR AGGREGATE_DEMAND EMPLOYMENT POP_ACTIVE SHARE_GOV_AD HOUSING_STOCK CGR D936 DEY DH EMP_GOV FRMCPR IFIXGR_C IFIXGR_M IMPORINDX_92 IPRCHIR MAN_US_CAP_UTIL_INDX MORTG_30 NUVIV_UNACCOUNTED NUVIVPU P_PER_FAM PP_VENEZUELA RGGDPUSR TIME UNDERGROUND_INDEX USTRPR

Endog Endog Endog Endog Endog Endog Endog Endog Endog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog

Eq30 Eq31 Eq32 Eq33 Eq34 Eq35 Eq36 Eq37 Eq38 Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog Exog

Real Fixed Domestic Investment Real Fixed Public Investment Real Gross Domestic Product deflated by imporindx_92 Real Gross National Product in 1992 prices deflated by imporindex_92 Real Aggregate Demand in Constant Prices 1992 Import Prices Total Employment (in thousands) Proportion of Total Population Employed Proportion of Government to Non-Government Aggregate Demand Housing Stock Consistent With Decenial Census Data Government Consumption Expenditures in 1992 Prices Dummy Accounting for the Demise of 936 Election Year Dummy Hurricane Year Dummy Employment in Government Prime Rate Real Fixed Public Investment Construction Government Real Fixed Public Investment Machinery and Equipment Government Price Index to Deflate Sector GDP 1992=100 Real Changes in Inventories Deflated by imporindex_92 Manufacturing Capacity Utilization Index US Year Averages Conventional 30 Years Mortgage Rate Housing Units Built Unaccounted Number of New Public Housing Units Number of Persons per Family Venezuela Ta Juana Light Real Rate of Growth of US GDP Year 1955=1 An Index of Underground Economic Activity Real Transfer Payments from US Government deflated by imporindx_92

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4.2 Productivity: the critical factorProductivity is dependent on capital, technology and population characteristics, education and skills. Productivity is also dependent on social organization and values. Higher standards of living, measured by real disposable income per capita, are dependent on productivity. Advances in productivity require savings (internal or external), investment, and capital accumulation. But they also require a qualitative contribution. Population qualities determine labor skills and management prowess. Together, these factors determine productivity growth rates. A crude measure of productivity can be obtained using real gross domestic product per employee. With two exceptions in fiscal years 1975-76 and 2000-01, since 1971 the economy of Puerto Rico has failed to exhibit real rates of growth of productivity in any year above 4.5% per year. Moreover, during this historical period, average productive growth has been below 2% per year and in 6 occasions, it has shown negative rates. This is clearly shown in Figure 4.

Figure 4: Economic CyclesGross Domestic Product at constant 1954 prices per employee (year % ch.) (Actual)10 8 6 4 2 0 -2 -4 1975 1980 1985 1990 1995 2000 2005

Thus, productivity constitutes a critical target for development policies. A scenario that explores the effects of a significant investment stimulus has been designed and tested with the Xplorah Final Demand model. This scenario explores the long-term effects of a sustained investment effort carried out by the public sector. This public investment push effort is simulated by assuming certain sustained rates of growth for the government components of fixed real investment expenditures in machinery and equipment, and fix investment in construction.

5 Alternative ScenariosAfter examining several options, two scenarios were chosen. Suggestive names were given to these scenarios: Accelerated Public Investment and Moderate Inflation Stagnant Public Investment and High Inflation

5.1.1 The AssumptionsThe Accelerated Public Investment scenario relies on a sustained rate of growth of real government investment in construction, starting in 2007 and sustaining itself until 2025,

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of 12 percent per year above the rate of inflation. The assumption is that a policy decision to improve and expand infrastructure is implemented. Inflation is accounted by the IMPORINDX_92 variable at a rate of 2 percent per year. The Stagnant Public Investment scenario relies on a stagnant level of real government investment in construction for the duration of the simulation period. Inflation was assumed to sustain at a rate of 7 percent per year.

Figure 5: Rates of Change of Real Public Investment 1972-2007 and assumed 2008 - 2025Real Fixed Public Investment (% ch. a.r.)50 40 30 20 10 0 -10 -20 -30 75 80 85 90 95 00 05 10 15 20 25

Actual Accelerated Public Investment & Moderate Inflation Stagnant Public Investment & High Inflation

Government employment stays constant at a level of 333,000. Government real expenditures grow at a rate of 1 percent per year (1 percentage point over inflation). The growth rate pattern of government investment in machinery and equipment fluctuates mimicking recent past cycles. These fluctuations are assumed to be associated with programmed replacement and other cyclical imperatives. The economy of Puerto Rico is eventually absorbs loss of federal industrial tax incentives, i.e., section 936 of the US Tax Code. This assumption is reflected the binary variable D936. However heroic the assumption may be, for purposes of this analysis, it is assumed that a political solution is reached between the two dominant political parties in Puerto Rico that once again enables the Commonwealth government to sustain a long-term effort to lift the economy from its present low savings, low investment, and slow productivity growth condition. The goal of the exercise is to gain a rough idea what would be the

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minimum sustained long-term public effort required, given that current rigidities persist. The scenario assumes that the government sector is able to control consumption expenditures and to redirect its priorities towards capital accumulation. It was further assumed that the public sector financial capacity improved in quality and increased in magnitude. This is achieved by a strategy consisting of two basic components: instituting a Value Added Tax ear-marked to finance the investment push and a wide ranging revision of tariff structures for utilities based on marginal cost pricing. The effort is assumed to be sustained for the length of the planning horizon. The likely results of these assumptions are explored by simulating them with the macroeconomic model. The model responds to values and trajectories for a set of four exogenous variables that reflecting the assumed conditions. These are: Once a set of parameters is estimated with data spanning the historical period, the model is solved for a longer period that includes the future. These solutions provide results that depend on the assumptions regarding exogenous variables and policy instruments. Solutions obtained this way make up alternative futures or scenario consistent with the structure of the model. A Base Line scenario acts as a benchmark. The simulations assume that the loss of federal incentives to possession US corporations operating in Puerto Rico is slowly absorbed. As this takes place, the economy adapts and the damaging effects from the loss of these incentives are dissipated. These assumptions are introduced through the dummy variable D936. An assumption regards the behavior of a variable that is key to Puerto Ricos economy due to its reliance on oil to meet energy demand. Thus, the price of oil is a critical exogenous factor. Venezuelas Tia Juana light petroleum price is used as a proxy for oil prices within the model. It is reasonable to assumed that the price of oil will approximate forecasted US refiners acquisition costs in the short to medium terms. On the other hand, In the long-run, it is a matter of speculation and/or geo-political analysis. Exogenous variables subject to change by external action are known as policy instruments Together, these variables define a scenario. Tables 4 and 5, included in the Appendix, compare two alternative scenarios. Table 4 lists endogenous variable values during the simulated period. Table 4 lists and compares values introduced for endogenous variables. Table 5 lists and compares values assumed for exogenous variables or policy instruments. Figure 3 illustrates the behavior of four instruments of government intervention in the economy. The charts included in the group that appears as Figure 5 show the historical and assumed future annual percentage change in: 1) short term interest rates (influenced by the US Federal Reserve monetary policy); 2) real Commonwealth government consumption expenditures; 3) fixed Commonwealth investment in construction; and 4) real Commonwealth investment in machinery and equipment. The projected paths of key policy instruments exogenous to the system, are depicted in Figure 6. The trajectories projected into the future define two scenarios: 1) Stagnant Public Investment & High Inflation; and 2) Accelerated Public Investment & Moderate Inflation.

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Figure 6: Time Paths for Key Exogenous and Policy VariablesGovernment Consumption Expenditures in 1992 Prices 9000 8000 7000 6000 5000 4000 3000 2000 75 14000 12000 10000 8000 6000 4000 2000 0 75 80 85 90 95 00 05 10 15 20 25 80 85 90 95 00 05 10 15 20 25 Real Fixed Public Investment Construction Government 4 0 75 80 85 90 95 00 05 10 15 20 25 Real Fixed Public Investment Machinery and Equipment Government 400 350 300 250 200 150 100 50 75 80 85 90 95 00 05 10 15 20 25 12 8 20 16 Prime Rate

Price Index to Deflate Sector GDP 1992=100 600 500 400 300 200 40 100 0 75 80 85 90 95 00 05 10 15 20 25 20 0 75 80 140 120 100 80 60

Venezuelan Tia Juana Light

85

90

95

00

05

10

15

20

25

The graph illustrates the paths of two important instruments: real fixed investment in construction and in machinery and equipment, undertaken by government agencies. The scenario simulates that Commonwealth government is able to finance a sustained push of capital accumulation, mainly in new and replacement infrastructure that will call for a sustained annual growth in real investment in machinery and equipment. A comparison is shown with the trajectory assumed by the alternative scenario. Alternative future behavior of oil prices are introduced through the future trajectory of Valenzuelas Tia Juana Light, the proxy variable. The path assumed for oil prices is also illustrated in the set of charts. The historical series runs from fiscal year 1971 to 2005. The simulated path starts in fiscal year 2006 and ends in 2025.

5.1.2 The Likely Long-term Response

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The following set of graphs illustrates the likely behavior of selected key endogenous variables responding to conditions under the two scenarios being explored. All graphs follow the same format. Actual observed values are depicted in blue dots while colored lines depict the projected paths of endogenous variables. The shaded areas depict the forecasted period 2006 2025. Note that a simulated investment effort by the Commonwealth, of 10% per year in real investment in machinery and equipment and 7% in construction, takes a relatively long period to reflect itself in increasing levels of real fixed investment. The income side of the economy keeps expanding under the influence of sources uncoupled from production activities, i.e., transfer payments, government employment and underground activities. A turning point in real fixed investment levels lags for at least 5 years into the future to take hold. Moreover, this pick up takes place with the help of an undefined process of structural adaptation to the demise of federal incentives to manufacturing. Thus, the model is a warning for policy makers. It appears that the economy of Puerto Rico faces rigid constraints. Growth potential in the short and medium terms is quite modest. Consumption components of aggregate demand, however, continue to grow, probably sustained by transfer payment flows and other underground activities. Population growth continues to decelerate. This deceleration helps to keep growth of per capita welfare indicators positive. However, this deceleration responds to an aging process that affects savings potential and productive capacity. Even when the new units built have been adjusted to account for those built without permits, the housing stock equation consistently yields figures above the official estimate of registered houses. This is observed since the beginning of the decade of the 1980s. The models results are indicative of the possibility that not only the annual additions to, but the housing stock itself, are indeed underestimated by official data.6 The housing equation tends to overestimate the units built during the historical period. This is especially true during the era of very high interest rates, stagnation, and inflation of the 1980s. The model apparently detects that a substantial number of houses are being built without permits. In fact, the model seems to be estimating the demand for housing, not the supply. Distinguishing from demand and supply has been a classic problem for econometricians. Demand is an ex-ante concept while supply is an ex-post result in the market. Thus, it is easier to measure supply than demand. In fact, the only time demand is actually measure is when the markets are in equilibrium and ex-post supply is equal to demand. Construction activities taking place under single plots schemes in non-urban areas without permits, and even illegally, make forecasting the housing stock a difficult task indeed. Adjustments for those particulars must relay on decennial census figures. Figure 14 includes such adjustments. Both scenarios are consistent with assumptions regardingExplicit inclusion of units built without permits has proved tricky in previous versions of the model. This is due to the fact that this construction can only be estimated for the inter-census years. That generates a step function that does not work too well or an interpolated smoothed series that introduces a lot of error into the system. I have also corrected the accounting stock equation to include public housing built by government. Although activity that has diminished over the years, in favor of private built units.6

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interest rates, oil prices, government intervention and family structure. The results that follow illustrate the assumed trajectories of key policy variables for the housing market, i. e., short and long-term interest rates. As previously stated, these were used to define the working scenarios. Ultimately, the performance of the economy and the effectiveness of economic policy are evaluated by the level of employment attained. The set of graphs included here in lustrates the performance of GDP generated and employment sustained distributed by sector. The set illustrates expected yearly behavior of sector GDP and employment levels, consistent with current technology, and with conditions set for the two compared scenarios.

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Figure 7: Real Aggregate DemandReal Aggregate Demand in Constant Prices 1992 Import Prices 240000 200000 160000 120000 80000 40000 0 75 80 85 90 95 00 05 10 15 20 25

Actuals Accelerated Public Investment & Moderate Inflation Stagnant Public Investment & High Inflation

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Figure 8: EmploymentTotal Employment (in thousands) 1600 1400 1200 1000 800 600 75 80 85 90 95 00 05 10 15 20 25


Figure 9: Employment in ManufacturingEmployment in Manufacturing 180 170 160 150 140 130 75 80 85 90 95 00 05 10 15 20 25


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Figure 10: Employment in ServicesEmployment in Services 1100 1000 900 800 700 600 500 400 300 75 80 85 90 95 00 05 10 15 20 25


Figure 11: Employment in ConstructionEmployment in Construction 90 80 70 60 50 40 30 75 80 85 90 95 00 05 10 15 20 25


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Figure 12: Employment in AgricultureEmployment in Agriculture 70 60 50 40 30 20 10 75 80 85 90 95 00 05 10 15 20 25


Figure 13: New Housing Units Built by Private SectorNumber of New Private Housing Units Unadjusted for Unaccounted 40000 35000 30000 25000 20000 15000 10000 5000 0 75 80 85 90 95 00 05 10 15 20 25


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Figure 14: Housing StockHousing Stock Consistent With Decenial Census Data 2400000 2000000 1600000 1200000 800000 400000 75 80 85 90 95 00 05 10 15 20 25


Figure 15 Active PopulationProportion of Total Population Employed .32 .31 .30 .29 .28 .27 .26 .25 .24 .23 75 80 85 90 95 00 05 10 15 20 25 Actuals Accelerated Public Investment & Moderate Inflation Stagnant Public Investment & High Inflation

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Figure 17 ProductivityMillions of GDP in 1992 prices per 1000 non-government employee 140 120 100 80 60 40 20 75 80 85 90 95 00 05 10 15 20 25


Figure 18: Proportion of Government to Private Aggregate DemandProportion of Government to Non-Government Aggregate Demand .30 .25 .20 .15 .10 .05 .00 75 80 85 90 95 00 05 10 15 20 25


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Figure 18: GDP for Five SectorsGross Domestic Product Agriculture 1200 1000 800 600 Gross Domestic Product Construction and Mining 400 200 0 75 80 85 90 95 00 05 10 15 20 2512000 8000 4000 0 75 80 85 90 95 00 05 10 15 20 25 20000 16000 80000 40000 0 75 80 85 90 95 00 05 10 15 20 25 240000 200000 160000 120000 Gross Domestic Product Serv ices

Actuals Accelerated Public Inv estment & Moderate Inf lation Stagnant Public Inv estment & High Inf lation Gross Domestic Product Gov ernment 50000 250000 40000 200000 30000 150000 20000 100000 10000 50000 0 75 80 85 90 95 00 05 10 15 20 25 0 75 80 85 90 95 00 05 10 15 20 25 Gross Domestic Product Manuf acturing

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5.2 A Short-term View for the US Economy as seen in 2006A synopsis of expectations obtained from the Fair-Parke econometric model for the US economy provides a short-term view of external forces influencing Puerto Ricos economy. Real Growth and the Unemployment Rate: The predicted growth rates for the next four quarters are 3.2, 2.9, 2.6, and 2.6 percent, respectively. The unemployment rate stays roughly unchanged throughout the forecast period. The jobs are expected to increase during the years four quarters by 1.9, 2.2, 2.2, and 2.0 percent, respectively. Inflation: Inflation as measured by the growth of the GDP deflator (GDPD) is predicted for the next four quarters to be 4.4, 4.2, 4.1, and 4.0 percent, respectively. These predicted values are considerably higher than the actual values in the past few years and probably higher than most others are predicting. If the Fair-Parke model is right, inflation is going to be a problem in the next year. It is the case, however, that the model has been over stating inflation expectations for the past few quarters, and the current forecast may be another example of this. Monetary Policy: The estimated model is predicting that the three months bill rate will rise to 5.3 percent by the end of 2007. Other Variables: The federal government budget deficit was predicted to be around $100 billion in the next four quarters. By the end of 2009, it was predicted to be only $81.0 billion. The U.S. current account deficit was forecast to be around $760 billion in the next four quarters, which is very large by historical standards. It falls to $662.0 billion by the end of 2009.

5.3 A Medium-term View for Puerto Ricos EconomyThe above-mentioned indicators of the US economy reflect important exogenous underlying forces that exert intense influence in the hemisphere and, indeed, in the world. In past decades, they would be seen as good news for the local economy. Although, a lag of several months was observable, higher rates of growth on the mainland translated eventually on stimuli of the local economy. However, the growth rate of the island economy has uncoupled from its historical synchronization with the US average. Real GNP contracted at a rate of -1.8 percent during fiscal 2006. Forecasted real GNP is expected to contract again this fiscal year. This trend reflects the changes in manufacturing, the slowdown in the real estate market, and increasing difficulty for the Commonwealth to expand private sector investment through anti-cyclical expansionary policies. Increasingly, the roots and the underlying logic of the current predicament, as well as the long-term trends that set conditions in the short-term, are political in essence. Thus, the medium-term must be defined in terms of the electoral cycle. The next three and a half years promise to be a period of turbulence. Badly needed initiatives will become even more difficult to launch. Fiscal reform and restructuring of the tax system promise to be unfeasible. Paradoxically, the difficulties involved in any structural change and the unlikely success of any such initiative should not be the source of major instability in certain markets in the island. For instance, even in the face of record gasoline prices, consumption will

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likely decrease in less than proportional quantities in light of the relative inelasticity of demand. It remains to be seen how the automobile market may adjust to new excise taxes, higher license registration fees, reduced disposable incomes, higher unemployment, and higher gas prices. A deeper economic crisis, occurring within the next three years, has the potential to adversely influence the number of new units offered per year. This will reflect on other high-ticket items, and on the payment behavior of consumer loan portfolios held by local financial institutions, as well as on and the resale value of repossessed units. The housing market is more subject to cyclical forces. However, housing usually lags behind the curve. This characteristic infuses a degree of risk associated with the supply side of the market. Lead times are long and tortuous for developers. If new units miss the market and come in line during times perceived to be risky or coincidental with high and rising interest rates, prices suffer, new projects are postponed, and construction, employment and incomes will feel the pressure, thus intensifying the spiraling effects. At any rate, if the shock is limited to one year, the initial adjustment will vanish in the out years. The wage bill will prove to be even more resilient. More than 80 percent of government expenditures are due to the wage bill. Voluntary reduction in public service employment faces huge obstacles. Attrition takes time. Substantial early retirement is costly and will be faced by the dire financial condition of the retirement systems. The actuarial deficit of the Commonwealth retirement system has reached $11 billion of unfunded liabilities. The political cost of layoffs in light of very limited opportunities in the private sector is predictable.

5.4 Alternative Long-term Views for Puerto Ricos EconomyAn econometric model of the Commonwealths macroeconomic system --described in another section of this document has been applied to explore alternative feasible futures. The exercise provides a very long-term view through simulated interventions. The dynamics of the present macroeconomic structure are assumed to remain in place during the period. The results obtained are not heartening. They underscore the difficulties stemming from the rigidities built into the economy throughout the years. Current predicaments reflect the dwindling number of options open to action from the public sector. Excessive use of government expenditures to stimulate aggregate demand together with an unsustainable public payroll, limits intervention possibilities without radical changes in tax and subsidy structures. The economy has become addicted to the expansionary public sector policies. The unintended results include very high transaction costs and a political environment that has become increasingly hostile to private capital. There are particularly worrisome aspects derived from the exploration, because they have political roots. The nature of the problems being faced by the economy of Puerto Rico is not in the nature of the economic cycle experience periodically by mature capitalistic economies. However, for decades Commonwealth administrations have been applying the remedies prescribed for precisely that sort of condition. The prescription calls for stimulating aggregate demand through government expenditures financed through public borrowing. The structural nature of the limitations faced by Puerto Ricos economy cannot be remedied by a strategy of permanent anti-cyclical fiscal policy. The result, of that policy has been a bloated public payroll, a dangerous level of public debt, an unjust and heavy tax burden that is being shouldered in disproportionate incidence by the middle class (especially working class families), and an economy that has grown insensitive to increasing doses of the same medicine.

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The structural nature of Puerto Ricos economic problem lies in a basic disequilibrium between aggregate demand and aggregate supply. Aggregate demand has achieved very high levels on aggregated and per capita basis. Aggregate supply, however, is mostly satisfied through imports. Local production activities are highly subsidized and, paradoxically, taxed. Ideologically driven political efforts have been successful doing harm to the productive potential of the island. The incentives that supported a thriving and technologically world-class manufacturing sector were attacked from multiple directions and, eventually, sabotaged. Recent initiatives proposed by the executive to overhaul the tax code in order to make less punitive on income, saving, and investment were blocked by the Legislature. Populism continues to fuel public opinion toward policies that do more harm than good. These have resulted in a maze of regulatory requirements that thwart development and competitiveness. From the early stages, development of tourism met cultural obstacles and premature labor unionization. This economy is not in a position to respond quickly even to a significant and sustained investment effort from the public sector. The supply side of aggregate demand has been weakened by a wounded productive sector. The consumption components, on the other hand, fueled by transfer payments, cash flows generated by growing underground activities, and sheer needs of a population undergoing demographic restructuring, remain strong and growing. The natural unwillingness of the electorate to accept sacrifices has crystallized into a system that has become almost ungovernable. Political forces exert tremendous pressures to shift resources to satisfy immediate needs and ignore the consequences for the future living standard potential of an aging population. Moreover, political forces impede the reallocation of priorities in the public sector. They resist essential changes in the tax structure to correct the present bias against saving and investing. They resist unavoidable restructuring of the government retirement funds. They resist restructuring of management practices and strategies at the public corporations in charge of building and managing utilities and other infrastructure. The question then is: what is the most likely scenario in the long run? The answer to this question is not easy, and searching for it is even more difficult. The tools at the disposal of economists and planners draw on the past and tend to be linear in their projection into the future. The social system, however, is not build on linear relations. Trends tend to generate forces that will eventually force changes in intensity and direction. The long view in the horizon can be characterized with few phrases: stagnation of production, expansion of consumption needs, increasing dependency of growing segments of the population, emigration of a larger fraction of the middle class and of the younger labor force. On the social dimension the view is of turbulence and immobility. However, as pointed out previously, the conditions seen in the long view horizon are of the nature that has caused radical course corrections in other places. This may very well be what the future will bring, i.e., stagnation in the initial years, a resulting decline in the standard of living, more political turbulence, and then, a radical restructuring. The process would follow a non-linear response to unacceptable conditions. In colloquial words: it may be that things must get worse for them to get better. The danger lies in the fact that non-linearity is not guaranteed to produce a change in the right direction for this economy. In fact, it may be that a situation that is even worse than anticipated may ensue. Such a situation would have no feasible satisfactory exit. Stagnation is compounded by demographics and current balance sheets. Puerto Rican families have highly leveraged balance sheets. The savings capacity has not been cultivated and the safety net of public sector pension funds has been jeopardized by

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predatory legislatures and irresponsible past administrations. The long view scenario describes a Puerto Rican society on the verge of increasingly becoming one where poor older residents become an unsustainable proportion of the population. An example of an unthinkable non-linearity would be a reversion of life expectancy trends. Such phenomenon has occurred in other social systems, e.g., the former Soviet Union. A reduction in life expectancies could trigger all sorts of economic, social and political effects. Non-linearity could manifest itself in a chaotic unraveling of the social infrastructure. It must be said that the economy of Puerto Rico has potential. This potential is even now evident. It manifests itself especially in the services sector. However, substantial investment is required. Investment in physical infrastructure and management systems is essential in order to increase export potential in quality services. Travel and tourism is a case in point. Other components of the service industries include financial and insurance industries and higher education. In order to become a true competitor in the global economy, Puerto Rico needs cities. Economic globalization is a phenomenon created from and by cities. Hardly any Puerto Rico urbanized area reaches the category of a city. The creation of a city serving as platform to participate in the world economy would open many opportunities and generate the activities most needed to break the stagnation long run trend.

6 Some Market-specific ImplicationsThe relative permanence of entitlements in the contemporaneous Puerto Rican society, coupled with the development of underground economic activities, suggests important implications for public and corporate planning. These entitlements are associated with three basic characteristics of the resident population: 1) aging; 2) a large juvenile dependent cohort; and 3) a large proportion of the labor force that is not absorbed by the labor market. Characteristics 2 and 3 promote marginal activities and cash transactions. The cash flows associated with these income sources guarantees a floor for demand of services and consumer goods. Given that money is fungible, these cash flows liberate other income funds to complement the demand for durables. In an open economy, transfer payments and income generated by underground activities provide steam for imports and thus help sustain the commercial distribution sectors. Value added by the manufacturing sector contributes with a substantial wage bill to personal income. Profits and dividends to non-residents, by far the principal component of the manufacturing sectors factor payments, tend to flow out of the island economy since section 936 of the US Code was modified and latter terminated. This characteristic tends to reduce the local spending multiplier effect. However, the sheer magnitudes of the cash flows involved represent a formidable cushion to aggregate demand in Puerto Rico. The income and expenditure established for decades in the island has resulted in the accumulation of considerable stocks by families and individuals. These stocks include two very salient components: motor vehicles and houses. A first rate financial system has been a key factor in facilitating the accumulation of both stocks. Obviously, replacement and growth of both stocks rests heavily on the financial sector. A vigorous competition among financial institutions is taking place and is to be expected in the future. Tax policies have had a huge influence in the accumulation of real assets in Puerto Rico. Housing has been heavily subsidized directly and indirectly. Federal and local policies subsidize both, construction and financing, of housing. The automobile has become a

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necessity, given the absence of a mass transit system and the land use pattern made possible by the automobile. Thus, demand for motor vehicles and gasoline are relatively inelastic and constitute important for tax revenue sources. Thus, the numbers of registered vehicles, and composition of the automobile stock, are not what one would expect in view of reported income levels. Consumption has become a complicated variable for economists in the present economic environment. Current consumption expenditures are dependent on disposable income, perceived value of assets, and expectations pertaining to prices, incomes and financial costs. Moreover, perceptions, needs and expectations are influenced by age. Demographics have become a critical strategic dimension for business and governments. Although still poor by US standards, Puerto Rico has acquired high levels of income, consumption and wealth per capita when compared to other countries especially in its own hemisphere. Coincidentally, the demographics of Puerto Rico have changed dramatically since the decade of the 1950s. Beyond the obvious relationship between consumption and income, one particularly important variable in understanding consumption behavior in the island is family wealth, and the role that home ownership plays in its perception. The dependence has been highlighted during the current low-mortgage rates environment. Population pressure, efficient financial markets and price expectations have combined to stimulate consumers to cash-in on perceived home equity values. These perceived values partially respond to inflated prices that reflect real supply-demand gaps and speculative pressures. Thus, in a process that feeds upon itself, high levels of demand for housing, in conjunction with speculation and the resulting housing price inflation have become important explanations of high consumption levels and highly leveraged household balance

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sheets.7 The graph that follows illustrates the close association shown by time series of finantial assets of persons, average value of new housing units built by the private sector and a the proxy variable that infers the perception of wealth. The proxy variable rests on the hypothesis that perception of wealth is a function of past years incomes and current employment status. Statistics tend to reveled that Puerto Ricans have been low savers. Most of the family savings are in real assets, mostly homes. The rate of home ownership in the island is higher that the average for the US. Thus, accumulation of financial assets is a recent development. Nonetheless, it is developing at a considerable pace. In part this is the result of recent surges in the modernization of the securities brokerage industry, raising values of equities in the securities markets, and tax incentives toward individual retirement plans. However, speculation in real estate is a formidable force and real assets remains the main depository of family wealth in the island. Asset values are complied by the PRPB for:

1. 2. 3. 4.7

Deposits in commercial banks Saving in federal saving banks (now non-existent) Savings in the Puerto Rico Commonwealth Employees' Association Savings in local cooperatives

A single equation model explaining family wealth perception in terms of average value of new housing units built lagged one year and the value of financial assets of persons per family, also lagged one year, yields very good fit results. See the graphical representation of the fitted values and a confidence band. The model explains 97.5 of the variation in the Wealth Perception variable during the historical fiscal years period 1971 - 2007. In future version of the model, the wealth proxy variable may be substituted by the two explanatory variables included in this single-equation model.240000 200000 160000 120000 80000 40000 0 1975 1980 1985 1990 1995 2000 2005 Forecast: WEALTH_FAMF Actual: WEALTH_FAM Forecast sample: 1971 2025 Adjusted sample: 1972 2008 Included observations: 36 Root Mean Squared Error Mean Absolute Error Mean Abs. Percent Error Theil Inequality Coefficient Bias Proportion Variance Proportion Covariance Proportion 8657.367 5901.606 6.605216 0.045363 0.000000 0.014024 0.985976

WEALTH_FAMF

Several shocks have probably shaken wealth perception. Periods of shock would include: the 2006 government shut-down; collapse of Puerto Rican based bank shares; slowdown of real estate prices; evidence of large flows of migration of physicians, nurses, university graduates, and skilled labor; and the financial markets correction that has taken place in March 2007.

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5. Savings in federal cooperatives 6. Reserves in public pension funds 7. Reserves in life insurance companiesAverage values of new housing units built by the private sector include a component, and feed the process, of speculation that has driven housing demand in Puerto Rico, and segmented the market. As a result, this process has had tremendous impact on urban sprawl and land use dynamics.

Figure 19 Financial Assets, Average Value of New Houses, Perceived Wealth80000 60000 40000 20000 0

160000 120000 80000 40000 0 75 80 85 90 95 00 05 10 15 20 25 Avearage Value of New Private Housing Units Financial Assets of Persons, Total Perceived Value of Families Wealth

These are segmented markets and demand-supply dynamics differs among segments. For instance, the housing market can be divided at least in four major segments: 1) the sought-after segment; 2) the directly subsidized segment; 3) the speculative post-shelter segment; and 4) the priced-out segment. The sought-after segment is the efficient market and constitutes the model long established as the goal of public policy. The subsidized segment faces the limitations of public resources to provide for those unable to satisfy the demand for housing given the prevailing price and income structure. A large portion of households in this market sees their demand for housing unmet. The speculative segment drives price inflation. Finally, an out-of-market segment includes lower middle class families that do not qualify for subsidized housing programs, but whose incomes and asset valuations are insufficient to meet down payment and mortgage financing requirements. Lack of an organized rental housing market --within the bounds of quality expectations-adds to unsatisfied housing demand pressures. This reality has become a driving force for multi-employment (second and third jobs) two-family incomes, and unreported and/or underground activities. The dynamics between interrelated forces further strengthen the

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demand for automobiles and other related products and services, given that travel to work is essential. The relative inelasticity of the demand for automobiles and gasoline is strengthen by the forces that drive new housing supply ever farther from the city and town centers. New housing projects are located on the least expensive lands. The logic of land values and relative location reinforces urban sprawl with the resulting need for transportation, based on private automobiles. This process, supported by a revolution in computing and communications technology, has propelled a structural change in the retail market and its channels of distribution. A collateral effect of these revolutions has been the rendering of traditional outlets obsolete. The political process has served to promote protection and to retard adaptation. The unintended consequences are generally inefficiency, inefficacy and eventual higher social costs. Ironically, this environment creates the basic conditions on which efficient competitors thrive. In a stagnant economy, these competitors eat away more and more market share from the traditional sector accelerating the process of decay found in the local town commercial and real estate markets. The economic structure that enabled rapid growth in decades past has suffered severe fractures. There is no guiding principle on the public policy realm, except for spending and tax privileges to benefit organized groups. The cost of such a fiscally questionable attitude is high and growing rapidly. On the private realm, realities have produced a zero-sum game mentality common under conditions of stagnation. Solutions and strategies to extricate the economy from the trap it has gotten into are not that difficult to envision. However, now, they are politically unfeasible. So, where will the market opportunities most likely emerge or continue to-- emerge? The following categories are obvious and represent a very limited set: Security related products and services. Health care for chronic conditions and illness typical of old age. Emerging industries and enterprises substituting public services rendered still by government. Energy and water efficient products for home and office or workshop. Innovative financial services for the old such as: Reverse mortgages Assisted care living quarters Small estate management Products and process required by an increasingly cashless economy. Consolidation and diversification will become intense

It is clear that the structure of present market conditions in Puerto Rico, though vulnerable and subject to the effects of shocks with exogenous origins, exhibits a degree of rigidity that provides it with certain stability in the short and medium terms. The longterm prospects are more difficult to fathom and require continuous monitoring of the underlying trends. Much will depend on a solution to the presently polarized and paralyzing political power sharing between both major parties.

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7 Spatial and Land Use Implications(To be developed)

8 SynthesisFiscal 2007 will show a contraction of real GNP for the Commonwealth economy of between -1.8 and -1.4 percent. Official forecasts for 2008 anticipate growth of 0.6 percent. This short-term expectation looks too optimistic. At most, a 0 growth rate would seem more consistent with short-term indicators and anecdotal information. A crisis similar to the one experienced in the summer of 2006, when the central Commonwealth government was forced into a shutdown, is very unlikely. If not for the strictly financial conditions then, for political realities that would guarantee a certain electoral result. The current general economic conditions look grim to knowledgeable observers. Skepticism permeates when government initiatives are considered given the record of failures accumulated through decades of misguided intervention. The small relative size of the private sector limits it is capability to serve as an engine of growth. This imposes even greater pressure on the public sector to stimulate aggregate demand. This follows an incorrect diagnosis of the economic problem, i.e., it assumes that it is cyclical in nature, when its true nature is secular and responds to an insufficient capital stock and inadequate production platform. Following the prescription for a cyclical condition, the public sector tries to stimulate aggregate demand but in doing so, it increases the problem by expanding public debt and crowding out private initiatives. The predominance of process over substance; the excessive litigation in the Puerto Rican society; and the lopsided regulatory infringement on all aspects of life, impose transaction costs and inefficiency on an economy that cannot compete under such a heavy load. Much of this heavy load of regulation and government intervention originates as protection to local sectors and a mentality that sees government as a paternalistic entity that must accept all transferred risks from individuals and groups. Here lies the key to the capacity to participate in the global markets. There is no way out, the long-run solution it will require facing and solving this conundrum in the short-run. The economy of Puerto Rico is undergoing a structural change under conditions that limit its growth potential and foretell a stagnant standard of living. Forecasting the future under conditions of structural change is a dangerous business. However, the momentum provided by demographic trends and the rigidity of the current structure provide a basis from where to launch expeditions into the possible futures. One of the tools at our disposal is a quantitative model that mimics in a simplified manner the intricate set of relations of the economic system. For this, one must rely on historical data. Moreover, the planner must assume that the structure of the system will remain in place during the forecast period. This is a heroic assumption, especially when there are symptoms of structural change taking place. To deal with such an uncertain environment planners can construct alternative future states or scenarios. These may be more or less likely but their analysis enables the identification of strategies that may reduce to acceptable minima the risks involved. This analysis may be also helpful in identifying areas of opportunity. This report has tried to provide a rough example of a combination between the application of a macroeconomic forecasting tool and the elaboration of alternative scenarios to search the long-term horizon. The basic policy instrument on which the Commonwealth has relied to gain a competitive advantage to attract non-resident capital to its manufacturing sector will

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vanish completely at years end. No substitute is in sight. Populist fiscal policies, abused for electoral gain, have reached a critical point. The relative size of government is no longer sustainable without painful tax measures. A mixed electoral outcome has brought about a divided government with one party dominating the legislative and the other the governorship. Under the gun of the credit rating agencies, a political battle royal unfolded with the drama of a national crisis, taking the budgetary process hostage. As the result of a rare attitude of fiscal responsibility pursued by the Governor, the executive branch implemented cost-cutting measures and submitted a tax reform package to the Legislature. Finally, the message that things could not go on as usual became clear to all but the partisan fanatics. Public employees were jolted by the sudden realization that government jobs can no longer offer immunity to the laws of economics. A slow growth regime has taken hold of the productive sectors of the economy. The demand side remains strong under the influence of a relatively large cash flow stemming from entitlements and a very large service sector. Underground economic activities add to the pool of cash, fueling consumption expenditures. Local tax policies provide a high degree of incentive to development, construction and purchases of housing. Land-use patterns, and the resulting absence of adequate mass transit, have stimulated the dependence on the automobile as the only means of transpiration. Thus, the demand for automobiles, parts, fuel, and other related goods and services is relatively inelastic -even in the medium term. In the long-term, adjustments are conceivable but will require major structural changes in urban design, the tax structure, user fees, and huge investments in infrastructure. All constitute politically difficult changes to achieve. It is likely that Puerto Rico will go through years of political turmoil and economic adjustment. Policy adjustments will require sacrifice to an electorate that has grown accustomed to being papered by populist politicians. As the current political crisis deepens, necessary policy adjustments will become even more difficult to achieve. Current tax policy is markedly biased against earned income, saving and investment. It is inefficient, ineffective and unjust. It has become a burden on the productive sector and has ceased to provide enough revenues to sustain government operations in the absence of restructuring. Manufacturing, especially in the technology intensive sectors, will probably continue to be the value added generator and the exporting engine of Puerto Ricos economy during the next two decades. However, under competitive pressures, its potential as a jobsustaining sector will continue to shrink. It will be up to the services sector to develop the exporting potential to absorb a labor force no longer employable in agriculture, manufacturing, or government. The pubic sector has reached its limits as an employer of last resort. It is no longer able to absorb an increasing labor supply that exceeds demand. The psychological impact of this reality cannot be minimized. The resulting behavior of key sectors of the electorate may generate a new political dynamics. In a non-linear world, these dynamics may shake the tree and force those now sharing power to change course. If this occurs, the present fiscal crisis may prove to be beneficial after all. The business community is by now well aware of the major trends underlying the Commonwealths economy. All point to a meager growth potential at the macroeconomic level of aggregation. Sector behavior will differ. Traditional agriculture continues its long decline. Manufacturing faces difficult times, trade and services are in a better position to exploit opportunities. However, in a no-growth regime, market share becomes a key factor for survival. Competitions will become even fiercer than experienced up to this date. Smart acquisitions, diversification and, as scales permit, expansion to markets

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outside the island, will become important elements of public and private business strategies. However, the awareness of the trends tends to be general in nature. It has failed to take notice of the profound causes and, most important, of the consequences brought about by these trends. Let us mention some of these important trends and the consequences they will precipitate. The failures of education, the expansion of dependency, and the irruption of the criminal drug business, have created a new dual social structure in Puerto Rico. Agrarianindustrial duality has given way to a duality in attitudes and values. The dual nature of Puerto Ricos social structure has generated cultural attitudes typical of failed communities found in inner cities that have lost their economic function. These cultural attitudes make it impossible for people to contribute anything positive to the economy. Crime destroys wealth. And, as it goes on with the destruction of wealth, the populations living in deprive areas demand increasing resources from taxpayers. The perceived injustice will induce increasing resistance to

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Socio-Economic Environment of The Commonwealth of Puerto Rico: a Long-term View