A note on the IRC reform proposal

This note is based on the preliminary proposal for a reform of the corporate income taxation in Portugal.


The subtitle of the proposal states the scope of the reform: to improve competitiveness, increase growth and create employment. To achieve the latter goals the proposal stands on three elements. First a simplification of the IRC code, the fiscal-legal element. Second a gradual and certain decrease in the tax rate, the budget-macro element. Third a corporate tax coherent with the new international environment, the international cooperation element.

The legal-fiscal dimension is the central focus of the proposal. The authors have produced an impressive and detailed code that contains new articles and alterations to the older ones. Being a macroeconomist with a weak understanding of the legal technical language, I am not in measure of evaluating the contents of these articles. Surely the objectives of simplification and increased efficiency are of primary importance. Overall given the background of the commission this appears to be the strong element of the reform. 

The budget-macro dimension is weaker.  The key point of the document is the large decrease in the average corporate tax rates across the OECD and G20 countries that went from 40.9 percent in 1990 and decreased to 26.3 percent in 2013. The authors maintain that this decrease has caused growth, investment, employment and a reduction of tax fraud. To strengthen the causal link they present several graphs showing a negative correlation between the tax rates and tax revenues. The idea is that the reduction in the tax rates has increased the revenues partially through a broadening of the tax basis and especially in response to a “virtuous” supply side mechanism (that also caused growth, investment and employment). The analysis should be more nuanced. The international reduction in corporate tax rates started 30 years ago is most likely a response to the greater mobility of capital.  Increased profitability in the corporate sector explains, at least partially, why revenues as a percentage of GDP did not decrease despite the reduction in rates. The large increase of the financial sector during this period is also part of the explanation. The authors recognise that beyond the stylised evidence presented, no evaluative research to legitimate the practical implications on competitiveness, growth and employment of the proposal has yet been done.


The budget implications have been quantified for three different scenarios and are approximately 220 million euro per year, with a 5 years cumulative effect on fiscal revenues in the range of 1200-1400 million euro.  The quinquennial horizon of the reform responds to the necessity of spreading the loss in tax revenues during this period of budget consolidation.  A legitimate question is to ask if the decrease of the corporate tax rate from 31.5% to 19% that costs 220 million euro per year is welfare superior to different proposals such as decreasing the tax on labor. It might well be that this is actually the case but evidence would be welcomed.

The international cooperation dimension suggested is the one I more tenaciously debate. The stance of the reform is the one of a realist state-centric small economy. Somewhat a paradoxical posture for a European country, especially when the G20 is pushing for new international standards to be designed to ensure stronger coherence of corporate taxation across countries. The OECD, called to develop an action plan, has heralded the proposal of cooperation a “once in a century” opportunity to fix a creaking taxes system. Critics will call it a rhetorical statement and that taxation is the last line of defence of countries sovereignty. Perhaps, but I believe that only through cooperation, nation states, especially the small and medium sized, will be able to maintain their sovereignty.

Ultimately the Portuguese authorities want to implement a corporate tax reform to increase the welfare of all Portuguese citizens. Trade-offs are present: fiscal stability versus stimuli effects, allocational efficiency between capital and labor, short term versus long-term effects. Overall the case on the desirability of the reform can be made. I would suggest changing the methodology and riding the opportunity given by the G20-OECD action plan on corporate income tax reform. Become the first mover to launch and implement the coordinated plan. This could be the stance of a cosmopolitan nation state.

Shrinking times

Blue lines are flows, green lines are prices, red lines are stocks. Click figures to enlarge.

meantime somewhere inside the EU central command: http://www.youtube.com/watch?v=yR0lWICH3rY

The biggest challenge

The crisis that I described in my previous post is still far from being solved. The president asked for the three institutional parties to reach an agreement. Since nobody knows what is going on in the President’s head, it is impossible to predict what he will do if such an agreement is not met.

Anyway, the biggest challenge that the new government will face for the next year is to cut 4.7 billion euros (about 2.85% of GDP) in public spending. Such a drastic cut seems like the wrong thing to do.

Economists from the Bank of Portugal, using a Small Open Economy DSGE specifically developed and calibrated for the Portuguese economy, haverecently concluded that in times of economic stress the public spending multiplieris about 2.

If this number is correct, then the 4.7 bn cut would lead to a contraction in GDP of 5.7%. This contraction in GDP, by itself, would cause the debt to GDP ratio to increase by 7 percentage points (from 125 to 132%). Additionally, the recession would also lead to a decrease in tax revenues. If tax revenues dropped by 3.3 bn then the budget deficit would decrease by 0.6 percentage points.*

In sum, if these cuts were to be implemented, Portugal, whose GDP is already at pre-millennium levels, would face a huge recession. Unemployment, which is already at an all-time high, would explode. The only benefits would be a decrease in the budget deficit by less than 1 pp. together with an upsurge in the debt to GDP ratio. This is just silly.

Given this, I would say that the biggest challenge that the new Government, whatever its form, will face is to convince the troika that this additional cut is simply stupid.

* I am assuming that the decrease in tax revenues corresponds to 35% of the shrinkage in GDP. Some may consider 35% to be too much, however in these calculations I am not taking in consideration the increased spending in unemployment benefits.

Portugal political crisis rooted in drastic economic measures

By Luís Aguiar-Conraria, University of Minho
This article was originally published at The Conversation. Read the original article.

The current political crisis in Portugal has surprised both local economists who know little about politics and international analysts who are ill-informed about the Portuguese economy.

In May, I had the chance to have dinner with the vice-president of a European central bank. He was quite surprised when I told him that austerity was not working in Portugal. All the information he had suggested otherwise.

On Thursday Mario Draghi, the president of the European Central Bank (ECB), declared: “The results that have been achieved [by Portugal] have been quite significant and remarkable, if not outstanding.” Unfortunately, most of this is propaganda. At best, it is only partially true.

Well known problems

Portugal’s main macroeconomic problems are well known: high debt, both private and public, combined with a chronic trade deficit and mediocre GDP growth since 2000.

The country was gradually trying to deal with these problems when the financial crisis and the following economic recession hit Europe. This quickly became a sovereign debt crisis, forcing the Portuguese government to ask for external financial assistance in April 2011. The €78 billion EU and IMF bailout duly happened, but it came with austerity requirements: improve the budget deficit by reducing spending and increasing tax revenues.

There have been some improvements over the past two years: total government spending has decreased substantially, families save more, private firms have less debt and the trade deficit has largely disappeared. But these triumphs were achieved at the cost of a huge recession. The budget deficit to GDP ratio remained almost unaffected and the public debt to GDP ratio dramatically increased.

How to start a recession

Let me provide some numbers. In 2011 — after removing the effect of one-off measures — the budget deficit in Portugal was 7%. The following year, the government raised several taxes and reduced pensions and public wages by the equivalent of two months' income. In the case of public employees, this was already a second reduction.

As a result, the economy went in to recession. Unemployment rose to the unprecedented level of 18%, which forced an increase in spending on unemployment benefits. Tax revenues dropped. The budget deficit did fall, to 6.4%, but not by nearly as much as hoped for.

When reviewing this year’s budget, Portugal’s Constitutional Court ruled that wage and pension cuts for public employees and retirees were unconstitutional, and the cuts were partially offset. At the same time, there was a brutal increase in taxes.

The numbers for the first trimester of 2013 are out: the budget deficit was 8.8% of GDP. The troika – the ECB, the European Commission and the International Monetary Fund – has already relaxed Portugal’s deficit targets twice and will have to do so again.

Demands for more cuts

In sum, it is true that all of the policy measures agreed with the troika, ranging from labour market reforms to spending cuts, were satisfied. Unfortunately, as the recessionary impacts of austerity were severely underestimated, Portugal fell short of the final targets. Instead of acknowledging that the programme failed, the troika demands that the government slashes spending by an additional €4 billion euros (about 5% of public spending).

It is politically impossible to implement such drastic additional cuts. This a country whose GDP has decreased to pre-millennium levels, where unemployment is at an all-time high, and where one half of the jobless are already excluded from unemployment benefits.

There are smoother and more effective alternatives. For example, freezing total government spending for a couple of years (with 2.5% inflation) would amount to a reduction in real spending of 5%.

From economics to politics

All this was fertile ground for the recent political crisis that has seen two major resignations thus far, leaving the government on the verge of collapse.

Economists are often quite oblivious about the political consequences of their policy recommendations. Teams who negotiate bailout agreements should include political scientists, who can assess the political feasibility of what is being agreed upon. A political scientist would know that Portuguese democracy is still young, and that all seven coalition governments the country has had so far fell before the end of their mandate.

On a positive note, in spite of the turmoil, the political system in Portugal is still working. All polls indicate that institutional parties should have no difficulties in forming a government at the next elections.

There may be a way out of this mess. Unlike Portugal, Spain and Italy both benefit from a European Central Bank programme known as Outright Monetary Transactions (OMT), under which the bank purchases sovereign bonds to lower a country’s borrowing costs.

It is not clear whether the economic situation is worse in Portugal than it is in Spain or Italy. What is obvious is that these other countries have more bargaining power, which allows them to receive support from the EU without having to engage in official external financial assistance, with all the strings that comes attached to.

If in the future this kind of support were extended to Portugal, the needed adjustment may become less harsh.

Luís Aguiar-Conraria does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

Consolidation tactics for the European integration strategy

To consolitade: to join together into one whole

To integrate: to form, coordinate, or blend into a functioning or unified whole

European strategy

Europe integration rests on two pillars. The first pillar consists in the adoption of arrangements between euro member states. These arrangements map into a sufficient set of conditions for the Union to function. The second pillar consists in policies adopted by each individual state. These policies map into a set of sufficient conditions to function within the Union. Both pillars are necessary.

At times, the first pillar is presented as the "grundnorm" that anchors the contents of the second pillar. For example most of the economic policies adopted by euro members during the current crisis were at least partially motivated by some european imperative. In reality, unconventional (= peaceful) European integration has been the main strategic objective of most European states for the last five decades. The effort, the commitment and the intelligence of the policies adopted by each individual member state to achieve European integration are ultimately the determinants of the Union. The individual state European impulses make of the second pillar another "grundnorm". They are twin pillars.

First crisis management tactical plan: frontal attack 

 One consequence of the Great Recession has been the fast deterioration of public finances across the Union. Given that Fiscal sustainability is a necessary condition for economies to function, fiscal consolidation has become, together with "structural reforms", a crucial policy objective for all member states. To achieve the stated objective, euro countries have decided to improve their budgets with a frontal attack: increase taxes and decrease expenditures, with a mix biased towards the former. In the mean time, broadly defined "structural reforms" would sustain the economy through increases in productivity, or if you wish assuring logistic support to the front line engaged in the consolidation. In most cases the tactic was not successful. Governments have been flanked by a larger than expected fiscal multiplier and by the lack of coordination between creditors and debtors. Put it simply: fiscal consolidation decreases internal demand, and when fiscal consolidation is adopted simultaneously by all your major trading partners, external demand also decreases. What was not foreseen (except by a few) is that demand/income/activity would decrease so much as to reduce revenues and possibly worse the medium run fiscal sustainability.  Figure 1 illustrates the point for Portugal. (click to enlarge)

The fiscal consolidation effort appeared to work at first: in 2011 expenditure decreased and revenues increased massively improving the budget deficit from -10% to -4% of GDP. The following year (2012) nominal GDP plunged to a lower level than in 2009 (the year of the Great Recession), revenues decreased (although tax rates had been increased both on income and value added) and even a further noticeable decrease in public expenditure was insufficient to stabilise let alone diminish the budget deficit that increased to -6.62% of GDP.  Structural reforms implementations/outcomes proved to be too slow to provide effective support. And as in a classical tragedy, the IMF, concerned with the macroeconomic/activity imperative, and the European commission, concerned with the microeconomic/efficiency imperative, clashed, creating a sense of mutually exclusive but equally legitimate causes.    

Evolving tactics to break the multiplier flanking

Sates have regrouped and are now ready for a second round. The new main tactical innovation is to shift the consolidation effort from tax increases towards expenditure decreases. The motivation is that, If done properly, fiscal consolidation through expenditure reductions gives the opportunity to increase efficiency of the public sector. Increased efficiency in the public sector translates into higher productivity, a force that should counterbalance the decrease in demand. This reminds the role of structural reforms in the first battle. However the frequency mismatch is still present. Improving efficiency takes time, say it delivers improvements in productivity in the medium run while the decrease in demand occurs in the short run. Furthermore, the discussion on public expenditure reduction inevitably initiate debates on more fundamental questions such as the size and the role of modern governments in the economy which also belong to a different frequency. I do not want to downplay the importance of having a more efficient government of the right size. This is certainly a strategic objective. However if fiscal consolidation prove to be not only contractionary but also self defeating the tactics followed are ultimately not coherent with our strategy. In what follows I will assume that best practices aimed at maximising efficiency are always implemented and focus on the macroeconomic issues.

Sources of strength of the multiplier        

To find the appropriate manoeuvre to break the multiplier flanking we need to identify what are the causes of its strength. To organise thoughts we can ideally (although artificially) separate between euro area (first pillar) and single state (second pillar) causes of large fiscal multipliers.

First pillar

The first identified cause is the malfunctioning of a policy instrument or the absence of accommodative monetary policy: rates are stuck. In the euro-core interest rates are stuck close to the zero lower bound and much worse, in the periphery, interest rates are stuck at high levels. The latter can be explained though fundamentals (positive probability of default ?) but is mostly the perverse outcome of the renewed financial fragmentation that impairs the monetary policy transmission. The ECB has adopted appropriate countermeasures: the Omt mechanism and the banking union plan.

The second identified cause is the absence of a policy instrument or the impossibility of a nominal devaluation. Although policies that could mimic a devaluation through budget neutral manipulation of taxes have been suggested, the efficacy of a devaluation (fiscal or nominal) is impaired by the lack of coordination between trading partners. Devaluations (fiscal or nominal) can help cost realignments across the euro zone, help employment, but if internal demand decreases simultaneously in all major trading partners the stimulative effect will be small.

Second Pillar

At a more granular level, a third cause of large multipliers is the presence of credit constraint households or more simply households that need to spend most, if not all, their disposable income. The appropriate countermeasure is to target expenditure decreases away from the credit constraint households that have larger marginal propensity to consume. Take again the case of Portugal who has committed to reduce public expenditure by 4.7 billion euro by end 2014. How to minimise the size of the multiplier?

Heterogenous advance to break the flanking

Let me proceed with a simplifying assumption and use the income distribution to proxy for credit constraints and marginal propensity to consume.  The assumption is that the poorer you are the more likely you are credit constraint and the higher your marginal propensity to consume. It follows that to minimise the contractionary effects of a decrease in public expenditure you need to target reductions according to income (share) distribution. Figure 2 shows how much of the decrease should weight on each decile or quintile of the income distribution. (click to enlarge)

A priori it is not obvious than the better off receive sufficiently large share of spending to enable such a reduction. In the case of services this might require a fee.  Or when the better off do receive a larger share of spending it usually reflects their contribution history. In general criticisms to this approach are closely linked to criticisms that would appear with an incase in taxes. The "details" of the Portuguese plan are that the wage bill is expected to decrease by 2.2 billion, pensions to decrease by 1.4 billion and intermediate consumption by 850 million. The logic is that the  government’s spending reduction target can only be achieved by focusing on major budget items, and these three are the largest. Figure 3 shows both the amount of public pensions received by each income quintile and the cuts for each quintile implied by the income share distribution. (click to enlarge)

For what regards the wage bill reduction, the specified measures contemplate 50% of savings through reductions of employment (summing attrition, termination and voluntary separation) and 50% through a remodulation of the wage schedule. The latter should also follow a mapping with the income share distribution to achieve progressivity of the compensation reduction (as opposed to the proportionality of cancelling extra months wages). Again let me stress that this recommendation is inspired by the sole consideration of minimising the number of households with larger propensity to consume from the fiscal consolidation.

Concluding remarks           

Do we have evidence inequality is related to the size of the multiplier? To answer we should know the size of the multiplier, and on this from progress has been made only very recently. Furthermore the link between income distribution and credit constraints might be less tight than assumed above. Certainly the recession has increased inequality, and if the link between inequality and the multiplier exists we have potentially another channel through which the state of the economy affects its size. Finally there is growing evidence that fiscal consolidations success stories are related to taming inequality.

  Coherence between policies and ethical values can ensure the type of broad consensus that is needed to support the adjustment process. The suggestion of reducing spending according to income distribution might have a better chance to reduce its contractionary effects and achieve greater consensus. Especially where inequality is larger. Certainly the issues of efficiency, size and modernisation of the state have to be addressed. But the latter are a continuously evolving process as opposed to a sustained but temporary macroeconomic policy. It is not impossible to project the reduction in expenditure by income share distribution into a bridge towards a state that charge fees for services according to income or even moves away from being the main service provider towards a guardian of standards. 

Today the first pillar shakes under the uncertainty of what will be the future common arrangements. The latest scene regards the questioning to the Omt mechanism put into place by the ECB. Can a currency area work without a lender of last resort? Let me rephrase the question. Is there any currency area in the last two centuries that worked without a lender of last resort? (and I count "reluctant" LLR as a de facto LLR). 

The second pillar must show the way. States have challenges ahead to continue the ascendance of Europe: they need to get back to growth, implement reforms and attain fiscal sustainability. Each state can propose solutions that fit best their society and their culture. How their solutions/proposals will perform will determine their right and their relative weight in the Union. This is the beauty of the European project, no country needs to abdicate his culture nor his language. It requires strength and vision but maintaining the status of exceptional cultures is an enduring process.  

Intermezzo Europeo

We will not extinguish the light

a scene I like link

External balance sheet interdependence

In the previous post I stated that gross external financial positions were not a problem if they proceeded at a fundamental pace and if countries accepted that they cause greater interdependence. However when they proceed precipitously, like in the case of Cyprus, they are a cause of concern.
There can be other causes than sudden inflows and outflows to precipitous changes in the external gross assets-liabilities positions. For example the adoption of a new currency. Take Germany, a large net external creditor of the euro-area, and assume it changes currency and adopts the Thaler. As a benchmark consider the case where only residents use the Thaler and all non-residents have a different currency, euro, dollar, yen, etc etc. The figure below from the Bundesbank shows the external position of Germany (GDP is around 2600 €bn). The figures are different from those in Eurostat who reports for Germany a 6100 €bn  asset position and 5000 €bn liability position for 2012. In any case Germany is a net creditor when assets and liabilities are valued in euro. With a change in currency there can be three possible cases:

1. the Thaler exchange rate with the euro is fixed at 1:1, in this case nothing substantial changes in the balance sheet,
2. the Thaler exchange rate with the euro (and all other currencies) is above parity (devaluation of Germany), in this case the value of the assets increases and the value of the liabilities decreases. Germany's international investment position improves, 
3. the Thaler exchange rate with the euro (and all other currencies) is below parity (revaluation of Germany), in this case the value of the assets decreases and the value of the liabilities increases. Germany's international investment position worsens.

The size of the gross positions is a multiple of GDP. Therefore even a small revaluation or a small devaluation causes a large balance sheet shock.

  

Cyprus, moral hazard and financial integration

Herbert Spencer: "The ultimate result of shielding man from the effects of folly is to people the world with fools"

Charles Kindleberger: "Such a view is understandable in a Darwinian age"

The possibility of extending the conditions of the Cyprus bail-out plan to other eurozone economies have increased uncertainty. The extinction of one of the two large Cypriote banks could have been anticipated. The tax on deposits above 100000 euro was unexpected.

Moral hazard

The rational for taxing uninsured depositors is that investors should bear the cost of the bail-out and not the tax-payers. If the policy authorities do proceed differently, say with a more traditional bail-out, the investors will feel protected and will continue to profit without bearing risk. It is again the moral hazard argument illustrated by the two introductory quotes: the reckless microeconomic behaviour of some investors cannot be insured by society. This reasoning is without question in our "Darwinian age". Nevertheless during the current crisis losses had to be absorbed by society to tame the macroeconomic consequences of some reckless investments. The reasoning is that society's  costs of inaction would in some cases exceed greatly the ex-post salvaging. This reasoning is also without question in our Social Welfare maximisation age. The only logical way to handle this trade off is to have skilled and knowledgeable policy makers supported by comprehensive, precise and timely analysis.

Cyprus

Let me go back to Cyprus. The narrative is that one or two banks (basically the financial sector) have engaged in a "casino" economic model: attracting external funds (read Russian, Uk, etc) offering high interest rates on deposits in a very favourable tax environment and engaging in reckless investments (read Greece). The casino appellation is important because it identifies a particular economic model, probably unique in the eurozone and suggests that the policy response of taxing uninsured deposits could only be extended to other casino models. No casino, no tax. I dismiss the suggestion to use in non casino economies similar measures without argument.

On the macroeconomic side, Cyprus behaves like a standard (very) small open economy in a currency area  with large current account deficits (they entered in 2008 in the euro, they are 865000 people and GDP is around 4.5 billion euro). They were hit by the crisis and when the flow of external funds suddenly stopped the economy stalled and the unemployment rate went to the roof (from 4 to 14 percent).

However when we look at the financing of the current account (the financial account) we see a massive and very rapid inflow of portfolio investment and "other investment" (a residual voice of the financial account which is not a residual because of size…). In the graph portfolioa_y is the stock of portfolio investment assets over gdp (while _l stands for liabilities, direct_y is net direct investment, iip_ is international investment position over gdp). Ex-post, this sudden inflow of short-term funds (true, a few quarters after the entry in the euro, but also simultaneously to Lehman brothers death) should have been contained. 

Policy makers might want to focus more on this huge and fast movement of capitals rather than on the size of the gross external positions. Gross external financial positions are a reflection of financial globalisation (see this older post) and are not a problem if they proceed at a "fundamental" pace (like in the other eurozone countries) and if we accept they cause greater interdependence. After all we read everyday that we live in Financial times.    

Siamo Europei

A recent survey published by Il Corriere Della Sera shows that 74% of the electors favours the permanence of Italy in the eurozone. The error margin is said to be 3.5%. Notably the percentage of young electors that favours the euro is larger (you need to go to the website).

 

Structural versus nominal deficits

Fiscal sustainability is a necessary condition for economies to function.
The conditions for sustainability are objective. For example, the difference between the rate of income growth and the interest rate on sovereign debt, and/or the path of fiscal deficits/surpluses, determine if the fiscal stance is sustainable (meaning that the inter-temporal budget constraint of the government holds).
These conditions are objective but linked and linked in an uncertain way. They are linked because a change in the path of deficits or surpluses affects both the growth rate of income and the interest rate on sovereign. They are linked in an uncertain way because the size of the effects appears to depend on the state of the economy.
The conditions for sustainability are also subjective. Conditional on the uncertainty, the path of deficits and surpluses must be credible. The capacity of a government to control tax revenues and expenditure is key.
The focus on structural deficits and surpluses in the new fiscal treaty allows governments to have fiscal plans conditional on uncertainty. This is most welcomed as it increases the probability of success of the plans and therefore their credibility.


   

The pace of internal devaluation in Portugal

Beware, this is wonkish.
How long does it take for the competitive disinflation, also known as the internal devaluation, to occur in Portugal? The question is relevant for it is the market based mechanism to adjust to external imbalances within the euro. Here is an attempt to estimate the pace and the required adjustment. Starting the projection from the fourth quarter of 2011(when the unemployment rate was at 14.1 percent) I project an increase of the unemployment rate between 4 and 6 percentage points and an improvement of the real exchange rate of approximatively 5 percentage points, both in 20 quarters. Obviously shocks will happens and policies will be taken and the actual path will be different (as they have been in 2012). Nevertheless the forecasts can be interpreted as a counterfactual path in the absence of new shocks and policies and therefore should be of some guidance in designing policies aimed at rebalancing the external adjustment.

After the Mayan

Rising wages in Germany "also contribute to eliminating imbalances within Europe."

Wolfgang Schauble, Germany Finance Minister 

as quoted in the Spiegel (here)

External financing and crowding out

INE has just published the Quarterly Sector Accounts for the third quarter, showing that for the first time in any quarter this century the net lending of the Portuguese economy has turned positive. In the year to 2012Q3, the net borrowing of the Portuguese economy amounted to just 1.1 billion euro, when in the year to 2011Q3 those needs amounted to 12.3 billion euro. An adjustment of 11 billion euro, or 6.7 percent of GDP, in one year, is an enormous external adjustment, and it was much higher than expected. For instance, the May 2011 IMF projections forecasted that by 2016 the Portuguese economy would still have external net borrowing of 1% of GDP. Why was Portugal's external adjustment so strong in the first year of the adjustment program?

The net lending of the Portuguese economy is equivalent to the sum of the current account and the capital account of the balance of payments. Since, by definition, the balance of payments always balances, it is also equivalent to the negative of the financial account. When there are no financing constraints, the real economy determines the financing needs, i.e. the top part of the balance of payments determines the bottom part. However, in a financing crisis, when there are strong financing constraints, the availability of financing is binding, implying that it is the bottom part of the balance of payments that determines the top part. The domestic agents must reduce their expenditure to the available financing, even if they had higher expenditure plans.

The INE data provides some evidence that financing was a binding constraint for Portuguese households. In the past, private consumption has always been smoother than disposable income, implying that in recessions consumption fell by less than disposable income, and the savings rate declined. However, this was not the case in the year up to 2012Q3. Private consumption fell by 3.4%, while disposable income fell by only 1.4%, relative to the year up to 2011Q3. While negative expectations may have played a part, this anomalous behavior is likely to have been determined by a binding financing constraint. Non financial corporations have also decreased their financing needs by 5.3 billion euro in the same period, while gross value added has fallen by 1 billion euro. It seems that the Portuguese economy has been operating under a binding external financing constraint, which is not surprising if one remembers that the immediate cause for the signing of the Financial and Economic Adjustment Program with the troika was the lack of financing for the Portuguese government and banks.

If the Portuguese economy is under a binding external financing constraint, and if the financing constraint is not specific to any domestic sector, then there is full crowding out of fiscal policy. Any increase in the public sector financing needs must be matched by a equivalent reduction in the private sector financing needs. In other words, if the external financing constraint is fully binding, the size of the budget deficit does not have any influence on domestic demand. If this is the case, then the fiscal policy that would foster private consumption and investment would be a reduction of the budget deficit. Under these circumstances, the government could reduce public expenditure as quickly as possible, in order to allow for sufficient financing to be available for the private sector, without decreasing GDP or increasing unemployment.

information on the Portuguese economy

Students at Nova School of Business and Economics produce regularly analysis and data on the Portuguese economy, in areas connected closely with the Memorandum of Understanding, so we have now:
- a report on the Portuguese banking sector,
- a report on the Justice System,
- a report on the labour market,
- a report on the housing market

Facts on nontradables in the Portuguese economy

The rise of nontradable sectors has been mentioned as one of the causes of low economic growth and external imbalances at the root of Portugal’s current predicament – João Ferreira do Amaral and Vítor Bento were among the first to ring that alarm bell. The ECB, the EU and the IMF (troika) seem to share the same view. The 2012 OECD Economic Survey of Portugal has also stressed the need for eliminating the distortions that tilted the Portuguese economy towards low-productivity domestically-oriented sectors. Recently, the President, Aníbal Cavaco Silva, and the Minister of the Economy, Álvaro Santos Pereira, have also been calling for the re-industrialization of the Portuguese economy.    

In a joint paper with Pedro Bação, we describe the main trends and jumps in the evolution of nontradable sectors, since the mid-1950s, using four different databases to shed light on different dimensions of this issue. From our analysis we stress the following points:

1. Despite the pattern of the growth of the share of services being similar to that observed in other developed countries, since the early 1990s it has been significantly larger than in most countries.

2. The shift to nontradables in Portugal has been fast and it occurred essentially at the expense of agriculture in the period 1953-95, and essentially at the expense of industry in the period 1995-2009.

3. In 2009, the share of nontradables (defined as the sum of services plus construction) in total GVA reached 68%, if we exclude open service sectors, and 81.1%, if we treat all service sectors as nontradable.

4. More than half of the change towards nontradables since joining the European Union took place in the period 1988-1993.

5. Finally, we show that construction and services facing a strong Government demand were the main drivers of the increasing weight of nontradables in the Portuguese economy since 1986.