 Everybody, and welcome here to CSIS. My name is Carl Meacham, and I am the director of the America's program. Thanks for coming out and this wonderful weather that we've had. It's very, is it reminiscent of Puerto Rico at all, or? No, not at all. So I just wanted to give you all a sense of what we're going to be talking about today for the viewers, but also for all of you, I know that this is something very exciting here in Washington, particularly because folks really don't talk as much as what I think they should about Puerto Rico. Today's event, and today is a special day, is the launching of our new report on Puerto Rico. The title is Why Puerto Rico's Economy Matters for US Security. I was thrilled to work on this project with Dr. Jose Villamil, the leading Puerto Rican economist looking at these issues, and I'm happy to have him here today with us. But before I turn the floor over to Jose, I just want to give some context, and friends are everywhere. And how are you, David? Nice to see you. I want to give some context to the discussion. This report came about following a series of conversations among myself and a number of colleagues either based or specializing in Puerto Rico. When we started, the project was an exploration of the current economic situation on the island, which the media has called the Detroit or the Greece of the Caribbean, which I think is an oversimplification of what's happening in Puerto Rico. But as we talked about what's happening there, we let the project expand into one that really delved into the deepening economic crisis. And as that discussion and the first draft of the report you all have in front of you, and you can get here at our website, which is behind me here. It's a long address. But suffice it to say, if you go to the CSIS website, you go to the Americas program, and then you'll be able to link up to it. We all became increasingly aware of the implications of the economic crisis, not just for Puerto Rico, but also the links that it had to US interest, particularly US security. So you'd ask, why Puerto Rico? There's no major Latin America think tank that's in Washington that's released a major report or project on this issue. I think that little attention has been brought to this issue in DC policy making and the DC policy making community. Puerto Rico is hard to cover, particularly given its ambiguous status and relationship in the United States. It's not a state. It's not a country. It's a commonwealth. The island has a governor, but its citizens aren't represented on the floor of the Congress, only in committee. They don't vote in the full house. About 5 million Puerto Ricans live here in the mainland in the United States in New York. I'm familiar with this large population. About 50% more live in the US than on the island itself. And despite its ties to the United States, the island is Spanish speaking and uniquely Caribbean and culture. So its place as a key player in the Caribbean economy and in the Caribbean security cannot be disputed either. That issue, what Puerto Rico means for US security answers a question central to all the work we do. We are CSIS. We do security work. But why does this matter? And what is the connection between the economy of Puerto Rico and US security, which I think we'll attempt to answer today with the presentation, but also in the report? In the last several years, the murder rate in Puerto Rico has reached all-time highs. In 2011, there were a record breaking 1,136 murders. And in 2010, the per capita murder rate in Puerto Rico exceeded Mexicos by nearly 15% and was almost 500% higher than that of the mainland US. Drug trafficking through the Caribbean is increasing. And much of it involves Puerto Rico, widely referred to as the third border of the United States. In 2011, Puerto Rico brought in about $5 billion in drug trafficking activity, comprising an enormous 10% of the island's GDP. Cocaine is the island's greatest drug threat, and seizures of the drug doubled from 2009 to 2010 alone. While 7% of US-bound cocaine was trafficked through the Caribbean in early 2012, a full 14% came along Caribbean routes in early 2013. Why is this relevant? Again, this issue of the relationship between the United States and Puerto Rico becomes more and more important here, as probably all of you know and some of the folks that are watching. But for folks that don't, traveling from Puerto Rico to the United States is just like traveling within the United States. So the movement of drugs, the movement of people is very easy and which adds, I think, a complicating factor in dealing with some of these issues with drug trafficking, et cetera. And all of these issues, all of these murders, all of these terrible statistics that I mentioned before, is happening in the midst of an economic crisis that has crippled the ability of the Puerto Rican government to deal with this issue. And because of its status as subordinate to US federal authority, its management of this issue has been challenged as well. And combating the growing presence of drug trafficking and violence has been difficult in addition. The island's debt to income ratio, for example, is nearly 83%. That's almost 14 times the same measure for New York, California, and Illinois. Typically, any attention Puerto Rico receives here in Washington focuses on the issue of status. And I'm sure you all know Puerto Rico's a commonwealth. And there's an ongoing debate over whether and how that should change moving forward. But ultimately though, it's not the island status that will prove most pivotal for US security. It's solving Puerto Rico's economic struggles. Only when Puerto Rico resolves its economic problems will we be able to make meaningful progress on US security. And Dr. Viemio was very clear when we had discussions about this and that that's really the connection and that's really sort of the relevance in doing something about Puerto Rico that makes I think very clear and relevant this issue being an issue that should have a lot of interest and should be of concern here in the United States. So I'm very happy to launch this report today to introduce Dr. Viemio to all of you. Dr. Viemio is the leading Puerto Rican economist looking at the current state of the island's economy. He prepared this report which looks at why Puerto Rico, where Puerto Rico is now and how it got there and what we might expect moving forward. And Puerto Rico Jose is the chairman of the board of the consulting firm Estudios Técnicos. An economist by training Jose has served many prestigious universities, Harvard being one of them as a professor of economics and has received numerous awards throughout his prolific career. He previously served as the president of the Puerto Rico Chamber of Commerce as well as several other economic institutions on the island. In short, I can't think of anyone better qualified to speak to the state and future of the Puerto Rican economy and it's my pleasure to have him here today. The usual procedures apply for today's event. We're on the record. We're on webcast and a recording of the audio will be placed on our website. For the Q and A, I would ask you to wait for one of our staff to come with a microphone. Please identify yourself. We wanna hear as many viewpoints as we can but please be brief when you ask your question. So again, I wanna thank everybody for joining us here today. And with that, Jose, the floor is yours. Thank you, Carl, and good morning to all of you. The one correction I would make is, actually my wife would make is that I'm not the leading economist. She's fond of saying that I'm among the best 500 economists in the island. But then, of course, that's the role that wives play. What I'll do today basically is I'll give you a little background on what's happened in Puerto Rico over the last 50, 60 years in terms of economic growth and so on. And then, as Carl said, we'll go into what needs to be done and what the prospects are. If you look back at the 50s and 60s, what you'll see is a Puerto Rico that was growing at 6, 7% growth rates every year. It was booming. It was not only booming, but it was held up as a model for developing economies. In fact, the Puerto Rican government supported the US government's 0.4 program, and we had thousands of people coming from all over the island to look at what was going on in Puerto Rico. I remember when I was at the Institute of Development Studies in Great Britain, the office across from mine was held by Hans Singer, the famous economist. And he told me once, he said, you couldn't call yourself a development economist if you didn't go to Puerto Rico. It was that important at that point. And I remember years later, when I was at the University of Pennsylvania, I basically was in charge of dealing with the students coming from abroad in the department, and they all wanted to come see Puerto Rico. The reason for that was that there was a great deal of literature at that point from well-known names, John Kenneth Galbraith, Werner Bayer, you name Kenneth Bolding, and a number of others. And Puerto Rico was held up as an example to the world. Now that was even more so after the Cuban Revolution when the Puerto Rican experience became the obvious alternative to what was going on in Cuba. But the point of this is that in the 50s and 60s, the economy was growing very fast. And not only that, but Puerto Rico was really a hotbed of innovation. If you look at housing, for example, Puerto Rico's self-help housing programs were used all over the world. The World Bank made reference to it and for years, for decades, in fact, that program was a major innovation. The same thing in health. The same thing in social planning and so on. Puerto Rico really was an economy, not only known for its fast growth rates, but because it was, as I said, a place where a great deal of innovation, both economic and social, was taking place. Now, there has been some misreading of that experience in Puerto Rico. I think the excessive importance attached to tax incentives led the government and led Puerto Rico for decades afterwards to continue to expound on the idea that tax incentives were the key to economic development. I think what the misreading of that experience is all about is that, of course, in the 40s, 50s, and 60s, early 60s, Puerto Rico was pretty much alone in terms of competing for FDI, for foreign direct investment. In the mid-60s, when you began to see countries like Spain, for example, coming into the shoe manufacturing business, you began to see things like greater access to US markets, which had been one of Puerto Rico's main advantages and so on, that model, which was very successful in the 40s and 50s, started losing traction and it began to wear down. And that gave rise to what we call the petrochemicals phase. In the mid-60s, Teodoro Moscoso, who went on to head the Alliance for Progress and so forth under Kennedy after serving in Puerto Rico's government, came up with the idea that if Puerto Rico had petroleum refining capacity, this would generate a downstream set of activities that would eventually end up creating thousands of jobs and so on. What actually happened, and part of that has to do with changes in the petroleum market, basically that phase lasted very little and it came to a halt with the 73 oil embargo and the subsequent events. What it left Puerto Rico with, however, was a very serious pollution problem because the petrochemicals ended up polluting coastal waterways and so forth and so on. And in fact, even today, as we speak, one of the major plans is being cleaned up after what, 40 years or something. That's the old Commonwealth refining company in the south of the island, which is a super fun site. And it's going to take another 30 years to clean it up and so on. So that, I think, was a second phase and it came to a halt. What happened then was that Puerto Rico in 1974, 75, experienced its first ever contraction, its first ever recession. And a local, a group of local financial sector people came up with the idea of, that became basically section 936 of the Internal Revenue Code. And what that section did, for those of you who are not familiar with it and not going to the details, what that section did was basically it permitted U.S. firms operating under section 936 to repatriate profits back to the states and essentially without paying federal taxes. Puerto Rico already had section 931 in its book since the 1920s or so on. And what section 931 did was exactly the same thing except that you could only repatriate your accumulated profits once you closed your operations in Puerto Rico. So what 936 did was it made it a lot more agile and so on. But together with 936, another section of the IRS Code, section 482 was also approved and what 482 did was it permitted U.S. firms to transfer intangibles, the result of R&D in the states back to Puerto Rico. Back to Puerto Rico manufacturing operations without any tax consequences. And of course what that did was it made Puerto Rico a very attractive location for R&D intensive activities. And that's how Puerto Rico became a major powerhouse of pharmaceutical, medical instruments and so forth in the years after 1976, which was when section 936 and 482 were approved. However, very soon after the approval of section 936, Congress began to question the benefits. And the first inkling of that came basically two years after the approval in 1978. I remember walking around with a little clip from business week I think it was about some representatives, some congressman talking about 936, I lost the clipping. But in 1985, there was a big threat and a major threat to 936, nothing much happened, but since nothing much happened, not much was done to prevent the consequences of eliminating section 936. And the benefits particularly from section 482 were cut through the years. And then in 1993 when the Clinton administration assumed power, they announced that 936 would be eliminated, which they did in 1996 with a 10 year transition period. There is still litigation on that 10 year transition period, what is it, eight years after the ending of section 936 about interpretations of what it meant and so on. But that's another story. The point here is that 936 was obviously a major factor in Puerto Rico's development since 1976 until very recently, I mean a decade ago. And it had substantial benefits, I mean, I'm not one of those who say that it was a total loss or anything like that. If you look at Puerto Rico's manpower situation, 936 companies were a major influence in creating in Puerto Rico a group of very competent managers that have gone on to hold positions in the global operations of many of these firms. It also generated a very capable manpower group in Puerto Rico. And of course, if you look at the financial sector in Puerto Rico, much of its growth in the last two decades until 2010, we'll go into that a little later, came about because of 936. There were other problems with 936. One was of course that it created so much liquidity in the Puerto Rican banking system that it made possible a real estate bubble which essentially collapsed a few years ago, four or five years ago. It also generated, how would you say, unsustainable banking practices that came undone in 2010 with a closing of three of the local banks which together had something like $20 billion in assets. So the 936 phenomenon that began in 1976, together with another event which began in that, roughly that year, which was the increase in federal transfer payments to Puerto Rico. Those two things basically define what happened in Puerto Rico since then. 936 ended in 2006, but federal funding is still a major part of Puerto Rican realities. In fact, if you look at the percent of personal income that comes from federal transfer payments, it went up from something like five or 6% in the mid-70s to around 22% now. So federal funding in 936 played a key role. Now, why was 936 ended? I think Treasury was under the impression that two things were happening. One was that 936 firms were not generating sufficient jobs to justify the tax cost to the US Treasury. And secondly, Treasury assumed that if you eliminated 936, fiscal income in the United States would increase by billions. It didn't happen. And the reason it didn't happen was that most 936 firms became controlled foreign corporations or CFCs and CFCs were able then to maintain basically the same tax benefits with the exception, of course, that they could not repatriate profits. To the extent that these firms were multinational, that made very little difference for the firms, but it made a great deal of difference for Puerto Rico because it no longer benefited from an exclusive incentive which was the case with 936. So then, at the end of section 936, basically in 1996, the transition period began, the island entered into a period in which it basically stopped growing. And this is, I think, what has generated the concerns that we were discussing here today. Although my point in all of this is that what happened beginning in the last decade, in the last decade is not something which one could call a rupture with historical trends, but rather a culmination of what happened, of what had been building up over at least three decades. If one looks at, for example, the experience of Puerto Rico over the last four or five decades, six decades, what one sees is a panorama, and if you have a copy of the graph in the handout, is that decade after decade, the growth rates, the average growth rates per decade was falling, were falling, and culminating in the decade between the last decade, basically 2002 through 2012, where the economy actually contracted. What happened, I think, was that the island began to lose its capacity to generate growth. How did we not realize that this was happening over the last two or three decades? I think basically the explanation for that is that federal funds were increasing, government expenditures and government employment was also increasing, and we had a growing informal economy or underground economy. That underground economy was measured on two occasions recently, in 2003 and 2010, and the estimate, our estimate of the informal economy said it's somewhere around 27, 28% of the formal economy. Now, not all of that is drug trafficking, of course, but a lot of it is, and if you look at detailed sectoral statistics on Puerto Rico, you'll see that the retail sector, retail sector, maintained pretty much a stable situation, even though the economy was contracting fairly severely, and the reason for that, of course, is that the underground economy, even though it's 27% of the formal economy on the income side, it's probably at least that much, and probably much higher than that, on the consumption side, and so the consumption sector in Puerto Rico remained fairly healthy, not because the production side of the economy was growing or was producing the work with all for sustaining consumption, but basically because of those three factors, federal funds, government employment and government expenditures, and the informal economy. So from a superficial perspective, things didn't look all that bad, but when one went into the endogenous capabilities of the economy, it became very clear that the island was not in the best of shapes. Now, if you look at Puerto Rico today, it's very clear that what we're seeing is the accumulated effects of a long-term series of mistakes in terms of economic and social policy. Each of the islands lasts for governors, the present one and the previous three, when assuming power in 2001, five, nine and 13 in January of that year, they all found themselves in exactly the same situation and each one blamed the previous one for its fiscal problems. In that sense, they're very much alike. The three previous ones were able to deal with a very difficult fiscal situation by a simple expedient, they increased the debt. Each one of them increased the debt and substantially, beginning in 2001. But what that tells us is that the present situation is not something which arose last year or the year before or three years before, it's something that we've been dragging for many, many years. But the present one, the present governor has not been able to issue debt. The reason for that I think has to do with the fact that beginning in 2006, the rating agencies became much more concerned about the level of appropriations debt. In other words, debt that had no repayment sources. And they began to tighten the screws and so on. Of course, the economy between 2008 and 2013 experienced severe contraction and that limited the government. And that's the reason why the present administration was severely constrained in terms of issuing debt. And what that did was it made increasing taxes an almost unavoidable event. And they did, they raised taxes substantially in order to lower the budget deficit, which was projected to be 335 million for 2014, but it turned out to be two billion. Why that huge difference had to do with some accounting of the government on the government side. And it also had to do with the fact that government fiscal income was substantially overstated. But whatever the reason, the fact is that Puerto Rico faced a very serious fiscal situation that it had to increase its income, the fiscal income. And the only short-term way of doing that was to raise taxes. Now a lot of people in Puerto Rico, particularly from the private sectors, ah, but they should have lowered expenses. Well, of course they did lower expenses, but the fact is that in Puerto Rico the government, the structure of government is such that payroll expenses are make up a substantial proportion of government expenditures. And had you decreased and decreasing expenses in the government would have meant basically laying off a substantial number of people. And in an economy where you have 14% unemployment and so forth, and the participation rate is very low, where the economy is not growing, that did not seem, and I agreed with that, that did not seem a viable alternative. Even so, even so, if you look at the numbers, employment in the government has been falling pretty much in the last few years. And that's a welcome development because the government of Puerto Rico salaries, I mean employment numbers, are a very large share of the economy. Now I think what we, the economists looking at the island, have not considered in the way we look at the island, is that economists tend to look at the world as a cyclical, as a cyclical phenomenon. And when they look at recessions, when they talk about recessions, economists typically think of short-term ups and downs of the economy. What's happened in Puerto Rico is not a recession in that sense, but basically the accumulated effects of a long-term trend. And when you accumulate the effects of long-term unemployment, long-term fiscal insufficiencies, long-term inefficiencies in government infrastructure services and so on, those accumulated effects become much more intractable and much more difficult to reverse. And I think this is the situation where we find ourselves in. Now if you look at the debt situation in Puerto Rico, actually in this year, the public debt to GNP was about 100%, 103%, something like that. And that's of course an unsustainable number. There has been however, I think a lot of oversimplification in the debt, because most of that debt belongs to public corporations. The electric power authority, which S&P just downgraded, aqueducts and sewers authority, the roads authority, public buildings, these are all public corporations. And there has been a great deal of talk about restructuring the debt, but really the central government debt, that is the government obligations and the debt that is backed by sales taxes. This debt really has no problems. I would say, I mean I wouldn't say no problems, but it's not the critical side of the debt equation. The critical side of the debt equation has to do with the public corporations and it's that debt, which is most susceptible to being restructured, not the public, not the central government debt. But people have bunched together the 70 million, 70 billion dollars in debt, as if it were one big homogeneous debt package and it's not. It has different repayment sources. It has different risk factors attached to it and so forth. And this I think has not been understood. The fact is, however, that if you look at Moody's December 23 report on Puerto Rico, the numbers that they quote are worrisome, obviously very worrisome because they indicate that between 2008 and 2013 Puerto Rico's overall debt increased from 35 billion to something like 54 billion. And that's a huge, that's a huge jump. So what is very clear is that at this stage, Puerto Rico cannot return to stimulating its economic development through debt. The government will issue debt again. They're saying February or March, but it's a very different situation. So now, if you look at what happened over the last few years in the handout, it's on page seven, you'll see what actually happened between 2001 and 2013 in terms of economic growth and what becomes abundantly clear there is that the island is now a much smaller economy than it was as recently as six or seven years ago. Now, we know we have a problem with economic statistics in Puerto Rico and I think these numbers probably should be taken not with a grain of salt, but certainly with some prudence in terms of what they indicate. But I have no doubt that when you put together these numbers with the employment figures and with other indicators, what they suggest is a correct situation. That the island has experienced a substantial contraction and that prospects for the next two or three years don't look much better. And I mentioned some of the other indicators, for example, investment in Puerto Rico has gone down from something like 30% to about 13% of GNP in the last few years. If you look at employment, well, the loss of upwards of 200,000 jobs, that sort of thing would lead me to believe that these numbers portray an economy which not only has contracted but an economy that has lost its capacity to generate growth and that is a very serious concern. Now, if we look going forward to what's in view for Puerto Rico, projections for next year and the next couple of years are for growth rates basically to fluctuate around zero growth. It won't be, we won't experience a severe contraction like we did in 2009, 2010, but the economy will not obviously be growing at anywhere an adequate rate. The government, the present administration has taken some steps that I think are very important in addition to the taxes. They reform the pension system, the government employees retirement system which should have been done 20 years ago. The way the system was designed it was no way it could be sustainable. And in addition to that, the legislature kept adding new benefits to the retirees without any sources of payment. To give you an idea what these new benefits meant was something like $267 million a year of benefits with no source of funding. But the government did was they eliminated a lot of that and introduced a number of other measures that will help at least to control the retirement system's fiscal problems. They also did the same thing, reform the teacher's retirement system but the Supreme Court basically paralyzed those reforms. mistakenly I think and with not very good consequences but that's where it stands. And I think that has affected a great deal the way Puerto Rico credit is being looked at in the States. They also changed the judicial systems tax reform, retirement system but that was more for image purposes than anything else because it's a very small system but the judges had a very good retirement system and I guess the government felt that they couldn't very well do something with the teachers and it's employees without dealing with the judges but the judges are complaining bitterly and since they have the last word, we might see a reverse on that but what is of greater concern greatest concern right now is the decision that the Supreme Court will eventually make on the teacher's retirement system because it has a deficit of something like $10 billion. The employees was about $35 billion. That adds up to the $45 billion that's mentioned in the paper. Now, so as I said, what we expect in the short term is essentially an economy that won't be growing substantially, the two main concerns that the rating agencies have raised recently have to do with two things. One, the government's liquidity and secondly, the prospects for economic growth. In general, the rating agencies have looked upon the fiscal measures that the government has adopted as a good thing and in fact, it looks as if the budget deficit objective will probably be met at the end of the fiscal year which was to keep the deficit below a billion dollars. If they do that, then downgrading could be postponed. If they don't, there is a rating agencies think that that won't happen, then we might have a problem but in general, I think the two concerns that are up front in terms of the rating agencies are the government's liquidity and the government's capacity to access financial markets. And the reason for that is that even if the budget targets are met, the government will still have to finance a substantial deficit. So the decision of the government to go to the financial markets with a two billion dollar debt issue, I think is a correct one. It's been criticized because it's going to be very expensive in terms of yields but I think the government has no option. They have to access the financial markets because otherwise their liquidity will be severely affected and the problems might be greater. So that's where it stands. Essentially, the other concern that the rating agencies have has to do with basically jump-starting the economy. And there, I think we have a long way to go. I think the government has not come up, has not yet come up with an overall strategy for doing that short-term and long-term. Now, the risks, of course, are immense for Puerto Rico's economy. The main one, of course, being the downgrading of the debt. The situation in Washington doesn't help and I think basically what we're looking at is further cuts in federal transfer payments to the economy. And the third risk, I think, is the fact that the tax system in Puerto Rico, which was already a very complex cumbersome and to some extent oppressive tax system, not so much in terms of the rates, but more so in terms of the compliance costs. The World Bank publishes this annual document on paying taxes and Puerto Rico does not come out very well in that report. And now it's going to come out even worse because the new taxes added basically 16 new taxes to the inventory of taxes, including extending the sales tax to business-to-business transactions and so forth. The governor appointed a tax reform commission and it should be presenting some recommendations on a new tax system. I think it's overdue. I think they should have already gone through that exercise and I think they should have come up with some suggestions for simplifying the tax system and making it much more inclined to stimulate investment rather than consumption. In fact, some of the problems that we've had in these last two years with budget deficits are directly attributed to law one of 2010, 2010, 2011, which lowered everybody's taxes. And the justification for that was that it would increase consumption in Puerto Rico and that would stimulate economic activity. Well, if an economy imports 80 or 85% of what it consumes, lowering taxes won't really get you any higher rate of growth. It might help the people who produce the things that you import, but it really won't do much for you. And I think that law one was a mistake, not in the sense that we don't like lower taxes, which everybody does, but in the moment in which it was approved with a very weak fragile fiscal situation, very fragile fiscal situation, it made the fiscal situation even worse. So basically, looking at long-term, one of the problems Puerto Rico has, of course, is that it's created a very rigid government structure. The government of Puerto Rico has 145 agencies, a budget which, a consolidated budget, which is close to 50% of GNP. It has an institutional framework which does not support flexibility. And I think basically what that has meant was that it's created a policy paralysis in the government that has not supported Puerto Rico's capacity to insert itself effectively into global trends. So one of the things that we need to do with a sense of urgency is restructure Puerto Rico's institutional framework so that it permits more agility in terms of adjusting to global trends and to what's going on. I think many, many years ago, a Puerto Rican writer said that the island was an island surrounded by mirrors. That, some of those mirrors have cracked, but it's still, to a large extent, Puerto Rican policymakers deal with economic policymaking as if the global economy didn't exist. So we need to create the flexibility to deal with that, with a changing external context that obviously has an impact on Puerto Rico. And I think part of it, or not part of the reason, I think a major reason for that lack of flexibility is an obsolete institutional framework, mostly put together in the 50s and 60s when the world was very different, and so was Puerto Rico. The second is that if you look back, and this is a particular theme of mine, what Puerto Rico did in the 50s, 40s, 50s, and even early 60s, was that it was a very innovative society. The innovation was a major component of things that the government did, not only in economics, as I said a little earlier, but also in the social sphere. In 1967, the National Science Foundation and the National Academy of Engineering did a study where they said, look, Puerto Rico has the foundations that should really move along the path of emphasizing much more the innovation in science, technology, and so forth. Well, after that study, it took 30 years for the government to finally adopt a public policy on science, technology, and innovation. And that policy lasted four years because when the new government came in, the policy went out the door. And then in 2004, the science, technology, and research trust fund was organized, and it's been there, it was a good step, and it's now beginning to take on a much more aggressive role, but we're still lacking an overall sense that we need to stimulate innovation as a key component of economic development strategy, and we lost that capacity to innovate. Why? Well, I think basically part of the reason is that we delegated to federal, economic, and social programs the innovation capacity to innovate in these programs. And what became the driver in Puerto Rico and the government of Puerto Rico was not to create programs that responded specifically to needs and so forth, but rather, how do you organize yourselves to maximize federal funding? And I think that had a great deal to do with the fact that the island lost its capacity to innovate. And the third thing that we need long-term is to address the social issue. Puerto Rico has many other countries that have followed that path, including the United States, Puerto Rico's a very unequal society, and that inequality in terms of opportunities and so forth has worsened with the contraction. If you look at the island's distribution of income, it's worsened, it's not particularly good. Access to jobs has become, as I indicated a little earlier, much more difficult. The public education system has not made it possible for people to improve their long-term prospects. And in fact, the island has become a society with very little social mobility. And in fact, social mobility to some extent has been defined as geographic mobility. If you want better opportunities, you leave the island. So we have to deal with that. Obviously, moving in the direction of high value added, capital, technology-intensive activity will not resolve your employment distribution problems. So we need to move into basically what I've called a two-path route for economic development where we continue to be competitive in terms of high-tech, high-value added firms, but we put in place a parallel route which is much more inclined towards job creation and the local markets, and that can be done. We can continue to move in those two parallel paths, but we have not. Essentially, if you look at the last 40 years in Puerto Rico, the promotion of local industry, community-based organizations and so on has been fairly weak. I think we're now beginning to realize that that's a needed change in the way we've addressed economic development, but you cannot divorce economic growth from social concerns, and that, to me, I think is something that we still need to learn in Puerto Rico. And I say we, I mean, we in the government and in particular in the private sector. Private sector continues to look at economic development from the perspective of lowering energy costs, lowering labor costs, that sort of thing, and that's not where we should be heading. So those three things are, I think, major needs for the long term, for the medium and long term. A more flexible government apparatus, a more innovative system, and third, a more pluralistic society. Now, obviously looking a little bit longer term, you have a graph on page 10 of the handout that suggests that we will not get back to real GNP levels of 2006 until 2001. And that's assuming fairly optimistic growth rates beginning in 2014. So what this tells me is that it won't be easy that reversing these long term trends will take time and we have a tough decade ahead of us, particularly with a decreasing population which we project to be, to continue decreasing until at least 2020. So the prospects for Puerto Rico are difficult. They'll require thinking a little bit different from what we've done before, but basically I think two things can be recommended. One is that we need to create a policy making system and separate the economic agenda from the economic cycles. And basically one of the recommendations that we make is that the task of defining that medium and long-term economic agenda for Puerto Rico should be handled by a non-political commission driven by private sector and community interests. The White House Task Force on Puerto Rico could be a key element in making possible such a commission, but we certainly need to separate the economic agenda from the political agenda. Short-term, two or three things can be done. One is revamp the tax system, really make it simpler, more efficient, less costly. Secondly, begin now a major overhaul of the institutional framework, including labor legislation, so forth and so on. And basically in the very short-term, put in place measures that will stimulate construction, investment in construction. No one would argue that investment in construction is a way to, for sustainable economic development, but it is the way to jumpstart the economy right now and we certainly need that. So in some ways, what I'm saying here is that the future of Puerto Rico is tightly related to its political system. I think the political system in Puerto Rico has become dysfunctional with the needs of the island. In general, I'm not talking about anyone in particular. And basically we need to separate the economic and social agenda from the political parties in the island. To the extent that we don't, it'll be very difficult to resolve these problems. Thank you. I didn't talk about standards. So that was an excellent, very comprehensive, very complete presentation. And once again, I really appreciate you working with us on this and appreciate the paper. So now on to the questions. One issue that you touched on, which I hope you could elaborate a little bit on, and in some of the conversations that we had in the preparation or in the drafting of this was basically Puerto Rico will only have the capacity to deal with some of its security issues that are related to the United States if it's able to deal with its economic situation. And you mentioned a lot of the accumulated efforts or the associated efforts through the years to deal with some of its economic situation. Nonetheless, we have a situation here where unemployment is close to 15%, or the credit rating agencies have put Puerto Rican bonds just above junk status. Growth rates in Puerto Rico are stalled. There's a loss of capacity to create growth. And the population is in decline. Will Puerto Rico be able to restart itself? I think is the key issue. Or through domestic reform, or will a Puerto Rico need direct U.S. federal assistance to deal with its recovery? Will it need a bailout? After that list of negative, I'd say, our weather is a lot better. Well, I think the White House Task Force, which was set up, I guess it was 2009, 2010, had its task was basically directed towards status issues. When you read the report, however, it's very clear that status took a secondary position there. It was put on the back burner because the report dealt primarily with economic and social issues. I think there won't be a bailout, and I don't think that's the route to go. But I do think the White House Task Force has a great deal to do with putting in place the correct policy measures going forward. And in fact, it was announced about a month ago that a group of federal government technicians have been working with a government of Puerto Rico officials to deal with some issues. But these are more specific issues dealing with federal funding and so forth. Whereas I think the White House could be a major influence in setting up a long-term commission. Now, this is not something which is unique to have an entity, an independent entity deal with a jurisdiction's economic and social problems in 1975, James Tobin, who was then an economist at Yale, was hired to work on Puerto Rico's economy. And there's a famous report, the Tobin Committee Report. The government of Puerto Rico always gave the impression that it had been their decision to create the Tobin Commission. In fact, it was not. It was an imposed commission on the government of Puerto Rico in 1975, or something like that. So in some ways, that commission, the Tobin Commission was pretty much the same sort of thing that I'm saying we need now. The other example, of course, is New York, where they created a committee that pretty much ran New York's finances and so on for close to 10 years. And it was run by a man named Felix Rohaton, who was a very well-known investment banker. Obviously, something like this won't come from an initiative of the local government, but it could be something that the White House could have an influence on. I'm gonna open it up to the audience a little bit. Why don't we go up front if we could get a microphone up here, David? We'll have for it. Great. Thank you, Carl, David Lewis, and just congrats to you and Huaco for putting this together. I know it's been a labor of love for some time. Two quick points for comment from each of you. Huaco, in economics, we talk about convergence. When in trade, we talk about integration. And I'm curious your views on the challenge of the island's macroeconomic convergence with the mainland, given that it is a common market, regardless of its status, all factors of production are just there, completely integrated, but clearly we haven't reached convergence on that. And Carl, on the security point, everything security-wise that you pointed in your introduction in Puerto Rico is federally controlled. Laws, regulations, agencies, executions. The biggest sting operation in the past 20 years was two years ago, and the culprits were a couple of nickel and dime companies, FedEx and American Airlines at the airport, for shipping for over eight years, drugs and guns into the mainland. Now, this is all people who get their security passes from U.S. government agencies, checks, and so on. So I'm wondering where's the linkage and what needs to be done? It's not so much the island. It's obviously, you know, this is federal mandate. You first, or me first? Well, I think on your question, I think that highlights sort of the challenges that we have in dealing with a, I was gonna say a country, you can't say country, you can't say state, with the Commonwealth that has a special kind of status with the United States. When things go in and out of Puerto Rico, they are domestic. So you don't have, you know, Homeland Security isn't gonna look at packages that are circulating from Puerto Rico to the United States the same way that they would at looking packages that are coming from Venezuela. So you have these challenges. And I think as far as how do you deal with it? I think, you know, we have close collaboration, obviously, with Puerto Ricans, with relevant or counterpart security and law enforcement in Puerto Rico. But I think this highlights some of the issues that we have to deal with in this. And I don't have a specific answer regarding how to deal with this. More than anything, what I think I do have is more and more questions. After having read your report and also having spent some time on the issue now, it just seems like there's so much that needs to still be figured out with regards to this relationship. I don't think that status is sort of the way to deal with it. I think that status is a big framework discussion. I think there are details within the current relationship that need clarity. And I think the one that you highlight is one of those issues. No, we have not converged on the contrary. I think the divergence with the U.S. has grown over the last three decades. And it'll probably became worse in the last decade or so. And I think that's also a reflection of what I've said that this Puerto Rico's problems today are something that we've been accumulating for many, many, many years. And I would agree with Carl that the whole status issue, which is a paralyzing issue in terms of dealing with economic problems, won't be solved either unless we deal with the economic situation. When you say that in Puerto Rico, immediately the assumption is that one is particularly keen on the present status, which is not the case. But the issue, I think, has to do with the fact that it's very improbable that statehood, for example, would make any headway in Congress with Puerto Rico's economic condition being what it is. And secondly, independence would not be feasible, again, given Puerto Rico's economic situation. So in that sense, we need to deal with the economic agenda first and then deal with the other stuff. Gentlemen here up front, get a microphone. Hold on one second, we're getting you a microphone. Hi, Andy Coble, the president and CEO of MedFarm, a U.S. generic pharmaceutical company. If as the owner, I were to consider setting up in Puerto Rico either a manufacturing facility or a pharmaceutical consolidation facility with the goal of what we're doing now of servicing and exporting to Central and South America. We contract manufacturing Europe, et cetera. But if you could then tell me what would be the incentives, the tax holiday, tax incentive, and other positive reasons for me to consider and then what are the downsides? Okay, well, looking at the upside, tax incentives are very generous and there are now not only tax incentives for manufacturing but you have very significant and very positive tax incentives for exporting services. Those two are key. Secondly, there is a highly trained labor force in Puerto Rico with experience in the pharmaceutical industry and the government has put in place programs to make available the space that some of the consolidations have liberated for additional new activities. So these are very, very definitely upsides. The man who now runs the Economic Development Agency, the Puerto Rico Industrial Development Company is somebody who comes from the pharmaceutical industry. So he knows the industry quite well, which is something that was missing before. The knowledge by government industrial development company people of the industries that they were promoting. Well, this is now, at least with the pharmaceutical and the medical instruments company, the fellow who runs the the Puerto Rico Industrial Development Company is very familiar. So those I think would be upsides. Downsides, it's still, we have fairly high, very high energy costs. And I think that would be probably the major downside to establishing a manufacturing operation in Puerto Rico. And some of the labor legislation is also perhaps not the best. But in general, I would say that still for firms like yours, Puerto Rico offers fairly significant advantages. Another downside would probably be that if you're thinking of using Puerto Rico as a base for exporting to Central America and so on, the connections could be improved. They're still not where they should be. Up front here, hold on. Good morning, Fred Riefko. Originally from Puerto Rico I know a lot of these problems intimately. I see, I don't see how, and I agree with you in a lot of the comments, how Puerto Rico can get out of its economic problems in the short term. I don't see the elements that you need for economic growth. I don't see population growth. I don't see productivity gains. I don't see a good regulatory framework. I don't see innovation. I don't see capital. And I don't see natural resources. Any one of those can generate economic development. But I would like your opinion on the politics, because I think the politics do, as you well know, tie very closely to the economic development. And I wonder if a plan like a Hong Kong plan or a Panama transition plan is something that could be viable, a 20 year or 30 year plan that addresses the economic development issue from the federal side, and then gives Puerto Rico the long term vision as well as the time to develop its education and its innovation, just like your reaction on it. That's sort of a, neither of the above that you mentioned before. Thank you Fred. I think the political system in Puerto Rico has become dysfunctional. And I think part of the reason for that is that the political class has become an economic class. Because as the economy stopped growing, the road to riches was through the political system. So you had a very privileged political class, not only in the legislature and in the executive branch, but also in the municipalities. So once that happens, then the political class begins to become a non-functioning or dysfunctional. But I think we tend to overlook the fact that the private sector leadership has been severely misdirected. There are major organizations, Chamber of Commerce, Manufacturers Association, you name them. And they have not been able to do two things. One is to put together a public, a private sector vision of Puerto Rico's economy that is basically agreed upon by all of them first. And secondly, they have not realized the seriousness of the situation. So you have, for example, the Food Importers Association going to court claiming that one of the new taxes is unconstitutional. And I remember talking to the fellow who ran the thing and I said, you realize what you're saying, that if that tax is declared unconstitutional, Puerto Rico's debt is degraded the next day. Oh, well, did you come up with any alternative? And he said, well, first we defend our members and then we, and I said, I think you got it wrong. You know, as the ship sinks, we all sink with it. And the private sector leadership, I think, has been severely weak, extremely weak, and has not contributed to solving the island's problems. And of course, what that has meant is that the political system has then adopted greater responsibility over things that they shouldn't have, particularly in the economic sphere. And there are many, many examples of that as we, you know, you look back at the legislative history of the island in the last few years, basically decisions have been made on political grounds rather than economic grounds. And right now, as we speak, there are hearings this week on the Jones Act in Puerto Rico. And it's all, it's all a political show, basically, because no one in the government has actually gone into the numbers and come up with any sort of sense of whether it's good, bad, or mediocre. I mean, it's just totally political. The last issue today was that it's a civil rights issue, that the Jones Act is depriving Puerto Rico of its civil rights, well, but certainly in terms of economics, any sensible analysis would tell you that the Jones Act has a very minimal impact on Puerto Rico's economy. But the political masses are moving along with hearings for two weeks and so on, and essentially with no analysis. So I think the private sector has been negligent in terms of its role in defining the island's economic agenda. Let me get one in the back, gentlemen with the goatee here on the left. Yes. Hi, my name is Alex Sanchez. Good to stand up. Thanks. I'm a research fellow at the Council on Hemispheric Affairs. My question's about the social angle of the economy. There have been a lot of alarming reports about mass migrations in the past couple of years of Puerto Ricans to the mainland. Some reports say that 76,000 people left in 2011, 27,000 people left in 2012. There was a report in the Huffington Post that said that by 2050, the population of the island will drop to 2.3 million if the current rate continues. I'm just wondering how do you jumpstart an economy with a shrinking population, especially if you have a brain drain of young educated Puerto Ricans? Thank you. Yeah, well, the 2050 figure I think is just illustrative. I don't think it's going to happen. We have lost populations. It's not the first time that this happens, although this time it's a little different because as you indicate, the people leaving the island tend to be younger, better educated, and so on. No, that obviously introduces a very serious obstacle to any initiative to jumpstart the economy. I'll give you an example. Over the last four decades, the island rate of household formation was something like 20,000, 22,000 per year. Last decade, it was 9,000, and the projection for this decade is that it'll be about seven or 8,000. What that means is that there won't be the need for new housing. So the housing construction industry really won't be able to come back, and that's a huge chunk of total investment in construction. It is, it's a major problem. I'm not trying to say that it's going to be a simple process, but in the very short term, the only thing that you can really do, in the very short term, the only thing that you can really do is basically investment in construction, and when I say investment in construction, I am not talking about the huge mega projects. For example, there are two large projects in that the public-private partnership authority is looking at. One is a train from San Juan to Cahuas, which is about 20 miles away, and the extension of a major expressway. But those two things are gonna take seven or eight years to come to a phase of actual construction. It may take a while, maybe four years, but the point is, I think, that you have to generate small infrastructure projects that can be handled very quickly, and that can be put in place very quickly, and that can have a broad impact throughout the island. If you look at a map of Puerto Rico, if you draw a line between two points, those of you who know Puerto Rico will know what I'm talking about, Arecibo on the north coast and Ponce on the south coast, which basically split the island into two islands. Towards the west, it's a total wasteland. Much of what's happening in the island is happening in the east, and more concretely in a very narrow band of municipalities. So you need to generate, for example, in the western part of the island, you need to generate very quickly small infrastructure projects that can get at least people to work and generate some income. It's not the long-term solution. It's not going to resolve the problems, but I think short-term, it's about the only thing you can do. A gentleman here up front with the laptop. Larry Luxner from the Washington Diplomat. In the 1980s, so much was made of the link between Section 936 and the Caribbean Basin Initiative. These days, we barely hear anything about Puerto Rico's trade relations with the Caribbean. In the meantime, the Dominican Republic is booming. Haiti is rebuilding, and even Cuba is passing major economic reforms. Could it be argued that Puerto Rico has been far too dependent on the U.S. mainland and that maybe it's time to pay more attention to Latin America? Thank you. Absolutely. And I think we are finally beginning to see some action in the government moving in that direction. Secretary of State Bernier, David Bernier, has been very aggressively pushing for extending trade and investment activities through the two Caribbean countries and Central America. And I don't know how successful he'll be because there are constraints as to what can be done, but what he's trying to do is, within the relationship with the United States, maximizing what Puerto Rico can do in other markets. And I think it'd be very useful for you, Larry, to maybe get in touch with the people in the local department of state to see how they've been doing and what they've been doing and so forth. And I think it's refreshing. I think the local department of state has a refreshing approach to things. They're a bunch of very good people. And one of the things that they're pursuing is precisely what you've indicated. I'm gonna take two more questions and we're gonna wrap up here and. Jump earlier from the American Dialogue. You've mentioned the status issue, but you've mostly talked about economics. You've mentioned the status issue. And I wanna come back to that a little bit. I think we can agree that Puerto Rico needs some sort of a medium to long term vision regarding economic policy and a policy based on that vision. My question is the extent to which the existing political status, the Commonwealth status, permits that kind of thing to happen or includes built into it constraints that make it very difficult to come up with that medium to long term economic policy. Let me just take the question in the back and then I'll like to answer both. Doctor, in reference to your first recommendation, how do you balance increased simplicity slash efficiency with a tax system with compliance of those regulations to mitigate anti-money laundering or countertax financing risk with drug trafficking organizations in Latin America? Could you go over the first part of your question? How do you balance the increased simplicity and efficiency of the tax system which you recommended with compliance and enforcement of that new system in order to prevent or mitigate anti-money laundering or countertax financing risk from drug trafficking organizations in Latin America and Puerto Rico? And could you identify yourself? Oh, my name is Neil Narona. I'm with the Office of National Drug Council Policy. Okay, well, let me answer that question first. Anti-money laundering and so on is handled by federal agencies in Puerto Rico, the FDIC, the Fed and so on. And that's an issue that's very tightly controlled. The Puerto Rico's banking system operates within the U.S. regulatory framework. So anti-money laundering legislation and so forth, no, your client legislation. All of those things are handled by the federal regulatory agencies. So that's really nothing to do with the tax system in some ways. Going back to the other question relating to status. I think the Commonwealth, well, as you all know, we've been at it for 115 years. But the recent, the most recent phase of the status debate began in 1967. There was a referendum then, Commonwealth status won the referendum, but it basically began a process in which every time there have been three or four of these things, statehood has improved its position slightly, but it still looks as if there's a stalemate between the two positions. So it won't be solved very easily and very soon. And very soon. My point, my position is that the popular party, which is a party that defends the Commonwealth status, has not understood or has been, I would say, not completely accurate in terms of identifying what the opportunities that the Commonwealth status offers. I think that if you look at the terms of the status debate over the last 40 years, basically the terms of this debate have not changed. And of course the world has changed. The way states relate to the federal government, the way states relate to other countries, the way a number of countries have decided to share their sovereignty, all these things have changed and yet the status debate in Puerto Rico is basically in terms of full independence or statehood without understanding what the global situation means. And I personally think without by any means, assuming that this is a perfect condition or anything like that, that Commonwealth can be used much more creatively than it has been up to now. And this is why I think Dr. Bernier's approach is so refreshing. There are obstacles, obviously, and if you look at the insertion of federal regulations and so on in the Puerto Rican economy, they've been growing significantly. And in fact, if one looks at it, in terms of how the economy of Puerto Rico operates, it's not much different from any state except for the fiscal autonomy that Puerto Rico still has. All right. Well, I wanna thank you for coming and presenting the paper. I'm happy and honored that I'm a part of the forward of that paper. And I want to direct all of you to www.csis.org. Under the America's program, you can find the paper there as well. So thanks again. And thank you, Dr. Guillermet. Thank you.