Tying our hands is not enough

"Joining the European Monetary System will result in efficiency and scale gains, which will be propagated over time and will promote and accelerate economic development."
QUANTUM report, Portuguese Ministry of Finance, June 1991

   After more than five centuries of colonial empire, the adhesion to the European Union in 1986 was expected to launch a new era for the Portuguese economy. In the first years, those expectations were fulfilled in many dimensions. After a turbulent decade, the political regime stabilized; in 1989, the path to a socialist economy and society was abandoned and the free market principles were adopted; continental European countries became the main trade partners; convergence to European average per capita income was resumed.

   These achievements made the participation in the three steps of the European Monetary Union (EMU) consensual among politicians and opinion makers (except for the timing). Therefore, in 1990, the crawling peg strategy, adopted in 1977 under the advice of Rudiger Dornbusch, was abandoned. The end of competitive devaluations and the restrictions imposed on monetary and fiscal policies were the main perceived costs of the new economic policy regime. Portugal joined the European Monetary System (EMS) in April 1992.

   For a project I am working on, I have been reading government reports, speeches and interviews delivered at the time by the proponents and supporters of a full-fledged participation in the EMU. There were very high expectations concerning both short run and long run benefits from tying policymakers’ hands.

   In the shorter run, participation in the exchange rate mechanism of the EMS was the way to import credibility, which was seen as necessary to curb down inflation and nominal interest rates to levels compatible with EMU. In January 1999, Portugal was one of the eleven founding members of the Euro.

   There were great expectations for the long run. Price stability and low interest rates would favour a better allocation of resources and promote higher rates of economic growth. Additionally, microeconomic long run efficiency gains, namely more efficient labour and capital markets, were also expected – the integration in one of the most competitive regions of the globe was expected to trigger the structural changes that would make the Portuguese highly productive. However, as Álvaro’s post shows, tying policymakers’ hands was not enough to reach those long run objectives. Something is missing.