The Real Effects of Liquidity: Evidence from a Quasi-Natural Experiment in Puerto Rico

Abstract

Research has found that negative liquidity shocks contract bank lending and amplify economic downturns. This paper investigates a reverse scenario — the effects of a flooding of liquidity on financial markets, using the case of Puerto Rico as a quasi-natural experiment. The U.S. Tax Reform Act of 1976 implemented tax incentives (through IRC Section 936) to stimulate economic development in Puerto Rico. In combination with local incentives, Section 936 corporations generated significant funds, most of which were deposited in local (PR) banks. The tax incentives were repealed in 1996, allowing for a 10-year phase-out period. I analyze the effect that the 936 funds had on Puerto Rico’s banking industry between 1984 and 2016. I find that 936 funds did stimulate loan growth — in particular, C&I lending, and real estate loans. However, the stimulus appears to have been “too much” — the incidence of troubled loans (90 day past due) among banks that received 936 funds was significantly higher after Section 936 tax subsidy was repealed, indicating that a sizable portion of the projects those banks were financing were inefficient. The implementation and subsequent removal of these tax incentives introduced an extended boom-bust cycle that dislocated Puerto Rico’s economic structure, contributing to the ongoing economic crisis.