The crisis that I described in my previous post is still far from being solved. The president asked for the three institutional parties to reach an agreement. Since nobody knows what is going on in the President’s head, it is impossible to predict what he will do if such an agreement is not met.
Anyway, the biggest challenge that the new government will face for the next year is to cut 4.7 billion euros (about 2.85% of GDP) in public spending. Such a drastic cut seems like the wrong thing to do.
Economists from the Bank of Portugal, using a Small Open Economy DSGE specifically developed and calibrated for the Portuguese economy, haverecently concluded that in times of economic stress the public spending multiplieris about 2.
If this number is correct, then the 4.7 bn cut would lead to a contraction in GDP of 5.7%. This contraction in GDP, by itself, would cause the debt to GDP ratio to increase by 7 percentage points (from 125 to 132%). Additionally, the recession would also lead to a decrease in tax revenues. If tax revenues dropped by 3.3 bn then the budget deficit would decrease by 0.6 percentage points.*
In sum, if these cuts were to be implemented, Portugal, whose GDP is already at pre-millennium levels, would face a huge recession. Unemployment, which is already at an all-time high, would explode. The only benefits would be a decrease in the budget deficit by less than 1 pp. together with an upsurge in the debt to GDP ratio. This is just silly.
Given this, I would say that the biggest challenge that the new Government, whatever its form, will face is to convince the troika that this additional cut is simply stupid.
* I am assuming that the decrease in tax revenues corresponds to 35% of the shrinkage in GDP. Some may consider 35% to be too much, however in these calculations I am not taking in consideration the increased spending in unemployment benefits.