HOW BAD IS IT?

Currently, Portugal faces not one, not two, but three crises, all of them presenting important challenges for the country‘s policymakers. All these crises are somewhat related, but it is worthwhile to study them separately in order to simplify. What are Portugal’s three crises then? First, in the last decade or so, Portugal has exhibited a low productive potential, which has been reflected in low rates of economic growth. Second, the country is increasingly facing a challenging crisis with regards to its public finances. And, third, in the last few years, Portugal has experienced substantial external imbalances, which have been translated into large trade deficits and an ever-increasing level of indebtness.
In order to understand what’s at stake, it is useful to look at the past to see how all these crises compare to previous episodes in the country’s history. Let’s start with the country’s productive potential, the most important crisis facing Portugal. As we can see in Figure 1, in the last decade or so, average growth rates have fallen to levels that have not been seen in Portugal since the 1910s, an era of substantial political and economic turmoil.

Figure 1 _ Portuguese GDP growth (HP filter), 1900-2007

Source: Maddison dataset

The same trend appears when we look at potential output in the last 15 years (figure 2): there is a steady decline in the growth of potential output from the mid 1990s onwards, a decline that was exacerbated after Portugal’s entry to the single currency. (Portugal is not unique in this respect, since other European countries, such as Italy, have exhibited exactly the same pattern of low growth after 1999).

Figure 2 _ Growth of Potential GDP, 1965-2009

Source: AMECO, European Commission

Studies have shown that this steady decline in average rates of growth is explained not only by Portugal’s “competitiveness problems” in the world markets (as many in this blog have emphasized), but also by a declining productivity and a sharp deceleration of investment.

On the other hand, the economic crisis of the last decade was exacerbated by the ineffectiveness of economic policy. As many studies have shown, in the last 10 years or so, economic policy has been notoriously pro-cyclical (and expenditure-based), which has reduced the effectiveness of policy to respond in recessionary times.

Once again, it is worthwhile looking at the past to see how uncommon Portugal’s fiscal woes really are. How bad is the crisis in Portugal’s country finances by historical standards? The answer is: not so bad, at least until recently. As we can see in figure 3, it is true that Portugal’s current public debt is reaching levels that hadn’t reached since the tumultuous 1920s. It is also true that if the predictions of the European Commission (shaded line) are correct (i.e. that Portugal’s public debt will reach 91% of GDP in 2011), then, in a couple of years, Portugal will reach its highest public debt in percentage of GDP for almost a century. Still, and in spite of the lack of real fiscal consolidation in the last few years, it is also true that, if it weren’t for the international crisis of 2008, Portugal would not be in such a weak position with regards to its public debt. Of course, this is not much of a consolation today, when the country faces serious credibility issues in the international markets.

Figure 3 _ Portuguese public debt in % of GDP, 1900-2009

Source: 1900-1973: Mata e Valério (1994), 1974-2009: AMECO, European Commission

Finally, Portugal’s external crisis is both related to the country’s entry to the euro (and the loss of competitiveness due to the adoption of a strong currency and the rise in unit labor costs that many have already mentioned in the blog), as well as with the liberalization of world trade and the EU’s expansion to Eastern Europe. As a recent study by the Bank of Portugal suggests, in the last 15 years or so, China and Eastern Europe became fierce competitors of Portugal’s traditional exports, which decreased Portugal’s market share in international markets. Again, how uncommon are Portugal’s external imbalances? If we look at net exports (in percentage of GDP), we can clearly see that Portugal has a chronic balance of trade deficit problem. The only exception was during World War II, when the country benefited from its neutrality. However, as the graph below also shows, the current trade deficit is not so large, at least by historical standards.

Figure 4 _ Portuguese net exports (goods and services) in % of GDP,

1910-2009

Source: 1910-1953: Baptista, Martins, Pinheiro e Reis (1997), 1954-1976: Banco de Portugal Séries Longas, 1977-2009: Banco de Portugal Estatísticas

Thus, the main differences with the past are twofold. First, in the past, trade imbalances were financed by the remittances of the country’s large emigrant community and/or by revenues from the colonies. Obviously, these mechanisms are not longer available (although things might change with the recent large outflow of new emigrants).

Second, the real break with the past (in the last 80 years or so) has mostly to do with the country’s level of external indebtness. The latter is also partly related to the country’s adhesion to the euro and the associated fall in interest rates. However, since this is already a long post, this topic will be the subject of future considerations.