External financing and crowding out

INE has just published the Quarterly Sector Accounts for the third quarter, showing that for the first time in any quarter this century the net lending of the Portuguese economy has turned positive. In the year to 2012Q3, the net borrowing of the Portuguese economy amounted to just 1.1 billion euro, when in the year to 2011Q3 those needs amounted to 12.3 billion euro. An adjustment of 11 billion euro, or 6.7 percent of GDP, in one year, is an enormous external adjustment, and it was much higher than expected. For instance, the May 2011 IMF projections forecasted that by 2016 the Portuguese economy would still have external net borrowing of 1% of GDP. Why was Portugal's external adjustment so strong in the first year of the adjustment program?

The net lending of the Portuguese economy is equivalent to the sum of the current account and the capital account of the balance of payments. Since, by definition, the balance of payments always balances, it is also equivalent to the negative of the financial account. When there are no financing constraints, the real economy determines the financing needs, i.e. the top part of the balance of payments determines the bottom part. However, in a financing crisis, when there are strong financing constraints, the availability of financing is binding, implying that it is the bottom part of the balance of payments that determines the top part. The domestic agents must reduce their expenditure to the available financing, even if they had higher expenditure plans.

The INE data provides some evidence that financing was a binding constraint for Portuguese households. In the past, private consumption has always been smoother than disposable income, implying that in recessions consumption fell by less than disposable income, and the savings rate declined. However, this was not the case in the year up to 2012Q3. Private consumption fell by 3.4%, while disposable income fell by only 1.4%, relative to the year up to 2011Q3. While negative expectations may have played a part, this anomalous behavior is likely to have been determined by a binding financing constraint. Non financial corporations have also decreased their financing needs by 5.3 billion euro in the same period, while gross value added has fallen by 1 billion euro. It seems that the Portuguese economy has been operating under a binding external financing constraint, which is not surprising if one remembers that the immediate cause for the signing of the Financial and Economic Adjustment Program with the troika was the lack of financing for the Portuguese government and banks.

If the Portuguese economy is under a binding external financing constraint, and if the financing constraint is not specific to any domestic sector, then there is full crowding out of fiscal policy. Any increase in the public sector financing needs must be matched by a equivalent reduction in the private sector financing needs. In other words, if the external financing constraint is fully binding, the size of the budget deficit does not have any influence on domestic demand. If this is the case, then the fiscal policy that would foster private consumption and investment would be a reduction of the budget deficit. Under these circumstances, the government could reduce public expenditure as quickly as possible, in order to allow for sufficient financing to be available for the private sector, without decreasing GDP or increasing unemployment.