Memorandum of Economic and Financial Policies: The Macroeconomic Framework

The macroeconomic framework of the Memorandum of Economic and Financial Policies (MEFP) is sound. It integrates the necessary structural reforms in a model that takes into account the effect of aggregate activity on the economy. This approach makes the underlying macroeconomic scenario realistic. (In the current environment where interest rates are set by the package and monetary policy is exogenous, the potentially expansionary channels of a fiscal consolidation are absent). The fundamental objectives of the policies described in the MEFP are to rebalance the economy and to increase its potential growth rate. The essential targets to achieve these objectives are an improvement of external competitiveness, an implementable fiscal consolidation and measures to insure a stable financial system. The external rebalancing is the most pressing and challenging target. The structural policies to achieve the external rebalancing aim to increase productivity and attractiveness of the tradable sector by liberalizing labor markets and increase competition in the nontradable sector. The short run policy to accelerate and sustain the external rebalancing is a fiscal devaluation: a budget neutral tax swap between VAT and the social security tax paid by the employers. The decrease in the TSU must be passed through lower prices to increase competitiveness and improve exports. The increase in the VAT will favor saving and decrease imports. The fiscal consolidation is based for two thirds in a decrease in expenditures and one third in an increase in revenues. The increase in revenue is achieved with a tax mix biased towards consumption. Therefore the revenue increase policy of the fiscal consolidation complements coherently the external rebalancing policy. Finally the plan reinforces the stability and resilience of the Portuguese banks to permit the large national deleveraging implied by the rebalancing to occur in an ordinate way.

The table shows the recent fiscal evolution together with the consolidation path implied by the MEFP.

The consolidation plan stabilizes the debt to GDP ratio and reaches the Maastricht deficit limit of three percent by 2013. The consistency of the consolidation path is conditional on the interest rate charged on the EU-EMU tranche of the loan (the ? in Table 1). The European authorities must offer an interest rate that does not jeopardize the fiscal consolidation. Furthermore, any spread above the interest rate at which the european facilities are able to finance themselves must be clearly justified. A punitive spread for accessing the bail-out facility is perfectly fine but a spread left without justification and open to interpretation is not acceptable. The frequent monitoring of the consolidation to ensure a timely and precise implementation of the fiscal measures (decrease expenditure, increase taxes) is equally crucial. Actually the plan foresees the creation of a “Portuguese Budget Office” to monitor, assist and prepare impartial reports on the budget process. A productive strategy could be to let the new “Portuguese Budget Office” participate to the continuous monitoring of the troika for the next three years.

The fiscal devaluation is a budget-neutral change of the tax structure that increases private saving and net exports that aim at substituting a nominal devaluation. The increase in the VAT (mostly from increasing lower rates) and the decrease in the employer's social security contribution tax can achieve the desired outcome in the short run if only and only if they are complemented with wage moderation and the tax decrease is passed through lower prices.

Update:

The fiscal devaluation can have significant effects on competitiveness only if the decrease in labor costs is substantial. A precise quantitative assesment will be defined in the next quarter but the lower bound is likely to be a decrease in the revenues generated by the labor tax of 3 to 4 percent of GDP coupled with an equal increase of the revenues generated by the tax on consumption. The increase in the consumption tax will be carefully calibrated to minimize any adverse effect on the weakest and poorest part of the population. Finally, a fiscal devaluation (and appreciation in a mirror case) appears to be one of the few adjustment mechanisms to external imbalances within the currency area.