Bailout and the 10 Capital Sins of Portuguese Public Finances

Now that Portugal will have a bailout it is important to understand, what can be labeled as the ten capital sins of Portuguese Public Finances from a politico-economic perspective. This small essay (provided here as times goes by) may be of interest to several groups of people. The technical experts of the institutions that will negotiate with Portugal the bailout (mainly from the European Commission, The European Central Bank and the International Monetary Fund); the European politicians that lead the EU, those who have worked out the revisions to the Stability and Growth Pact (SGP) and those who are now redesigning the European Stabilization Fund ; the Portuguese citizens who will mostly suffer from the mismanagement of public finances, in particular the young generations who will pay the major part of the bill; economic journalists; and last but not least the Portuguese politicians who will run Portugal (and those who will stay in opposition) after the 5th of June general election .
As will become apparent some of the "sins" have developed in close connection with the structure of incentives embodied in European rules. Others are more idiosyncratic. The interest in presenting them is that although they are specifically Portuguese, and should be taken into account by different “stakeholders”, they exist in slightly different forms in several Europeans countries. So what some of them reveal is the urgent need for reforms at an European level.


The order of presentation will not be the sequence of relevance and all comments will be welcome. The timing of writing is uncertain, but I will try (not promise!) one or two contributions per week.

PS Some economists disregard the problem of public finances saying that the problem of Portugal is lack of economic growth and that having the latter the former will be solved. We all know that there is a relationship between the nominal growth rate, and the deficit-to GDP ratio that sustains a constant debt-to-GDP ratio. When the Stability and Growth Pact was designed, politicians assumed European economies will grow nominally on average at 5% so that a deficit ratio of 3% will keep the debt ratio at 60%. Although it is obviously truth that growth really matters, the argument that deficit and debt are just a byproduct of other issues is not only fallacious but also dangerous. As we will show the mismanagement of Public Finances in Portugal is a consequence of several structural problems, the sources of which are independent from economic growth. If these problems are not solved, they will impair economic growth, ie they will have a counter-effect on any measures taken to improve growth. That is why it is dangerous to disregard them.

The Future of the Past

History does not repeat itself, but in Portugal it certainly rhymes. It's easy to say now that the request for foreign aid made yesterday by the Prime Minister was the inevitable outcome of the accumulated stress of the last two years. But during that time the government, the European Commission and even the IMF sought to persuade us that the Portuguese case was different from the Greek and then the Irish. There might be merit in this differentiation, but sometimes it's useful to compare the present with our own past, even if distant. A quarter century of European integration and ten years of Euro membership were enough to convince us that Portugal had 'graduated' in the class of nations, leaving behind a past of financial and currency instability. The dreaded return of the IMF (or EFSF, as the President insists) re-evokes the memories of 1978 and 1984, but in my opinion the past that best rhymes with the present is the late nineteenth century. I speak, of course, of the crisis of 1890-92, which culminated in the last Portuguese bankruptcy. The parallels are striking and instructive.

For the most forgetful among you here's a brief recap. The problems began in April 1890 when the government had trouble placing a loan in Paris. A banking crisis followed in September with a run on the Montepio Geral, which was saved by the Bank of Portugal. Meanwhile, the current account took a wrong turn by the fall in the remittances from emigrants in Brazil. Despite the guarantees (avais) given by the Bank of Portugal and the government to a number of banks and railway companies, heavily indebted abroad, capital started flowing out of the country. Until 1892 the government committed about 12% of total public expenditure to these guarantees to not much avail. In November, the house of Barings, one of the most reputable London bankers, went bankrupt under the weight of its exposure to Argentinean debt (Argentina had defaulted in June). This precipitated a financial crisis worldwide, with capital drying up to peripheral nations such as Portugal. To make matters worse, Barings was the main external agent of the Portuguese government, and its failure cut off the access of Portugal to critical short-term credit. 1891 opened up with a failed republican uprising in Porto and, more importantly, with the bankruptcy of the Banco Lusitano, which the authorities were impotent to prevent. The Bank of Portugal itself had dried up its sources of credit and was in trouble to make up on the debt raised the year before. Under a situation of renewed capital flight (gold), and the threat of a banking collapse the government responded, in May, with a moratorium of 60 days and the suspension of convertibility in gold. By the end of June the currency had lost 6% of its value, adding up to more than a quarter until December. In the second half of 1891 the government negotiated a 'bridge financing' of £6.4 million, in exchange for the 35 year monopoly of the production and sale of tobacco to a group of domestic and foreign investors. Finally, in January 1892, Oliveira Martins (another Northerner at the finance ministry) decreed the suspension of debt payments in gold and began negotiations with foreign creditors. These were quickly interrupted, on 13 June 1892, by a change of government and the imposition of a partial default on the external debt.

Now replace Montepio and Lusitano with BPN and BPP; the railway companies with Refer and the Lisbon and Porto subways; tobacco with the pension funds of PT and the Social Security; and the Barings case with the current fears of exposure of European banks to the 'PIGS' and the story begins to sound like déjà vu. Today, as 120 years ago, the structural imbalance of the current account, particularly in the context of exchange rate stability, brought about an excessive foreign debt under the guarantee (directly or implicit) of the Portuguese state and the inevitable failure to honor the debt service.

There are, to be sure, important differences. Even though the abandonment of the gold standard was perceived to carry severe reputational costs, it was much easier to organize than the putative opting out of the Euro. It also helped that back then the external indebtment was mostly a sovereign affair, compared to today. Although it is hard to reconstitute the magnitudes, my own research suggests that the level of external debt just before the default represented about 40% of GDP, 35% of which government owed. These figures are in strike contrast with the statistics quoted here earlier by Ricardo Cabral. Despite their many design flaws, a network of European and international institutions (EFSF, IMF, ECB) form today a guarantee against an immediate dry up of financing to the Portuguese economy, which would result in a banking meltdown and a painful current account reversal – particularly under the no devaluation option. I agree with everyone who has rejected here the option of leaving the Euro, given the devastating balance sheet effects it would entail, but I also believe that Portugal, Greece, and Ireland should demand a better deal than what has been on offer. Adding up to the high interest charged by the EFSF to Greece and Ireland, the recent reference of Trichet to the peripheral nations as the 'collateral damage' of the fight against inflation in the Eurozone and yesterday's rise of the ECB rate are disturbing. I hope Trichet is playing Janus: indulging the inflation hawks while keeping the floodgates open to the banks.

Sovereign spreads - then versus now

Here is an interesting comparison of the pace of the recent Eurozone sovereign crisis with our own debt crisis of the 1890s. Portuguese troubles started in April 1890 and culminated in January 1892 (21 months). The subprime crisis spread to Europe around October 2008 and by May 2010 Greece had appealed to foreign aid (20 months). There is a also striking similarity between the levels of historical Portuguese spreads up to and after the January 1892 default (green dashed line) and the Greek bailout (blue dashed). By most historical precedent, Greece is clearly bust and will need a debt rescheduling. How about Portugal? Long spreads are still markedly lower than the comparators, although that may be just the time lag from contagion from Greece and Ireland. As we don't have the benefit of the hindsight of the next months this invites speculation. But if Portugal follows the same path of Greece and Ireland, I would bet that we would witness a similar pattern, perhaps more accelerated. Plus ça change?

Public Debt 1850-2011

It's now official. We have the largest public debt as a percentage of GDP since, at least, 1850. A sad, sad legacy.

Public Debt as % of GDP, 1850-2011

 Source: Mata and Valerio (1992), Neves (1994), INE, Santos Pereira (2011)

An Economic or a Political Problem?

Source: P. Pereira et al. (2009) Economia e Finanças Públicas, Escolar Editora, Lisboa

Several posts below have wondered whether Portugal has an economic or political problem. I believe it has both. I shall illustrate with the topic of public finances.

When we look at the history of public finances after the revolution (1974) four main facts emerge. Firts, Portugal never had a superavit in 36 years of democracy. Second, the only time it reduced the weight of public expenditure in GDP (without off-budget measures) was after the second IMF intervention (1983-84).

Third, the growth of public debt has been curved down only through privatization of a huge amount of public assets nationalized after the revolution (a pattern followed with and without the IMF). Fourth, there is a strong evidence of political business cycles over the last 20 years in all legislative elections (1991, 1995, 2002, 2005, 2009) except one (1999).

Now, do we have an economic or a political problem? As we all know a deficit of 3% would not be a problem with a nominal growth rate of 5%, because it woul stabilize the debt to GDP ratio at 60%. The problem is that we did not have that growth rate in the last decade and will not have it in the next decade. So, we have an economic problem.

However, we also have a political problem. As I see it Portugal (and peripheral mediterranean countries) has the instituional disease Mancur Olson identified almost 3 decades ago in The Rise and Decline of Nations: institutional sclerosis. And only a strong government with wisdom, and a majority support in parliament can tackle it. It is a necessary (but not sufficient) condition...

We also have political problems!

(for my articles in Portuguese see Publico http://jornal.publico.pt/noticia/22-01-2011/execucao-do-oe-2011-bussiness-as-usual-21079652.htm and for earlier writings http://www.iseg.utl.pt/~ppereira/finpub)

A Little Common Sense

In the last few days, we witnessed dramatic reactions to the downgrade of the rating of the Portuguese public debt and to the volatility in the financial markets. Some analysts and politicians went as far to alert us that we were pretty much on the edge of an abyss and that the country has no future. Some have even argued that the spreads are increasing so much that soon enough we will not be able to repay our debts and we will have to declare bankruptcy. They might as well be right (although I suspect, and I hope, that they are not). Still, in spite of all the hype and drama, shall we have a little common sense here? How can anyone honestly say that 6%-7% interest rates are unprecedented and that will make the repayment of our public debt unsustainable? Really? It might worthwhile remembering some things from our recent past then. When the IMF came to Portugal in 1983, Portuguese public finances were also in very bad shape, and thus the IMF imposed some draconian measures in order to put things back in shape. A couple of years after, the IMF was praising Portugal for being so successful in correcting its fiscal imbalances (there are important lessons to learn from this period, in fact). It is also interesting to remember that, at the time, the government was paying more than 20% interest rates in order to finance its debts (see table below). In fact, we don’t even have to go that far in time. In the 1990s, before we started the process of nominal convergence on the way to the euro, the interest rates on government bonds were still hovering around 10%.

What has changed since then? Well, we stopped growing (our biggest problem) and the country’s external indebtedness increased substantially. Thus, the risks associated with our debt are now greater. Still, this does not mean necessarily that we are on the edge of the abyss. As long as the government is responsible enough to follow some good policies (i.e., cut expenditure, suspend the large public works projected, and stops increasing future public debt through the PPPs), we will certainly be a lot more prepared to convince the markets that we don’t deserve their wrath. The big question is thus whether this government can, for once, stop behaving irresponsibly. After the latest news, I am not so sure.