Hedge Fund-Driven Austerity Could Come Back to Bite the Hedge Funds Driving it in Puerto Rico

Virtually every headline about the Puerto Rican government’s newly released fiscal plan has focused on its finding that the island won’t be able to pay back the vast majority of funds owed to its creditors, many of them American-based hedge and mutual funds. Even in the new plan’s rosy projections for economic growth, the island would only be able to return a small fraction of its at least $74 billion in municipal debt in the next 30 years.

But informing those growth projections is an economic doctrine that has gotten it wrong in nation after nation. The borderline religious belief in austerity holds that cutting government spending is the route to growth for struggling economies, but it generally has the opposite effect in real life. 

In Puerto Rico, the approach involves a series of punishingly deep cuts to the island’s public sphere, including shuttering over two-thirds of Puerto Rican governmental bodies, closing more than 300 public schools, and putting huge swaths of the island’s public infrastructure up for sale.

“The record is unambiguous that austerity does not lead to economic growth. It leads to contraction,” Nobel Prize winner and former chief World Bank economist Joseph Stiglitz told The Intercept when asked about the plan. “What is deeply disturbing is that when you have cuts to things like health care, education, and infrastructure, that’s inevitably going to have implications for long-term economic growth.” He and 25 other economists recently released their own fiscal plan for Puerto Rico as the new official one was being drafted.

Slower growth would mean even less ability for the government to pay back its creditors.

The government plan, released last Wednesday, is intended to replace the plan approved by the Washington-appointed fiscal control board last March and respond to the damage caused by hurricanes Irma and Maria. It, too, will have to be approved by the control board, known colloquially as the “junta” on the island. Created by the PROMESA law, which was passed by Congress in the summer of 2015, that body has broad authority over economic life in Puerto Rico and is tasked with interfacing between its government and creditors.

The fiscal control board will analyze the new fiscal plan over the next several weeks and will either approve the plan, reject it, or send it back to the governor’s office for revisions. Sources close to the matter suggest a final plan could be approved as soon as March.

“Puerto Rico is a colony, but it was a colony that we said could be self-governing. Now we’ve taken away that self-governing aspect,” Stiglitz told me. “For a country like the U.S. that makes a big claim to believing in democracy, it’s pretty terrible for it to say, ‘You’re a democracy, but — by the way — the hedge funds are just as important as you are, so you may have to lose your votes.’”

As an alternative to austerity, he and the other economists call for a write-down of “most if not all” of the island’s debt and large-scale public investment, as a means of recovery from both last year’s brutal hurricane season and the over-a-decadelong recession the island had been grappling with well before the storms hit. Stiglitz emphasized that spending — expansionary fiscal policy — is especially important as Puerto Rico doesn’t have a means of changing its monetary policy, which is the same as that set for the mainland U.S. “Austerity will actually lead them to a weaker economy, what we’ve seen over and over again is that countries [where austerity is enacted] become more financially precarious,” he said, likening Puerto Rico’s situation to that of Greece, another indebted economy without a sovereign currency.

“Fiscal policy’s what you need to jumpstart the economy. Puerto Rico is in an even worse situation because one of the other peculiar features there is extreme migration to the U.S. When jobs get scarce, people leave. That makes demand even weaker, and the economy even weaker. It’s a vicious cycle,” Stiglitz noted. Estimates vary for how many have already left post-Maria, though the fiscal plan predicts a nearly 20 percent population dropoff by 2022.

“Just look around places in the U.S. where there was population exodus,” he said. “You can’t sustain public facilities or the public framework that’s necessary for a prosperous economy.”

Sitglitz and other economists argued that the government’s previous fiscal plan “did not provide for economic recovery” and adopted a number of “unrealistic assumptions,” including “an over-optimistic view of how structural reforms, such as pension and other spending cuts, or downsizing the government labor force might stimulate growth, when the most likely effect is the opposite.”

The next plan, they added, “must be fundamentally different than the previous one if Puerto Rico is to have a chance for recovery.”

It isn’t. Aside from even more bullish projections for economic growth, the government’s new draft is similar in spirit to the previous one and considerably longer — 92 pages compared to just 37 in the last version. It includes far more detailed proposals for sector-by-sector cuts and how to integrate more private sector involvement in the island’s essential services. To the chagrin of bondholders, neither the economists’ plan or the one put forward by Gov. Ricardo Rosselló’s office predict that the island will have any capacity to service its debt over the short-term; the latter suggests it won’t be until 2048 when the island could handle paying off — at most — $15 billion.

“The largest difference between this fiscal plan and our sketch is that the government and the Fiscal Control Board continue to bet on austerity and other neoliberal policies that have not worked in Puerto Rico or in most of the countries,” says José Caraballo Cueto, a University of Puerto Rico economist who signed and helped draft the alternate proposal.

Compared to the previous version, the government’s new plan premises even minimal repayment on a projected spike in the island’s gross national product. Its authors predict the GNP will swell by 7.6 percent next year, compared to the 3.4 percent drop in GNP state analysts projected several months ago. The gap will be “fueled by federal support,” they argue, alongside structural reforms to roll back government spending and create a more welcoming environment for private investment.

Asked if such projections were realistic, Caraballo Cueto told me, “No. A real (adjusted by inflation) economic growth of 7.6% in 2019 is unrealistic.” He suggested, as well, that a bill introduced late last year by Sens. Elizabeth Warren, D-Mass., and Bernie Sanders, I-Vt. —for massive federal spending on the island and debt cancellation — might be among the most realistic options for jumpstarting Puerto Rico’s economy. “I think that if Congress takes seriously their shared responsibility and approves the project of Warren and Sanders that asks for more than $146 billion for Puerto Rico, we can expect a relatively high economic growth for two years,” he said. “But not as high as 7.6 percent, and that growth will not last forever, as reconstruction probably will only take between one or two years.”

Puerto Rican Gov. Ricardo Rosselló is interviewed by a TV channel after a House vote at the Capitol on Dec. 21, 2017 in Washington, D.C.

The scale of that proposed redesign is extraordinary. The government downsizing outlined amounts to a deconstruction of the island’s administrative state, condensing the total number of government entities from 115 to just 35.

One of the main levers for that consolidation passed through Puerto Rico’s legislature late last year. Called the New Government of Puerto Rico Act, the measure outlines ways to “address inefficiencies within the Executive Branch through a careful analysis of services offerings that will allow for externalizations and consolidations of agencies.”

In the next five years, Rosselló’s office further hopes to eliminate more than 8,000 government jobs. Toward that end, he recently unveiled a Voluntary Transition program, which incentivizes public sector employees to either retire early or seek employment in the private or nonprofit sector. The remainder are expected to leave through attrition or as their departments are liquidated.

In line with this “right-sizing” goal, as well — and that to increase the “ease of doing business” in Puerto Rico — is a proposed transformation of the island’s regulatory frameworks, including everything from shipping laws to occupational licensing. The plan further includes generous tax incentives for corporations to do business on the island and invest in both public-private partnerships. “Those kinds of supply-side measures have almost never worked,” Stiglitz said, “particularly in a small economy with the kinds of handicaps that Puerto Rico has.”

One of the key goals of the structural reforms proposed is to “reduce unnecessary regulatory burdens to reduce the drag of government on the public sector.” The first such overhaul, which also appears in the plan, has already been announced: to combine the regulators overseeing everything from telecoms to energy into one three-member body.

This is especially relevant to the government’s recently announced plan to privatize the Puerto Rico Electric Power Authority, or PREPA, the island’s public electric utility. By auctioning off parts of the utility to private bidders, the plan would leave different pieces of the utility’s operations up to different companies. If all goes according to plan, that process would happen with as little regulatory oversight as possible, leaving a slew of corporations free to set their own rules regarding everything from rates to reliability to power sourcing.

“Privatization is one of those market reforms where a lot of faith is put,” Caraballo Cueto said. “Providing the same service for a higher price is not how efficiency is defined in economics. In the case of the San Juan airport, a provision was included in the contract which says that if another airport in Puerto Rico is developed and that causes a reduction of revenues to the airport of San Juan, the government of Puerto Rico has to compensate those revenue losses. This runs against those that argue that one of the ‘advantages’ of privatization is promoting competition and a free market.”

Besides its airport and toll roads, the government’s other major experiment with privatization was carried out under Gov. Ricardo Rosselló’s father, Pedro Rosselló, who served as governor from 1992 to 1996. In 1995 he sold the Puerto Rico Aqueduct and Sewer Authority, or PRASA, to a subsidiary of the French company now known as Veolia. Prices rose and quality plummeted, with some of the worst service in the island’s poorest parts. The utility’s debt swelled, and it was fined $6.2 million by the Environmental Protection Agency for noncompliance. “Deficiencies in the maintenance, repair, administration and operation of aqueducts and sewers, and required financial reports that were either late or not submitted at all,” Puerto Rico’s comptroller office wrote in a scathing 1999 report. After being sold off again, the water utility was eventually brought back under public ownership.

Also on the chopping block in the new fiscal plan is Puerto Rico’s public education system. In addition to closing more than 300 schools by 2022, the plan would consolidate the island’s 35 school districts into seven along the same timeline, simultaneously “improving” the student teacher ratio by raising it from 11:1 to 14:1. Many schools on the island — especially those in rural areas — have sat empty since the storm, and teachers’ unions on the island fear it could be paving the way for the kind of wholesale privatization that happened in New Orleans after Hurricane Katrina.

In a joint statement, Asociación de Maestros de Puerto Rico President Aida Diaz and American Federation of Teachers President Randi Weingarten slammed the plan. “High-quality public education is a crucial driver of economic growth and societal equity,” they write, “There are some positive aspects to the governor’s plan — the decision to halt debt payments for one. But to thrive, Puerto Rico needs to keep schools open, not close them, and that’s why the push for mass school closings falls wide of the mark.”

The University of Puerto Rico would also be subject to hundreds of millions of dollars in additional cuts.

Hundreds of millions of dollars in cuts to municipalities slated to take place this fall have been stalled, but would be reinstated pending approval of the plan, eventually scaling up to a total of $219.7 million by 2022. Additional cuts are planned for the Department of Corrections and to the island’s already beleaguered health care system, where the plan’s authors encourage “patient accountability and responsibility measures” and the establishment of “limits to benefits according to the actual needs of the beneficiaries and in alignment with market trends.”

While emphasizing the role of the private sector, the plan places almost superhuman faith in the capacity of market forces to satisfy the island’s most basic needs on every front from public safety to mass transit.

“Given Puerto Rico’s fiscal and economic conditions, it is expected for projects to carry certain risk premiums and have feasibility challenges,” its authors write. “However, the market recognizes well-structured projects, critical and transformative projects and has the ability to formulate innovative solutions to improve the financial profile of projects.” If we build a corporate-friendly economy, in other words, industry will come.

Young members of the extended Medina family eat dinner at dusk with light from a cellphone on Dec. 21, 2017 in San Isidro, Puerto Rico.

“In Puerto Rico today, there continues to be hundreds of thousands of people who still do not have electricity and clean drinking water. We must pass disaster relief right now which is adequate, which treats Puerto Rico and the Virgin Islands just as we will treat Texas and Florida,” Sanders said via email on upcoming budget talks. “We cannot continue to delay given the enormous suffering that exists in Puerto Rico and in the Virgin Islands.”

Warren’s office has been working on separate debt relief legislation for some time, a draft page of which — apparently co-sponsored by Sanders and Sen. Kirsten Gillibrand, D-N.Y. — was leaked late last week. Tentatively titled the “Territorial Relief Act of 2018,” the one-page summary outlines a path to debt relief for Puerto Rico and other U.S. territories: “The bill gives territories the option to terminate their debt obligations, much in the way U.S. cities and towns can do, if they meet certain stringent legal criteria,” while also compensating mainland-based creditors — individuals, pension funds and trade unions, for instance — with up to $15 million in federal funds. “Hedge funds and their investors, bond insurers, many financial firms with consolidated assets greater than $2 billion, repo or swaps” would be ineligible. The leaked file appears to be just the first page of a longer document.

While neither Sanders or Warren would comment on pending legislation, each agreed that Puerto Rico is deeply in need of debt relief. “Puerto Rico’s budget should go to rebuilding the island and addressing the ongoing humanitarian crisis. Not one cent should go to the vulture funds who snapped up their debt,” Warren told The Intercept.

Top photo: Mother Isamar holds her baby Saniel, 9 months, at their makeshift home, under reconstruction, after being mostly destroyed by Hurricane Maria, on Dec. 23, 2017 in San Isidro, Puerto Rico.