The Portuguese Economy

A desvalorização fiscal mudou de poiso

2012-01-09T21:05:00.002Z

Dois membros deste blogue, eu e o Francesco Franco, devotámos muita energia nos últimos 21 meses a defender que Portugal deveria ter baixado a TSU e subir o IVA, uma desvalorização fiscal com efeito neutro nas finanças públicas e com potencial para estimular a nossa economia no curto prazo e combater a recessão. Para os argumentos iniciais, podem ver a minha página ou ver as várias entradas neste blogue.

Não foi essa a opção deste governo, em parte por algumas boas razões. Mas uma crítica que me fez confusão foi que esta era uma ideia esotérica, coisa de académicos, e que Portugal não se devia por com experiências. Até alguns antigos ministros das finanças, comentadores sérios e sisudos, bradaram contra o arrojo da nossa proposta.

Estou curioso em ver a reacção destas pessoas ao anúncio que a França, que começa agora a entrar numa recessão bem mais pequena que a nossa, vai.... fazer uma desvalorização fiscal exactamente nos moldes defendidos por mim e pelo Francesco. Devem estar loucos, os franceses.

Second review of the IMF - December 2011

2011-12-20T16:15:00.002Z

The IMF has concluded the second review, see press release

Relevant note: the drop of the fiscal devaluation is now official, but no substitute is known up to the moment.

combate de blogs

2011-12-18T08:47:00.003Z

This is a post with a different nature, the portuguese economy has been nominated in the short list to win the category of best collective blog in Portugal.

You can see all categories and nominations here.

It is always good to know that others pay attention to our efforts!

Smart interpretations of a Treaty and debt management

2011-12-13T18:42:00.003Z

If you have followed the debate on the ECB as a lender of last resort you probably came across Article 123 of the Lisbon treaty. Article 123 prohibits the ECB from purchasing bonds directly from public bodies. Paragraph 1 says:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

However Paragraph 2 allows the ECB to purchase bonds from a public bank.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

(Paragraph 2 was the basis of Soros proposal to transform the ESF into a bank in order to have access to the ECB liquidity. The proposal was rejected.).

Now the key question is who qualifies as a "publicly owned credit institution" described in paragraph 2? At first sight the German Finance Agency (Finanzagentur) qualifies (any one can confirm?). Finanzagentur auctions german debt, through the Buba, using a retention mechanism. The retention mechanism, that came in the highlights with the last November Bund auction, allows Germany to use "the sale of German Government securities in the secondary market that stem from the portions set aside in the auctions" to meet borrowing requirement. According to the Corriere della Sera, the Italian treasury already expressed interest in the retention mechanism as it permits a less risky debt management (if you check the graphs below, you will notice that the last bund auction, where 40% of the bonds have been retained has commanded an average yield of 1.98% when the coupon offered was 2%). Other euro governments might want to follow as well.

(click to enlarge)

Webinar on European Safe Bonds (ESBies)

2011-12-13T15:54:00.002Z

Tomorrow at noon (New York time. EST), 5pm Portugal time (GMT). Register here if you want to listen in or ask questions:
http://prmia.org/events/view_events.php?eventID=T4705

The European Debt Crisis: a succession of bad ideas

2011-12-09T23:12:00.002Z

I recently gave a talk about the European debt crises. I focussed on the many policy blunders committed so far, as well as on the many that are still occupying the agenda. Here was my list:

Bad idea #1: You can run a monetary union and have a single currency and central bank without:

1. Fiscal backing for your central bank

2. European-wide banking regulation and deposit insurance

3. A European-wide safe asset

Bad idea #2: In the midst of a run on your debt (currency), words that are not not backed by actions, and hard cash, are enough.

Bad idea #3: To recapitalize banks you should, above all, avoid coming in with public capital. Rather, set targets for capital ratios and give banks enough time to reach those targets.

Bad idea #4: To a public debt crisis, respond with tighter fiscal discipline rules and tougher penalties even if you don’t have:

1. Anything like a wide agreement, either political, popular or intellectual.

2. Overseeing institutions in place.

3. Healthy banks not in need of a fiscal rescue.

Bad idea #5: Issuing large-scale Eurobonds without having:

1. The institutions in the previous point

2. Some joint taxation power

Bad idea #6: All countries should strive to have current account surpluses, now and always. Do not give in to the temptation to run irresponsible imbalances.

Bad idea #7: Two, seemingly opposed, but equally bad ideas:

One side: the European Central Bank can/should monetize the debt.

Other side: the European Central Bank should do nothing. It should not admit to even the possibility of higher future inflation. It should not buy sovereign debt of countries in trouble right now.

Portuguese State Budget was approved but it needs corrections.

2011-12-01T23:37:00.009Z

The Portuguese State Budget (SB) was approved last wednesday (30th of November)with the votes of the political parties who support government (PSD and CDS) and the abstention of the Socialist Party. It is the toughest budget ever approved in Portugal with a progressive cut in summer and christmas bonuses of civil servants and pensioners (more than 600 euros up to 1100) and a proportional cut (2/14) when income is above 1100 euros, equivalent to two salaries.

Apart from a possible unconstitutionality of these measures, this Budget implements certain aspects of the memorandum with the troika, but departs from it in several important respects. First, the memorandum predicts a cut in transfers to regional and local governments of, at least 150M. euros and also predicts that civil servants' salaries should be freezed. Therefore, we would expect that other expenditures (not wages) would be cut at least in 150M. However, with the bonuses' cuts local governments save around 240M. euros. This means that instead of leading to a reduction in other expenditures the Budget leads to an increase in local exenditures (other than wages).

An additional problem is an error in calculating the state budget deficit in public accounts
(cash basis) of 297,4 million euros due to a consolidation problem (see my article in Publico newspaper today here). What is worrying about this mistake, not clarifyed yet by the Ministry of Finance, is that it may increase the Budget deficit in this amount, and also what it reveals in terms of lacking of cross checking information in the Ministry of finance.

In Portugal there are two seminal initiatives of civil society that scrutinize the budget and the budget process. The budget watch (2012 results will be available soon) and the open budget initiative. They start producing results. But it is also important that the Council for Public Finances, an independent body predicted in the memorandum is also implemented.

To whom does Portugal owe?

2011-11-22T13:24:00.008Z

In a recent article, BBC News identified for major Eurozone (highly indebted) countries, the US, the UK and Japan how much money is owed by each country to banks in other nations. Focusing on the Portuguese case, whose foreign debt amounts to 251% of GDP (equivalent to about 38.000 euros per person), the country is, first and foremost, highly indebted to Spain (65.7 bn euros). To a lesser extent it is also indebted to Germany, France and the UK (26.6bn, 19.1bn and 18.9 bn euros, respectively). Moreover, Portuguese banks are owed 7.5bn euros by Greece.
There are, naturally, worse cases starting with Ireland with a foreign debt to GDP ratio above 1000%, followed by the UK (436%), Spain (284%) and Greece (252%). Greece seems to have a figure almost identical to Portugal's level but the two countries are quite different in terms of its composition, namely the level of public debt: 100% of GDP vs. 166% of GDP for Portugal and Greece, respectively.

In the figure below (retrieved from the above-mentioned article) we can have a graphical representation of the current external debt situation in Portugal. The arrows point from the debtor to the creditor and are proportional to the money owed as of the end of June 2011 (data sources: Bank for International Settlements, IMF, World Bank, UN Population Division)

The bank recapitalization law proposal: throwing good money after bad

2011-11-21T11:59:00.002Z

I had forewarned, on this blog (here and here) and in a 2009 paper that the Portuguese banking system was on route to nationalization.

The current Government has submitted to the Parliament (Assembleia da República) a new law proposal (which revises a prior law) to promote the recapitalization of the banking system with €12bn of public funds. The law proposal has been unanimously approved by the Economics and Public Works Committee. It is to be discussed and voted this week (November 22) by the plenary, a mere 15 days after it was first submitted to the Parliament.

Sadly, the recapitalization option is far more costly than what international best practice would recommend (special resolution regime), and it is poorly implemented. As implied in an interview by its Governor, Carlos Costa, the Bank of Portugal seems to have had a leading role in crafting this law proposal. In various issues (see 1, 2 and 3), the Bank of Portugal sides with the banks, and against the public interest, in an appalling display of regulatory forbearance.

The costs the taxpayers will incur to support the bank recapitalization program are substantial. The Portuguese Government will likely pay an interest rate of 3.5%-4% on the €12bn of loans from the IMF and EFSF that are being used to recapitalize the banking sector.

To put it in context, the interest outlays will likely come to represent around €450 million per year or nearly 50% of the entire 2012 budget allocated to higher education (which in addition to the transfers to public universities and colleges includes financial support to students from low income families). It is as if the government had created an entirely new large entitlement program that does not appear separately in the budget (it will appear under interest expenditure).

In fact, the casual ease with which our policy leaders and legislators dispense with large sums of public funds does not cease to surprise me. It is really a case of cutting costs on the pennies in order splurge on bit item expenditures.

In return for this large outlay of capital, the government gets very little back.

Now, countries like the US, the UK, and Germany had somewhat similar bank recapitalization programs in 2008-2009 and banks received what can only be interpreted as the “glove” treatment. But that was then and those programs generally had far harsher conditions for the banks. Moreover, since then, these countries have put in place much stronger special resolution regime legislation which, for example, in the case of the US Dodd-Frank Act, obliges the government to use an orderly liquidation regime to manage the wind-down of failing large financial institutions (a regime that is much stronger than what I advocate).

In its October 26, 2011 meeting, the European Council agreed to increase bank capital requirements to 9%. But left to national governments significant leeway on how to achieve the capital increase, if additional private sector capital fails to materialize.

Instead, the law proposal under consideration by the Parliament has various deficiencies. Contrary to past international practice, the public interest is not adequately represented in the board, and banks want to reduce the already de minimis representation of the government. This is bound to result in incentives to act against the interest of the largest shareholder (the Government).

Moreover, bank management is not replaced, as occurred, for example, in the case of Sweden, and the UK, and is internationally accepted best practice.

The aim seems to be to avoid political nominations. But, for example, the UK government supported the hiring of a Portuguese (António Horta-Osório) to manage one of its largest (nationalized) banks, the Lloyds Banking Group. The Swedish equally hired foreigners to manage their nationalized banks in their banking crises in the 1990s. So why won’t the Portuguese government replace current managers with foreign managers, for example?

The banks are up in arms because they want to ensure that if share prices recover to earlier levels, the government will not keep the profits. In fact, a recent proposal by the banks, which was also supported by the Bank of Portugal, in essence means that the government gives away to the banks a free and highly valuable 5-year call option to buy the stock back (perhaps even at the original price paid by the government). Depending on the exercise price of the option, it may be worth several billions of euro.

Notwithstanding these details, which are highly detrimental to the public and national interest and much worse than comparable bank recapitalization programs elsewhere in Europe, it is far more likely that the government capital investment in the banks will have to be substantially written down by the Government in a couple of years, i.e., the Government (and the country) will likely suffer large losses on this investment.

In sum, the law proposal should be rejected (though I have little hope of seeing this happening). There are far better and less costly alternatives, namely one based on a special resolution regime. A special resolution regime would ensure a functioning and healthy banking system, at a fraction of the costs. This bank recapitalization law will do neither.

Finally, the IMF staff (together with the remainder of the troika) were in Portugal last week for the 2^nd quarterly review of the adjustment program. One would have thought they would have had a hawk-like focus on the law proposal. After all, the €12bn foreseen in it represents in excess of 15% of the entire bailout package. No such luck, unfortunately. IMF staff focused on the trivia.

The IMF staff is making a disservice to clients and to their own institution by condoning this type of policy measure. The IMF staff is not following best practice recommendations (including IMF lessons learned from the Asian crisis and that described in various IMF working papers) and is violating its fiduciary duties towards IMF shareholders, by not being good stewards of the capital the IMF is lending to Portugal and to other European peripheral countries, in this and in other instances.

IMF staff should note that at some point more sensible leadership will arrive at positions of power, who will most certainly dispute the IMF credit so carelessly dispensed. Future leaders will have a fertile ground from which to pick evidence of policy mistakes and responsibility by IMF staff.

Looking further ahead, given this and other mishaps, it seems increasingly unlikely that the IMF will be able to survive the Eurozone sovereign debt crisis. In my view, it will, in a not so distant future, be replaced by some new multilateral institution based in Beijing.

the discussion on "fiscal disinflation" continues...

2011-11-14T15:37:00.002Z

The discussion provided by Francesco Franco on fiscal disinflation / fiscal devaluation reached The Economist. You can follow it here

Health sector and the adjustment due to the financial rescue plan

2011-11-12T14:21:00.004Z

The financial rescue program of Portugal has a Memorandum of Understanding - MoU - detailing the policies to be applied in the public sector to achieve balance in the Government accounts.

One targeted sector is health care, with several measures aimed at reducing the public expenditure on health care goods and services.

Another review period of compliance with the MoU has started. I provide here an assessment of the degree of progress in the adoption of the policy measures contained in the MoU. In summary, some are done, some are ahead of schedule, some are still to fully develop and just started. Overall, the level of compliance is quite good. We can always ask for more, and more was achievable in my view, but current situation meets the demands.

ULC and trade deficits

2011-11-11T17:27:00.004Z

If I focus on ULC in manufacturing (as opposed to total economy) and the trade balance in goods (as opposed to goods and services) I see a strong correlation. It is also interesting to observe that Germany stops to be the outlier in cost dynamics (again for the manufacturing sector).

(click to enlarge)

Fiscal devaluation, a PR failure?

2011-11-09T12:30:00.003Z

The memorandum of understanding signed last May by the main Portuguese political parties contains a measure designed to improve competitiveness and accelerate the necessary improvement in the trade balance. The measure consists in a budget neutral tax swap: an increase in the effective VAT rate (by increasing the low and intermediate rates) and a reduction of the social security tax paid by employers (TSU). The measure has been compared by scholars, journalists, experts and others (myself) to a nominal devaluation. The idea was that to show that even if the euro has eliminated the exchange rate, euro members could implement policies with a similar outcome to realignments of the exchange rate.

This comparison might have been unproductive for two reasons.

The first is a public relations failure. The name of the suggested policy contains the word devaluation. I remember an influential journalist calling the fiscal devaluation a "new drug" to replace the old one (i.e. nominal devaluation).
While from a from a technical point of view this affirmation is incorrect, it reminds us that "devaluation" is considered a dirty word. In fact, southern euro countries have adopted the euro in part to tie their hands and avoid external adjustments through devaluations.

The second is that for practical (as opposed to academic) purposes we should have compared the fiscal devaluation with a competitive disinflation. The latter is the market based mechanism that takes place within a fixed exchange rate system to adjust to external imbalances (in the absence of fiscal transfers and with limited labor mobility). It can be described as follows: unemployment increases and pushes the growth rate of nominal wages down until the country’s competitiveness is restored. It is obviously a painful mechanism that relies on two key market transmission mechanisms:

1) the decrease in nominal wages in face of higher unemployment, and
2) the decrease in prices in face of a decrease in the wages.

Consider impediments to the first mechanism: when nominal wages are sticky and adjust slowly, the competitive disinflation requires a high unemployment rate. Are nominal wages (downward) flexible in Portugal? If I remember well it is very difficult (unconstitutional) to decrease private wages. The Portuguese government has recently cut the public sector wages. This should help alleviate the necessary increase in unemployment as it can signals to the private sector wage setters the necessity to accept a lower wage.

Now consider the alternative of a fiscal devaluation. The decrease in the social security contributions aims at reducing the cost of labor in substitution of a decrease in the nominal wages. It does not require unemployment and works when wages are sticky. Moreover it affects simultaneously both public and private sectors.

It appears that on the first key transmission mechanism, fiscal devaluation works better than competitive disinflation. For what regards the transmission from labor costs to prices, there are no differences between the fiscal devaluation and the competitive disinflation.

A critique to the decrease in the TSU is that it will lower revenues and jeopardize the financial stability of the social security system. The fiscal devaluation is designed to be budget neutral: the second element of the measure is an increase in consumption taxes that offsets the decrease in revenues. In reality, to increase consumption taxes in Portugal is objectively difficult as VAT has already been increased to diminish the budget deficit. Again the comparison with the competitive disinflation is useful. A decrease in nominal wages decreases social security contributions and requires a decrease in benefits to maintain financial sustainability. This suggests that the loss in revenues that follows the substantial decrease in the TSU can be financed through a combination of lower benefits and higher consumption taxes. To a first approximation if wages are expected to decrease by 25%, social security contributions will decrease by 25%. To maintain the solvency of the social security system benefits will have to decrease by 25%. The same reduction of benefits could be used to finance part of the decrease in TSU so that the increase in the consumption taxes can be lower.

Another advantage of the fiscal devaluation is that the real debt due by wage earners (debt deflated by wages) does not increase. This is not a secondary point in an environment of fragile banks balance sheets.

The fiscal devaluation and the competitive disinflation have also different distributional effects. The latter are important as they are likely to determine the political feasibility of the measure.

I am surely missing something, but as of today I see the fiscal devaluation as a superior policy than trying to manipulate the nominal wages in the private sector or to wait for unemployment to be sufficiently high to exert downward pressures on those same wages. So what explains the opposition to such a measure? Should we call the fiscal devaluation "fiscal disinflation"?

Le dernier ressort

2011-10-27T12:37:00.005+01:00

"...The historical record shows abundantly, in contradiction of such theories, that financial crises are a persistent phenomenon and that they are generally, but not always, alleviated by a lender of last resort, often one that insisted in advance that it would not come to the rescue."

In his fascinating Financial History of Western Europe, Kindleberger describes the genesis of the lender of last resort and the gradual assumption of this role by central banks. But why should we care about our own financial history? Obviously This time is different...

here Paul de Grauwe on the ECB and the LLR.

Were the last 10 years different?

2011-10-24T16:27:00.006+01:00

Via facebook, I got to this post by the founder of The Portuguese Economy blog, Pedro Lains. I am not sure I understood everything Pedro wrote. But I think that Pedro is arguing that Portugal has always been dependent on foreign financing, so there is nothing new with the current crisis.

I agree with the first part of this sentence, and the mechanics of how a country can run a current account deficit for centuries is part of my lecture notes, where Portugal and Canada are the two examples that I use. But I don't understand the second one.

Below is a figure of the current account divided by GDP since 1953, split in 1995, when there was a change in the source of the data (before 1995, series longas para a economia portuguesa, afterwards Pordata). Also plotted is a horizontal line with the average current account deficit of the last 10 years (-9.8%).

The pattern of deficits may not be new, but the size and duration seem quite unusual to me.

Update: Here is the picture, subtracting transfers from the current account.

New Fiscal Data released by DGO (end-of-September 2011 cash data)

2011-10-21T10:36:00.002+01:00

For the interested reader, the cash data for the January-September 2011 budgetary execution (released yesterday by DGO – publicly available here) points to a State budget deficit of 3.8% of GDP which compares to a deficit of 5.4% of GDP over the same period back in 2010. The year-on-year growth rates of revenues and expenditures of the State were 5.2% (1.9% in 2010) and -3.8% (2.0% in 2010), respectively.

Jornal de Negocios’ news elaborate on this by reporting that expenditure with public employees is falling more than 6%, reflecting the 5% average wage cut that took place earlier this year (see here). Simultaneously, the revenues’ side is over performing, mostly driven by direct taxes paid by enterprises and VAT (see here).
All in all, the State budget deficit is falling more than 30% since January (more here).

Portugal remains one of the OECD countries with the highest unemployment rate

2011-10-12T11:42:00.007+01:00

According to the latest OECD figures, updated until August 2011, the 12,3% unemployment rate in Portugal is only overcome by 5 countries. In particular, by Estonia (12,8% in June), Slovakia (13,4%), Ireland (14,6%), Greece (16,7%, in June) and Spain (where, contrarily to the trend, unemployed people keep on growing and they currently amount to 21,2% of the labour force).

The average unemployment rate for the aggregate OECD group was kept unchanged in August, at 8,2%, sligthly smaller than the Euro-area and US' numbers, 10% and 9,1% respectively.

More information here.

Source: Labour Force Statistics

New conditions in terms of financial assistance to Portugal

2011-10-11T18:13:00.001+01:00

Copied from the COUNCIL OF THE EUROPEAN UNION, provisional version, press release, 3119th Council meeting, Luxembourg, 11 October 2011:

"PROVISIONAL VERSION 11.X.2011 ECONOMIC AND FINANCIAL AFFAIRS

Financial assistance to Ireland and Portugal

The Council adopted two decisions amending the terms of financial assistance granted to Ireland and Portugal under the European Financial Stabilisation Mechanism

The decisions extend the maximum average maturity of the loans to Ireland and Portugal to
12,5 years, while the maturity of individual tranches of the loan facilities may be of up to 30 years. The interest rate margins will be reduced to the EU's cost of funding. The extension of maturities and the reduction in the interest rate margin will also apply to the tranches that have already
been disbursed.

The decisions amend implementing decisions 2011/77/EU and 2011/344/EU on granting EU financial assistance to Ireland and Portugal. They implement conclusions reached by the euro area heads of state or government on 21 July 2011."

Updated information and data on Portuguese's Quarterly National Accounts Q2-2011

2011-10-10T13:45:00.003+01:00

On 30th of September INE published data on the national accounts for the institutional sectors for the 2nd quarter of 2011.

In summary, the General Government deficit (national accounts) was 8.8% of GDP in the 12 months ending in Q2 (decreasing from 9.3% in the previous quarter), mainly due to reductions in wages and social transfers in kind.

Indebted Madeira votes long-time leader back

2011-10-10T12:56:00.005+01:00

Alberto Joao Jardim, president of Portugal's autonomous Madeira archipelago, won regional elections Sunday, even though he has been blamed for (unreported) debts that boosted the country's overall deficit. This relates to Fitch's statement last Friday that Portugal's outlook was negative, meaning that its BBB- rating could be further downgraded in the near future. Recall that the Madeira bill further burdened Portugal's deficit (it amounted to 8.3% of GDP in June, far from the 5.9% end-of-year target). In fact the Finance Minister Vitor Gaspar said recently "These irregularities... impact negatively on the country's credibility".

Official results showed that the Social Democrat Party (PSD) obtained 48.56% of the vote, its worst result under Jardim's 33-year leadership.
CDS-PP, which forms the national ruling coalition along with the PSD, came second with 17.63%, well up on the 5.34% it got in the last elections in 2007.
Portugal's main opposition party, the Socialist Party (PS), had to content itself with third place taking just 11.5% of the vote, down from second place and 15% in 2007.

Americans Sargent and Sims Win Nobel Economics Prize

2011-10-10T12:28:00.004+01:00

Today the Royal Swedish Academy of Sciences awarded two Americans, Thomas Sargent and Christopher Sims, the Nobel in economics. The prize's justification is as follows: "for their empirical research on cause and effect in the macroeconomy".

According to the prize committee the winners developed methods for answering questions such as how economic growth and inflation are affected by a temporary increase in the interest rate or a tax cut. Sargent and Sims, both 68 years old, carried out their research independently in the 1970s and 1980s.

More details on the prize can be found here.
For the winners' personal webpages: Thomas Sargent and Chris Sims.

updated information on the Portuguese economy

2011-10-06T16:34:00.002+01:00

The Bank of Portugal released today forecasts for the Portuguese economy. The recession is predicted to be worst than in previous assessments. This of course will create more problems in meeting the targets for the public deficit.

Portugal's productivity curse and the need for credit/investment

2011-09-26T09:05:00.007+01:00

According to Olivier Blanchard (IMF Chief Economist) in a recent interview provided to the "Jornal de Negocios", Portugal needs a productivity boost since the "fiscal devaluation" strategy will be insufficient to get us out of the current crisis.
To put this in perspective, below I plot the growth rates of TFP for the total economy between 1960 and 2012 (estimate) for both Portugal and the EU15 average.

We do observe that since the last economic and financial crisis (in 2008) Portugal has had an average productivity growth rate of -0.18% and this is expected to remain below zero in 2011 and 2012 (in line with the latest GDP growth projections), contrarily to EU15's average which foresees a better performance for the year to come (and which has shown, over time, smaller volatility as well).
To this end, more investment and lower unit labour costs are necessary but not sufficient conditions to increase productivity levels. One also needs such approach to be coupled with banks' recapitalization so that credit flows into the economy at the "right" speed (and amount). Such idea has been reinforced in recent meetings held in Washington DC this past weekend where the European crisis was scrutinized by world leaders and economists. Raghuram Rajan, (former IMF Chief Economist) stressed exactly the financing point in today's article in the Financial Times (here). More specifically, some of the EFSF funds will have to be used to recapitalise banks that are not able to get money from the markets. The problem is the lack of consensus in this matter. For Rajan, "the world has to recognise that the eurozone’s problems are too big to leave to eurozone countries alone to deal with. The world has a stake in their resolution. And it has an institution that can channel help, the IMF." He suggests that the IMF could set up a special vehicle that would offer large lines of credit to illiquid countries like Italy or Spain. This is one additional suggestion that joins a plethora of others being considered for Europe's crisis resolution.

For those who need it stated more bluntly

2011-09-20T17:20:00.002+01:00

This is why I and the IMF were insisting last week on the need for a fiscal devaluation. It seems the political appetite for this policy is not there. That is fine; it was one option, and there are alternatives. What is not fine is to ignore that the dismal growth forecasts for 2012 can compromise the entire adjustment and rescue package. As I wrote in my essay last week:

"Se o governo não quer cumprir esta parte do acordo, então tem de pensar a sério, e rápido, noutras medidas que evitem uma recessão profunda. Seria uma pena se a desvalorização fiscal tivesse dado o seu último fôlego, mas seria uma tragédia se fosse a economia portuguesa a perder o fôlego."

Intermezzo romantico

2011-09-19T16:06:00.004+01:00

Once upon a time in 1969

extract:

"If all were well with Europe, we would not be meeting today. If the Community were able to speak with one voice our main topic here would be foreign policy: the question of the peaceful organization of Europe, negotiations with the countries of Eastern Europe and our interests with regard to the conflict in the Middle East.

Instead...

... The links that have been forged between us [note: us = Europe] must be indissoluble and must grow ever closer. If we want to achieve the necessary harmonization we must give each other support, that is to say, we must apply solidarity in practice. On behalf of the German Government, I declare that we are ready to do this. And German public opinion is behind us in this..."

Willy Brandt, Chancellor of the Federal Republic of Germany, The Hague 1969

reference: (here full transcript)

"Greece must abandon the Euro and Portugal should do the same" (Nouriel Roubini)

2011-09-19T13:38:00.009+01:00

Following up on my previous post, where I alluded to a research piece published by Roubini Global Economics, today the FT published its summary in the "Opinion" section - here.
The "Diario Economico" newspaper also comments on this - here (in portuguese).

The quest for a "Polish"-Consensus?: sovereign debt crisis, Greek's problem/contagion and the future of the Euro-zone

2011-09-16T13:35:00.005+01:00

Today the 17 ministers of Finance are gathered in Wroclaw, Poland, to dig out solutions for the (general) sovereign debt crisis while simultaneously having to deal with an urgent solution to the “Greek” problem (in terms of the most pressing financing needs). Vitor Constancio (ECB Board Member) told the press this morning that contagion to Portugal is always possible as long as the present (Greek) situation is not clarified (and resolved).(click here)
Such statement comes one day after both Merkel and Sarkozy have reaffirmed Greece’s place in the Monetary Union and reiterated their countries’ support to finding a solution that must prevent the country from abandoning the Euro-area. Timothy Geithner has also urged for a credible, coherent and quick Euro-zone response to the present conjuncture advocating that both the European Commission and the ECB still have several tools at their disposal. Despite these voices, Nouriel Roubini (Dr. “Doom”) published today an economic research piece in Roubini Global Economics entitled “Greece should default and abandon the Euro”. His views are that “Greece is insolvent, uncompetitive and stuck in an ever-deepening recession, exacerbated by harsh and excessive fiscal consolidation.” Some arguments are a bit too pushy, particularly when he compares the Greek with the Argentinean case. Portugal is also briefly mentioned (but not Ireland) with respect to some economic similarities shared with the Greek economy (such as the competitiveness issue) and the possibility of becoming the next “default” victim.
Irrespectively of who says what and where is the reason, the general public can, nevertheless, witness the absence of a unifying (and unique) “voice” in Europe as well as the lack of concrete plan of action to enforce…
Today’s article on the Economist, “Fighting for its life” (click here), suggests/asks for a greater role of the ECB, particularly given the growing financing difficulties of the banking system as a whole. Estimates from Goldman Sachs advert to the fact that Europe’s 38 largest banks may need between 30-92 billion euros in extra capital to cope with haircuts to Greek, Irish and Portuguese government bonds (as well as losses in Italian and Spanish government debt). IMF’s projections are even worse.
In face of increasing pressures from the financial markets, the 17 members may need to take measures to increase the scope and firepower of the European Financial Stability Facility (EFSF), Europe’s bailout fund. At the same time, the ongoing discussions about ECB’s willingness to buy without limit the bonds of solvent Euro-zone countries as well as the question regarding the issuing of Euro-bonds, does not seem to be heading towards generalized consensus. In the end, it is all about credibility and time (in-)consistency of policy-based (political?) actions.

First update of the memorandum of understanding

2011-09-13T16:37:00.002+01:00

As troubled times hit Greece, it is worth reading the first update of the Portuguese Memorandum of Understanding, to see what has been the view about progress made in Portugal. You find the document here

Fiscal devaluations

2011-09-10T15:35:00.006+01:00

Today's "Dinheiro Vivo" supplemento to Jornal de Noticias e Diario de Noticias had an essay by me on fiscal devaluations. (It is here, but a better version is here.)

There are some pros and cons to this measure, but many of the arguments that have dominated the public debate in the last month are, in my view, not valid. In particular:

1) Fiscal devaluations have nothing to add to our deficit target, positive or negative. They are budget neutral. They are a growth measure.

2) Devaluations are not some funky idea by esoteric or disreputable economists or crazy wonks. They are part of almost every IMF plan, including those in Portugal in the early 80s.

3) The price of Portuguese non-tradables does not change with the measure. The price of imports rises, the price of exports falls, and that is it.

4) Profits are likewise unchanged.

5) Fiscal devaluation is not the same as lowering payroll taxes. Raising VAT is as important as lowering the payroll tax in the measure.

6) One feature that hasn't been given its due attention is that you have to raise the consumption tax on sectors exempt from VAT, especially real estate.

7) According to the study put out by the Bank of Portugal and several Ministries, lowering payroll taxes by 3.7% as part of a fiscal devaluation leads to a fall in the real exchange rate of about 2.2%. That is a lot. The measure has a lot of bite on competitiveness, in spite of what a naive look at the labor content of exports may show.

8) Contrary to what the press reported, that official study, in my view, supports the use of a fiscal devaluation. The study spent (too) much of its time talking about lowering payroll taxes, which is not the same as a fiscal devaluation (point 5 above). Also, its more reliable estimates show a positive impact of 0.5% of GDP to a 3.7% lower TSU plus 2.2% higher VAT combination. That's a big impact. Extrapolating, it says that if you doubled or quadrupled the measure (like I have defended, and the IMF has supported) you could get a huge impact, likely well above 1% of GDP. Show me any other measure that has that short-run impact on output.

This the summary of the essay in English, for those who do not speak Portuguese.

US payroll taxes and Portuguese TSU

2011-09-09T17:38:00.005+01:00

President Obama announced his plan to cut the payroll tax paid by employees from 6.2% to 3.1%, and the part of the tax paid by employers from 6.2% to 3.1%. That is a combined 6.2% reduction in payroll taxes for existing workers. For new hires, all of the 12.4% combined tax will be waived.

This in an economy that is expected to have modest GDP growth around 2 or 3%, and where the unemployment rate is 9.1%.

In Portugal , the unemployment rate is 11.1%. GDP will likely fall, with a growth rate between -0.5% and -2% in 2011-12.

But cutting payroll taxes (via taxa social unica) in Portugal by more than 3%, as part of a fiscal devaluation, was pronounced in the last couple of months as far too much. Not feasible, dangerous, irresponsible, unnecessary were some of the adjectives to describe it.

In the land of small government, it seems that when it wants to, the government can do way more than in the land of "Estado omnipresente". Not so much of a contradiction, when you think about it.

one more piece of information

2011-09-01T20:37:00.002+01:00

The Portuguese Government made available a new document containing the strategy to bring the budget deficit into control (the document is in Portuguese). Although most, if not all, press has given prime time to the increase in taxes for the higher income bracket and to firms with profits above a certain threshold, the document actually contains more information.

An important one, in my view, is a picture showing that past programs have failed dramatically predictions of return to economic growth, and overstated in a systematic way the control of public spending. This puts obvious pressure for the current Government to do differently. And there is a very specific concern in the document to improve the tools for budget control within the Government.

VAT gap in Portugal

2011-08-29T10:58:00.004+01:00

Not too long ago, a blogger suggested that an increase in the VAT rates would not generate the expected tax revenue because of tax fraud. As I had no clue on the real severity of VAT tax evasion in Portugal, I had to spend sometime documenting myself.

Well, according to this study commissioned by the European Commission, Portugal behaves quite well with a VAT gap of 4%. The VAT gap (the gap between actual and theoretical revenues) is not a direct measure of fraud, just an upper bound. For details I defer the interested reader to the report that covers the period 2000-2006. The time series dimension is of some interest as it is probable that the gap increases during recessions. In any case, international markets should welcome Portuguese diligence.

This little pig went to the market, the others...

2011-08-26T19:23:00.005+01:00

See here, and also here.

The end of Europe as we know it

2011-08-18T15:38:00.004+01:00

The eurozone is in a deep crisis, which will have serious consequences for the Portuguese and for the European Union. In the beginning of the sovereign debt crisis, Greece, Portugal and Ireland owed thousands of millions of euros and the problem was theirs, i.e., they would have to correct their imbalances through austerity measures. In the current stage of the crisis, Spain, Italy, Belgium and France owe millions of millions of euros, and the debt crisis is now also a problem for the creditor countries – and the final word in the solution of the eurozone crisis is theirs.

Since the beginning of the sovereign debt crisis, several commentators have expressed the hope that surplus countries agree to three measures. First, to change the orientation of the ECB towards a more expansionary monetary policy. Second, to adopt themselves expansionary fiscal policies, which would stimulate imports of goods produced by deficit countries. Finally, countries such as Germany could also take measures to increase wages and thus further stimulate demand. Associated to this view is the idea that a permanent solution to the structural fragility of the euro is the creation of a “European government” that would collect taxes and distribute subsidies and other public expenditures at the European scale. This government would put into work a mechanism of “automatic stabilization” in the eurozone: when Portugal is in recession, as is the case, and Germany is in an expansion, taxes collected in Germany would pay, for instance, unemployment subsidies in Portugal. By definition, this European government would be financed by euro-bonds.

In that scenario, the countries currently in crisis, which implemented economic policies incompatible with the stability of the euro, would determine the economic policy of the wealthier countries and of the ECB. This solution is very unlikely to be accepted by most Germans and Central and Northern European peoples, who would most likely prefer to let the indebted countries default. This would lead to the end of the euro and also of the European Union as we know it; at the very least, the number of member countries would be significantly reduced. A period of economic, social and political chaos would follow, with abrupt falls in standards of living, accompanied by the resurgence of international tensions. This process would have unpredictable consequences, unthinkable in pre-crisis Western Europe. As for Portugal, after the chaos, it would probably return to its pre-European integration status: a poor and peripheral country, politically unstable.

However, eurozone countries may still choose alternative solutions, involving more active ECB policies and/or greater fiscal coordination, which we group into two scenarios.

In the first scenario, during the next few years, the ECB (and the EFSF) intervenes resolutely and in large scale in the sovereign debt market, buying debt issued by European countries with funding problems. At the same time, the countries in trouble successfully implement fiscal consolidation programmes, possibly aided by some form of soft restructuring of their debt. In a few years, investors regain some confidence in those countries and the ECB and the EFSF may stop buying public debt issued by them. At that time, the eurozone will return to the normality of its first years, but with higher spreads for less credible countries.

However, this solution has two problems. The first problem is that it does not guarantee that the behaviour of governments will change so as to avoid a repetition of the crisis – the moral hazard problem remains, and may even worsen in this context. The second problem is that the change in the behaviour of the ECB will hardly be accepted by the German public opinion. Clearly, financial markets do not believe this solution will work, a feeling deepened by the erratic behaviour and the lack of consensus among European leaders. The proposals to revise the stability and growth pact, namely through the establishment of automatic sanctions, are a way of trying to bypass this problem. But, if the stability and growth pact failed, why should one believe that the new proposals will be more effective (even assuming that they are accepted by all countries, which cannot be taken for granted)?

In the second scenario, the European countries reach a political agreement to reduce, if not eliminate, the probability that the eurozone faces a crisis of this kind. The measures include (besides ECB intervention and soft restructuring) a transfer of budgetary powers to a European entity designed by Central and Northern European countries. This entity is committed to presenting balanced budgets for each country under its supervision. National authorities may choose the level and composition of public expenditure, and the type of taxes. The intervention of that European entity in the budgetary process will guarantee that the budgetary targets are met, as it will be able to impose the measures required to correct deviations. For deficit countries, this solution should imply the continuation of austerity, with the goal of reducing the weight of public debt. The refinancing of debt and the financing of temporary deficits might employ euro-bonds, as a way to alleviate austerity.

This solution eliminates the moral hazard risk through a transfer of powers to a more credible entity. However, this would certainly be met with opposition from important sectors within eurozone countries, which would view it as a loss of sovereign powers and a submission to stupid rules (which in any case would be very hard to define).

Last Tuesday’s meeting between Angela Merkel and Nicolas Sarkozy suggests that European leaders are moving from the first to the second scenario. If none of these solutions work, the collapse of the euro, followed by European Union chaos, especially in peripheral countries, will become inevitable.

(with Pedro Bação)

The Ministry of Finance report on fiscal devaluation

2011-08-15T11:08:00.002+01:00

The Portuguese Ministry of Finance has posted a report on the implementation of a fiscal devaluation in Portugal.

I wish to make a few comments:

1. The authors should state that the report is preliminary. The report does not contain any conclusion, therefore, in its current form, it is still incomplete and preliminary.

2. The report is acknowledged to be a patchwork of views of four different institutions (Bank of Portugal, Ministry of Finance, Ministry of the Economy and Employment, Ministry of Solidarity and Social Security). While a list of all four different stances is a useful starting point, the final document must find a coherent and unique position on the matter. After all there is only one entity that must fiscally devaluate, Portugal.

3. The structure of the document appears to be biased against the fiscal devaluation.

3.1. The first quarter of the study consists in a detailed description of the social security's financing sources. It is useful to know these details, and there is a lot of interesting information (see below Remark in 3.3). It is important to know which laws should be abrogated and/or changed if the government implements the reduction of the social security contributions paid by employers. The chapter ends with a comparison between Portugal and EU's fiscal revenues structures and states that Portugal relies more heavily than the rest of EU on indirect taxation (read VAT) and less on social contributions (paid by employers). These numbers are obviously influenced by the composition of aggregate demand and income shares. For example, in Germany private consumption (basically the tax basis for VAT) is around 56% of GDP and in the Netherlands private consumption is 45% of GDP. In Portugal private consumption is around 64% of GDP. I would imagine this section as an appendix and not as the initial chapter of the report.

3.2 The second section which addresses the macroeconomic effects (the core of the matter) of the fiscal devaluation is short. The evaluation is performed using a dynamic stochastic general equilibrium (DSGE) model developed at the Bank of Portugal. Two similar DSGE models developed by the ECB and the European Commission have also been used to confirm the results. Personally I believe that these models are very useful for theoretical guidance but should be complemented by more empirical approaches for a more robust quantitative evaluation of the suggested policy. [For the more analytical inclined readers : in the technical description of the macroeconomic effects, a neat identification of short term effects (fiscal devaluation), medium term effects (firm entry in the tradable sector) and long term effects (new steady state due to possible non neutral shift in aggregate labor demand and labor supply) is absent, which makes the quantitative results difficult to interpret].

3.3 The third section is the central part of the report and describes a menu of options to implement the measure. The benchmark measure, the only one that can be labeled as a fiscal devaluation, is the reduction of the payroll tax across all sectors compensated by an increase in VAT (and/or a decrease in public expenditure). The report correctly identifies the main weakness of the measure in the market power of the non-tradable sector (Remark: I noticed that in Table 3 Section1, a large non-tradable industry, or network industry, such as Telecommunication pays a payroll tax of 7.8%, as opposed to the general rate of 23.7%. Given that such a company-industry will not see its payroll tax being reduced the above weakness does not apply).

The alternatives suggested are not fiscal devaluations but could be labeled as :
a) Incentives to job creation (low payroll tax only for new jobs) ;
b) Export oriented Industrial policy (payroll reduction in export industries);
c) Tradable (?) oriented industrial policy (reduction of payroll tax only for lower wages).

3.4 The last page and a half is concerned with the financing of the payroll tax reduction. The last sentence briefly mentions that if the measure is implemented, the necessary fiscal revenues will have to be found by increasing the lower VAT rates. Obviously the financing of the reduction in the payroll tax is a (the) key aspect for the implementability of the measure. After all, who would disagree to lower labor costs if the sustainability of the social security system was secured? This is the section I would have expected the government to put more (all) efforts in order to reach an educated opinion on how much revenues an increase in the lower VAT rates could generate (0.5% of GDP, 1% of GDP, 2% of GDP…4% of GDP?).

As a final remark: I am confident international observers would welcome a report in English (only the executive summary and a technical appendix by the Bank of Portugal are in English), especially if the government plans to convince the troika not to implement the measure or to transform it in a different policy.

On the Economic and Budgetary Impact of Fiscal Devaluation in Portugal

2011-08-09T22:35:00.001+01:00

Abstract
In this paper we show that fiscal devaluation, of the most dis puted issues in the current policy debate in Portugal, has the technical capacity to stimulate employment and investment and increase GDP while improving the foreign account position. More importantly, as this has been a point ignored in the debate, it can significantly contribute towards budgetary consolidation. Here

How much will the new Greek bailout cost private bondholders?

2011-07-29T16:28:00.006+01:00

Ricardo Cabral © VoxEU.org: On 21 July 2011, the Council of the EU agreed to a second bailout for Greece. The deal was predicated on “private-sector-involvement”. This column explores what this actually means. It estimates that the haircut for private bondholders may well be one-third of the figure initially proposed. It stresses that such uncertainties could spell more trouble for Greece and Europe as a whole.

You shall foster competitiveness

2011-07-29T09:58:00.003+01:00

Euro area leaders face demanding tasks. The high level task is the requisite to concur on the analytical model of the currency area. The more practical task is the need to dampen the imbalances generated by relative cost misalignments of the participating countries. To adress the latter, leaders can choose from a collection of solutions ordered by the degree of economic and financial integration that individual members wish to pursue. Unfortunately the identification of what member states wish cannot be defered to the next european election (2014). As of today, european leaders have agreed or announced measures (my reading could be biased) to:

1)Improve financial markets and banks stability mainly through the EFSF

2)Strenghten real convergence through the Euro Plus Pact adopted last March

Regarding 1), leaders should enhance the quest of stability with a movement towards further financial and banking integration. I will not engage this argument but point the interested reader to this lucid analysis.

Regarding 2), leaders should be more ambitious on the instruments and instutions needed to achieve the desired level of policy coordination.

Let me change scale somewhat abruptly, and focus on the first policy commitment of the Euro Plus Pact, namely “to foster competitiveness”. The text agreed by the European head of states says that the assessment of competitiveness adjustment needs will be based on “unit labour costs (ULC) for the economy as a whole and for each major sector.” A precise identification of competitiveness as ULC is useful and necessary as it permits to adopt concrete policy measures.

The competitiveness of an economy is a multidimensional idea and economists have constructed several different indices to measure it. This multidimensionality necessarily leads the different indexes to exhibit different patterns. Some commentators interpret negatively the observed difference in the dynamics of these indexes. Their argument is that, if different measures of competitiveness exhibit different patterns, they must lead to different conclusions. Therefore these indexes of competitiveness, such as ULC, are flawed and cannot provide guidance to the unidimensional objective of promoting export growth. I will not dispute that measures of Real Effective Exchange Rate (REER) based on different deflators and/or weights exhibit “unsatisfactory” behavior. However, I believe, the above reasoning on the heterogeneous behavior of the indexes, does not consider the dimensionality of the idea of competitiveness.

I am more concerned by a subset of commentators, who build on the possibly contradictory pattern of the different REER, and shift the focus from relative costs misalignment to composition issues. In simpler words they argue that if Portugal has a trade deficit, it is not because its relative costs are high but because it produces the wrong goods. I bypass the economics of this argument, but I am curious to know what type of good is not produced in Portugal (exclude military submarines). Consider the following thought experiment. Assume Portugal was part of an exchange rate mechanism instead of a currency area. Would we expect a nominal devaluation to improve the trade balance? If the answer is yes, I would defend that trade deficits have more to do with cost misalignment than type of products. (Even after acknowledging the “this time is different” echo in light of China & co access to the WTO.)

The Euro plus pact correctly focuses on intra-european competitiveness. Eurozone members are obviously free to improve their trade balances vis-a-vis the rest of the World. However they must consider that their trade balances respond much more to change in relative costs and external demand within the currency area (“long-term price elasticities for intra-euro area exports appear to be at least double those for extra-euro area exports” ). I could not find estimates of Portuguese elasticites for intra-euro and extra-euro exports. It would be useful to have them.

Let me end with a digression. During the last two years, commentators have changed the designation of euro members that could not anymore access financial markets from “southern” to “peripheral”. I find this labebling both imprecise and misleading. We should relabel the so called peripheral countries as current account deficit countries and the so-called core countries as current account surpluses countries.

Caixa Geral de Depósitos

2011-07-23T17:05:00.003+01:00

Quite surprisingly, the appointment of a new administration for the state-owned banking corporation CGD has emerged as priority. CGD operates in a highly regulated industry. The Bank of Portugal is the regulator. CGD is the largest bank in Portugal. The government selects the one who regulates to manage the one who is regulated. Economists call this the revolving door problem in regulation. Hundreds of papers in the economics of regulation and public choice address the perverse effects of the revolving door behavior in politics. Nobody in Portugal, but literally nobody seems to be worried about it. Remarkable! More remarkable when there have been accusations of regulatory failure against the Bank of Portugal (due to BPN and BPP scandals a couple of years ago).

Dynamic inconsistency again

2011-07-22T12:58:00.001+01:00

In a famous paper, Kydland and Prescott (1977) show that when policymakers announce a low-inflation policy, agents will expect high inflation, as long as the marginal cost for policymakers of additional inflation in the future is low compared to the marginal benefits of pushing output temporarily above its normal level. The reason this happens is because the policymakers discretion to change policy in the future makes the announcement of a low-inflation policy not dynamically consistent (equivalently, it is not subgame-perfect).
I could not help thinking about this issue when I read yesterday’s statement by the heads of state or government of the euro area and EU institutions, which stated in point 6 that regarding private sector involvement Greece “requires an exceptional and unique solution” and in point 7 that “all other euro countries reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments”.
Didn’t the Greek government commit in the past to fully honour their responsibilities? Nevertheless, yesterday’s agreement requires private sector involvement in terms that some consider a selective default. If Merkel thinks that the political cost of not involving the private sector is too high now, why should markets believe that Germany will have a different view if Portugal needs additional EU financing sometime in the future?

Do the right thing

2011-07-21T15:12:00.004+01:00

So here we are, at (another) potentially decisive Eurozone summit. There's little need to go into what's at stake. Growing numbers of decision-makers (including notional ones) have alluded to this, and countless column inches have been devoted to the burgeoning Eurozone crisis. Churchill used to say that "Americans can always be counted on to do the right thing... after they have exhausted all other possibilities." Perhaps today will be a good test of the applicability of the Churchillian aphorism to us Europeans also.

Portugal is not Greece, the US are neither Greece nor Portugal, but there are similarities

2011-07-16T17:22:00.003+01:00

Wage productivity gap again

2011-07-11T21:25:00.010+01:00

I didn't show the figure below in my earlier post, because I really don't know how to import it and make it readable. But I believe it illustrates quite well the main ideas, so I do it now:

1. Wage-productivity gaps are observed in building construction and agriculture: reality or fiction (decreasing informality...)?

2- In any case, for manufactures, services and the economy as a whole (total), deviations are not significant

3 - Prices/ULC in services increased faster than in manufactures. The later are linked to PPP. The increase in the former explains the RER appreciation: once again, Pn/Pt is the issue , not wage productivity gaps.

To this, I could add a figure showing that on average wages in services are higher than in manufactures.

Thus, the challenge is to convince workers (and unemployed) to accept a lower pay while moving from services to manufactures.

The macroeconomic addjustment will be impaired not only by the economic climate, which is not investment-friendly, but also by any incentives unemployed may have to wait and see, rather than to accept an immediate move to a less friendly production environment.

The Importance of Being Euro

2011-07-11T15:51:00.003+01:00

Lady Bracknell. Now to minor matters. Are your parents living?
Jack. I have lost both my parents.
Lady Bracknell. To lose one parent, Mr. Worthing, may be regarded as a misfortune; to lose both looks like carelessness.

Oscar Wilde, The Importance of Being Earnest

In this initial post, I would like to share a recurring thought. In pondering about the current crisis, I am often reminded of the above exchange in Wilde's The Importance of Being Earnest. Yes, I know that the Portuguese situation has its own very particular (perhaps even peculiar) national dimensions - just like the Greek and Irish crises have their own domestic specificities, echoing Tolstoy's oft-quoted dictum about each unhappy family being unhappy in its own way. Yet I find myself invariably returning to Lady Bracknell’s response above. To paraphrase Wilde, if losing one (Greece) could be considered misfortune on the part of the Eurozone, to lose three really does look like carelessness. With another two or three (Italy, Spain, maybe even Belgium further down the road?) edging towards the brink, it seems that Europe has yet to fully realise the political importance of being Euro.

More on wage-productivity gap

2011-07-11T14:32:00.003+01:00

Like Miguel Lebre de Freitas in the post below, I have also been exploring the Campos e Cunha hypothesis for Portugal's stagnation. And I am growing increasingly convinced. Miguel gives you some numbers: here is the one plot that makes the point for me, where TOT are terms of trade, RER-ULC is the real exchange rate using unit labor costs against 35 developed economies from the AMECO database, and REC-CPI is the real exchange rate using consumer price indices from the CPI database.

Could bank deposits be used to fund sovereign debt?

2011-07-11T13:52:00.002+01:00

Probably yes (available also in my webpage with additional footnote. Sorry, in Portuguese only).

Too much talk about economic growth

2011-07-11T08:53:00.001+01:00

It seems to me that this government is going to commit the same mistake of the former one by conveying the message that resuming economic growth is the way out of the crisis. It is not. Economic growth will not resume in the short run and the debt crisis demands very short run domestic solutions. All the talk must be focused on the adjustment of expenditure, private and public. However, passing on that message is very hard for political leaders and for a people that have lived (and were educated) in an age of prosperity and high public spending growth.

Wage-productivity gap: where is it?

2011-07-10T22:02:00.013+01:00

The problem with exports is not wages being too high in tradables. On the contrary, the evidence is that wages have evolved quite in shape with productivity, especially in manufactures. The problem is about to convince workers and unemployed to move from services, where wages are higher, to manufactures, where wages are lower.

INTRO

Competitiveness is a rather complex concept. In a broad sense, it refers to the extent to which a nation provides economic agents with (socially-aligned) incentives to produce and invest. For a moment, however, let’s focus on a narrow concept of competitiveness, related to wage costs. In particular, let’s stick with a definition proposed by Olivier Blanchard (2007), who refers to competitiveness as the inverse of unit labour cost (ULC) in tradable goods sectors relative to the corresponding world value.
In its influential paper, Blanchard (2007) argues that competitiveness in Portugal deteriorated significantly since the mid-nineties. According to the author, this reflected a misalignment between wages and productivity growth, which caused profitability in tradable goods sectors to shrink. However, Blanchard did not provide evidence supporting the claimed loss of competitiveness. The author showed that economy-wide ULC increased in Portugal faster than in the EU15, but he did not distinguished tradable goods (T) from non-tradable goods (N). The European Commission (2011) goes along with the same argument: “Since the introduction of the euro, Portugal has experienced significant real exchange rate (REER) appreciation vis-à-vis its trading partners, due to wage growth largely outstripping productivity advances (Graph 3)”. However, Graph 3 in the document only displays economy-wide real exchange rate indexes…
In a contrasting view, Campos e Cunha (2008) argues that “there is no room to claim a loss of competitiveness (...)” (p.158). The author points out that, in a small open economy, the real exchange rate and aggregate demand are two sides of the same coin. As it is well known, in a well functioning economy, an aggregate demand expansion translates into higher N-prices, while T-prices are bounded to remain unchanged. This causes a real exchange rate appreciation that has nothing to do with wage-productivity gaps. Fagan and Gaspar (2007) illustrate the argument is in the context of an endowment economy where, by definition, there is no such a thing as competitiveness.
Competitiveness and the real exchange rate do not necessarily go along.

FORMAL

To illustrate this, let’s look at the real exchange rate index based on nominal unit labour costs. By definition, ULC=W/a, where W refers to the compensation per employee (“nominal wage”) and a refers to Gross Value Added at constant prices per worker (“productivity”). Now, assume that the production function is a Cob-Douglas with labour-output elasticity equal to b and let Z be a variable measuring the wage-productivity gap: Z=ba/(W/P)=bP/ULC. When computed in terms of a base year (the constant b disappears) the index 1/Z is labelled Real Unit Labour Cost (RULC) or “real wage gap”. In a frictionless economy, Z=1. In a world with frictions, in face of a wage push, firms may opt to maintain a higher level of employment than that implied by the textbook wage-productivity rule. When this is so, the producer margin shrinks (Z<1).
Using the definitions above, the real exchange rate index based on nominal unit labour costs (RER-ULC) becomes ULC/ULC*=(P/P*)(Z*/Z). This means that RER-ULC accounts for two effects: wage-productivity misalignments (Z*/Z) and the increase in the relative price of non-tradable goods (P/P*). In a well functioning economy there are no wage-productivity misalignments, so Z=Z*=1. Still, unit labour costs may increase relative to abroad, whenever non-tradable good prices increase relative to abroad. This means that we can hardly rely on RER-ULC as an indicator of competitiveness. Competitiveness a la Blanchard is accounted for by the component (Z*/Z) and in the proportion corresponding to tradable goods, only.

EVIDENCE

Returning to Portugal, we now look at the data. In Table 1, se see that between 1995 and 2010 there was a
significant real exchange rate appreciation, both measured in terms of RER-ULC and in terms of relative price deflators (RER-P). As we just showed, the difference between these two indexes captures the real wage gap in Portugal relative to the real wage gap abroad (relative RULC, line c). As shown in the table, most of the RER-ULC appreciation along 1995-2010 was accounted for the relative price effect, RER-P. The distance between RER-ULC and RER-P peaked up at 6% in 2005, to decline to 3% in 2010. Definitely, this is too little to support the usual narrative, that Portugal faces a huge problem of wage competitiveness.

Table 1: Real exchange rate indexes and adjusted wage share

1995 2000 2005 2010
(a) RER - ULC 100 107 116 115
(b) RER- P 100 104 109 112
(c) Relative RULC 100 103 106 103
(d) Labour share (Port) 66.0 67.2 68.2 66.3
(e) Labour share (EU 15) 66.9 66.8 65.5 66.0

It should be noted that the measure Z*/Z accounts for both domestic developments and developments abroad. As for developments abroad, during this period Germany was recovering from excessive wages that came along with unification. This helps explain the slight decline in the EU15 labour share (e) between 1995 and 2005.
As far as Portugal is concerned, a branch level inspection reveals that most of the (small) increase in the labour share along 1995-2005 is accounted for weird developments in the sectors of building construction and agriculture. In these two sectors, indeed, wage bills increased well beyond productivity. I suspect, however, that this is more a statistical artefact – mirroring the decreasing informality in these sectors - than evidence of dysfunctional wage setting. In any case, in the sectors of manufactures and services, real wages have evolved quite in shape with productivity along the entire period. Because these two sectors account for the bulk of gross value added in Portugal, with no surprise the share of labour on domestic income (d) remained pretty constant: at the aggregate level, there is no evidence of wage productivity mismatches. If there is any, I’m missing something.

WHAT HAPPENED?

All in all, the evidence suggests that so far Campos e Cunha was right: relative price effects, rather than dysfunctional wage setting explain the recent process of real exchange rate appreciation. This accord to the widely accepted narrative that at the origin of the current external imbalance is the once-and-for-all shock consisting in the liberalization of capital inflows followed by EMU accession: this triggered the aggregate demand and pushed the relative prices of non-tradable goods above the level that is consistent with the internal and external balance.
The story has to be however completed with the oil shock that marked the dump phase: Portugal is highly vulnerable to oil prices and after 2000 the relative price of oil increased sharply. As it is well known, in a small open economy a terms of trade deterioration is equivalent to a “negative” Dutch Disease: the relative price of non-tradable goods has to decrease to restore the external balance. In an ongoing work with Miguel Faria e Castro, we find that the recent oil price shock accounts for roughly one half of the current real exchange rate misalignment in Portugal (either measured in terms of RER-P or RER-ULC).

SO WHAT?

It may be argued that this discussion is irrelevant: after all, a real exchange rate appreciation impacts negatively in the current account, irrespectively as to whether it comes through an increase in the relative price of non-tradable goods or through wage-productivity misalignments. For policy purposes, however, the distinction is very important.
Indeed, if the real exchange rate appreciation was related to dysfunctional wage setting institutions, one would be tempted to question whether Portugal would be able to sustain its membership in a low inflation club like the euro-area.
If, as it appears to be the case, the real exchange rate over-valuation is wage-gap free, then there are no reasons to conclude - at least by now - that nominal wage rigidities will impair the upcoming macroeconomic adjustment: after all, the return to external balance involves the re-allocation of labour across industries, which necessarily entails the celebration of new labour contracts.
This does not mean that the average wage in the economy shall not decline. As a rule, a “white collar” to “blue collar” metamorphosis will involve the acceptance of lower wages. Not only because wages are on average lower in manufactures than in services, but also because recycled workers will lose the value of whatever specific knowledge they accumulated in the job they had before. Hence, we shall expect workers to resist the move until it becomes a matter of personal urgency.
This discussion drives us back to the beginning of this post. Eventually a policy of reducing wages in existing contracts will not help workers to move from non-tradable good sectors to tradable good sectors. What we really need is to remove those barriers lying on the path of entrepreneurs and job-seekers that impair investment and are delaying the re-allocation of labour from N to T. On the policy dimension, this includes the provision of a stable macroeconomic environment, fiscal sustainability, lower costs on dismissals and less incentive for workers to remain unemployed while searching for a perfect match. In a word, we need more focus on competitiveness, broad sense.

REFERENCES

Blanchard, O., 2007. Adjustment within the euro: the difficult case of Portugal, Portuguese Economic Journal 6(1): 1-21.
Campos e Cunha, L. , 2008. Is the Dutch disease pandemic in the South? In Francesco Franco (ed.), Challenges Ahead for the Portuguese Economy, Imprensa de Ciencias Sociais, Lisbon.
European Commission, 2011. The Economic Adjustment Programme for Portugal, European Economy: Occasional papers 79, June.
Fagan, G., Gaspar, V., 2007. Adjusting to the euro. ECB Working Paper Series, Nº716, January.

Openness, internal devaluation and competitiveness

2011-07-09T20:26:00.007+01:00

One is entitled to ask if the "internal devaluation" will lead to an improvement in Portuguese's competitiveness given the recent euro-appreciation trend.

First, with respect to the euro-appreciation, given the growing importance of intra-euro are trade for Portugal (> 65% of exports), such phenomenon is not expected to severely damage the trade balance.

Secondly, internal devaluation should be coupled with crucial structural reforms (including the labour market) such that we assist to an emergence of new economic activities. In particular the MoU is highly reliant on opening up the nontradable sector to competition to decrease rent-seeking behaviour and encourage profitability in the tradable sector. The emphasis should then be on export-led-growth rather than specific sectors, which may, at the beginning, naturally favour those with strong(-er) comparative advantages.

Thirdly, internal devaluation can take the form of i) planned fiscal devaluation (as suggested/endorsed by our co-blogger Francesco) which basically adjust relative prices by simulating a currency depreciation; ii) a (further) compression of nominal wages (despite not ideal, may still be necessary); iii) a push for increasing competition (resulting in smaller prices of domestically produced goods).

Regardless of how it is going to be implemented, the timing and correct design of an internal devaluation strategy should take into account its social impact and the existing room for manoeuvre (in terms of available measures) in face of the already large fiscal adjustment in progress...

All in all, the above points together with no increases in the minimum wage (as envisaged by the MoU) should contribute to zero growth in unit labour costs (ULC). This combined with sensible projections for trading partners should imply an important cumulative depreciation by 2016.

Moody's lazy screw up

2011-07-09T07:36:00.000+01:00

Moody's has really taken a beating in the last few days in Europe. Their hard to understand, sudden, and dramatic downgrade of Portuguese debt has had people, from the FT and policymakers all the way down to blogs and facebook accounts, calling Moody's analysts names that range from incompetent to dishonest.

I don't agree, since I tend to see Moody's as a serious company that does a good job with often little information in tough circumstances. But the downgrade of Portuguese debt in 4 ratings to junk on Tuesday, is far from its best moments. Actually, it is a moment that the people there should be embarrassed about: it is hard to avoid the conclusion that, at least, they are lazy.

The downgrade decision was justified by Moody's on two accounts. First, the low growth of the Portuguese economy, the high budget deficit, and the political uncertainty on the government's ability to change things. But, these problems are years-old news, and nothing in the past week made them look worse. In fact, with recent elections giving 80% of the vote to parties that are committed to the IMF program, and the announcement of a surprise tax hike, the news has been moderately positive on those concerns. The only backing I can find for this Moody's argument is the revision down of growth forecasts and poor numbers on government spending in the first quarter. But these are week-old news. So, at best, Moody's analysis are right, but lazy, taking weeks to digest simple news.

Second, Moody's points to the new plan to "voluntarily" restructure Greek debt, and the suggestion that this plan could be offered to Portugal's creditors as well. This makes a lot of sense to me, although the Sarkozy plan is very far from likely being adopted. As Alvaro puts it below, it puts the blame of the downgrade squarely on the EU's too-frequent grand announcements and retreats. But if this European shock justifies a 4-level downgrading of Portugal, how can it not involve an even modest change in outlook for Ireland, Spain or Italy? Again, the only explanation that I can come up with is that Moody is being lazy, and will downgrade those ratings too but only in the next few weeks, when it gets around to it.

A downgrade a week or two earlier I could understand; a downgrade later for a group of European countries, including Portugal, would be a gamble, but hey that's forecasting. A downgrade last Tuesday just seems like laziness.

Incomplete information is a fact of life. Poor economic models are a trap for anyone who ventures into forecasting. But laziness is an embarrassing attribute for people monitoring credit.

More on this in Portuguese in today's Expresso.

Domestic extraordinary measures are not a solution for our structural problems

2011-07-08T13:48:00.003+01:00

The adoption of extraordinary measures has become an ordinary behavior of Portuguese governments. The most recent example was the extraordinary income tax announced last week. The events of this week have shown that extraordinary measures are not a solution for the structural problems of the Portuguese economy. There are two aspects to this. First, the markets clearly do not believe that these measures are enough to tackle those problems. Second, to the Portuguese people they convey the idea that the problems are, like the measures, temporary and thus the measures fail to put in motion the process of adjustment of expectations (and behavior) that the seriousness of the problems demands – therefore confirming the beliefs of the financial markets.

Structural measures are therefore required. The unsustainable current account deficit is a reflection of the structural problem of the Portuguese economy. It embodies the disconnect that exists between the structures of consumption and production. Devaluation would be the obvious (easy and non-structural) solution outside a common currency area. Absent this possibility, a significant cut in wages has been suggested as a means to restore the competitiveness of Portuguese firms.

A structural measure that would have the same competitiveness effect as a 7% wage cut would be to eliminate, permanently, the 14th wage payment, for both workers and pensioners. Beside the competitiveness effect, this measure would reduce public expenditure permanently. It should also have an impact on expectations, bringing the behavior of Portuguese consumers closer to our economic possibilities and sending a clear message of commitment to the financial markets and to the European Union (i.e., Germany), on top of the commitment to the memorandum of understanding.

Finally, except for legal problems that would have to be dealt with, this is simpler than other measures that would introduce additional complications into our fiscal system, with uncertain effects on the structure of incentives, such as the much discussed reduction in payroll tax. It should also be noticed that other structural measures, such as those in the memorandum, will take a long time to produce effects – if they do.

This kind of measure should be implemented from 2012 onwards. The Portuguese households should be given time to adjust their consumption plans. Obviously, such a measure will deepen our recession. But there is no way out of our problems without a serious recession, except if the Germans accept to pay the bill for our past excesses. Given the events in Greece, this would appear quite extraordinary.

Ich bin ein Grieche!

2011-07-07T23:28:00.003+01:00

To fight the North American ones, more and more politicians are suggesting the creation of an European rating agency. It seems that they are not aware of the several dozens of rating agencies that are spread around the world, including Portugal.

Anyway, if there is going to be a new European credit rating agency, I propose that this new rating agency uses the Greek alphabet instead of Latin. Therefore, instead of aaa we would have ααα, or βββ instead of bbb, and so on and so forth.

Misquoting Kennedy, one would say: “Two thousand years ago the proudest boast was civis Romanus sum. Today, in the world of freedom, the proudest boast is 'Ich bin ein Grieche!'... All free men, wherever they may live, are citizens of Greece, and, therefore, as a free man, I take pride in the words 'Ich bin ein Grieche!'”

Moody’s decision was correct…

2011-07-06T22:33:00.000+01:00

… if one accepts the ratings agencies’ view that the debt rollover involving private creditors proposed for Greece should be considered “default”. Given that the consensus seems to be that Moody’s decision is absurd, I feel I must explain my previous post and the previous sentence. Considering that:
1. The Portuguese “program entails important risks” (see the IMF’s staff report, page 23, available here), “in particular, refinancing risks”;
2. If the program fails to deliver the results projected, additional official financing will be necessary; i.e. there is an “important” probability that Portugal will need new financing from the European Financial Stability Facility (EFSF), which implies approval from all the Eurogroup governments;
3. It is very likely that France and Germany will apply the principles of the latest Greek program to all future EFSF financing, requiring private creditors to rollover their debts, an event ratings agencies consider to be “default”.
Then, there is “very likely” an “important” probability that an event called “default” will occur, regarding Portuguese debt. That is exactly what a junk rating means, that there is a important probability of default.
This also means that Portugal’s downgrade has nothing to do with Portuguese fundamentals, but it is related to the fact that France and Germany are requiring private creditors to rollover their debts.

Growth and Employment "Trackers"

2011-07-06T00:46:00.016+01:00

The growth and employment "trackers" (see footnote for technical details) give a sense of the dramatic decline in economic activity and employment following the last economic crisis and its tepid recovery (particularly in the labour market) in Portugal between 2000-Q1 and 2011-Q1 (from here up to 2015-Q1 the trackers are based on forecasts - grey shade).

The profile of GDP growth forecasts are somewhat in line with what the new Minister of Finance (Vitor Gaspar) has recently said: “Portugal is expected to have 9 terms of consecutive negative growth” (see here).

Source: author’s calculations based on OECD data.

According to these estimates we shall have “contraction at a moderating rate” until around mid 2013 and only then we should begin growing below trend at a moderate rate. Perhaps we won’t go through another “lost decade”, but we are certainly expected to experience at least half a decade of negative, stagnant or moderate growth (at best). More reassuring, might be the case of employment if the “right” structural policies are enacted and put into action such that the “job-destruction” process is reversed and productivity and competitiveness improved. (Note, however, that projections shouldn't be viewed as an exact science but solely as an indication as to where the economy is expected to move based on a number of mathematical and statistical assumptions.)

Footnote: The trackers are constructed using a univariate fitted Structural Time Series Model with unobserved components over the period 1970Q1:2011Q1 allowing for a stochastic trend, cycle and seasonal and estimated by maximum-likelihood via the Kalman filter. Forecasts are then obtained up to 16 periods ahead and the classifications represented in the figure are based on the behavior of a centered 4-quarter moving average.

Time-inconsistency in European policy

2011-07-05T22:45:00.000+01:00

We must thank Mr. Sarkozy and Mrs. Merkel for today’s downgrade of Portugal’s debt rating by Moody’s. The main driver of Moody’s decision was “the growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition”. Why? Because Moody’s believes that the EU’s decision to require private sector creditors to participate in the new financing package for Greece is the new official EU policy on financing programs. As such, private sector creditors will not be willing to provide financing to any country that may require official financing in the future, and Portugal will not be able to return to the markets when expected. Mr. Sarkozy and Mrs. Merkel have managed to transform the availability of official financing from a market confidence booster to a sign of future default. Someone needs to teach European politicians about time-inconsistent economic policy, before they completely destroy the euro and a few small countries with it…

Should a struggling country predict too much?

2011-07-05T09:38:00.006+01:00

So we have a new centre-right government and, despite previous promises, a new extraordinary income tax, on the 14th monthly pay check (I guess a southern oddity but already factored in by international wage comparisons). The tax is biased against the lower strata of the population, as it is almost flat above 3,000 euro monthly wage or so, and dividends and profits are exempt. Not a very well designed tax, one should say.

The EU/IMF/ECB troika didn't ask for it, at least until now. So, the key question is: should the government of a distressed country, such as Portugal, going through an already massive restructuring program, compress further the economy before it is necessary? Or should it have waited and see whether it would be necessary? The more I think about it, the more I get close to the conclusion that the move was in the wrong direction.

I think I still prefer to be ruled by policies set in Brussels then by too imaginative local officials. At least in Brussels they do not follow so closely the electoral cycle, which may be one of the reasons why the Portuguese government acted as it did on this matter. In fact, it looks as if they were following the same old rule of doing the hard stuff at the beginning of the electoral cycle to ease up later one. Unfortunately, in this juncture, that may have considerable negative macroeconomic effects.

Can the public sector monster be tamed?

2011-07-03T12:38:00.001+01:00

On this initial post, I will refer to my experience at the IMF to speculate about economic policy in Portugal in the next few months. It is usually claimed that economic policy will be limited to the application of the vast program agreed with the international institutions, but this is not necessarily true. Every IMF program has quarterly reviews when staff assess whether the program is on track, a necessary condition for the IMF’s Executive Board to approve the corresponding disbursement. The approval of Portugal’s first review, to be completed by September 15th, will release €3,8 billion from the IMF and twice as much from the European financing facilities. In preparation for that review, a troika mission will be in Lisbon for much of August, to analyze June data and the conditionality for end-July.
It is very common that the details of an IMF program change during the quarterly reviews. As long as the main objectives of the program are not at risk, the IMF tends to accept any changes of one measure for another that the local government proposes. It is possible that review dynamics are different in the case of euro-zone countries, making changes less likely since many institutions are involved. However, yesterday’s Eurogroup decision to approve the latest review of the Greek program, has proved that even for euro-zone countries the program that is implemented can be quite different from the program initially approved.
Less than two months ago, international experts made a thorough review of Portugal’s budget, and concluded that the 2011 targets could be achieved with implementation of the 2011 budget and a few extra expenditure measures. Nevertheless, the first real decision of the new Portuguese government was the creation of an extraordinary income tax to raise an additional €800 million. Why? My guess is that the government realized that the expenditure cuts incorporated in the 2011 budget will not materialize, and went for the easy option: a tax increase. Given that programs can be adjusted during reviews, I am afraid that this will happen often: having failed to achieve the proposed expenditure cuts, the government will replace them with tax increases. In the end, instead of a program with a reasonable expenditure / revenue mix of measures (two thirds / one third), we may end with a growth crippling one third / two thirds mix.

The “New Normal” in Portuguese’s Labour Market?

2011-07-01T16:36:00.016+01:00

This is my first post.

Eurostat has just released a new report (click here) with new unemployment figures and Portugal keeps its place in the “pole-position”, with 12,4% of unemployed people registered in May. More striking are the numbers for youth unemployment which have been rising at a faster rate and reaching now 28,1% of youngsters (up to 25 years-old). Only Spain, Slovakia and Italy get ahead by presenting even higher statistics.

It is known that employment has taken a deep hit in this last recession, and has been much slower to recover than output (McKinsey Report on jobless recoveries).

This is related to the ongoing debate as to whether the crisis has permanently shifted the level of potential output or whether output will eventually meet the pre-recession trend level. Are we facing structural or cyclical shifts in the labour market? Structural and statistical estimates tend to produce disparate results depending on the country under scrutiny.

If we plot Portugal’s GDP trend growth (see footnote) and corresponding output gap using quarterly data between 1970-Q1 and 2011-Q1 we obtain the figure below.

It is clear that the “golden” days are over and that the so-called “lost decade” seems to have arrived to stay… Not only do we have negative trend growth, despite some mild signs of moderation/reversion(?), but also negative output gap.

Output can be decomposed into a product of population (p), the labor force participation rate (lfpr), the unemployment rate (u), hours per worker (h) and labor productivity (lp): Y=pop*lfpr*(1-u)*h*lp. Let’s just (briefly) analyse some of these components.

Plotting the trend growth of employment, labour force and unemployment we get the following:

One does see a downward evolution of the employment trend growth up to a point where around 2006 it became negative. Evidence seems to suggest than the trend may be reverting and the inflection point reached. A similar, but lagged behaviour, can also be seen in the case of labour force. Simultaneously, unemployment trend growth has been positive (since the early 2000s) having reached a peak in 2009-Q1 and signaling a downward movement. In any case, it seems a “New Normal” has arrived, characterized by higher unemployment and lower employment across all economic sectors and age-ranges which, most likely, won’t go back to pre-crisis levels.

One certainly needs to revert these variables’ behaviour in the short to medium-run for which a sine qua non condition is getting the Portuguese economy back on the growth track, increasing its potential output and closing the gap. All in all, some of these stylized facts should encourage policy-makers and the new government to "do something".

Footnote: For the interested reader, trends were computed by means of a univariate fitted Structural Time Series Model with unobserved components allowing for a stochastic trend, cycle and seasonal and estimated by maximum-likelihood via the Kalman filter. Source: OECD data; author's calculations.

The Portuguese legal system and economic growth

2011-06-30T13:09:00.004+01:00

This is my first post. Given my particular research interests (law and economics, comparative law, judicial behavior), I will focus on legal reform and the impact of the Memorandum of Understanding (MoU) on the Portuguese legal system. Two initial quick notes:

(I) As I wrote in a document compiled by Nova, the MoU failed to grasp the complexity of problems faced by the Portuguese legal system. As a consequence, it is technically deficient and potentially counter-productive (for example, eliminating backlogs by June 2012 is simply unfeasible and undermines the credibility of the whole plan). Furthermore, the proposed reform of court districting is based on a clear misunderstanding: Portugal is NOT eliminating 200 courts but rather concentrating the management of such courts, which is a very different issue.

(II) The Portuguese court system is not worse than the Spanish, the Italian, the Greek or the French court systems (probably better according to the numbers produced by the World Bank Governance Indicators and the World Bank’s Doing Business). It is certainly better than most Central and East Europe, Latin America, Africa and China. Blaming the legal system for lack of FDI and economic growth is simply misplaced and a myth that covers other structural determinants. In fact, the inefficiencies of the Portuguese legal system are more likely to impose significant costs to small domestic investors and firms than to foreign investors and multinationals (they use international commercial arbitration anyway).

On the 19th constitutional government

2011-06-30T13:01:00.002+01:00

A few quick facts on the new cabinet in comparison with past ones:

1. It's one of the smallest cabinets ever: 12 ministers, including the PM, and 35 "junior ministers" - secretários de estado (the previous cabinet had 17 ministers and 38 junior ministers). Not the smallest ever, though, if you add ministers and junior ministers. That record (assuming one thinks this is a good thing, although I'm somewhat more agnostic there) belongs to the current President, Cavaco Silva, who in 1985 led a cabinet formed just by 14 ministers and 32 junior ministers. It surprises me a bit that, historically speaking, there is no relation between cabinet size and whether a government is supported by coalition or not. Average of 56 for coalition governments, average of 57 for single-party governments. In any case, this is a small cabinet by any standards.

2. There are eight women (two of them senior ministers), less than one out of five cabinet members. But the previous cabinet had nine women, which was proportionally even less (albeit five of them were senior ministers). Overall, the average of women cabinet members from 1976 until now is about 6% (but rising), so this cabinet is clearly in the upper half in terms of female cabinet participation in Portugal. It is also apparently not far from the European average, although much below than, well, you know where (Scandinavia in case you really didn't know).

3. Judging from newspaper reports, of the 47 cabinet members, 18 are affiliated to the PSD, 11 to the CDS-PP and there are 18 "independents". There's been a lot of talk about the large number of independents (nearly two out of five in this cabinet), but two notes are necessary. First, this is a very broad definition of "independence", which encompasses, for example, MP's included in party lists although unaffiliated to the party. Second, this is far from a new trend. The average of "independents" per cabinet since 1976 is one out of four, and they represented 35% of the 2005-2009 Sócrates cabinet. So the 19th government has a high share of independents - the highest ever, I think, if we discount our "presidential initiative cabinets in the 1970s - but not inordinately so for Portuguese standards. It is a pattern also shared with Spain, and that sets us apart from most European democracies, as far as I can tell from the literature.

4. I would need much more time to look at educational backgrounds, since vitas of all the cabinet members are not available in the government's website. But among the senior ministers, half of them are lawyers (typical in cabinets of the Right) and five are Business or Economics majors (with two of them Economics PhDs and another a Mathematics PhD). I don't recall a cabinet where not a single senior minister was an Engineering major (somebody made a joke the other day that this was a revenge against you know who). And hey: there's one Political Science major.

For scholarship on the composition of cabinets in Portugal, this is probably a good place to start.

The case for a fiscal devaluation

2011-06-28T10:57:00.002+01:00

Here is a link to a piece published by Publico last Sunday. The readers of the blog will not find anything new, but I thought it would be useful to have a summary in Portuguese on the challenges posed by the external adjustment ahead.

Farewell

2011-06-27T23:03:00.007+01:00

Three former authors of this blog are now in the new Portuguese government, namely, Álvaro Santos Pereira (Minister for the Economy), Pedro S. Martins (Secretary of State for Employment), and Miguel Morgado (Political Advisor to the Prime Minister). We expected of course a larger number of departures and promise to do best in the future. In any case, we wish our former co-bloggers lots of good luck and courage and will certainly miss their posts. We promise that we won't be too severe on their new roles... at least during their first 100 days.

Fiscal devaluation - the arguments in favor

2011-06-27T20:45:00.002+01:00

Francesco Franco has published here the arguments in favor of a fiscal devaluation (in Portuguese). See also his other posts in this blog about the economic situation in Portugal.

The international compared view of Southern economies

2011-06-26T07:58:00.002+01:00

A "helping hand" from Bran Hollis, on the external view on Greece, Portugal and Spain, resulting from the protest movements and their characteristics; quite useful links, thanks!

"I don't think it is easy to categorize the protest movements. In Greece it is the EPP (right) ND party which does not agree with further austerity. The 'indignant' protesters in Greece are supported by 80% of the population , according to a recent uni. survey. In Spain it is a distinct and varied movement that is protesting. In Spain the unions have demonstrated 'quietly' or symbolically while accepting a certain amount of austerity from the socialist government. If the right wing center PP comes to power the union protests would be stronger. To put it bluntly, few are happy with the economy in these countries under current circumstance. Also as austerity sets in, depending on politics etc. various kinds of protests start. Go back a couple of years and it was the transporters in Spain over fuel costs for example. No space here to write a full article, but for English readers I suggest the following websites:
http://www.ekathimerini.com/
http://www.athensnews.gr/
http://www.keeptalkinggreece.com/category/1-news/1-economy/
http://eurowatch.blogspot.com/
http://www.economonitor.com/blog/2011/06/nine-reasons-why-spains-economy-is-more-different-than-you-think/
http://www.eurointelligence.com (partly subscription)
http://www.finfacts.ie/irishfinancenews/European_3/index.shtml
http://globaleconomicanalysis.blogspot.com/
http://www.acting-man.com/
http://www.voxeu.org/
In the Greek sites you would find full reports on the sentiment of the population, if you follow long enough. The Spanish indignados movement is covered by El Pais, Eleconomista, amongst many others. There are also good articles in the FT Der spiegel, the Telegraph etc. from time to time. Portugal has not had much press really abroad, except when agreements must be made or default is possible. EU is a very big topic , and it depends on each persons view what is fair or right I suppose-personally I am pro EU but not convinced about the direction since the eurozone, and current handling."

This last paragraph also deserves a quick comment. Portuguese authorities and politicians should not be obsessed with image in the outside of the country; just focus on what has to be done, and Portugal will be out of the news. Portugal is sufficiently small to be news only when things go wrong.

Politics meets economics and both meet the international media

2011-06-23T16:51:00.003+01:00

The current economic problems in Greece, Ireland and Portugal demanded rescue plans.

The application of rescue plans is a political issue as much as it is an economic one.

Portugal has just elected a new Parliament. A majority Government has been formed with an alliance of two parties, providing a stable support for 4 years. More importantly, the three main parties all have declared, during the recent electoral campaign, the support to the Memorandum of Understanding with EC/ECB/IMF. The other parties have clearly advocated a different course of action, and have overall lost votes. It is fair to say that most of the population supports the MoU. The impact of it may be feared by many, but this was the road chosen by the majority of the population.

As the new Government is from the right-wing of the political spectrum, it is expectable that left-wing unions and parties will try to create civil unrest, which most likely will produce news outside Portugal. Still, and at the risk of repeating it, this will come from a minority.

Hopefully, outsiders will see through what may be news in the international media.

In this respect, Portugal and Greece populations are, apparently, behaving very differently (at least for the time being).

Greece is under some civil unrest, according to the news in the international media, which may actually provide a wrong picture, it would be nice to have a reference blog on the greek economy that gives a clear view on this, any suggestion from our readers and friends from Greece?

Anyway, the MoU demands that politics meets economics, and both must meet the international media, I hope that an accurate picture of the country can be given.

Another one that goes...

2011-06-22T15:58:00.002+01:00

This blog is becoming shorter in authors everyday.

According to the news, Pedro Martins, who blogs often here and on his own blogg, will become secretary of state for employment. See it here (in Portuguese).

All the best to Pedro for his new role. We will miss your blogging action.

The new minister of Finance: Vitor Gaspar

2011-06-17T19:05:00.004+01:00

A couple of day ago, I wrote here about the ideal characteristics of the new minister of Finance: (i) deep knowledge of the deep workings of the public administration, (ii) Volcker-like determination on the goal (hit the deficit targets) while resisting the temptation to place public finances above the economy, and (iii) sharp knowledge of economic theory to be able to distinguish the good and bad ideas in this time of great change.

With Vitor Gaspar announced as the new minister, how did Passos Coelho do in his choice?

On (i), I don't know. On the positive side, Vitor has worked in the Ministry of Finance in the past, but it was a long time ago. On (ii), he was a phenomenal head of research at the ECB when the institution started, creating a great department out of nothing, well focused on what mattered. The challenge is of course now much greater, and Vitor's strength to stay focussed is going to be tested more than ever, but there is reason for optimism. On (iii), the choice could hardly have been better. In his combination of analytical knowledge of theory plus a good sense of pragmatism plus a generally sensible approach to using the little that we know about the economy, it is hard to think of too many Portuguese economists that are clearly better.

So overall, a fantastic choice. Well done, Mr. Passos Coelho.

New Government in Portugal

2011-06-17T18:56:00.002+01:00

The new Government is now official: http://www.presidencia.pt/

Good luck to our friend of this blog, Álvaro Santos Pereira, in his new role

in the Portuguese Government. :D

And of course to all of the new cabinet.

A quick assessment (of a few ones):

Vitor Gaspar - Minister of Finance - large economic policy experience in Europe and Portugal, very knowledgable about the portuguese economy and the relation with the EU; unexpected, but logical choice.

Nuno Crato - has over the years expressed clear and strong opinions about education, it has now the chance to "do it"

Paulo Macedo - better known for his previous work in Government, highly-qualified manager, a required skill for the coming years in the health sector.

Overall, a relatively young Government, something that is refreshing. A good start, I would say.

Eurosis

2011-06-09T13:48:00.004+01:00

A while ago, I wrote that the global financial crisis had sharpened risk perception and unearthed weaknesses in the EMU construct. These two factors have precipitated a crisis in euro peripherical countries with weak economic fundamentals. The response of governments and European institutions has been centered on two pillars: 1)the implementation of national policies by individual members, 2) a financial support (conditional on 1) from the other member countries to shield the periphery from speculative attacks.

This is not the first time that the European integration construct faces challenges. Jump back in time to the 1992-1993 crisis of European exchange-rate mechanism (ERM). Members had experienced different path in unit labor costs (divergence), there had been a (very) large assymetric shock (Germany reunification), the European political project was perceived as weaker (French and Danish referendum) and European leaders unable to coordinate (Bath summit).

The next graphs show the case of Italy during the EMS crisis. I use this case to make two points.

The first is that Italy was ultimately able to adjust without external help thanks to, an ambitious fiscal consolidation, structural reforms and privatizations (circa 10% GDP). However in that case as in many others the forced devaluation of the Italian lira improved the trade balance and contributed significantly to the success of the adjustment.

The second is on coordination. The 13 years of ERM existence at the moment of the crisis had pushed members to design effective procedures to coordinate the setting of the exchange rate parities. In the best European tradition, the decision of setting central rates required unanimous approval. Unfortunately the “un pour tous, tous pour un” approach is designed for a group that stays loyal to each other through thick and thin. The latter is not the best description of European leaders during the EMS crisis when realignment became “a dirty word in Bath.” In absence of multilateral consensus, Italy and Germany had to bilaterally propose that the Lira would devalue by 3.5% and the Mark revalue by 3.5% against all currencies in the ERM. Some members refused. The lira was initially the only currency to be devalued (by 7%). Ultimately the lira took a leave from the ERM to reenter a few years later with a currency devalued by 30%.

Today the absence of a nominal devaluation implies that the adjustments are more difficult. The number of national policies that can emulate the effects of a devaluation and help the adjustment of external imbalances is reduced.

A possibility is to use neutral tax swaps. In a recent work I have looked to the effects of a “fiscal devaluation,” namely a decrease in labor taxes balanced by an increase in consumption taxes. It is not a perfect substitute of a nominal devaluation: it has advantages, such as no adverse effect from foreign denominated debt (different situation from 1992), and has disadvantages, such as the difficulty to implement it compared to a currency devaluation. Nevertheless, it is a policy that aims at reducing external imbalances within a currency area. The existence of policies that can achieve a devaluation or a revaluation (do the opposite: decrease consumption tax, increase labor tax) within the currency area suggests that such policies require coordination between members. Here the lessons learned during the ERM period can prove useful. During the ERM, in front of imbalances, European finance ministers were changing parities between exchange rates. During the EMU, in front of imbalances, European finance ministers could change the composition of their tax rates. In the “un pour tous, tous pour un” world this would imply that EMU members with large and persistent trade deficits should fiscally devalue, while members with large and persistent trade surpluses should fiscally revalue.

Another possibility would be to increase the fiscal integration of the union and allow for implicit or explicit fiscal transfers between members (many good proposals have been advanced). Realistically it is a medium run perspective. Monetary union required decades, fiscal union will not be made in a week nor in a year.

We have experienced that in our journey towards European economic integration and convergence, imbalances continue to appear. Now we need these imbalances to be controlled using policy instruments that are coherent with the degree of national sovereignty determined by political constraints. Ultimately we need to accept that these imbalances matter.

Portugal: A post-election report

2011-06-08T18:00:00.000+01:00

My take on last Sunday's elections and beyond, again at The Monkey Cage.

Election results

2011-06-08T14:17:00.001+01:00

Nearly 90% of the new parliament corresponds to MP's of parties that supported the memorandum. And the most voted party was arguably the one closest to the policies dictated in that document. These outcomes add considerable legitimacy - and momentum - towards the fulfilment of the challenging but long overdue reforms imposed by the troika.

Puzzles....

2011-06-08T11:52:00.002+01:00

Elections, new Government on the making, some puzzles to be solved.

The first one, the size of the Government - the new-to-be prime-minister announced he would like to have a smaller number of Ministers, he has two paths for it:

a) concentrate Ministries, reorganizing them, this will take 4 to 6 months, perhaps more

b) keep Ministries as is, but have the same person accumulating posts across Ministries,

We do not have the time to go for option a), so it remains b), though the puzzle then is whether we have super-ministers or not ?

(Luis: I am waiting for your answer)

Portugal’s bailout: reinventing the wheel

2011-05-28T00:25:00.003+01:00

The details of the EU/IMF-Portugal financial aid agreement (see draft Memorandum of Understanding on Specific Economic Policy Conditionality or MoU – available here) that were first made public seemed to suggest that the EC/ECB/IMF troika that negotiated it had finessed its strategy ever so slightly, and had learnt from the experiences of Greece and Ireland.

Instead, the agreement with Portugal, as laid out in the draft MoU, is overwhelming in scope. The implied message from the troika seems to be that the approach is failing in Greece and Ireland because it did not go far enough.

The agreement has important measures and impresses by its breadth. However, it also suggests that the troika may not have had the time to check their facts on issues such as, for example, external trade or on housing prices. Data collected by Carmen Reinhart and Kenneth Rogoff in a 2008 paper suggests that Portugal had one of the lowest housing price increases between 2002 and 2006 amongst 43 developed and developing countries. Therefore, one wonders why the troika imposed measures that make house buying more expensive at this stage of the cycle where numerous families are being forced to sell their homes either to avoid foreclosure or due to foreclosure on their mortgages.

More importantly, the agreement has serious issues of process and substance, of which four should be emphasized:

First, there is no discussion of the causes of this crisis, what led Portugal to this situation. It is like going to a doctor seriously ill, and coming back with no diagnosis of the illness but instead with 222 different prescriptions (the number of main action items in the MoU which runs to 34 pages, or roughly twice the length of action items in Greece and Ireland’s MoUs), hoping that some of the medicaments will work. They won’t. The patient’s health will worsen. Portugal faces a balance of payments and external debt crisis, rather than simply a sovereign debt crisis. Perhaps because the MoU does not identify the causes of the crisis, the policy response measures are misguided and likely to fail.

Moreover, given the sheer number of measures, there is no way that a future government, regardless of the party in power, will be able to fully meet the terms of the agreement. The government will likely miss several targets fairly early in the program and this will call its competence into question with its European Union partners, unnecessarily, but perhaps by design.

Second, the agreement does not ask nor respond to the question of who was responsible for what went wrong. One might argue it is neither possible nor relevant at this stage to do so. Quite in contrary, it is important to identify who erred because market economies are all about risk, reward, and punishment. It is also possible to find them. We just have to look for the proverbial elephant in the room.

Who are the largest debtors now unable to pay? Answer: in Portugal’s case, the government and the banks. So, they must have made mistakes. In this, the picture that emerges is similar to that found in Greece and in Ireland.

Who are the largest creditors now afraid of not getting their money back? Answer: large banks and insurers in a number of countries and the Eurosystem (ECB and Eurozone national central banks). In fact, the Eurosystem is the largest creditor of Portugal as well as of Greece and of Ireland’s banking systems and governments. So these creditors also made mistakes.

The consequences of the mistakes should be borne by those who made them. But it is not to be. Instead, the costs of the bailout are to be exclusively assumed by the Portuguese taxpayers and citizens. This is not the culture of merit and accountability the European Union deserves.

Third, the agreement focuses on the minutiae, on far too many wishful thinking ideas in a cross-section of areas from financial sector regulation and support, judicial system organization, to local and regional administration, to name a few. The large number of measures precludes any serious attempt to evaluate their individual effectiveness. Instead, the MoU should select the 20% of ideas with 80% of the economic impact (each with an economic impact above, say, €250 million per year) and thoroughly dissect each of them. Otherwise, it is simply obfuscation.

Finally, the policy measure with the largest economic impact is not correctly implemented. Specifically, in dealing with the Portuguese banks, whose combined liabilities represent 250% of GDP, the agreement does not adopt international best practice. This would have required, before any capital increase or guarantee, the introduction of a special bank resolution procedure (Special Resolution Regime with Prompt Corrective Action), like those available in the US and in the UK, for example. A strong and prompt bank resolution procedure would, among other things, impose losses on the creditors of failing banks and would force out failing banks’ management. Instead, the troika required the Portuguese taxpayer to further support the banking system with up to €47 billion (27.2% of GDP) between guarantees and capital increases.

Moreover, rather than replace failing banks' management, following, for example, the practice of the US FDIC, the MoU (p.7) states that the capital increases “will be designed in way that preserves the control of the management of the banks by their non-state owners”. That is, the taxpayer will likely recapitalize the private banking system, in effect nationalizing it, and yet management control will remain with the old owners. One possible explanation for the troika’s inaction on the banks Special Resolution Regime is the conflicts of interest faced by one of the troika members, the ECB. The ECB is a member of the Eurosystem, which would have faced large losses if a proper bank resolution procedure were adopted immediately.

The idea substantiated in the MoU that an entire country can be reengineered - notwithstanding its faults, the World’s 38^th biggest economy - based on a 3-week 34-page outline is remarkable. The agreement seeks to reinvent the wheel and in the meantime destroy what does work. This treatment of Iceland, Hungary, Latvia, Greece, Ireland, and Portugal is beginning to seem like the West’s version of China’s Great Leap Forward: impossible targets based on but pure ideology. It is simply too sad to watch.

Headlines from the annual report of the Bank of Portugal

2011-05-23T14:15:00.004+01:00

The strict implementation of the economic and financial programme is desirable and inevitable

Economic activity accelerated temporarily in 2010 - partly influenced by non-sustainable factors on the domestic demand side - but the labour market conditions continued to deteriorate

In 2010 a significant adjustment of the imbalances of the Portuguese economy was again postponed

[I]nsufficient consolidation of public finances

[I]nsufficient adjustment of the external deficit

The Portuguese economy continued to be characterized by a significant number of structural fragilities

The important challenge of achieving a deleveraging of the banking sector and hence of the non-financial private sector

The economic and financial adjustment Programme represents a demanding but reasoned opportunity to lay the foundations of sustained economic growth in the medium term

Here's the link.

New opportunities, higher wages?

2011-05-18T16:43:00.002+01:00

The current discussion about "Novas oportunidades", a multi-million-euro public program introduced in 2006 to certify skills and improve schooling levels, highlights the dearth of evidence about its effects, especially in the labour market.

So let me present some preliminary results from my ongoing research on this issue, based on data from "Quadros de Pessoal". The sample used is based on over one million workers with between four and 12 years of schooling that are working in the same firms in both 2006 and 2009. I then focused on those who increased their schooling levels between those two years and compared their wage growth over that period with the wage growth of other workers whose schooling levels did not change.

The estimates are, of course, just a first approximation and are subject to a number of caveats, which will bias the results in different directions. For instance, some of the workers whose schooling levels increased may have obtained their higher degree from a standard school, not NO. Some of the changes in schooling may be driven by measurement error, not NO. And the wage growth of people whose schooling levels do not change may not provide a good counterfactual. However, as far as I know, there are no studies about the labour-market effects of NO and very little data available. In this context, these estimates will hopefully be of some interest.

What do the results indicate? First, that average nominal wage growth over the period for the entire sample was about 12%; and that about 5% of those workers increased their schooling levels, mostly from 6 to 9 or from 9 to 12 years of schooling.

Second, and more importantly, the wage growth of those workers that increased their schooling degrees (presumably in many cases because of NO) was, on average, about 0.6 percentage points higher than those that had the same schooling in 2009 and in 2006. Dividing by the number of additional years of schooling (i.e. on a per year of schooling basis), the effect of NO is around 0.2 percentage points. This compares with a 0.4 percentage increase in wage growth for each extra year of schooling across the full sample.

My take on these preliminary results is that the labour-market effects of NO appear to be weak. Perhaps this is not surprising - if the program is essentially about certifying skills that people already have, then presumably those skills are already rewarded by the labour market. In other words, it matters much more what people can do than the diplomas that they have. If the program is to be adjusted in the future, it would probably be good to strengthen the skills dimension to the detriment of the certification element. Releasing data for researchers would also be nice.

Some economics of payroll taxes

2011-05-16T15:54:00.004+01:00

The cut in employer payroll taxes (TSU) is perhaps one of the few memorandum items that can be seen as expansionary. However, this policy created great controversy in Portugal, in part because it will have to be funded from higher VAT rates, in part because the party supporting the current government appears to be unsure about its original pledge on this matter.

In any case, the motivation for this "fiscal devaluation" is clear - wages are high, compared to productivity, and this contributed to the huge imbalances of the Portuguese economy. According to some authors, wages need to fall by around 20% before the country can restore its lost competitiveness. Without any action, the economy would correct this imbalances only over a slow and painful adjustment process involving very high unemployment rates: Extrapolating from studies that find that real entry wages tend to be about two percent higher when the unemployment rate is one percentage point lower, the unemployment rate would have to increase by at least ten percentage points, to a Spanish-sounding level of 21%.

Cutting payroll taxes could make the adjustment process less hurtful, as it would reduce the wages paid by employers without damaging the incomes of workers. According to the estimates above, cutting TSU by four percentage points (from their current level of 23.75%) would reduce the increase in the unemployment rate by two percentage points. The remaining competitiveness gap could then be closed by the other items in the memorandum - public sector cuts and higher productivity stemming from structural reforms -, without further increases in the unemployment rate beyond the already unprecedented 13% predicted for 2013.

In my view, the main issue with this idea is actually whether firms would be able to ensure that the cuts in the payroll tax would not be passed on to their employees. Previous evidence from somewhat similar reforms in Chile and Finland suggests that wage moderation in this context can be weak. Several results also indicate that "rent sharing" is an important phenomenon in Portugal (as in many other countries): Employees - in particular those with more tenure - tend to be able to extract a considerable share of any windfalls in profits in the form of higher wages.

For the TSU cuts to be successful, they should be directed towards industries where labour demand is more sensitive to the wage rate. Many of them will be industries which are exposed to international trade but not necessarily low-wage industries. A national agreement about wage moderation involving the main unions would also be important, as well as cuts in labour adjustment costs (some of which are also in the memorandum even if perhaps somewhat timid).

3.25%=5.5% (warning: very nerdy)

2011-05-14T05:22:00.007+01:00

I have been away from the blog for the past week. After reading the discussion here early today, I think I have to explain why the interest rates in the Portuguese rescue package are not at all mysterious. Actually, there isn't even much genuine news around them.

This is hard and very nerdy, but here's my attempt at a short explanation:

1. The IMF interest rate follows a strict rule. There is no discretion involved. Anyone with a calculator could see it was going to be 3.25% for the first three years and 4.25% after, as soon as the size of the loan was announced.

2. The ESFS and the ESM have announced they follow the same rule as the IMF. They used to charge a bigger risk premium, but now the discussion is only whether they should charge an extra premium between 0 or 0.50%. That was the only thing under debate, and the only relevant news. So again anyone with a calculator could have figured out that the ESFS rate would be between 5.5% and 6%.

3. Why then 3.25% in the IMF loan and 5.5% in the EU loan? Because the first depends on the IMF's cost of funds (the SDR rate) whereas the second depends on the EU's cost of funds. The first is 0.52% right now, and the second is about 2,8% right now (it was 2,89% in January). So , here is (approximately) your 2,25% gap.

4. Why are the costs of funds so different? The main reason is that the IMF rate is variable, the ESFS rate is fixed. Or, to be more concrete: go to the bank to get a mortgage and they will offer you a rate if you want a variable loan (LIBOR + "Spread"), and a different rate if you want a fixed-rate loan. The difference between the two can be pretty high, but the bank is (roughly) offering you the same deal in expected value. I'd have to go super-nerdy to explain why. (A second reason for the gap is the exchange rate risk: the IMF lends in a different currency than euros, but I think the more important is the fixed-variable difference.)

5. What is the relevant interest rate for debt sustainability calculations over the next 7 years? That is tricky. If you believe the market prices for the swap contracts associated with the differences in point 4, then the answer is that 5.5% is the right number.

6. To sum up, the IMF rate and the ESFS rates are different things, apples and oranges. Converting the two loans into the same thing, you get that (approximately) 3,25%=5,5%.

Update: This is a hard and specialized topic, and my guess is that most economists would likely be confused about it. So there is no shame in getting it wrong. A tribute to Rui Peres Jorge, a journalist for Jornal de Negocios, and one of the best economics reporters in Portugal for explaining it well.

Update 2 (Sunday, 5/15): I have edited my previous update to remove references to some articles that were confusing about these calculations. Some people seem to have interpreted those links as some kind of criticism, which could not be farther from my intention. I was only trying to illustrate that this is a really technical and specific (nerdy) topic, so even good economists could get confused about it. My guess is that the majority of even my distinguished colleagues at Columbia wouldn't have known how these interest rates are set. Also, I completely agree that the interest rate charged is too high and that we may be able to negotiate it down. I know it is election campaign time in Portugal, and people are getting into smear campaigns, personal attacks and ego clashes but, please, don't drag me into it.

Finally, Diario Economico asked me to publish a longer article (simpler and in Portuguese) explaining these interest rates: it will come out in tomorrow's (Monday) edition.

Relief, denial, what's next?

2011-05-13T19:51:00.002+01:00

The first feeling, after disclosure of the Memorandum of Understanding, among Portuguese politicians was one of relief - it was not as tough as some feared.

The second feeling is now denial - after all, it seems to be building up among Portuguese politicians, the MoU is just a starting point, it can and should be adjusted... (?)

This is a dangerous path, and should not be pursued. We need to stick to spirit and letter of the MoU, not because it is sacred, but because our credibility is at stake here, otherwise we will be rewriting a book by Gabriel Garcia Marquez. The title will be, of course, Chronicle of a Death Foretold.

Punishment phase: "Somewhere in the scale of over 5.5%, but clearly below 6%":

2011-05-10T16:43:00.002+01:00

The interest rate in the Portuguese bailout has been announced to be

"Somewhere in the scale of over 5.5%, but clearly below 6%".

This raises a couple of issues - since the IMF intereste rate is 3.25%, the 2.25 (at least) mean exactly what?

- default risk ? but the default risk is probably larger the larger the interest rate set, it is also dangerously close to the value that will make the plan work or not - see the previous post by Francesco Franco in this blog.

- market power ? another origin of a high interest rate would be exercise of market power - take advantage of the weak bargaining position and lets extract rents. It seems doubtful that this is an issue in this case.

- punishment phase ? make an example out of this small country to avoid larger ones getting into the same troubles. Seems the more plausible explanation to me. But then it should be clearly stated, to avoid misinterpretations about the risk of the bailout plan.

Any competing explanations?

Any vote on which one you think is more plausible?

Memorandum of Economic and Financial Policies: The Macroeconomic Framework

2011-05-09T16:21:00.004+01:00

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.

The Memo and the health sector adjustments

2011-05-06T23:12:00.002+01:00

The Memorandum of Understanding has several measures related to the health sector. I provide my own view on them.

The savings required are important: 550 Million euro. The proposed measures do aim more than just short-run expenditure savings. There is a concern of building mechanisms for future control of expenditures in the public sector. These mechanisms involve performance assessment and benchmark, use of competition forces in public procurement, and introduction of best-practices in transparency and information on the evolution of the National Health Service.

Several of the measures are important and deserve to be implemented, even outside the current crisis setting. They must be seen as stepping stones for the future. They are not disruptive of the National Health Service, only of its culture of opacity.

Curiously, some - but not all - of the measures were already present in the recommendations of 2006 report commissioned by the Government.

A good deal of the effort lies in time horizon for implementation, forcing both technical excellence and political determination to be present.

In a quick appraisal of the main areas:

- moderating fees - values are to be revised, should be updated according to inflation, the structure of fees should guide patients to primary care and away from emergency departments.

- pharmaceuticals - margin reduction in distribution, change in margin structure making it regressive (here I believe we should go for dispensing fee approach instead of margin as percentage of retail price), redefine the international referencing price system to the minimum of the prices in reference countries, instead of current average.

- electronic prescription and quality in prescription - this area has been little explored as a source for savings, and the steps announced are good news for improvement. It will be essential the cooperation from the medical profession, and the IT system will have to work properly (finally, I would add!!)

- Efficiency gains - without mentioning specific areas, but looks for the incentive role that transparency and clear benchmark analysis may have. Continue redefinition of supply network of the National Health Service (including closure of unnecessary or unsafe units). The major warning is about the political process of closure, to avoid unwarranted population unrest.

- planing of health expenditures and projections over 3 or 5 years ahead. This is definitely a good idea. It was used in one specific programme (continued care network). Should be expanded to the whole system.

- reduction in fiscal benefits / tax allowances - it will mean an increase in effective copayments paid by the population, as the implicit health insurance provided is reduced. The tax allowance should not be totally removed on the account of tax evasion of providers if patients lose all interest in asking for receipts for tax purposes.

- explicit planning and follow-up of medical profession dynamics (training, exit, retirement decisions). I would take the chance to do it with all health professions.

Overall, the effect of this set of measures is crucially dependent on Government commitment . There are adjustments to be made in several points, which cumulatively have to produce the aimed savings. But the proposal plan attempts to reach these savings without compromising basic values of the National Health Service. A closer scrutiny needs to be in place, to ensure progress is achieved.

Opinion polls

2011-05-06T20:29:00.002+01:00

For those interested in the Portuguese elections, I suggest you follow the opinion polls summary and analysis by Pedro Magalhães (in portuguese).

Panic?

2011-05-06T17:47:00.003+01:00

Greece Considers Exit from Euro Zone

Hopefully, a false alarm.

Update: euro crashing, confusing statements, emergency meetings tonight. The FT's alphaville is following and trying to make sense of it.

Another update: False alarm seems confirmed. But just the fact that this was a serious possibility for a few hours shows how weak the euro institutional framework is right now.

Firm (but not too strong) labour cuts

2011-05-05T02:34:00.009+01:00

My summary of the main labour-market policies put forward by the troika:

1. Unemployment benefits: Capping unemployment benefits at 18 months and at around 1000 euros initially, plus a cut of at least 10% after six months (but not applying to those who lost jobs before the reform is introduced, while not reducing "accrued-to-date" rights of employees - more on this below); Reducing the minimum contributory period from 15 to 12 months and extending UB's to some workers under "recibos verdes";

2. Employment protection: Reducing severance to 20 days (10 of which paid by the employers' fund) per year of tenure with a cap of 12 months both for permanent and temporary jobs - to apply in full to new hires and in such a way that does not reduce "accrued-to-date" rights of current employees; Extending the grounds for dismissals for cause (e.g. when worker does not meet objectives agreed in advance for reasons of the worker's responsibility); and

3. Other aspects: Increasing flexibility in work hours (including reduction of overtime premium); Freezing the minimum wage; restricting the extension of collective agreements, strengthening works councils (to the detriment of unions); Assessing the effectiveness of current active labour market policies and designing plan for possible improvements.

The "accrued-to-date" formulation is not very clear but I think it means that a worker is always entitled to at least whatever s/he would have been entitled according to the current/old law by the time the new law is introduced. For instance, a worker with 15 years of tenure when the new law comes into force that is subject to a collective dismissal in his 16th year with the firm would be entitled to 15 months of severance - although the new law imposes a 12 month cap - given that the old/current law indicates one month of severance per year of tenure.

In this case, this approach would be a "generous" compromise between the tripartite agreement and the demands by some employers that the reduced severance levels would apply in full to all employees, not only the new employees. Also note that unemployment benefits access is widened - including to some people on "recibos verdes".

All in all, overdue policies to make the Portuguese labour market more modern and less segmented and the economy more competitive - so that the country can get out of the current utterly avoidable mess. Of course, it would be so much better to introduce some of these policies in periods of expansion - but the country was in some cases doing precisely the opposite of that in those times.

My take (so far) on the forthcoming Portuguese elections

2011-05-05T00:45:00.000+01:00

"June 2011 Portuguese Parliamentary Elections: Pre-Election Report", on The Monkey Cage.

The ECB/EC/IMF did not touch in the Peculiar Case of Portuguese Fiscal Federalism.

2011-05-04T23:51:00.002+01:00

(The 10 capital sins: #1)
Today we finally knew the “Memorandum of Understanding Of Specific Economic Policy Conditionality” produce by the troika (ECB/EC/IMF). It has some positive contributions, but as I expected it sidestepped some major “capital sins” of public finances. Let us start with Portuguese “federalism”: MAIN PROPOSALS from the troika: to reduce transfers to local and regional governments by at least 175M in 2012 and by 175M in 2012 and limit the reduction of the regional personal and corporation income tax rates to 20%, when compared with mainland tax rates. These measures do not address the structural problem of Portuguese strange “Federalism”.
When Wally Oates developed his seminal work - "Fiscal Federalism" - almost 30 years ago and gave birth to 1st generation theory of fiscal federalism, he was cautious saying that his approach was economic, although he acknowledge that political issues were relevant. Two decades after, a 2nd generation theory has given more importance to political issues.
Well, in the case of Portugal political issues are determinant in shaping and they are responsible for increased public expenditure. What economic theory still suggests is that countries with several tiers of government (federal or unitary states) should have the main taxes (mainly personal and corporate income taxes and VAT) shared by the upper two levels of government (federal/central and regional) or three (also including municipalities) and this should be supplemented by a set of intergovernmental grants designed in a way to somewhat partially equalize revenues (positively discriminating in favour of poor regions) and other to promote efficiency.
The Portuguese model is very peculiar, and almost nonexistent in Europe. One level of government (the Regions of Azores and Madeira) have all tax revenue generated in the territories. Citizens of these regions do not contribute one cent to the national functions of the state. Additionaly, there is a generous regional finance Act that transfers funds to the regions, and also a Local Finance Act which transfers funds to regional (and mainland) Municipalities. Finally, several regional expenditures are funded directly by the State Budget (e.g. Police, Universities, etc.). Obviously all these transfers and expenditures are funded by taxes generated in mainland Portugal. A particular weird situation exists today, since the current Local Finance Act (2007) gives the municipalities the possibility to have up to 5% of the personal income tax (IRS). The government of Portugal wants this revenue to come from the regional IRS, but the governments of the regions want it to come again from the State Budget.
It is clear that this peculiar model of "Portuguese Fiscal Federalism" has no economic rationality, but it has a political explanation. This article of the Constitution was introduced in 1976 after the revolution. At that time a minor threat of independence of the islands must have frightened the politicians in mainland Portugal and the norm was adopted. Over the last 30 years, there were several amendments of the Constitution, which did not change this norm. Also the laws regulating the relationships between the Republic and the Regions (Estatutos Politico Administrativos) have been revised and the tendency has been an ever increasing degree of autonomy. Again the explanation is political. Members of Parliament (MPs) elected from these regions have been pivotal to produce majorities in the national parliament, so that they usually have a big bargaining power.
These issues obviously were not considered by the troika. We just have some cuts in transfers. When the storm of the fiscal unbalance will be over, expenditure will grow again, since here no structural reform is suggested.
Proposal 1 : Preferably to change this norm in the Constitution and the regional finance act, in line with what are the best practices in developed countries (tax sharing arrangements) and the economic theory of fiscal federalism suggests. If this is considered not politically feasible decrease substantially (!) regional transfers. Deduct the value of expenditures that should continue to be financed through the budget (e.g. police), from the value of transfers.
Proposal 2 : Suggest to Eurostat that revenues and expenditures of the regions be classified in S1312 (where state accounts are considered en federal countries). If the regions in Portugal have more taxing powers and a greater share of revenues than states in federations why should they not be considered in S1312? This would increase transparency.

One group of people to NOT be congratulated about the package..

2011-05-04T18:34:00.002+01:00

The EU/ECB, which after three packages, still does not have a comprehensive approach to deal with the problem. Still no talk of institutional reforms, still no attempt to go to the heart of the debt/bank crisis in Europe. Just continuing to muddle along, waiting for the next crisis to hit.

One group of people to be congratulated about the package..

2011-05-04T18:31:00.003+01:00

The officials at the Ministerio das Financas and at the IMF. They worked hard, made sensible proposals, did not exactly have strong political backing, and managed to avoid the kind of crazy/inapplicable grand measures that these packages often contain.

Relative to the original Greek package, there was good progress in terms of doing sound economics.

A very good thing about the package

2011-05-04T18:24:00.002+01:00

Lowering payroll taxes and raising VAT in order to effectively do a devaluation of the currency via fiscal instruments (or, more appropriately, levy an implicit import tax).

But perhaps I am biased towards that idea...

A big unknown from the package

2011-05-04T18:16:00.002+01:00

Privatizing EDP (electricity provider), REN (electricity grid), and TAP (airline) in the next 7 months. Where is the private money going to come for these?

The usual pattern in privatizations in Portugal has been for big economic groups to borrow heavily from banks. But then how can you square these big loan with the increases in capital ratios in the banking sector?

My guess is that the IMF/EU/ECB team, aware of this, was trying to force a sell-off of these companies to foreign owners. But the political resistance to this will be tremendous. So I fear that, in the end, pressured to sell quickly, the government will sell cheap and give *very* good deals to the big Portuguese economic groups.

It will be especially important to see the kind of financial engineering tricks that they will come up with to hide implicit loans form the government to these groups.

Another quick (political) reaction to the package

2011-05-04T17:47:00.001+01:00

Conditionality in these circumstances is as powerful a constraint as they get. But what kind of stable political coalition in parliament in support of what kind of government will be able to pass in the next three years the kind of legislation required in the fields of justice, health, education, housing market, local government, scrutiny and elimination of public or semi-public entities, and regulated professions? And what technical capabilities, expertise and - especially - independent agencies are there to adequately perform the kind of analysis and cost-benefit evaluations prescribed in the package? Not sure.

The bad side of the package

2011-05-04T17:27:00.003+01:00

After the "big bad wolf" said that they could solve Portugal's problems without firing government employees or even further lowering their wages, the political ability for any party to defend these policies went to zero. One of the many reasons why signing these deals before, rather than after elections, is a bad idea

The wishful thinking part of the package

2011-05-04T17:26:00.001+01:00

550 million in cost reductions in health care. They should let the US and other countries fighting with cost control in health care in on the magic secret to do this.

The good side of the package

2011-05-04T17:23:00.006+01:00

The economic analysis is quite sound. It tries to fix the problems in public finances by trying to work on multiple margins rather than enforcing any revolution.

On BBC world service

2011-05-04T17:23:00.003+01:00

If you want to hear my reaction to the rescue package, you can catch me on the BBC world service.

Quick reaction to the memorandum

2011-05-04T16:18:00.000+01:00

Detailed...but what is the interest rate on the loan?

MoU - Portugal

2011-05-04T15:47:00.001+01:00

PORTUGAL: MEMORANDUM OF UNDERSTANDING ON SPECIFIC ECONOMIC POLICY CONDITIONALITY - get it here

Reminder

2011-05-03T23:49:00.001+01:00

Link.
PS: This is probably why the EU/IMF bailout will be less severe on Portugal.

Always surprising !

2011-05-03T23:25:00.002+01:00

The Prime-Minister announced today not the measures involved in the bail-out agreement.

Instead, announced the measures that are NOT involved!!

Well, actually the ones that have been reported in the press and are not involved!

Should then we anticipate that ones that circulated, and were absent from the NOT list

will be included? Stay tuned to the next chapter.

What's in the NOT list:

- no pay general pay cuts, not even wages paid with public debt

- no change in pensions below 1500 euros

- no wage cuts to civil servants

- no reduction in minimum wage

- no constitutional revision

- no privatization of the public bank (CGD)

- no change in copayments of the National Health Service

- no change in publicly-funded schools

- no dismissals in civil service

- no dismissals without cause in companies

- no privatization of social security

- no caps in social security

- no increase in retirement age

You can read the portuguese version in the site of the Government here (I find funny the link address has "troika" in it)

Now, let's wait to see the "IN" list !

The length of unemployment benefits

2011-05-03T13:09:00.003+01:00

What are the effects of more generous unemployment benefits? This question is addressed in a paper by Mario Centeno and Alvaro Novo delivered last week in a labour economics conference. The paper studies a 1999 reform in Portugal, when the unemployment benefit (UB) entitlement period was increased from 15 to 18 months for people aged 30-34. However, the entitlement was left unchanged at 18 months for people aged 35-39, who are used as a counterfactual.

The figure above displays job finding rates at different unemployment durations and finds very clear spikes exactly at the time when unemployment benefits run out. Consistently with previous evidence, these results indicate that unemployment duration increases very closely with the maximum UB length. Moreover, although one could expect that more generous entitlements would allow the unemployed to look for better jobs, the paper also reports that re-employment wages do not benefit, on average, from longer UB entitlement.

(On the other hand, there is evidence that those that leave unemployment at about 15 months when the maximum entitlement was 18 have higher re-employment wages than those that leave unemployment again at about 15 months but when that was also the maximum entitlement. However, it is not clear if the best comparison would be with workers that leave unemployment at say 12 months when the maximum entitlement was 15 months.)

All in all, the decision to extend unemployment benefits in 1999 (in a period of economic expansion) seems, in my opinion, to have been misguided and wasteful. Let's just hope that, now that the troika-led reforms are about to be unveiled, the findings from the paper prove symmetric in both the business cycle and the direction of change, i.e. that any cuts in UB duration (and generosity?) during a recession will also speed up job finding.