Thursday 22 April 2010

Rescuing Portugal from the wrath of the markets

   In the last few days, several prominent economists and international organizations expressed their fears that Portugal might be the next European country to be targeted by the markets in the sovereign debt saga. Portuguese politicians protested and contested such an assessment, but, up to now, all has been in vain. The wrath of the markets has, indeed, turned on us with a vengeance, and the next few weeks will be crucial to see how we can weather the storm. Therefore, one of the most important questions that we face currently is: what will it take to calm down the markets and avoid substantial damage? How can we restore the confidence of the markets in Portugal? So far, our policymakers have argued that things are under control and that everything is going according to plan. The main problem is that the markets are not so certain about how controlled things really are and, even worse, they seem to believe that the plan is not so good, or, at the very least, not comprehensive enough. In fact, arguing that markets are irrational and/or that we don’t deserve this fate and/or that there is even a conspiracy against us (or the euro) is more often counterproductive than not and a road to nowhere. Therefore, it would be probably wise if our policymakers started designing a Plan B to prevent bigger harm to the country and to the Portuguese economy.
   In the short run, there is obviously no silver bullet to fix our fiscal and financial woes. However, the Portuguese government could help cool down the situation if it followed a series of procedures and implemented some forceful policies aimed at reiterating our commitment to fix our deficit and debt problems in a sustainable way. Although certainly not exhaustive, here are some possibilities that the government could follow to do try to calm the markets and to divert their attention from us:
a) improve credibility
   It is clear by now that the government’s latest Stability and Growth Program (SGP) has failed to convince markets that the Portuguese finances are in a sound and sustainable path. Far from it. Our politicians might argue that the markets are being shortsighted, that this is not fair and that the government has a (brief) history of consolidation (between 2005 and 2007). Well, the government should have learned a long time ago that the markets are not fair. Their business is not to be fair or unfair. So, live with it. The government might also proclaim as forceful as it can that it has everything under control. However, the sad truth is that the markets (and most analysts) no longer believe that this is accurate. The big problem for the government is that it lacks credibility.
   To put it mildly, the government’s strategy with regards to the SGP was simply close to disastrous. The Portuguese government was one of the last European governments to hand in the SGP document to Brussels; when it did it the document was more a letter of intentions than a proper plan, and, when it was finally delivered, it became patently clear that the government’s plan was to try to weather the storm by postponing the harshest decisions to the future (i.e. to future government and taxpayers). This was a reasonable strategy a few years ago (and every government in the last 15 years followed it), but not when the country is under close scrutiny by the financial markets. And thus, the next question is: how can the government improve its credibility? Well, by pursuing a strategy that includes some of the following:
b) Be more ambitious
   Once again, neither the markets nor the international organizations (most notably the IMF) really believed that the government’s targets to fight the deficit and to invert the rise of public debt were really adequate to fight our current fiscal woes. Most notably, by announcing a target reduction in the public deficit of a mere 1% of GDP for 2010 (from 9,4% to 8,3% of GDP), the government might be playing a smart political card (since, at the end of the year, it will likely be able to do better than this), but, sadly, it is also toying with disaster. Why? Because by announcing a decrease of 1% of GDP in the budget deficit at a time when the public debt is ballooning and the deficit reached historical levels, the government is passing the message that it is really not committed to tackle our fiscal woes in a decisive way. In other words, the government is giving out the wrong signals to the financial markets about its commitment to solve the public sector imbalances.
   Thus, in order to calm down the situation, the government should come out and state that the recent improvement in the economic situation and the efficiency gains of its reform of the Public Sector (the now-forgotten PRACE) will allow for a reduction in expenditures this year and the next few years of X% per year. If you want to sound credible, say that this will be done now, not only in 2-3 years time. 2-3 years is an eternity for financial markets. Many things can change until then.
c) Improve transparency

   The current speculative attack is in part explained by the lack of confidence of the markets on the public accounts of several European countries. Since the Greek governments fudged (or, at least, embellished) their accounts for several years (including to enter the euro), there is an understandable suspicion on the part of the financial markets (and many European governments) that the countries in greater difficulties might have done the same. Portugal is no exception. In fact, we know that this is so, albeit not in the same degree done by others. Therefore, if we want to restore the confidence of the markets in us, an improvement in transparency is crucial. How can we do it? We have two possibilities. One is to nominate a special committee of independent economists and accountants to audit the public accounts and confirm what the government is saying. We can ask the Bank of Portugal or even the Tribunal de Contas to do it. Another possibility is to call in auditors from the IMF or from the European Commission, so that they assess our fiscal situation and the government’s plan to combat the imbalances of the public sector. At this stage, the latter solution would be preferable to the former, since it would be more credible and would be more noted by the financial markets. 
d) announce real cuts in public expenditures

   It is true that the latest SGP mentions cuts in public expenditures. However, it is also clear that not only these alleged expenditure cuts are way too modest, but also most of them are going to be done in 2-3 years time. That is, the expenditure cuts of this SGP are too little and too far way into the future to be deemed as credible by the markets in our strategy of deficit reduction. Thus, in order to improve our credibility and to reassure the markets, the government should surprise everyone by announcing new specific targets for cutting expenditures, something like a 5% decrease in non-wage expenditures across the board. Yes, across the board. The government should impose target cuts by individual Ministries and governmental departments and let them decide where to cut, as long as an objective of 5% reduction is implemented.
   I say non-wage cuts, because, right now, it seems to me that cutting wages is akin to political suicide. No government will do it, much less a minority government. And if any government does do it, it can expect radical and unpleasant demonstrations in the streets. As we have seen in Greece, this is certainly not good publicity for a country that wants to avoid the wrath of the markets. Therefore, it is really not worth it, even though it would help the competitiveness of our exports. At least for now, wage freezes will have to do.
e) be prepared to raise taxes, if necessary
   Let me be clear: The last thing that the Portuguese economy needs right now is an increase in taxes. The tax burden is already around the European average, but, if we take into account our GDP per capita, our tax burden is substantially higher than that of countries with similar incomes per capita. Thus, increasing taxes will not only make us even less attractive, but also it would punish even more companies and entrepreneurs that are already struggling. Also, it is also patently clear that increasing taxes will solve none of the problems with our “fattening” State. Having said that, it is also very clear that a default or a serious speculative attack against us will be a lot more damaging than a small increase in taxes. Thus, as a backup plan, the government should tell the financial markets that if the targets for expenditure reduction (the aforementioned 5% decrease in expenditures across the board) have not been met in, say, 3 or 6 months, a 1 or 2 percentage points increase in the sales (IVA) tax is not out of the question. Will this solve our problems? Of course not. At most, it will help only marginally to combat the fiscal imbalances of the public sector. However, such a measure would pass the message that we are in business. That is, it would show that the government is, indeed, serious about fighting the deficit and the growth of the public debt, even at great cost. And this would boost our credibility in the eyes of the markets, and would help to diffuse attentions from us.
f) scrap the projects for big public works

   Also, it would help if the government would come out and postpone sine die the big public works projected for the next few years. The last SGP pretended to do it, but it certainly does not go far enough. The TGV between Lisbon and Madrid is still here, the other high-speed lines were only postponed for a couple of years or so, the new Lisbon airport is still here, as are dozens of new roads and highways. Coming out and state that we are, indeed, scraping these projects would go a long way to improve our credibility and our standing in the international arena. Alas, I also realize that this government does not want to do it, because they know that won’t be the ones that will have to pay the bill. Most of these projects are public-private partnerships and will start being paid only after 2013, i.e., by other governments. Thus, there is almost no incentive for the current government to dump these  projects, unless they were really concerned about future generations. Even so, what better way for the government to boost its credibility if it announced the scraping of its darling big-public-works projects? What better way to show that they really care about the so-fashionable and so popular "national interest"?
g) go Greek
   Of course, there is always an alternative: going the Greek way. That is, pretend for as long as we can that all is well and dandy and, if things don’t go our way, we will just wait (and hope) that the other Europeans (i.e. the Germans) will bail us out. This is the so-called show-us-some-European-solidarity strategy. In my view, this is not only risky (we might not get exactly what we are asking for), but also undesirable, because a bailout will obviously not solve any of our structural imbalances in the public finances. It is also worth remembering for anyone tempted by a going-alone strategy (i.e. leaving the euro and in order to engineer a real depreciation) that there are tremendous risks associated with this path (as I argued here). Essentially, leaving the euro would imply higher interest rates and further rating downgrades (at least temporarily), which would further aggravate the costs of servicing the debt and would cause substantially financial and economic stress. No big advantage then...
Summing up
   Thus, at this stage, the only viable strategy seems to be to calm the markets by announcing specific targets for cutting expenditures, by increasing the transparency of the public accounts, by threatening new taxes, and by postponing public works projects. All of this might not be enough. However, as Ireland has shown a few months ago, this strategy might help us going a long way to avoid financial disaster and the sorrow fate of Greece.
   Finally, it is important to reiterate one additional idea: although there are serious fiscal imbalances in our public accounts that need to be tackled as soon as possible, we should also not forget that our main problem is economic stagnation. Economic stagnation has had a terrible toll on us, by deteriorating our public finances, by increasing unemployment and by resurrecting the ghost of emigration. Until Portugal solves this problem, it is very likely that our worries will not go away.


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  2. I'm sorry to say this, but you and i guess too many people still do not understand what the crisis is all about.

    It's got to due with financial markets not working the way they should. Economists should recognize and understand the implications of the complete failure of the Efficient Markets Hypothesis.

    Markets need "trends", which are nothing but colective fevers.
    This time, people are "bubbling" over a few nations' public debt, and what you ask is for all of us to make further sacrifices to keep the markets happy?

    It's not our public accounts that are unsustainable, it's the financial markets' dictatorialship that makes them look that way.

    And with your line of thought, you are saluting the dictator on the parade, as he passes by to his next conquest...

  3. There are indeed many collective fevers in markets, but we have borrowed so much money from them that we must recognize their hold on us. There was probably a "collective fever" when they follishly decided to lend us so much money, but we did not complain then, did we? Many people willingly indebteded themselves above their possibilities, and now the chickens have come home to roost :-( Every penny borrowed must be returned later, and too many governments and individuals forget that.

  4. As an English expat with a Portuguese wife living on The Silver Coast it saddens me to see what a sorry state successive governments have got Portugal into.As you quite rightly say the government has to "pull it's head from the sand" and tackle the problems head on.Relying on the EU "begging bowl" to get the country out of it's problem's is a short term solution which will lead to long term disaster.Unpopular decisions have to be made sooner rather than later,the buck has been passed too many times.