A desvalorização fiscal mudou de poiso

Dois membros deste blogue, eu e o Francesco Franco, devotámos muita energia nos últimos 21 meses a defender que Portugal deveria ter baixado a TSU e subir o IVA, uma desvalorização fiscal com efeito neutro nas finanças públicas e com potencial para estimular a nossa economia no curto prazo e combater a recessão. Para os argumentos iniciais, podem ver a minha página ou ver as várias entradas neste blogue.

Não foi essa a opção deste governo, em parte por algumas boas razões. Mas uma crítica que me fez confusão foi que esta era uma ideia esotérica, coisa de académicos, e que Portugal não se devia por com experiências. Até alguns antigos ministros das finanças, comentadores sérios e sisudos, bradaram contra o arrojo da nossa proposta.

Estou curioso em ver a reacção destas pessoas ao anúncio que a França, que começa agora a entrar numa recessão bem mais pequena que a nossa, vai.... fazer uma desvalorização fiscal exactamente nos moldes defendidos por mim e pelo Francesco. Devem estar loucos, os franceses.

Second review of the IMF - December 2011

The IMF has concluded the second review, see press release

Relevant note: the drop of the fiscal devaluation is now official, but no substitute is known up to the moment.

combate de blogs

This is a post with a different nature, the portuguese economy has been nominated in the short list to win the category of best collective blog in Portugal.

You can see all categories and nominations here.

It is always good to know that others pay attention to our efforts!

Smart interpretations of a Treaty and debt management

If you have followed the debate on the ECB as a lender of last resort you probably came across Article 123 of the Lisbon treaty. Article 123 prohibits the ECB from purchasing bonds directly from public bodies. Paragraph 1 says:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

However Paragraph 2 allows the ECB to purchase bonds from a public bank.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

(Paragraph 2 was the basis of Soros proposal to transform the ESF into a bank in order to have access to the ECB liquidity. The proposal was rejected.).

Now the key question is who qualifies as a "publicly owned credit institution" described in paragraph 2? At first sight the German Finance Agency (Finanzagentur) qualifies (any one can confirm?). Finanzagentur auctions german debt, through the Buba, using a retention mechanism. The retention mechanism, that came in the highlights with the last November Bund auction, allows Germany to use "the sale of German Government securities in the secondary market that stem from the portions set aside in the auctions" to meet borrowing requirement. According to the Corriere della Sera, the Italian treasury already expressed interest in the retention mechanism as it permits a less risky debt management (if you check the graphs below, you will notice that the last bund auction, where 40% of the bonds have been retained has commanded an average yield of 1.98% when the coupon offered was 2%). Other euro governments might want to follow as well.


(click to enlarge)

Webinar on European Safe Bonds (ESBies)

Tomorrow at noon (New York time. EST), 5pm Portugal time (GMT). Register here if you want to listen in or ask questions:
http://prmia.org/events/view_events.php?eventID=T4705

The European Debt Crisis: a succession of bad ideas

I recently gave a talk about the European debt crises. I focussed on the many policy blunders committed so far, as well as on the many that are still occupying the agenda. Here was my list:

Bad idea #1: You can run a monetary union and have a single currency and central bank without:

1. Fiscal backing for your central bank

2. European-wide banking regulation and deposit insurance

3. A European-wide safe asset

Portuguese State Budget was approved but it needs corrections.

The Portuguese State Budget (SB) was approved last wednesday (30th of November)with the votes of the political parties who support government (PSD and CDS) and the abstention of the Socialist Party. It is the toughest budget ever approved in Portugal with a progressive cut in summer and christmas bonuses of civil servants and pensioners (more than 600 euros up to 1100) and a proportional cut (2/14) when income is above 1100 euros, equivalent to two salaries.

Apart from a possible unconstitutionality of these measures, this Budget implements certain aspects of the memorandum with the troika, but departs from it in several important respects. First, the memorandum predicts a cut in transfers to regional and local governments of, at least 150M. euros and also predicts that civil servants' salaries should be freezed. Therefore, we would expect that other expenditures (not wages) would be cut at least in 150M. However, with the bonuses' cuts local governments save around 240M. euros. This means that instead of leading to a reduction in other expenditures the Budget leads to an increase in local exenditures (other than wages).

An additional problem is an error in calculating the state budget deficit in public accounts
(cash basis) of 297,4 million euros due to a consolidation problem (see my article in Publico newspaper today here). What is worrying about this mistake, not clarifyed yet by the Ministry of Finance, is that it may increase the Budget deficit in this amount, and also what it reveals in terms of lacking of cross checking information in the Ministry of finance.

In Portugal there are two seminal initiatives of civil society that scrutinize the budget and the budget process. The budget watch (2012 results will be available soon) and the open budget initiative. They start producing results. But it is also important that the Council for Public Finances, an independent body predicted in the memorandum is also implemented.

To whom does Portugal owe?

In a recent article, BBC News identified for major Eurozone (highly indebted) countries, the US, the UK and Japan how much money is owed by each country to banks in other nations. Focusing on the Portuguese case, whose foreign debt amounts to 251% of GDP (equivalent to about 38.000 euros per person), the country is, first and foremost, highly indebted to Spain (65.7 bn euros). To a lesser extent it is also indebted to Germany, France and the UK (26.6bn, 19.1bn and 18.9 bn euros, respectively). Moreover, Portuguese banks are owed 7.5bn euros by Greece.
There are, naturally, worse cases starting with Ireland with a foreign debt to GDP ratio above 1000%, followed by the UK (436%), Spain (284%) and Greece (252%). Greece seems to have a figure almost identical to Portugal's level but the two countries are quite different in terms of its composition, namely the level of public debt: 100% of GDP vs. 166% of GDP for Portugal and Greece, respectively.

In the figure below (retrieved from the above-mentioned article) we can have a graphical representation of the current external debt situation in Portugal. The arrows point from the debtor to the creditor and are proportional to the money owed as of the end of June 2011 (data sources: Bank for International Settlements, IMF, World Bank, UN Population Division)

The bank recapitalization law proposal: throwing good money after bad

I had forewarned, on this blog (here and here) and in a 2009 paper that the Portuguese banking system was on route to nationalization.

The current Government has submitted to the Parliament (Assembleia da República) a new law proposal (which revises a prior law) to promote the recapitalization of the banking system with €12bn of public funds. The law proposal has been unanimously approved by the Economics and Public Works Committee. It is to be discussed and voted this week (November 22) by the plenary, a mere 15 days after it was first submitted to the Parliament.

Sadly, the recapitalization option is far more costly than what international best practice would recommend (special resolution regime), and it is poorly implemented. As implied in an interview by its Governor, Carlos Costa, the Bank of Portugal seems to have had a leading role in crafting this law proposal. In various issues (see 1, 2 and 3), the Bank of Portugal sides with the banks, and against the public interest, in an appalling display of regulatory forbearance.

The costs the taxpayers will incur to support the bank recapitalization program are substantial. The Portuguese Government will likely pay an interest rate of 3.5%-4% on the €12bn of loans from the IMF and EFSF that are being used to recapitalize the banking sector.

To put it in context, the interest outlays will likely come to represent around €450 million per year or nearly 50% of the entire 2012 budget allocated to higher education (which in addition to the transfers to public universities and colleges includes financial support to students from low income families). It is as if the government had created an entirely new large entitlement program that does not appear separately in the budget (it will appear under interest expenditure).

In fact, the casual ease with which our policy leaders and legislators dispense with large sums of public funds does not cease to surprise me. It is really a case of cutting costs on the pennies in order splurge on bit item expenditures.

In return for this large outlay of capital, the government gets very little back.

Now, countries like the US, the UK, and Germany had somewhat similar bank recapitalization programs in 2008-2009 and banks received what can only be interpreted as the “glove” treatment. But that was then and those programs generally had far harsher conditions for the banks. Moreover, since then, these countries have put in place much stronger special resolution regime legislation which, for example, in the case of the US Dodd-Frank Act, obliges the government to use an orderly liquidation regime to manage the wind-down of failing large financial institutions (a regime that is much stronger than what I advocate).

In its October 26, 2011 meeting, the European Council agreed to increase bank capital requirements to 9%. But left to national governments significant leeway on how to achieve the capital increase, if additional private sector capital fails to materialize.

Instead, the law proposal under consideration by the Parliament has various deficiencies. Contrary to past international practice, the public interest is not adequately represented in the board, and banks want to reduce the already de minimis representation of the government. This is bound to result in incentives to act against the interest of the largest shareholder (the Government).

Moreover, bank management is not replaced, as occurred, for example, in the case of Sweden, and the UK, and is internationally accepted best practice.

The aim seems to be to avoid political nominations. But, for example, the UK government supported the hiring of a Portuguese (António Horta-Osório) to manage one of its largest (nationalized) banks, the Lloyds Banking Group. The Swedish equally hired foreigners to manage their nationalized banks in their banking crises in the 1990s. So why won’t the Portuguese government replace current managers with foreign managers, for example?

The banks are up in arms because they want to ensure that if share prices recover to earlier levels, the government will not keep the profits. In fact, a recent proposal by the banks, which was also supported by the Bank of Portugal, in essence means that the government gives away to the banks a free and highly valuable 5-year call option to buy the stock back (perhaps even at the original price paid by the government). Depending on the exercise price of the option, it may be worth several billions of euro.

Notwithstanding these details, which are highly detrimental to the public and national interest and much worse than comparable bank recapitalization programs elsewhere in Europe, it is far more likely that the government capital investment in the banks will have to be substantially written down by the Government in a couple of years, i.e., the Government (and the country) will likely suffer large losses on this investment.

In sum, the law proposal should be rejected (though I have little hope of seeing this happening). There are far better and less costly alternatives, namely one based on a special resolution regime. A special resolution regime would ensure a functioning and healthy banking system, at a fraction of the costs. This bank recapitalization law will do neither.

Finally, the IMF staff (together with the remainder of the troika) were in Portugal last week for the 2^nd quarterly review of the adjustment program. One would have thought they would have had a hawk-like focus on the law proposal. After all, the €12bn foreseen in it represents in excess of 15% of the entire bailout package. No such luck, unfortunately. IMF staff focused on the trivia.

The IMF staff is making a disservice to clients and to their own institution by condoning this type of policy measure. The IMF staff is not following best practice recommendations (including IMF lessons learned from the Asian crisis and that described in various IMF working papers) and is violating its fiduciary duties towards IMF shareholders, by not being good stewards of the capital the IMF is lending to Portugal and to other European peripheral countries, in this and in other instances.

IMF staff should note that at some point more sensible leadership will arrive at positions of power, who will most certainly dispute the IMF credit so carelessly dispensed. Future leaders will have a fertile ground from which to pick evidence of policy mistakes and responsibility by IMF staff.

Looking further ahead, given this and other mishaps, it seems increasingly unlikely that the IMF will be able to survive the Eurozone sovereign debt crisis. In my view, it will, in a not so distant future, be replaced by some new multilateral institution based in Beijing.

the discussion on "fiscal disinflation" continues...

The discussion provided by Francesco Franco on fiscal disinflation / fiscal devaluation reached The Economist. You can follow it here

Health sector and the adjustment due to the financial rescue plan

The financial rescue program of Portugal has a Memorandum of Understanding - MoU - detailing the policies to be applied in the public sector to achieve balance in the Government accounts.

One targeted sector is health care, with several measures aimed at reducing the public expenditure on health care goods and services.

Another review period of compliance with the MoU has started. I provide here an assessment of the degree of progress in the adoption of the policy measures contained in the MoU. In summary, some are done, some are ahead of schedule, some are still to fully develop and just started. Overall, the level of compliance is quite good. We can always ask for more, and more was achievable in my view, but current situation meets the demands.

ULC and trade deficits

If I focus on ULC in manufacturing (as opposed to total economy) and the trade balance in goods (as opposed to goods and services) I see a strong correlation. It is also interesting to observe that Germany stops to be the outlier in cost dynamics (again for the manufacturing sector).

(click to enlarge)

Fiscal devaluation, a PR failure?

The memorandum of understanding signed last May by the main Portuguese political parties contains a measure designed to improve competitiveness and accelerate the necessary improvement in the trade balance. The measure consists in a budget neutral tax swap: an increase in the effective VAT rate (by increasing the low and intermediate rates) and a reduction of the social security tax paid by employers (TSU). The measure has been compared by scholars, journalists, experts and others (myself) to a nominal devaluation. The idea was that to show that even if the euro has eliminated the exchange rate, euro members could implement policies with a similar outcome to realignments of the exchange rate.

This comparison might have been unproductive for two reasons.

The first is a public relations failure. The name of the suggested policy contains the word devaluation. I remember an influential journalist calling the fiscal devaluation a "new drug" to replace the old one (i.e. nominal devaluation).
While from a from a technical point of view this affirmation is incorrect, it reminds us that "devaluation" is considered a dirty word. In fact, southern euro countries have adopted the euro in part to tie their hands and avoid external adjustments through devaluations.

The second is that for practical (as opposed to academic) purposes we should have compared the fiscal devaluation with a competitive disinflation. The latter is the market based mechanism that takes place within a fixed exchange rate system to adjust to external imbalances (in the absence of fiscal transfers and with limited labor mobility). It can be described as follows: unemployment increases and pushes the growth rate of nominal wages down until the country’s competitiveness is restored. It is obviously a painful mechanism that relies on two key market transmission mechanisms:

1) the decrease in nominal wages in face of higher unemployment, and
2) the decrease in prices in face of a decrease in the wages.

Consider impediments to the first mechanism: when nominal wages are sticky and adjust slowly, the competitive disinflation requires a high unemployment rate. Are nominal wages (downward) flexible in Portugal? If I remember well it is very difficult (unconstitutional) to decrease private wages. The Portuguese government has recently cut the public sector wages. This should help alleviate the necessary increase in unemployment as it can signals to the private sector wage setters the necessity to accept a lower wage.

Now consider the alternative of a fiscal devaluation. The decrease in the social security contributions aims at reducing the cost of labor in substitution of a decrease in the nominal wages. It does not require unemployment and works when wages are sticky. Moreover it affects simultaneously both public and private sectors.

It appears that on the first key transmission mechanism, fiscal devaluation works better than competitive disinflation. For what regards the transmission from labor costs to prices, there are no differences between the fiscal devaluation and the competitive disinflation.

A critique to the decrease in the TSU is that it will lower revenues and jeopardize the financial stability of the social security system. The fiscal devaluation is designed to be budget neutral: the second element of the measure is an increase in consumption taxes that offsets the decrease in revenues. In reality, to increase consumption taxes in Portugal is objectively difficult as VAT has already been increased to diminish the budget deficit. Again the comparison with the competitive disinflation is useful. A decrease in nominal wages decreases social security contributions and requires a decrease in benefits to maintain financial sustainability. This suggests that the loss in revenues that follows the substantial decrease in the TSU can be financed through a combination of lower benefits and higher consumption taxes. To a first approximation if wages are expected to decrease by 25%, social security contributions will decrease by 25%. To maintain the solvency of the social security system benefits will have to decrease by 25%. The same reduction of benefits could be used to finance part of the decrease in TSU so that the increase in the consumption taxes can be lower.

Another advantage of the fiscal devaluation is that the real debt due by wage earners (debt deflated by wages) does not increase. This is not a secondary point in an environment of fragile banks balance sheets.

The fiscal devaluation and the competitive disinflation have also different distributional effects. The latter are important as they are likely to determine the political feasibility of the measure.

I am surely missing something, but as of today I see the fiscal devaluation as a superior policy than trying to manipulate the nominal wages in the private sector or to wait for unemployment to be sufficiently high to exert downward pressures on those same wages. So what explains the opposition to such a measure? Should we call the fiscal devaluation "fiscal disinflation"?

Le dernier ressort

"...The historical record shows abundantly, in contradiction of such theories, that financial crises are a persistent phenomenon and that they are generally, but not always, alleviated by a lender of last resort, often one that insisted in advance that it would not come to the rescue."


In his fascinating Financial History of Western Europe, Kindleberger describes the genesis of the lender of last resort and the gradual assumption of this role by central banks. But why should we care about our own financial history? Obviously This time is different...

here Paul de Grauwe on the ECB and the LLR.

Were the last 10 years different?

Via facebook, I got to this post by the founder of The Portuguese Economy blog, Pedro Lains. I am not sure I understood everything Pedro wrote. But I think that Pedro is arguing that Portugal has always been dependent on foreign financing, so there is nothing new with the current crisis.

I agree with the first part of this sentence, and the mechanics of how a country can run a current account deficit for centuries is part of my lecture notes, where Portugal and Canada are the two examples that I use. But I don't understand the second one.

Below is a figure of the current account divided by GDP since 1953, split in 1995, when there was a change in the source of the data (before 1995, series longas para a economia portuguesa, afterwards Pordata). Also plotted is a horizontal line with the average current account deficit of the last 10 years (-9.8%).

The pattern of deficits may not be new, but the size and duration seem quite unusual to me.

Update: Here is the picture, subtracting transfers from the current account.