Peaceful demonstration

We have seen in the news a crescendo of interest on today's demonstration,

and how it could go.

In the end, despite the announcement of more hard and harsh measures to

bring the budget deficit under control, despite interest rates in Government debt reaching

historical maximum in financial markets, all of it went peacefully in Lisbon, Oporto

and the other cities.

If the international press (and perhaps some national press as well) was hoping

for tears, blood and smashed windows of stores, nothing of that sort resulted.

Not sure what it means... but much better than having violence around, for sure.

The New Austerity

In the last year or so the Portuguese government has been announcing successive measures to control public expenditure and deficit. This is in line with what is asked for by Berlin, Brussels and Frankfurt. Clearly, austerity measures in Portugal are the reflexion of the new Europe. Germany may be blamed for that but we all know that finding the culprit, be it Germany or Socrates, or the ECB (or Greenspan…), generally means that one has reached the wrong answer. Austerity is not about Merkel or Germany, although domestic pressure there and in the other “northern” countries should be accounted for. But the bottom line has to lie elsewhere, namely, on the gradual redefinition of how the European Union is going to work in the next decade or so. And what will it be? It will be a Union where “fiscal responsibility” will prevail over “cohesion”. I am not worried about that, frankly. Portugal can live with the new Europe on the making, and the changes may even have positive effects on the structure of the economy and on the overall institutional framework. It is a shame, however, that changes had to be imposed on such a short notice and in such a drastic way, mostly because their effects on the less protected parts of the population will be felt more severely. But Portugal will cope with what the new Europe implies: lower wages, lower pensions, higher retirement age, smaller welfare state, lower infrastructure investments, etc. All counterfactual scenarios are most probably worse. And in the end we may have higher savings rates, higher export growth, and lower dependence on foreign capital.

Portugal needs peace but no Carthaginian peace

Portugal needs to secure stable access to funding at 4% for the next five to seven years and the rest of Europe must offer such funding to Portugal. The conditions that Europe granted to Ireland, namely funding at 5.8%, are a non starter. Consider that from 1999 to 2007 nominal GDP growth in Portugal averaged 4.8% per year. Any cost of funding that is above the nominal GDP growth rate requires a switch from deficit to surplus just to stabilize the debt to GDP ratio. In short, “Irish conditions” imply that, in a scenario where Portugal follows the right set of policies (defined below), debt will start stop increasing in a decade or so. I assume Europe will grant funding to Portugal at 4%. (Assumption1 cost of funding is 4%)

Assessing if Portugal needs a bailout is hard and somewhat subjective as it requires a consistent and uniform analytical model. I sidestep this difficulty by assessing Portugal solvency only using an intertemporal budget constraint (IBC). In words Portugal becomes bankrupt if unable to pay off foreign obligations at their face values, and if this happen the Portuguese IBC would not hold with foreign debts valued at par. I focus on national solvency as opposed to government solvency as I stronlgy believe the priority is on stabilizing the external debt. As a reminder Figures 1 and 2 show the government and the external debt as a share of GDP. On one hand the government debt dynamics are worrysome but hardly justify the risk premium markets are requiring to finance Portugal. On the other hand the external debt dynamics are just explosive and might well scare any international investor.

Eurostat forecasts Portugal nominal GDP growth to be 0% in 2011 and 1.8% in 2012. To extrapolate further into the future I assume that from 2013 on, nominal GDP growth will stand at 4.8% per year. (Assumption 2: nominal GDP growth is 0 in 2011, 1.8% in 2012 and 4.8% from 2013.)

All other things equal, securing access to reasonable rates will not be sufficient to make Portugal solvent. The trade balance has averaged -8.8% per year from 1999 to 2007 and stands at -6.25% in the first three quarters of 2010. If Portugal does not improve the trade balance any attempt to assess its solvency is futile.

Let me illustrate a favourable scenario. Assume that Portugal does initiate a process that transforms the country in a net exporter. I do not discuss specific proposals to achieve such a target and interpret the process as a reduced form of many policies. The process improves the trade deficit (now at -6.25%) by 1% every year starting in 2012 and stabilizes at 6.75% in 2024. This scenario correponds to the blue line in Figure 3. By that year Portugal’s trade balance would resemble the Netherlands’ trade balance (6.7% is the average 1999-2007 Netherlands trade balance). If such a policy is implemented, the Portuguese international investment position stabilizes around 2015 at 136% of GDP and starts to decline the year after. Notice that the external net debt is stabilized before the trade balance turns positive and the subsequent trade surpluses will repay the debt. Things could go worse (yellow line) because of bad shocks or better (green line) maybe if the structural change is complemented with other policies such as a fiscal devaluation that would affect positively the trade balance in the short run. In any case Portugal would remain solvent and the European fixed rate coupled with the Portuguese transformation would have been successful.

Difficult scenario? Challenging. Obviously the “real” policies behind the transformation must be enumerated and discussed but as a target they are necessary to live in the currency union. Realistically the undertaking of such reforms during a period of severe fiscal consolidation might require further help from Europe. One possibility could be to use the EU Structural Funds intertemporal budget constraint and front load all expenditure allocated to Portugal to the next five years period. On paper it would not be an additional transfer from other European partners, call it a timely transfer. In any case square one is to secure funding at a reasonable rate.

Does Portugal need a bail-out?

Here are the views on this key question as contributed by some of the economists writing in this blog:

Alvaro Santos Pereira:
Absolutely. There is no doubt in my mind that Portugal will be bailed out, whether that is done through the “conventional” means that have been used by Greece and Ireland, or whether Europe gets its act together and agrees on a permanent framework to deal with these situations (a big if, indeed). Still, in both instances, Portugal needs to solve rapidly the acute liquidity shortage that threatens to dampen even more the country’s economic activity.

Why is a bailout almost inevitable? Because the credit constraints and the lack of financing of the economy are untenable, the debt dynamics are unsustainable, and because, frankly, there is a self-sustaining belief that Portugal is the next country to fall in the European sovereign debt domino.

Independently of what will happen in the next few days, the fact is that Portugal has a very serious debt problem in its hands, which will likely not go away with a mere bailout. Just to put things into perspective, in 2011, Portugal will have its highest public debt (as % of GDP) of the last 160 years, and the largest external debt in the last 120 years. Our public debt will be higher than 91% of GDP, and that does not even include the debt of public enterprises or the future debt already committed with the private-public partnerships that substituted for public investment in the last decade. In addition, the country’s gross external debt amounts to more than 240% of GDP, and net external debt is around 110% of GDP. The economy has not grown significantly in the last decade, and there is no major indication (with the possible exception of exports) to make us believe that we are on a prelude for an unforeseen economic miracle. To make things worse, government policies have been close to disastrous, and have only aggravated Portugal’s economic ailments. In short, the situation is dire, and it is difficult to envision any scenario in which a bailout will not take place, even though the latter might not be enough to help resolve Portugal’s debt problems in the medium and long term.

The fact is that the only reason that has prevented Portugal to ask for a bailout are the political costs that will be associated with such a decision. Everyone in Portugal knows that as soon as the country is rescued, the government will (deservedly) fall and new elections will be scheduled. That is the sole reason that has made the Portuguese government so reluctant to activate the bailout mechanisms. It’s not national pride, it’s really high political costs. The prime-minister and the government don’t want to be judged by History for being responsible for the most serious financial crisis that Portugal has experienced since it was forced to declare bankruptcy in 1892. Alas, they are and they will. And, unfortunately for us, even their stubbornness will likely not be enough to prevent an more-than-probable bailout.


Pedro Lains:
Yes it does. But no, thanks.
Where should we look at to find the answer?
The Government is not interested because it would have large political costs. So let’s look elsewhere.
The IMF is probably interested in the bailout, as they are part of its business. So, most analysts linked to the Fund say that it should be asked for. Merkel’s government follows this line of thought.
Would medium term average sovereign debt interest rates be reduced with a bailout? Apparently that was not the case with Greece and Ireland. Saying the sooner the better does not help either.
Portuguese bankers and those voices in Europe that favour the deepening of European integration are against. Bankers in Portugal fear the bailout because, they say, it would reduce (domestic and foreign) deposits. The pro-deepening people argue that a European response would be enough to curb interest rates on peripheral sovereign debt. Interestingly the head of the European rescue fund also says no, that it is not needed for now.
So, I guess that my reading of these different positions leads to the conclusion that at this stage the costs of a bailout would be higher than its benefits.


Pedro Pita Barros:
Portugal can benefit from a bail out. Is it essential? Not necessarily, depends on what price is to be paid for it. An Irish-like intervention will not help much. If that's what is on the table, then I would say no to the bail out. The bail out is worthwhile only if the discipline mechanism does not include to a considerable extent high interest rates.


Pedro S. Martins:
Yes. Things need to change as the current combination of high debt and high interest rates is clearly unsustainable. It's not equitable to burden young people and the future generations with so much debt and all the taxes that follow. The bail-out would mark a clear threshold in the management of the Portuguese economy and prompt much-delayed reforms that can restore productivity growth and ensure this decade will not be completely lost.


Paulo Trigo Pereira:
With 6% yields in 2 year sovereign bonds issued this Wednesday, Portugal has reached interest rate levels on sovereign debt that are unbearable. Although there are good signs that fiscal consolidation will reduce the primary balance in 2011 (mainly through the increase of tax revenues), part of this reduction will be offset by increase in debt interests so that public deficit will not decrease as much as it could.

GDP growth in 2011 is unpredictable, basically given the uncertainty on exports, but it is reasonable to assume a recession this year around 1%, and since fiscal consolidation will have to continue in 2012, a close to zero growth in 2012. Under this scenario, unemployment rate will keep its actual two digits, and long term yields, with or without bail out (see the cases of Greece and Ireland), will remain above 7% in the next two years starting to decline in the second half of 2012, when (and if) there are good signs that reduction of public deficit is sustainable and will continue in 2013. Available data suggests that we are in a consolidation path, but some time is needed to gain credibility.

Under this framework it seems wise to have immediate access to the European Financial Stability Facility (EFSF) covering most of our gross borrowing requirements for the next two years, while yields would remain high. The exact amount will depend on the expected privatization revenues over these two years.

The access to the EFSF should be carefully worked out with a reasonable agreement not only with respect to the yields (around 5% is acceptable), but also all the “package” of measures that will be included in the memorandum of understanding.

Finally, a bail out has to be demanded by the prime minister, and domestic political debate has mixed this demand with a political crisis and general elections. The two issues should be disentangled. And in order to do so a political agreement should be set between the government and the main political party.

A development of this argument will be set out in my “Público” article this Friday 11th March (in Portuguese). Simulations of savings in interests having access to EFSF, with two scenarios, done by myself and João Duque will be presented at Instituto Superior de Economia e Gestão, Friday 11th at 6pm in Auditório 2 (Rua do Quelhas).

Deolinda's sad song

Youth unemployment in Portugal is 23%. Firms tend to reduce their hirings considerably during slumps. Germany demands more reforms including, presumably, some labour market deregulation. But the Portuguese government now decides to impose a minimum wage and several other contractual constraints on traineeships (e.g., a minimum duration of 12 months).

Traineeships are a form of investment in one's human capital - even if trainees are not paid, they may be better off given the gains in experience, networks, signaling/screening, etc. Why make it more costly for employers to take on trainees? Why risk pricing out many more youngsters from the labour market?

The Portuguese Economists

The 2011 issue of "Economics Research in Portugal: People and Institutions", which lists and ranks academic research in economics, is now available.

This is a notable effort (by Paulo Guimaraes and Miguel Portela) in compiling and disseminating information about the work done by Portuguese economists (and non-Portuguese economists based in Portugal) in pushing the frontiers of knowledge in the "dismal science".

According to the website, there's somewhat surprising evidence that 2010 was a not very good year in terms of academic results, given the upward trend starting in the mid-1980s. But perhaps this is only a one-off blip (or, alternatively, 2008 and 2009 were one-off spikes):

Here's the list of top 10 economists, according to one of the many criteria (summing all research contributions since 1970 and weighting each article using a combination of metrics):

1: Sergio Rebelo, Northwestern U
2: Luis Cabral, New York U
3: Pedro Pita Barros, U Nova
4: Miguel Villas-Boas, U CA, Berkeley
5: Nuno Garoupa, U Illinois
6: Alfredo Marvão Pereira, Col William & Mary
7: João Santos Silva, U Essex
8: Guilherme Carmona, U Nova
9: Nuno Limão, U Maryland
10: Pedro Portugal, U Nova

It's interesting to note that only three out of those ten economists are based in Portugal (and all of those are in the same university, Nova).

Bail whom?

The presidents of the top three Portuguese private banks have been saying that they are against an eventual IMF/EU loan to Portugal. Today Ricardo Salgado, the President of Banco Espírito Santo, explained why: because, he says, a negative correlation between the bailout and deposits by residents could be observed in Greece and Ireland. The link is that the bailout reduces confidence and thus domestic savings. Is this so? Is there a literature on the determinants of domestic savings, particularly in those two countries and Portugal? Salgado's reasoning seems a bit odd to me. He certainly knows better, but I wonder whether his "feeling" would be confirmed by a proper analysis of the data.

Portugal and the euro: expectations and reality

Faculdade de Economia da Universidade de Coimbra, wednesday 23 February 2011: João Ferreira do Amaral and Miguel Beleza shared their views on the Portuguese performance under the euro, in another event of the project "1986-2010 A Economia Portuguesa na União Europeia".

João Ferreira do Amaral's main thesis was the following. 1) Adoption of the euro led to a systematic bias in the allocation of resources from tradable goods sectors to non-tradable goods sectors; 2) the only way to possibly avoid such bias (and, thus, to prevent the current foreign debt crisis) would have been to devalue the national currency.

True; if (and only if) Portugal merely aims at avoiding foreign debt crisis. But I always thought we wanted to improve our real per capita income (in purchasing power parity, obviously).
Think about the crawling-peg 1976-1990. It was instrumental to rebalance our payments balance. To the cost of postponing structural change in our tradable goods sectors. See where that led us: low structural competitiveness and... a foreign debt crisis.

It is simply too hard to believe in an exchange-rate devaluation policy as a means to promote a positive structural productive change.
I thought we all believed that monetary policy is ineffective in the long-run.

Correction: monetary policy may effectively destroy the stability conditions that a healthy growth process requires. Thank you, Miguel Beleza, for reminding that to last wednesday's audience (those with hears will have heard).

If only fiscal policy had countered the aggregate demand expansion that we all knew would arise after adopting the euro... we wouldn't have the twin deficits crisis that we do have (yes, please do not forget that the public deficit is at the center of the problem).
Healthy fiscal policies would have structurally balanced the budget and, also crucial, would have given private economic agents the proper message and incentives on their inter-temporal budget constraints. That could avoid the twin deficits-debts crisis.

I fear that a corollary that some may extract from João Ferreira do Amaral's thesis is that we are, after all, devaluing our wages, which is the macro equivalent to an exchange-rate devaluation.
Well, not quite the micro equivalent, though (and, thus, not quite the macro equivalent). What is necessary and should be done is to devalue the wages in the sectors and firms that are not achieving high enough productivity growth. An exchange-rate devaluation devalues all the wages in the economy. I fail to see the point in doing that, if we want to stimulate structural change.

Last wednesday's audience was largely composed of students that were born after the end of the crawling-peg, after the creation of the single market and who do not have any recollection of the pre-euro years. If only they had experienced life in a highly protected domestic market, with a chronic devaluation of their international purchasing power, with high and volatile inflation...
The best way to repeat an error is to forget about its consequences when we last did it. Hence the importance of good pedagogy in explaining the current crisis and its possible solutions. Thank you, Miguel Beleza.

From politics to policies

The current problems of the Portuguese economy highlight the desperate need for public debates on concrete policies: the country needs to discuss the positives and negatives of different alternatives, the relative urgency of each policy, their likely effectiveness in terms of addressing the current bottlenecks. This is particularly important now that difficult choices need to be made by the government on a daily basis - opportunity costs are everywhere and this cannot be hidden any more.

How to fix the justice system is probably the most conspicuous example of the urgency of specific proposals for reform. On the other hand, teacher evaluation - a terribly important idea that, in my view, was terribly implemented - is a good example of the problems that can arise when big reforms are introduced without prior debate. In fact, the education ministry is still discussing how to implement that reform already four years after first introducing it.

In an ideal world, political parties would present their manifestos - where they outline the key reforms they plan to introduce in a relatively detailed way - and then stick to them if they get elected. But, apparently, it seems that nobody wins elections in Portugal by announcing unpopular reforms, especially when the other parties can take the populist route and claim that all is well, that we can borrow our way out of the current mess and that, in the end, the State will sort everything out.

But the blame needs to be shared. For instance, a media that does not like to discuss "details" doesn't help. (Is this because they somehow know that "details" don't sell - or because they simply don't have the know-how to do "details" properly, despite the abundant number of graduates available at low salaries?) On the other hand, many academics in Portugal either target their efforts on international journals - which, for understandable reasons, won't care too much about case studies involving Portugal - or simply do not engage with public policy issues, at least not in a way that will generate reasonable prospects for evidence-based policy.

PS [24 Feb] - Things may be changing.

Exports and Public Policy

I believe the discussion on export incentives should focus on having a public policy framework driven by exports. The distinction between tradables and non tradables does not seem particularly interesting in this context. The main point should be the evaluation of public policy options, including investment options, according to an export promotion criteria. Moreover, we should not discard the need to have a policy of positive export discrimination, as long as it is consistent with the Lisbon Treaty.

Export incentives

After the more macroeconomic point of view in the previous post by Francesco Franco, let me offer some microeconomic remarks, in my case partly motivated by the grandiose Exports Congress held yesterday:

1. While it’s clear that Portugal needs to pay off its debt, it is far from obvious that “incentives” to exporters are the best way of achieving that. For instance, the asymmetry of information between applicants and the civil servants in Terreiro do Paço (or anywhere else) picking applicants is such that it is very difficult in practice to select probable winners. If one then factors in the “small worlds” people in Portugal live in and the short-run perspective induced by the current stage of the political cycle, it is likely that most picks will actually be losers, not winners.

2. Funding these schemes will imply taxes (either now or in the future), which will distort choices and create inefficiencies. One needs to be sure that the benefits outweigh the costs – an obvious comparison but, alas, often ignored in many public programmes. Even if exporting may make firms more productive, is that effect big enough that one really wants to cut public servants salaries and social spending again in a few years time?

3. Supporting these schemes will not only generate inefficiencies from taxes. It will also distort competition by destroying any (slim) chances of a level-playing field and economic mobility in the industries affected. How discouraging it must be for a business to have a good product or service to sell (in the domestic or international markets) but then be systematically passed over because competitors happen to know the right people and/or don’t bother to follow laws that actually are not really enforced?!

4. As Olivier Blanchard made clear in a paper mentioned before, improvements in the non-tradables sector (and I would include here all public services, in particular the justice system) may actually be a much more effective way of increasing the efficiency (and “competitiveness”) of the tradables sector. But this is the back-of-the-scenes management work (streamlining processes, monitoring practices, setting sensible incentives, etc) that unfortunately does not get headlines and systematically falls down in the long list of politicians’ priorities.

5. Many of these themes that are now currently being rehearsed by the government have already received a lot of attention in the very promising but apparently defunct “Plataforma para a Exportação, Inovação e Competitividade”, launched in 2005.

The path ahead

“Long is the way, and hard, that out of trade deficit leads up to trade balance”

I feel a little unease to edit Milton but I am searching for strong words to convey a truth that is hard to accept. It will take time and efforts to convince international investors that the Portuguese economy external position is sustainable. The news that exports are increasing is good. Notice that imports too are increasing and what ultimately matters for the current account balance is the difference between exports and imports. Consider the data published by the Portuguese statistical office: in 2010 exports of goods have increased by 15.7% (to 36.8b) and imports of goods have increased by 10.2% (to 56.8b). The trade balance for goods is negative and therefore contributes to increase the current account deficit. The fact that Portugal imports are still much larger than exports (1.5x) implies that the trade balance for goods has deteriorated by 2.1% and therefore contributes negatively on GDP growth. Now assume (imagine) that from this day on exports continue to increase by 15.7% per year and imports continue to increase by 10.2% per year. If that was true, net exports would start to improve in 2012 (contribution to GDP growth) and become positive in 2019 (finally helping the current account). These dates are wrong as they do not take into account the correct growth forecasts for exports and imports, but they convey part of a truth. It will take time to adjust the trade balance of goods. And the whole truth is that it will also require efforts to adjust the trade balance within our currency area. In a now classic paper, cited a few days ago in this blog by Pedro Martins, Olivier Blanchard described back in 2006 the difficulties and the efforts required for the current account adjustment to occur. And there is no doubt that the adjustment has to predominantly occur inside the euro area (Eurostat).

The day when the current account will become positive will be the day Portugal will start to repay its external debt. Policies aimed at bringing that day closer might be welcomed by external creditors.

Maybe one day the many euro area national debts will be guaranteed by the single currency area and become one. That would help decrease the income outflow. Maybe that day will not happen. Concessions from euro area creditors would certainly help. In any case Portugal debt must be brought on a sustainable path.

Interview with Mário Centeno

Mário Centeno's interview to the newspaper Público deserves a close reading (although only for those of you fortunate enough to read Portuguese, I'm afraid)

Some economics of teacher evaluation

A chapter in the forthcoming Handbook of the Economics of Education, "The Design of Performance Pay in Education", by Derek Neal, includes this extract motivated in part by the Portuguese reforms:

In private firms, the person who evaluates a worker’s performance is either an owner of the firm or an agent of the owner. In public education, subjective performance evaluation is more problematic because many principals and administrators work under employment and salary rules that create only weak links between the quality of their personnel decisions and their own compensation. Thus, some may not be surprised that performance pay systems that involve one group of public employees making subjective determinations about the bonus payments given to another group of public employees did not generate noteworthy gains in student achievement.

More details here.

Economic history

Probably the most important prediction of the current challenges of the Portuguese economy - and including many suggestions for reform: the address delivered at the 2006 Bank of Portugal conference on economic development by Olivier Blanchard, then at the MIT, now at the IMF.

The paper was subsequently published by the Portuguese Economic Journal in early 2007. The abstract is:

"In the second half of the 1990s, the prospect of entry in the euro led to an output boom and large current account deficits in Portugal. Since then, the boom has turned into a slump. Current account deficits are still large, and so are budget deficits. This paper reviews the facts, the likely adjustment in the absence of major policy changes, and examines policy options."