Wednesday 5 May 2010

Debt, expectations and reality

Private debt in the Portuguese economy increased sharply after the mid-1990s – households and non-financial firms’ debts increased from 26% and 47% of GDP, in 1995, to 99% and 115%, in 2009, respectively. Lower inflation rates and interest rates (that followed the adhesion to the EMS and to the Euro), high GDP growth rates until 2000, development of the financial system and urbanization are among the main causes of that trend. Although consumption smoothing is the obvious explanation for households’ behaviour, the causes of the huge non-financial firms’ indebtedness is not so obvious (it does not show up in productivity statistics, for example). Public debt as a percentage of GDP was fairly stable in this period, despite the increasing weight of public expenditure in GDP. The increasing trend in private debt coincided with a decreasing trend in households’ savings. Greece, Spain and Ireland shared some of those trends and its corollary: significant current account deficits.

In the first years of the euro, there was a scholarly discussion on the implications of current account deficits in the context of the European Monetary Union. The position that prevailed in this debate was that external imbalances were benign and should not be the cause of concern: poorest countries were catching up and needed more investment (which was expected to get a higher return in these countries). This was also the conclusion of Olivier Blanchard and Francesco Giavazzi, in 2002, published in Brookings Papers in Economic Activity:

The fact that Portugal and Greece are members of both the European Union and the euro area, and the fact that they are the poorest members of both groups, suggest a natural explanation for today’s current account deficits. They are exactly what theory suggests can and should happen (…).
(…) we discuss whether the current attitude of benign neglect vis-à-vis the current account in the euro area countries is appropriate, or whether countries such as Portugal and Greece should take measures to reduce their deficits. We conclude that, as a general rule, they should not.

The behaviour of interest rates suggests that, until the disruption of the international financial crisis, markets shared that view, that is, they seemed to have taken Germany and Portuguese debt as almost perfect substitutes.

The recent increase in the risk premium of Portuguese debt seems to be an adjustment to reality. We hope there is not too much overshooting in that process. And, of course, we should improve our reality.

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