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Stagflation threatens Puerto Rico’s economy

With stagnant growth, rising inflation, and high unemployment, the economic menace that happened in the states in the ‘70s now is threatening Puerto Rico

By Georgianne Ocasio Teissonniere of Caribbean Business

August 25, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

A cornered economy

Stagnant growth, higher costs, rising inflation, double-digit unemployment, reduced incomes, the threat of salary cuts and layoffs in the commonwealth government, and loss of confidence are backing Puerto Rico’s economy into a tight corner.

Hold on to your wallets and pocketbooks because the cost of living and doing business in Puerto Rico is literally going through the roof and threatens to only get worse. The price of gasoline, water, electricity, food, medicine, tolls, and everything is on the rise. Everything that is, except for income.

In a 2005 study of cities prepared by Mercer Human Resource Consulting, San Juan was declared the most expensive city in all of Latin America and the Caribbean. This not only affects individuals, but it also impacts businesses, forcing many to pass on their costs to consumers who, in turn, are left with less disposable income, aggravating an already bad situation for Puerto Rico residents.

The problem of limited personal-income growth has been a part of the economic dilemma afflicting Puerto Rico since the 1970s. Furthermore, the island’s limited-income growth will only get worse, as the Commonwealth threatens to impose salary cuts by as much as 15% to 20% on a substantial number of government employees. Spending cuts also will affect numerous government agencies, consequently impacting the quality of services, already considered poor by many standards when it comes to productivity.

The private sector, in turn, faced with higher expenses due to increasing oil prices, utility rates, transportation expenses, and the cost of doing business, will be unable to absorb employees from the public sector who need additional income or are seeking alternative employment opportunities.

The domino effect resulting from the Commonwealth’s budget challenges and obsolete economic model has backed Puerto Rico’s economy into a corner. While the government can’t continue to spend as it has in the past, pushing the cost of living on the island even higher as public corporations adjust rates and taxes are increased to help resolve the fiscal crisis, salaries remain stuck and economic growth has become stagnant. The overwhelming situation easily can be described with one word, stagflation.


In the early ’70s, there was a need in the U.S. and other countries to describe the situation of slow economic growth and relatively high unemployment–a time of economic stagnation accompanied by a rise in prices, or inflation, that resulted from a spike in oil prices at the time. The term stagflation, the combination of stagnancy and inflation, was thus born. In Spanish, it would be estanflación, the combination of estancamiento and inflación.

Stagflation–an economic condition of both continuing inflation and stagnant business activity, together with an increasing unemployment rate–was used in the U.S. to describe the economic malaise of the 1970s. At the time, inflation seemed to feed on itself in the U.S. People began to expect continuous increases in the price of goods, so they bought more. This increased demand pushed up prices, leading to demands for higher wages, which pushed prices higher still in a continuing upward spiral. Labor contracts increasingly came to include automatic cost-of-living clauses, and the government began to peg some payments, such as those for Social Security, to the Consumer Price Index, the best-known inflation gauge.

While these practices helped workers and retirees cope with inflation, they perpetuated inflation. The government’s ever-rising need for funds swelled the budget deficit and led to greater government borrowing which, in turn, pushed up interest rates and increased costs for businesses and consumers even further. With energy costs and interest rates high, business investment languished and unemployment rose to uncomfortable levels. In desperation, President Jimmy Carter (1977-1981) tried to combat economic weakness and unemployment by increasing government spending, and he established voluntary wage and price guidelines to control inflation. Both were largely unsuccessful. A perhaps more successful but less dramatic attack on inflation involved the deregulation of numerous industries, including airlines, trucking, and railroads. The final result was double-digit inflation and double-digit interest rates.

Today, stagflation, which impacted the U.S. mainland’s economy in the late 1970s, seems to perfectly describe Puerto Rico’s current economic situation, which can find the roots of many of its problems embedded in the island’s political status and its obsolete economic model.

"Puerto Rico’s current economic situation reflects the characteristics of stagflation. We have to see if in the coming months the current projections of oil prices, economic growth, and unemployment maintain the current trend," explained Manuel E. Maldonado, senior vice president of research & forecasting at Quality for Business Services (QBS). Using data provided by the Puerto Rico Planning Board, CARIBBEAN BUSINESS and QBS prepared an analysis that shows the average annual growth rate of the real gross product in Puerto Rico to be 1.79% so far during this decade. That was preceded by a growth rate of 2.75% from 1990 to 1999 and a lower 2.02% growth rate from 1980 to 1989. The last time significant growth was seen on the island was in the 1960s and early 1970s, when the average growth rate of real gross product was 7.02% and 3.97%, respectively.

QBS projects the growth rate for 2005 will be 1.8%. The Puerto Rico Manufacturers Association agrees, stating economic growth will be below 2% for fiscal 2006 (July 1 to June 30). In a recent presentation, economist Juan Lara of Estudios Técnicos spoke of an even more negative growth panorama. Presenting potential scenarios, Lara calculated that if the conditions of the local economy didn’t improve, economic growth between 2005 and 2010 would be 2.5%. If conditions were to deteriorate into a situation of crisis and stagnation, he projected the growth rate would be 1.3%.

Meanwhile, the International Monetary Fund expects the U.S. economy to grow 3.5% in 2005. In South America, the economy is expected to grow 4.7% and, in Mexico and Central America, growth should register at 3.7%, according to the Economic Study of Latin America & the Caribbean 2004-2005. Needless to say, Puerto Rico’s projected growth rate lags behind not only the mainland U.S., but also the rest of the region.

Unemployment in Puerto Rico also remains in the double digits. In May, with 1.26 million people working in Puerto Rico, unemployment registered at 10.9%, more than double the unemployment rate registered in the U.S., which averaged 5% as of July.

Puerto Rico’s unemployment would be even higher if participation rates were equal to those in the U.S. For example, in 2004, the participation rate in Puerto Rico, meaning the portion of the working-age civilian population that is employed or actively looking for work, was 46.4%; while in the U.S., it was 66%. If Puerto Rico had the same employment participation rate as the mainland, unemployment on the island would have been over 30%. Puerto Rico’s economic model has proven to be incapable of providing sufficient job opportunities for its working-age population.

For decades, migration to the U.S. mainland has been Puerto Rico’s safety valve and has proven to be an effective way to disguise the Commonwealth system’s inefficiencies. With the economic model unable to generate sufficient job opportunities in the private sector, Commonwealth officials found another economic safety valve: government employment. A fiscal crisis, however, has taken the Commonwealth to the verge of reducing employees’ salaries and potentially cutting jobs, which makes government employment no longer an option for reducing unemployment.

Typical worker vs. CPI

With the average Puerto Rico worker facing increasing prices across the board, the risk of facing an even more challenging economic situation isn’t far off. "This could lead to a consumption stalemate–that means a scenario in which people need to consume goods and services but won’t have the capacity to do so, which could lead to a number of other risks, such as future deflation," warned Maldonado. Deflation is defined by the Dictionary of Business & Economics as a decrease in the general price level, owing to a decrease in total spending relative to the supply of goods on the market. The immediate effect of deflation is to increase purchasing power: If prices fall, the same amount of money will buy more. It tends, however, to benefit only people on fixed incomes and creditors, whereas businesses suffer sharp declines in income and workers lose their jobs.

According to statistics released by the U.S. Bureau of Economic Analysis and the Puerto Rico Planning Board, personal income per capita in Puerto Rico in 2000 was $10,204, less than half of Mississippi, the poorest state in the nation, which had an average of $21,007. Per capita income on the island was 34% of the U.S. national average. By 2004, personal income per capita in Puerto Rico had risen to $12,031, an annual growth of 2.49% from 2000 to 2004. The annual average real gross product per capita grew only 1.29% in the same period.

The U.S. Labor Department defines the Consumer Price Index (CPI) as a program that produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. In Puerto Rico, that basket of goods and services hasn’t been reviewed since the Study of Income & Expenditures of Families in 1977. Consequently, the system of weights is considered to be outdated and is believed to overstate the overall movements of the index in Puerto Rico. In other words, there are certain items that are no longer consumed, and others, such as products pertinent to increased health awareness, that alter the composition of the CPI basket that aren’t included. Despite this caveat, the increasing cost of living in Puerto Rico continues to be evident from the index’s results.

"Even with the old index, the tendency to increase is evident. The cost of living in Puerto Rico has undoubtedly continued to grow…the increase in salaries definitely hasn’t been as high," stated economist Heidie Calero, president of H. Calero Consulting. In 2000, the rate of inflation in Puerto Rico registered at 5.7%. As of May, inflation was 15.8%, Calero pointed out. The rate of inflation in the U.S. for 2004 was 2.75%. The divergence from price trends in the U.S. has persisted for nearly a decade, as stated by the Government Development Bank (GDB).

As indicated by the Planning Board, in June, the CPI registered a level of 277.2 points. This means an increment of 14.4% when compared with June 2004, when the index had climbed to 242.3 points. Having completed fiscal 2005, the CPI averaged 263.4 points, which represented an increase of 13.6% with relation to fiscal 2004. All the major groups showed increases. The sectors that grew most were food and beverage, 20.5%; transportation, 8.7%; housing, 5.2%; other articles and services, 3.7%; and medical care, 2.9%.

The increase in milk prices had a direct effect in the increase in overall prices within the food and beverage section. Since May, a liter of milk went up 5 cents, taking prices to $1.05 a quart, $2.08 a half gallon, and $3.95 for a gallon.

An impasse

The Commonwealth of Puerto Rico currently is operating under the same budget as the previous fiscal year as a consequence of Gov. Aníbal Acevedo Vilá’s veto of the budget approved by the Legislature for fiscal 2006. Claiming the $9.258 billion budget approved by the Legislature was unbalanced and insufficient to cover the spending needs of the government, which are estimated to be as much as $10 billion, the governor opted instead for the veto. Yet, with expected revenue of $9.005 billion, as announced by the Treasury secretary, the government currently faces a shortfall of nearly $1 billion.

Faced with the need to cut approximately $1 billion in spending, the government decided to cut its primary source of expenditures, its payroll. According to the GDB, payroll accounts for approximately 80% of the central government’s budget, while approximately another 10% goes to paying interest on the government’s debt. As the largest expense for the government, cuts in payroll are considered unavoidable.

The governor recently announced a voluntary plan that will reduce the workweek for nonessential employees to four days, with a 15% pay cut. Essential employees, described as teachers, police officers, and other key employees, wouldn’t be allowed to participate in the program. The government, however, was later pressured into excluding the workers of public corporations from the program as well. Initially the plan was expected to result in $200 million in savings, but it is unclear how much will be saved now that the program has been altered.

Many believe the pay cut would be too much of a burden for the typical public-sector employee. Union leaders currently are threatening to join in a general, islandwide strike in protest of the measure. Ombudsman Carlos Lopéz Nieves also has spoken out against the administration’s initiative. "That is barbaric…cutting 20% from the salaries of public employees…those are the same people who have to pay the increases in tolls and utility rates," he stated.

Running out of fuel

As worldwide oil prices continue to set new market highs, at times reaching over $66 per barrel last week, Puerto Rico’s economy continues to be hit hard, especially when taking into account that the majority of goods are imported to the island via plane or ships, both of which are impacted by rising fuel costs.

"The main problem we are seeing is the fluctuation of oil prices, which has a considerable impact on the cost-of-living structure in Puerto Rico. On the other side, the weakness in the convergence of the income of the typical Puerto Rican with the income of the citizens of the most developed or competitive countries also is having an impact," explained QBS’ Maldonado, adding, "What people need to understand is that the independent variable in Puerto Rico’s economy is oil price per barrel. Everything that occurs in terms of its fluctuation resonates in Puerto Rico’s entire price structure, including goods and services."

Gasoline prices have mimicked oil’s price hike. According to the Monthly Poll of Average Gasoline Prices completed during June 23 and 24 by the Puerto Rico Department of Consumer Affairs, gasoline prices averaged $2.103 per gallon. This represented an increase of 0.44 cents per gallon with respect to May ($2.0988 per gallon) and an increase of 17.12 cents compared with the same month last year. Premium gasoline price per gallon increased 18.27 cents from year to year.

A recent truck drivers strike that cut supplies for gasoline stations on the island, created havoc in the streets and led to long lines at gas stations as consumers attempted to get whatever gasoline they could, even if it wasn’t in their budget. In the following weeks, rumors of the strike resuming led many consumers to take the same precaution once again, leading to yet more contingency expenses. The possibility of truck drivers negotiating rate increases also could lead to increases in goods and services as a consequence of the extra transportation expenses implied for businesses.

The hike in gas prices hit consumers’ pockets directly via the prices they are forced to pay for gas and indirectly through the increases they must pay for other services that directly or indirectly use oil.

The rate for electric power, for example, also reflects the increase in fuel prices. The Puerto Rico Electric Power Authority (Prepa) estimated its annual fuel-oil cost from its main suppliers for this year at $1.694 billion, nearly double the cost for fuel oil in fiscal 2004, which was $864.7 million. This cost is directly passed on to the consumer, as established in a legal clause that links electric energy rates with fuel costs. Surcharges for fuel adjustments and purchased power increased from 45.23% to 57.65% of the electric bill for the six-month period ended Dec. 31, 2004.

Approximately 11% of the energy generated or purchased by Prepa also is lost due in part to the fact that 70% of Prepa’s generating capacity is on the southern coast of Puerto Rico while 70% of the demand is on the northern coast. This leads many to question the efficiency of Prepa’s operations.

"At Prepa, all increases are passed on to the consumer. [Prepa] has no incentive to be efficient because of a clause stating adjustable rates based on oil prices, or the purchase of energy from the co-generators, will be passed on to the client. Prepa doesn’t feel pressured to find any savings; now, if they didn’t have the option to increase rates, it would be a different story," Calero stated.

During the six-month period ended Dec. 31, 2004, total average residential charges per kilowatt-hour was 13.15 cents, 14.71 cents for commercial, and 11.6 cents for industrial clients. The average for all sectors was 13.65 cents. These rates are substantially higher than the average charged on the U.S. mainland in 2004, which were 8.38 cents for residential, 7.82 cents for commercial, and 4.9 cents for industrial.

As commercial and industrial sectors see their costs rise, the spillover effects start to transform the price structure for acquiring goods and services, thus drowning the purchasing power of consumers.

Drowning in increases

As part of its spending cuts, Acevedo Vilá’s administration decided to eliminate the Commonwealth’s $400 million subsidy to the Puerto Rico Aqueduct & Sewer Authority (Prasa). The public corporations responded by saying they would have to increase water rates for consumers by 128%, but some estimates put the increases as high as 357%.

While the current rate per cubic meter is 65 cents, the proposal is to increase it to $1.97, as reported by Prasa. Applying the higher rate, consumers would get 264.2 gallons, the equivalent of one cubic meter, for $1.97. According to the American Water Works Association, the average price for 1,000 gallons in the U.S. is $1.50. In Puerto Rico, 1,000 gallons would cost approximately $7.45, almost four times as much.

As an example of the rate increase, Prasa explained the basic rate for water and wastewater services would go from $8.64 to $19.71, an increase of 128% for residences. For the commercial sector, the basic rate would go from $17.14 to $39.10; and for the industrial sector, the rate would go from $120.24 to $274.26.

After the basic rate, the rates for consumption would increase by block; the more cubic meters used, the higher the increase. For example, for residential clients who used between 11 and 15 cubic meters, the rate for consumption would go up 125%; for those who consumed between 16 and 40 cubic meters, it would go up 146%; and for those who consumed more than 40, the increase would be 168%.

Critics of Prasa’s increase believe this scaled consumption rate penalizes users who have larger families. The ombudsman isn’t only fearful of the present increases, but of future ones as well. "For me, something that is more dangerous than the increase in water rates is the adjustment coefficient in fine print in [Prasa’s] press release–which is nothing more than the same formula for Prepa’s fuel-cost adjustment clause–in which every year on account of increases in operational costs, rates will be increased without public hearings and without analysis…it can be up to a 25% increase every year," explained López Nieves. The clause would allow Prasa to pass on all increases in operational costs, including payroll and repayment of debt. That would be a blank check for more overstaffing and inefficiency.

The ombudsman questioned the efficiency of the corporation. "That is another problem; currently, 45% of the bill is estimated. Now, they are proposing to increase that to 70%. They want to read the meter every two months, but bill every month…that is ridiculous." In a public hearing Aug. 8, he stated Prasa invests an average of $57,072 per employee when, in 1986, they invested $14,770, an increase of almost 300%. From 2000 to 2005, the increase has been $15,954 per employee, a boost of more than $3,000 a year per worker.

The new rate structure proposed by Prasa also would limit the subsidies for elderly citizens who are participants in the federal Nutritional Assistance Program (PAN by its Spanish acronym) and other qualifying consumers. The subsidy would be limited to $25 million–a sum the ombudsman’s office argues should be double that amount.

"For the basic consumption of goods such as milk, ice, coffee, gasoline, prices all are up; essential services such as energy and water also have increased and, on the other side, you also are telling them government subsidies are eliminated for residents of government housing, recipients of PAN, and citizens living on pensions?" López Nieves asked.

In their own defense, Prasa officials explained rates hadn’t increased since 1986 and that while operational costs have gone up 273%, operational income only has risen 38%. Prasa claims it could have justifiably increased rates 250% over the period. According to Prasa figures, the average monthly cost of water, which is $36, still is cheaper than the average price for electricity, which is $125; for cable, $60; for cellphones, $45; and for a family visit to the movies, which is $40.

López Nieves suggested the rate increases should wait until a forthcoming tax reform, which will bring tax relief to needy consumers and will attack the underground economy, leading to more revenue in the general fund and fairer increases. He also pointed out that if consumers are going to be paying more, they should be guaranteed better service. "What is being presented here has to be accompanied with parameters of quality. We are requesting the increase come accompanied with a plan that should be divulged to the people about how services will be improved," he said.

While few disagree the rate increase is a necessary step, the timing of the matter has become an issue of debate. "For many years, their rates have been too low. It is reasonable for them to increase rates. What we question is that the increase is so high, all at once, and it combines with so many other increases. It is too many hits at the same time for the consumers’ pocket," said Calero.

Transportation woes

Adding to consumers’ woes, the Department of Highways & Transportation announced a plan to increase toll rates by 43%. Sources estimate that if the increase goes into effect, the tolls that cost 70 cents will jump to $1, 50-cent tolls will be 75 cents, and those that now cost $1.00 would be $1.50.

"I am totally against toll-rate increases. Last year, we paid $144 million in tolls. Highway maintenance cost only $42 million, which means we are subsidizing the operations of the department through tolls by more than $100 million a year…Highways are a basic necessity, not a luxury," explained López Nieves, adding, "Looking at it from the other side, if you are going to exclusively use toll revenue for highway maintenance, the rates would have to be cut 300% in Puerto Rico."

The ombudsman’s office once again questioned the efficiency of the Transportation Department, citing as an example highway projects whose initial price estimate and final cost vary by as much as 251%.

If the toll increase were to pass, and commuters decided instead to rely on public transportation as a cheaper alternative, they would find little comfort considering there is no public islandwide transportation system.

Furthermore, within the San Juan metro area, public transportation also will see an increase. The Metropolitan Bus Authority is considering hiking rates from 25 cents to 75 cents, a move that likely will impact elderly passengers, students, and the poorest sector of the economy.

Dangerous risks

"I wouldn’t say it is unreasonable for these rates to go up. The problem is that the increases are too many and too big during a period in which salaries aren’t increasing at the same level and we aren’t seeing much growth in employment either," stated Calero, warning it will take time for the private sector to potentially absorb the number of government employees seeking other opportunities.

"There will be less income. Everyone will have to adjust his or her budgets. Even the private sector, although they don’t face the same fiscal crisis as the government, now they will be faced with higher costs that weren’t budgeted and salaries aren’t rising as fast. That could lead to an even more accelerated inflation…It could be a rising spiral," added Calero, pointing out that even the underground economy will feel the impact of higher prices.

The increases proposed by the government are in addition to a 40% hike in tuition in the government’s university, increases in the capital-gains tax, another tax on banking institutions, removal of exemptions on the excise tax on certain businesses and consumer items, automobile taxes and licenses fees, and additional taxes on individuals and businesses that are currently being considered by several government committees.

Although the growth of Puerto Rico’s economy has been extremely limited in recent years, one of its major motors has been consumption, an engine that could quickly be running out of gas. "All this will be reflected in consumption. Until now, it had stayed up; people kept on buying, but now in the next couple of months it will be felt in the pockets of consumers; there will be less money to spend, even when there are credit cards," concluded Calero.

Ombudsman López Nieves pointed out that the situation could lead to dangerous unrest in Puerto Rico’s society. "This is a situation that can unleash social violence. We are in a situation in which the middle-low- and low-income classes, in economic terms, have no alternatives; they have blocked all exits for them…we are very worried with this situation," he stated, adding, "When people can’t pay, what are they going to do? They are going to steal water, electricity, find ways to get an additional income, and that can translate into social violence. The state isn’t providing them with alternatives to get sufficient income…We are dealing with something very delicate, very explosive."

Although López Nieves accepts the current situation is the result of historical mistakes and challenges, he believes an already bad situation was made even worse by the proposed short-term solutions. "This problem wasn’t born yesterday, but the crisis was provoked in a day. The decision of eliminating the subsidy in a day… the manner in which the situation is being handled is too abrupt," he commented.

Squeezing out of the corner

The risks and challenges Puerto Rico faces as a consequence of the stagnant economy, the increasing cost of living, and persistently high unemployment are by no means an easy situation to remedy. The stagflation that is affecting the island has a direct impact on every aspect of living, working, and doing business in Puerto Rico. The conventional remedies that the island’s economy has turned to in the past will no longer suffice to remedy the situation.

Finding a way out of the tight corner Puerto Rico’s economy has backed into may seem like an overwhelming task, one that QBS’ senior economist Maldonado says will require an environment of cooperation and dialogue among all sectors. "The solutions must be aimed toward the long-term sustainability of Puerto Rico’s economic structure, not the short term. It is imperative that all sectors of the economic landscape contribute ideas, strategies, and approaches to solve this puzzle. No one in their individual capacity can deal effectively with this situation," Maldonado said.

Reiterating the risks of inaction, Maldonado insisted there is a light at the end of the tunnel. "The Commonwealth’s basic social fabric could be forever altered if we try to resolve a complex problem with simple approaches, simple answers, and quick fixes. These times demand profound and well-rounded solutions. I am confident Puerto Rico can stand up with pride, resolve, and strength of will to decisively deal with the current reality."

In the 1970s, the U.S. mainland government managed to deal with stagflation, thanks to the Federal Reserve clamping down on the money supply and by government deregulation, something many in Puerto Rico’s private sector have been calling for. Support for deregulation continued beyond the Carter administration and, in the 1980s under President Ronald Reagan, deregulation went even further when the federal government relaxed controls on bank interest rates and long-distance telephone service. Less government and a growing pro-business climate are among the primary ways to get Puerto Rico out of the corner.

Puerto Rico Gross Product

Average Growth Rate

1950-59: 5.26%

1960-69: 7.02%

1970-79: 3.97%

1980-89: 2.02%

1990-99: 2.75%

2000-04: 1.79%

Analysis: CB Research & QBS Intelligence Unit

Source: Puerto Planning Board

Consumer Price Index


Year: Points / Percent

2000: 179.7 / 6.3%

2001: 195.9 / 9.0%

2002: 204.0 / 4.1%

2003: 218.1 / 6.9%

2004: 242.3 / 11.1%

2005: 277.2 / 14.4%

Source: Department of Labor & Human Resources

Puerto Rico Real Personal Income Per Capita

Average Growth

Year: Percent

1950-59: 4.30%

1960-69: 6.22%

1970-79: 3.41%

1980-89: 1.67%

1990-99: 3.86%

2000-04: 2.49%

Analysis: CB Research & QBS Intelligence Unit

Source: Puerto Rico Planning Board

Puerto Rico Real Gross Product Per Capita

Average Growth

Year: Percent

1950-59: 4.72%

1960-69: 5.43%

1970-79: 2.35%

1980-89: 0.99%

1990-99: 1.87%

2000-04: 1.29%

Analysis: CB Research & QBS Intelligence Unit

Source: Puerto Rico Planning Board

This Caribbean Business article appears courtesy of Casiano Communications.
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