Sunday, 25 May 2014

A few thoughts on Portugal and the Euro

Consensus exists on what should be the present and future path of the the Portuguese economy. Portugal needs to reach a state of sustained current account surpluses and simultaneously reabsorb a large number of unemployed while deleveraging the balance sheets of the Households, the Government and the Corporations (see Figure 1).
Where we see opinions differ vividly is in the actions to implement this path. One end of the opinion spectrum thinks that Portugal should exit the euro, regain monetary policy autonomy, stay in the common market with a devalued escudo and restructure national liabilities. The other end believes that structural reforms coupled with a medium-term consolidation anchored in a coherent euro membership will rebalance and relaunch the economy. 
The pro-euro-exit narrative follows the textbook description of a devaluation. Real wages will fall, the real exchange rate will depreciate. This will favour temporarily (2-3 years?) employment and the tradable sector. Yes but... economies have evolved faster than textbooks and supply chains, increasing the import content of exports, have likely changed the importance of the nominal exchange rate in determining the trade balance. Portugal is no different and is highly integrated with other producers in Spain, Germany Italy and France. Its energy trade balance is negative (although has improved).  Not so sure a nominal devaluation would improve significantly the trade balance (lower labor costs will help). In any case, even with a national currency, the most likely exchange rate arrangement with the rest of the common market would be a fixed or managed exchange regime that de facto will subordinate national monetary policy to the ECB. The extra degree of freedom, which is more a fraction of a degree of freedom, would be that Portugal could change the central parity (value) relative to the euro. One certainty is that financial markets will reflect this possibility in higher interest rates. All assets and liabilities denominated in euro (and other currencies) that do not include the contingency of a change in denomination (if they exist) will see their value increase in terms of the new currency.  Given the large negative investment position, strongly biased toward debt, Portugal will need to restructure its liabilities. The restructuring would also be reflected into higher interest rates. The capacity to attract foreign investment will decrease. Finally the exit from the euro and the permanence in the common market is not an option contemplated by the treaties and will have to be negotiated with the rest of the EU members. Would it be a temporary exit with a subsequent medium term strategy to attain the conditions to be part of the euro at a later date, or would it be a change of course towards a more standalone posture vis-a-vis Europe and the World? This uncertainty will imply a disorderly period and diminish any positive effects of the devaluation. 
It is also true that the adjustment within the euro is difficult. It requires well functioning markets and a coherent currency area. By well functioning I mean markets that permit adjustment through the demand-supply mechanism and deliver competitive outcomes. Ireland for example appears to have better functioning markets than Portugal. This did not protect Ireland from the consequences of a tremendous financial shock but helped to quicken the adjustment relative to Portugal. (see Figure 2) The policy prescriptions to improve labor markets functioning are reforms that increase job flexibility and maintain workers protection. Fairness suggests to address both legs, flexibility and protection, simultaneously. The policy prescriptions for better functioning goods markets are to increase competition in the non-tradable and networks sectors. We need to recognise that scale and some market power can be a source of R&D and innovation especially in the ITC and energy sector. If this is the case, the creation of integrated pan-european markets in the network industries can break national resistance to better competition (which is very strong),  allow sufficient scale for innovation and simultaneously permit European countries to operate on a level playing field by facing similar telecommunication and energy costs. This is the solution the euro area has adopted with the Banking Union to ensure that firms face similar competitive conditions in crucial inputs such as financial services and credit. The latter goes beyond the competition argument as it also aim at improving the transmission of monetary policy across the euro area. When fully implemented, Portugal like the other periphery countries, will see credit supply conditions improve and be at par with other euro members. Improving competition in the network sectors will help the rebalancing towards the tradable sector. It might not be sufficient to reabsorb sufficiently rapidly the large number of unskilled unemployed. (Can we find non-resident resources to reabsorb the unemployed coming out of the construction sector by finding resources to repair and maintain the existing stock of houses?) To be credible (in the sense of having a positive probability of success), the deleveraging and consolidations processes cannot be made unconditional to the state of the economy. They need to be designed around sound measures of structural unemployment and potential output level and growth. (For example some measures put the structural unemployment rate in Portugal at approximately 13% based on a non accelerating nominal wage model: nominal wages do not decrease therefore the unemployment rate is structural. Assume just for a moment that nominal wages never decrease, then there is no upper bound to the structural unemployment rate measured with this model.) Fiscal consolidation must also be made progressive to have as low as possible recessionary effects and ensure social cohesion and fairness.

A note on the euro. Yes we lost the possibility to devalue against other euro members. But was it really such a bonanza to devalue in the past? (read this older post). Yes the nominal convergence started in the mid 1990's towards German rates caused a boom that the periphery was not capable to channel towards higher productivity capital. Portuguese 10 years government bonds went from 11.8% in 1995q1 to 4% in 1999q1. But German interest rates on Bunds went from 7.4% to 4% in the same period: there were (and are) forces beyond the euro at play. Yes some euro zone members do not fully accept that to a current account deficit must correspond a current account surplus. And now the euro-area has the largest current account surplus in the World. With a fairly high unemployment rate. One certainty: international imbalances require international cooperation. Another certainty: inter-nations imbalances within a currency area require its members to have coherent policies.
Figure 1 (click to enlarge)

Figure 2 (click to enlarge)

10 comments:

  1. Most of the discussion on the euro has understandbly focused on the short term effects of leaving versus staying. I find it very hard to argue for an exit on those grounds, given that no one really knows what an exit would look like right now. The risk of chaos is very real. Why take the chance when the economy is already recovering?
    But the more interesting question, I think, is about the long term. What should we do when the crisis is over?
    When the decision to join the euro was made, the dominant view was that the main benefit of joining would be macroeconomic stability, especially low inflation. And that Portugal lacked the institutional credibility to achieve that on its own. It was understood that there were costs, namely the loss of an exchange rate and interest rate as mechanisms to absorb shocks like the current crisis. But it was thought that increased European integration would both decrease the asymmetry of these shocks and increase the European economy's capacity to absorb them through labor mobility.
    So what have we learned since then? Three things at least.
    First, that achieving low inflation is not that hard. Inflation has been brought under control all over the world, in rich and developing countries alike, with very few exceptions. Even countries with a history of hyper inflation like Brazil have been able to achieve low inflation on their own. Surely Portugal would have been able to do at least as well.
    Second, that European integration has not prevented a large shock from triggering a major crisis, and that adjustment through wages and labor mobility is incredibly slow and costly.
    Third, that a central bank has a much larger role to play in a crisis like this one than we previously thought. Compare the actions of the Fed to those of the ECB. The Fed acted immediately to guarantee the liquidity and solvency of the banking system in the US, and it implemented aggressive and unconventional monetary policy to stimulate spending. The ECB was much more passive, held back by the fact that northern Europe was doing ok and that Germany especially has a very restrictive view of the proper role for a central bank. The results are painfully obvious, with the US avoiding a major recession and Portugal and other crisis-hit European countries hitting unemployment record after record.
    So the question to me is not about euro membership right now, but in the long run. It seems clear that the benefits of membership are lower than we thought, and that the costs are higher. And we should not debate euro membership in the abstract, but in the context of a German-led ECB. That is a reality that is not going to change, and whatever reforms are in the pipeline, such as banking union, will reflect that. So what is the (economic) case for long term membership? Surely we have no reason to think this crisis was a unique event?

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  2. Good points above. In the long-run we have naturally to include also the aspects related to supply-side and investment, which may bring forward the advantages of participating in a large market, mobility of inputs, and the like. The long run is not just about macroeconomic management.

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    1. Agreed that participating in a large market and increased mobility are a plus, but to what extent do those depend on participation in the euro, rather than just in the single market? Several EU countries participate in the latter but not the former, that should be an option for Portugal as well.

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  3. All of the devaluations since 1982 in industrialized countries performed well .

    Faster GDP grow and employment.

    No single case of failure.

    The doom and gloom is baseless

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    1. I am not sure past experience is a good guide here, exiting the euro is not the same thing as abandoning a fixed exchange rate. There are serious legal risks involved. What happens to existing debt? Creditors would challenge any forced conversion from euros to the new currency in courts here and abroad. That could trigger widespread defaults and lead to a new financial crisis.

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  4. 3 comments in case Portugal would leave the EURO. 1) Portugal Republic would legally default on all its sovereign debt (it was issued in EUR, reimbursing in ESCUDO is a case of default). 2) Out of the EUR, it is unlikely that the ESCUDO would remain in a fixed exchange rate mechanism vs EUR. ERM is an entry stage to get into the EUR. Not an exit. If Portugal exits, other EUR countries will not feel obliged to defend the ESC parity. Portugal could only run an unilateral peg, prone to speculative attacks. 3) If Portugal (or any other country) leaves the EUR, it will not be temporary. There is no chance that Portugal would re-enter later at a devalued exchange rate. If other countries allowed such a re-entry, that would destroy any EUR membership for others: the EUR would just become like the defunct Exchange Rate Mechanism, where countries could enter/leave as they wanted. That would destroy the credibility of others' membership. As a French, for political reason, I would hope that Portugal remains in the EUR, but if she leaves, it is a one-way ticket. What we collectively have to do: how to make sure that such a crisis never happen again? How to make sure that countries/ sectors adjust to asymmetric shocks? Before leaving, Portugal should contemplate its long run horizon...

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    1. @ J.D.

      you have a good point on the impossibility of going back and forth between ERM and euro. One mechanism to tame asymmetric shocks within the currency area would be a form of automatic stabilisers at the euro level to facilitate market based adjustments. Today we have labor mobility: emigration from Portugal has been large, very large, and yet the unemployment rate is large, very large. Creating an automatic stabiliser that complements the labor mobility mechanism should be a good starting point.


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  5. Leaving the euro is very similar to devalue the currency when a country has a big external debt. Many cases of those cases existed all with happy and fast ends.

    All the external debts will be maintained in euros but the payment schedule could be longed, a normal procedure in balance of payments crisis.


    Because we have a balanced current account the devaluation imposed by the market would no be larger, because the market is not so stupid.

    If the Escudo goes down to much plenty of investors would take the chance to buy cheap assets.

    So a devaluation to the dollar value will be more than enough.

    The apocalyptic scenarios are "sound money" propaganda with any base.

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  7. The last 20 years are a proof that the Portuguese economy does't stand a strong currency because of the weak export sector and a big import tendency.

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