Second review of the IMF - December 2011

The IMF has concluded the second review, see press release

Relevant note: the drop of the fiscal devaluation is now official, but no substitute is known up to the moment.

combate de blogs

This is a post with a different nature, the portuguese economy has been nominated in the short list to win the category of best collective blog in Portugal.

You can see all categories and nominations here.

It is always good to know that others pay attention to our efforts!

Smart interpretations of a Treaty and debt management

If you have followed the debate on the ECB as a lender of last resort you probably came across Article 123 of the Lisbon treaty. Article 123 prohibits the ECB from purchasing bonds directly from public bodies. Paragraph 1 says:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

However Paragraph 2 allows the ECB to purchase bonds from a public bank.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

(Paragraph 2 was the basis of Soros proposal to transform the ESF into a bank in order to have access to the ECB liquidity. The proposal was rejected.).

Now the key question is who qualifies as a "publicly owned credit institution" described in paragraph 2? At first sight the German Finance Agency (Finanzagentur) qualifies (any one can confirm?). Finanzagentur auctions german debt, through the Buba, using a retention mechanism. The retention mechanism, that came in the highlights with the last November Bund auction, allows Germany to use "the sale of German Government securities in the secondary market that stem from the portions set aside in the auctions" to meet borrowing requirement. According to the Corriere della Sera, the Italian treasury already expressed interest in the retention mechanism as it permits a less risky debt management (if you check the graphs below, you will notice that the last bund auction, where 40% of the bonds have been retained has commanded an average yield of 1.98% when the coupon offered was 2%). Other euro governments might want to follow as well.


(click to enlarge)

Webinar on European Safe Bonds (ESBies)

Tomorrow at noon (New York time. EST), 5pm Portugal time (GMT). Register here if you want to listen in or ask questions:
http://prmia.org/events/view_events.php?eventID=T4705

The European Debt Crisis: a succession of bad ideas

I recently gave a talk about the European debt crises. I focussed on the many policy blunders committed so far, as well as on the many that are still occupying the agenda. Here was my list:

Bad idea #1: You can run a monetary union and have a single currency and central bank without:

1. Fiscal backing for your central bank

2. European-wide banking regulation and deposit insurance

3. A European-wide safe asset

Portuguese State Budget was approved but it needs corrections.

The Portuguese State Budget (SB) was approved last wednesday (30th of November)with the votes of the political parties who support government (PSD and CDS) and the abstention of the Socialist Party. It is the toughest budget ever approved in Portugal with a progressive cut in summer and christmas bonuses of civil servants and pensioners (more than 600 euros up to 1100) and a proportional cut (2/14) when income is above 1100 euros, equivalent to two salaries.

Apart from a possible unconstitutionality of these measures, this Budget implements certain aspects of the memorandum with the troika, but departs from it in several important respects. First, the memorandum predicts a cut in transfers to regional and local governments of, at least 150M. euros and also predicts that civil servants' salaries should be freezed. Therefore, we would expect that other expenditures (not wages) would be cut at least in 150M. However, with the bonuses' cuts local governments save around 240M. euros. This means that instead of leading to a reduction in other expenditures the Budget leads to an increase in local exenditures (other than wages).

An additional problem is an error in calculating the state budget deficit in public accounts
(cash basis) of 297,4 million euros due to a consolidation problem (see my article in Publico newspaper today here). What is worrying about this mistake, not clarifyed yet by the Ministry of Finance, is that it may increase the Budget deficit in this amount, and also what it reveals in terms of lacking of cross checking information in the Ministry of finance.

In Portugal there are two seminal initiatives of civil society that scrutinize the budget and the budget process. The budget watch (2012 results will be available soon) and the open budget initiative. They start producing results. But it is also important that the Council for Public Finances, an independent body predicted in the memorandum is also implemented.

To whom does Portugal owe?

In a recent article, BBC News identified for major Eurozone (highly indebted) countries, the US, the UK and Japan how much money is owed by each country to banks in other nations. Focusing on the Portuguese case, whose foreign debt amounts to 251% of GDP (equivalent to about 38.000 euros per person), the country is, first and foremost, highly indebted to Spain (65.7 bn euros). To a lesser extent it is also indebted to Germany, France and the UK (26.6bn, 19.1bn and 18.9 bn euros, respectively). Moreover, Portuguese banks are owed 7.5bn euros by Greece.
There are, naturally, worse cases starting with Ireland with a foreign debt to GDP ratio above 1000%, followed by the UK (436%), Spain (284%) and Greece (252%). Greece seems to have a figure almost identical to Portugal's level but the two countries are quite different in terms of its composition, namely the level of public debt: 100% of GDP vs. 166% of GDP for Portugal and Greece, respectively.

In the figure below (retrieved from the above-mentioned article) we can have a graphical representation of the current external debt situation in Portugal. The arrows point from the debtor to the creditor and are proportional to the money owed as of the end of June 2011 (data sources: Bank for International Settlements, IMF, World Bank, UN Population Division)

The bank recapitalization law proposal: throwing good money after bad

I had forewarned, on this blog (here and here) and in a 2009 paper that the Portuguese banking system was on route to nationalization.

The current Government has submitted to the Parliament (Assembleia da República) a new law proposal (which revises a prior law) to promote the recapitalization of the banking system with €12bn of public funds. The law proposal has been unanimously approved by the Economics and Public Works Committee. It is to be discussed and voted this week (November 22) by the plenary, a mere 15 days after it was first submitted to the Parliament.

Sadly, the recapitalization option is far more costly than what international best practice would recommend (special resolution regime), and it is poorly implemented. As implied in an interview by its Governor, Carlos Costa, the Bank of Portugal seems to have had a leading role in crafting this law proposal. In various issues (see 1, 2 and 3), the Bank of Portugal sides with the banks, and against the public interest, in an appalling display of regulatory forbearance.

The costs the taxpayers will incur to support the bank recapitalization program are substantial. The Portuguese Government will likely pay an interest rate of 3.5%-4% on the €12bn of loans from the IMF and EFSF that are being used to recapitalize the banking sector.

To put it in context, the interest outlays will likely come to represent around €450 million per year or nearly 50% of the entire 2012 budget allocated to higher education (which in addition to the transfers to public universities and colleges includes financial support to students from low income families). It is as if the government had created an entirely new large entitlement program that does not appear separately in the budget (it will appear under interest expenditure).

In fact, the casual ease with which our policy leaders and legislators dispense with large sums of public funds does not cease to surprise me. It is really a case of cutting costs on the pennies in order splurge on bit item expenditures.

In return for this large outlay of capital, the government gets very little back.

Now, countries like the US, the UK, and Germany had somewhat similar bank recapitalization programs in 2008-2009 and banks received what can only be interpreted as the “glove” treatment. But that was then and those programs generally had far harsher conditions for the banks. Moreover, since then, these countries have put in place much stronger special resolution regime legislation which, for example, in the case of the US Dodd-Frank Act, obliges the government to use an orderly liquidation regime to manage the wind-down of failing large financial institutions (a regime that is much stronger than what I advocate).

In its October 26, 2011 meeting, the European Council agreed to increase bank capital requirements to 9%. But left to national governments significant leeway on how to achieve the capital increase, if additional private sector capital fails to materialize.

Instead, the law proposal under consideration by the Parliament has various deficiencies. Contrary to past international practice, the public interest is not adequately represented in the board, and banks want to reduce the already de minimis representation of the government. This is bound to result in incentives to act against the interest of the largest shareholder (the Government).

Moreover, bank management is not replaced, as occurred, for example, in the case of Sweden, and the UK, and is internationally accepted best practice.

The aim seems to be to avoid political nominations. But, for example, the UK government supported the hiring of a Portuguese (António Horta-Osório) to manage one of its largest (nationalized) banks, the Lloyds Banking Group. The Swedish equally hired foreigners to manage their nationalized banks in their banking crises in the 1990s. So why won’t the Portuguese government replace current managers with foreign managers, for example?

The banks are up in arms because they want to ensure that if share prices recover to earlier levels, the government will not keep the profits. In fact, a recent proposal by the banks, which was also supported by the Bank of Portugal, in essence means that the government gives away to the banks a free and highly valuable 5-year call option to buy the stock back (perhaps even at the original price paid by the government). Depending on the exercise price of the option, it may be worth several billions of euro.

Notwithstanding these details, which are highly detrimental to the public and national interest and much worse than comparable bank recapitalization programs elsewhere in Europe, it is far more likely that the government capital investment in the banks will have to be substantially written down by the Government in a couple of years, i.e., the Government (and the country) will likely suffer large losses on this investment.

In sum, the law proposal should be rejected (though I have little hope of seeing this happening). There are far better and less costly alternatives, namely one based on a special resolution regime. A special resolution regime would ensure a functioning and healthy banking system, at a fraction of the costs. This bank recapitalization law will do neither.

Finally, the IMF staff (together with the remainder of the troika) were in Portugal last week for the 2^nd quarterly review of the adjustment program. One would have thought they would have had a hawk-like focus on the law proposal. After all, the €12bn foreseen in it represents in excess of 15% of the entire bailout package. No such luck, unfortunately. IMF staff focused on the trivia.

The IMF staff is making a disservice to clients and to their own institution by condoning this type of policy measure. The IMF staff is not following best practice recommendations (including IMF lessons learned from the Asian crisis and that described in various IMF working papers) and is violating its fiduciary duties towards IMF shareholders, by not being good stewards of the capital the IMF is lending to Portugal and to other European peripheral countries, in this and in other instances.

IMF staff should note that at some point more sensible leadership will arrive at positions of power, who will most certainly dispute the IMF credit so carelessly dispensed. Future leaders will have a fertile ground from which to pick evidence of policy mistakes and responsibility by IMF staff.

Looking further ahead, given this and other mishaps, it seems increasingly unlikely that the IMF will be able to survive the Eurozone sovereign debt crisis. In my view, it will, in a not so distant future, be replaced by some new multilateral institution based in Beijing.

the discussion on "fiscal disinflation" continues...

The discussion provided by Francesco Franco on fiscal disinflation / fiscal devaluation reached The Economist. You can follow it here

Health sector and the adjustment due to the financial rescue plan

The financial rescue program of Portugal has a Memorandum of Understanding - MoU - detailing the policies to be applied in the public sector to achieve balance in the Government accounts.

One targeted sector is health care, with several measures aimed at reducing the public expenditure on health care goods and services.

Another review period of compliance with the MoU has started. I provide here an assessment of the degree of progress in the adoption of the policy measures contained in the MoU. In summary, some are done, some are ahead of schedule, some are still to fully develop and just started. Overall, the level of compliance is quite good. We can always ask for more, and more was achievable in my view, but current situation meets the demands.

ULC and trade deficits

If I focus on ULC in manufacturing (as opposed to total economy) and the trade balance in goods (as opposed to goods and services) I see a strong correlation. It is also interesting to observe that Germany stops to be the outlier in cost dynamics (again for the manufacturing sector).

(click to enlarge)

Fiscal devaluation, a PR failure?

The memorandum of understanding signed last May by the main Portuguese political parties contains a measure designed to improve competitiveness and accelerate the necessary improvement in the trade balance. The measure consists in a budget neutral tax swap: an increase in the effective VAT rate (by increasing the low and intermediate rates) and a reduction of the social security tax paid by employers (TSU). The measure has been compared by scholars, journalists, experts and others (myself) to a nominal devaluation. The idea was that to show that even if the euro has eliminated the exchange rate, euro members could implement policies with a similar outcome to realignments of the exchange rate.

This comparison might have been unproductive for two reasons.

The first is a public relations failure. The name of the suggested policy contains the word devaluation. I remember an influential journalist calling the fiscal devaluation a "new drug" to replace the old one (i.e. nominal devaluation).
While from a from a technical point of view this affirmation is incorrect, it reminds us that "devaluation" is considered a dirty word. In fact, southern euro countries have adopted the euro in part to tie their hands and avoid external adjustments through devaluations.

The second is that for practical (as opposed to academic) purposes we should have compared the fiscal devaluation with a competitive disinflation. The latter is the market based mechanism that takes place within a fixed exchange rate system to adjust to external imbalances (in the absence of fiscal transfers and with limited labor mobility). It can be described as follows: unemployment increases and pushes the growth rate of nominal wages down until the country’s competitiveness is restored. It is obviously a painful mechanism that relies on two key market transmission mechanisms:

1) the decrease in nominal wages in face of higher unemployment, and
2) the decrease in prices in face of a decrease in the wages.

Consider impediments to the first mechanism: when nominal wages are sticky and adjust slowly, the competitive disinflation requires a high unemployment rate. Are nominal wages (downward) flexible in Portugal? If I remember well it is very difficult (unconstitutional) to decrease private wages. The Portuguese government has recently cut the public sector wages. This should help alleviate the necessary increase in unemployment as it can signals to the private sector wage setters the necessity to accept a lower wage.

Now consider the alternative of a fiscal devaluation. The decrease in the social security contributions aims at reducing the cost of labor in substitution of a decrease in the nominal wages. It does not require unemployment and works when wages are sticky. Moreover it affects simultaneously both public and private sectors.

It appears that on the first key transmission mechanism, fiscal devaluation works better than competitive disinflation. For what regards the transmission from labor costs to prices, there are no differences between the fiscal devaluation and the competitive disinflation.

A critique to the decrease in the TSU is that it will lower revenues and jeopardize the financial stability of the social security system. The fiscal devaluation is designed to be budget neutral: the second element of the measure is an increase in consumption taxes that offsets the decrease in revenues. In reality, to increase consumption taxes in Portugal is objectively difficult as VAT has already been increased to diminish the budget deficit. Again the comparison with the competitive disinflation is useful. A decrease in nominal wages decreases social security contributions and requires a decrease in benefits to maintain financial sustainability. This suggests that the loss in revenues that follows the substantial decrease in the TSU can be financed through a combination of lower benefits and higher consumption taxes. To a first approximation if wages are expected to decrease by 25%, social security contributions will decrease by 25%. To maintain the solvency of the social security system benefits will have to decrease by 25%. The same reduction of benefits could be used to finance part of the decrease in TSU so that the increase in the consumption taxes can be lower.

Another advantage of the fiscal devaluation is that the real debt due by wage earners (debt deflated by wages) does not increase. This is not a secondary point in an environment of fragile banks balance sheets.

The fiscal devaluation and the competitive disinflation have also different distributional effects. The latter are important as they are likely to determine the political feasibility of the measure.

I am surely missing something, but as of today I see the fiscal devaluation as a superior policy than trying to manipulate the nominal wages in the private sector or to wait for unemployment to be sufficiently high to exert downward pressures on those same wages. So what explains the opposition to such a measure? Should we call the fiscal devaluation "fiscal disinflation"?

Le dernier ressort

"...The historical record shows abundantly, in contradiction of such theories, that financial crises are a persistent phenomenon and that they are generally, but not always, alleviated by a lender of last resort, often one that insisted in advance that it would not come to the rescue."


In his fascinating Financial History of Western Europe, Kindleberger describes the genesis of the lender of last resort and the gradual assumption of this role by central banks. But why should we care about our own financial history? Obviously This time is different...

here Paul de Grauwe on the ECB and the LLR.

Were the last 10 years different?

Via facebook, I got to this post by the founder of The Portuguese Economy blog, Pedro Lains. I am not sure I understood everything Pedro wrote. But I think that Pedro is arguing that Portugal has always been dependent on foreign financing, so there is nothing new with the current crisis.

I agree with the first part of this sentence, and the mechanics of how a country can run a current account deficit for centuries is part of my lecture notes, where Portugal and Canada are the two examples that I use. But I don't understand the second one.

Below is a figure of the current account divided by GDP since 1953, split in 1995, when there was a change in the source of the data (before 1995, series longas para a economia portuguesa, afterwards Pordata). Also plotted is a horizontal line with the average current account deficit of the last 10 years (-9.8%).

The pattern of deficits may not be new, but the size and duration seem quite unusual to me.

Update: Here is the picture, subtracting transfers from the current account.

New Fiscal Data released by DGO (end-of-September 2011 cash data)

For the interested reader, the cash data for the January-September 2011 budgetary execution (released yesterday by DGO – publicly available here) points to a State budget deficit of 3.8% of GDP which compares to a deficit of 5.4% of GDP over the same period back in 2010. The year-on-year growth rates of revenues and expenditures of the State were 5.2% (1.9% in 2010) and -3.8% (2.0% in 2010), respectively.

Jornal de Negocios’ news elaborate on this by reporting that expenditure with public employees is falling more than 6%, reflecting the 5% average wage cut that took place earlier this year (see here). Simultaneously, the revenues’ side is over performing, mostly driven by direct taxes paid by enterprises and VAT (see here).
All in all, the State budget deficit is falling more than 30% since January (more here).

Portugal remains one of the OECD countries with the highest unemployment rate

According to the latest OECD figures, updated until August 2011, the 12,3% unemployment rate in Portugal is only overcome by 5 countries. In particular, by Estonia (12,8% in June), Slovakia (13,4%), Ireland (14,6%), Greece (16,7%, in June) and Spain (where, contrarily to the trend, unemployed people keep on growing and they currently amount to 21,2% of the labour force).

The average unemployment rate for the aggregate OECD group was kept unchanged in August, at 8,2%, sligthly smaller than the Euro-area and US' numbers, 10% and 9,1% respectively.

More information here.

Source: Labour Force Statistics

New conditions in terms of financial assistance to Portugal

Copied from the COUNCIL OF THE EUROPEAN UNION, provisional version, press release, 3119th Council meeting, Luxembourg, 11 October 2011:

"PROVISIONAL VERSION 11.X.2011 ECONOMIC AND FINANCIAL AFFAIRS

Financial assistance to Ireland and Portugal

The Council adopted two decisions amending the terms of financial assistance granted to Ireland and Portugal under the European Financial Stabilisation Mechanism

The decisions extend the maximum average maturity of the loans to Ireland and Portugal to
12,5 years, while the maturity of individual tranches of the loan facilities may be of up to 30 years. The interest rate margins will be reduced to the EU's cost of funding. The extension of maturities and the reduction in the interest rate margin will also apply to the tranches that have already
been disbursed.

The decisions amend implementing decisions 2011/77/EU and 2011/344/EU on granting EU financial assistance to Ireland and Portugal. They implement conclusions reached by the euro area heads of state or government on 21 July 2011."

Updated information and data on Portuguese's Quarterly National Accounts Q2-2011

On 30th of September INE published data on the national accounts for the institutional sectors for the 2nd quarter of 2011.

In summary, the General Government deficit (national accounts) was 8.8% of GDP in the 12 months ending in Q2 (decreasing from 9.3% in the previous quarter), mainly due to reductions in wages and social transfers in kind.

Indebted Madeira votes long-time leader back

Alberto Joao Jardim, president of Portugal's autonomous Madeira archipelago, won regional elections Sunday, even though he has been blamed for (unreported) debts that boosted the country's overall deficit. This relates to Fitch's statement last Friday that Portugal's outlook was negative, meaning that its BBB- rating could be further downgraded in the near future. Recall that the Madeira bill further burdened Portugal's deficit (it amounted to 8.3% of GDP in June, far from the 5.9% end-of-year target). In fact the Finance Minister Vitor Gaspar said recently "These irregularities... impact negatively on the country's credibility".

Official results showed that the Social Democrat Party (PSD) obtained 48.56% of the vote, its worst result under Jardim's 33-year leadership.
CDS-PP, which forms the national ruling coalition along with the PSD, came second with 17.63%, well up on the 5.34% it got in the last elections in 2007.
Portugal's main opposition party, the Socialist Party (PS), had to content itself with third place taking just 11.5% of the vote, down from second place and 15% in 2007.

Americans Sargent and Sims Win Nobel Economics Prize

Today the Royal Swedish Academy of Sciences awarded two Americans, Thomas Sargent and Christopher Sims, the Nobel in economics. The prize's justification is as follows: "for their empirical research on cause and effect in the macroeconomy".

According to the prize committee the winners developed methods for answering questions such as how economic growth and inflation are affected by a temporary increase in the interest rate or a tax cut. Sargent and Sims, both 68 years old, carried out their research independently in the 1970s and 1980s.

More details on the prize can be found here.
For the winners' personal webpages: Thomas Sargent and Chris Sims.

updated information on the Portuguese economy

The Bank of Portugal released today forecasts for the Portuguese economy. The recession is predicted to be worst than in previous assessments. This of course will create more problems in meeting the targets for the public deficit.

Portugal's productivity curse and the need for credit/investment

According to Olivier Blanchard (IMF Chief Economist) in a recent interview provided to the "Jornal de Negocios", Portugal needs a productivity boost since the "fiscal devaluation" strategy will be insufficient to get us out of the current crisis.
To put this in perspective, below I plot the growth rates of TFP for the total economy between 1960 and 2012 (estimate) for both Portugal and the EU15 average.

We do observe that since the last economic and financial crisis (in 2008) Portugal has had an average productivity growth rate of -0.18% and this is expected to remain below zero in 2011 and 2012 (in line with the latest GDP growth projections), contrarily to EU15's average which foresees a better performance for the year to come (and which has shown, over time, smaller volatility as well).
To this end, more investment and lower unit labour costs are necessary but not sufficient conditions to increase productivity levels. One also needs such approach to be coupled with banks' recapitalization so that credit flows into the economy at the "right" speed (and amount). Such idea has been reinforced in recent meetings held in Washington DC this past weekend where the European crisis was scrutinized by world leaders and economists. Raghuram Rajan, (former IMF Chief Economist) stressed exactly the financing point in today's article in the Financial Times (here). More specifically, some of the EFSF funds will have to be used to recapitalise banks that are not able to get money from the markets. The problem is the lack of consensus in this matter. For Rajan, "the world has to recognise that the eurozone’s problems are too big to leave to eurozone countries alone to deal with. The world has a stake in their resolution. And it has an institution that can channel help, the IMF." He suggests that the IMF could set up a special vehicle that would offer large lines of credit to illiquid countries like Italy or Spain. This is one additional suggestion that joins a plethora of others being considered for Europe's crisis resolution.

For those who need it stated more bluntly

This is why I and the IMF were insisting last week on the need for a fiscal devaluation. It seems the political appetite for this policy is not there. That is fine; it was one option, and there are alternatives. What is not fine is to ignore that the dismal growth forecasts for 2012 can compromise the entire adjustment and rescue package. As I wrote in my essay last week:

"Se o governo não quer cumprir esta parte do acordo, então tem de pensar a sério, e rápido, noutras medidas que evitem uma recessão profunda. Seria uma pena se a desvalorização fiscal tivesse dado o seu último fôlego, mas seria uma tragédia se fosse a economia portuguesa a perder o fôlego."

Intermezzo romantico

Once upon a time in 1969

extract:

"If all were well with Europe, we would not be meeting today. If the Community were able to speak with one voice our main topic here would be foreign policy: the question of the peaceful organization of Europe, negotiations with the countries of Eastern Europe and our interests with regard to the conflict in the Middle East.

Instead...

... The links that have been forged between us [note: us = Europe] must be indissoluble and must grow ever closer. If we want to achieve the necessary harmonization we must give each other support, that is to say, we must apply solidarity in practice. On behalf of the German Government, I declare that we are ready to do this. And German public opinion is behind us in this..."

Willy Brandt, Chancellor of the Federal Republic of Germany, The Hague 1969

reference: (here full transcript)

"Greece must abandon the Euro and Portugal should do the same" (Nouriel Roubini)

Following up on my previous post, where I alluded to a research piece published by Roubini Global Economics, today the FT published its summary in the "Opinion" section - here.
The "Diario Economico" newspaper also comments on this - here (in portuguese).

The quest for a "Polish"-Consensus?: sovereign debt crisis, Greek's problem/contagion and the future of the Euro-zone

Today the 17 ministers of Finance are gathered in Wroclaw, Poland, to dig out solutions for the (general) sovereign debt crisis while simultaneously having to deal with an urgent solution to the “Greek” problem (in terms of the most pressing financing needs). Vitor Constancio (ECB Board Member) told the press this morning that contagion to Portugal is always possible as long as the present (Greek) situation is not clarified (and resolved).(click here)
Such statement comes one day after both Merkel and Sarkozy have reaffirmed Greece’s place in the Monetary Union and reiterated their countries’ support to finding a solution that must prevent the country from abandoning the Euro-area. Timothy Geithner has also urged for a credible, coherent and quick Euro-zone response to the present conjuncture advocating that both the European Commission and the ECB still have several tools at their disposal. Despite these voices, Nouriel Roubini (Dr. “Doom”) published today an economic research piece in Roubini Global Economics entitled “Greece should default and abandon the Euro”. His views are that “Greece is insolvent, uncompetitive and stuck in an ever-deepening recession, exacerbated by harsh and excessive fiscal consolidation.” Some arguments are a bit too pushy, particularly when he compares the Greek with the Argentinean case. Portugal is also briefly mentioned (but not Ireland) with respect to some economic similarities shared with the Greek economy (such as the competitiveness issue) and the possibility of becoming the next “default” victim.
Irrespectively of who says what and where is the reason, the general public can, nevertheless, witness the absence of a unifying (and unique) “voice” in Europe as well as the lack of concrete plan of action to enforce…
Today’s article on the Economist, “Fighting for its life” (click here), suggests/asks for a greater role of the ECB, particularly given the growing financing difficulties of the banking system as a whole. Estimates from Goldman Sachs advert to the fact that Europe’s 38 largest banks may need between 30-92 billion euros in extra capital to cope with haircuts to Greek, Irish and Portuguese government bonds (as well as losses in Italian and Spanish government debt). IMF’s projections are even worse.
In face of increasing pressures from the financial markets, the 17 members may need to take measures to increase the scope and firepower of the European Financial Stability Facility (EFSF), Europe’s bailout fund. At the same time, the ongoing discussions about ECB’s willingness to buy without limit the bonds of solvent Euro-zone countries as well as the question regarding the issuing of Euro-bonds, does not seem to be heading towards generalized consensus. In the end, it is all about credibility and time (in-)consistency of policy-based (political?) actions.

First update of the memorandum of understanding

As troubled times hit Greece, it is worth reading the first update of the Portuguese Memorandum of Understanding, to see what has been the view about progress made in Portugal. You find the document here

Fiscal devaluations

Today's "Dinheiro Vivo" supplemento to Jornal de Noticias e Diario de Noticias had an essay by me on fiscal devaluations. (It is here, but a better version is here.)

There are some pros and cons to this measure, but many of the arguments that have dominated the public debate in the last month are, in my view, not valid. In particular:

1) Fiscal devaluations have nothing to add to our deficit target, positive or negative. They are budget neutral. They are a growth measure.

US payroll taxes and Portuguese TSU

President Obama announced his plan to cut the payroll tax paid by employees from 6.2% to 3.1%, and the part of the tax paid by employers from 6.2% to 3.1%. That is a combined 6.2% reduction in payroll taxes for existing workers. For new hires, all of the 12.4% combined tax will be waived.

This in an economy that is expected to have modest GDP growth around 2 or 3%, and where the unemployment rate is 9.1%.

In Portugal , the unemployment rate is 11.1%. GDP will likely fall, with a growth rate between -0.5% and -2% in 2011-12.

But cutting payroll taxes (via taxa social unica) in Portugal by more than 3%, as part of a fiscal devaluation, was pronounced in the last couple of months as far too much. Not feasible, dangerous, irresponsible, unnecessary were some of the adjectives to describe it.

In the land of small government, it seems that when it wants to, the government can do way more than in the land of "Estado omnipresente". Not so much of a contradiction, when you think about it.

one more piece of information

The Portuguese Government made available a new document containing the strategy to bring the budget deficit into control (the document is in Portuguese). Although most, if not all, press has given prime time to the increase in taxes for the higher income bracket and to firms with profits above a certain threshold, the document actually contains more information.

An important one, in my view, is a picture showing that past programs have failed dramatically predictions of return to economic growth, and overstated in a systematic way the control of public spending. This puts obvious pressure for the current Government to do differently. And there is a very specific concern in the document to improve the tools for budget control within the Government.

VAT gap in Portugal

Not too long ago, a blogger suggested that an increase in the VAT rates would not generate the expected tax revenue because of tax fraud. As I had no clue on the real severity of VAT tax evasion in Portugal, I had to spend sometime documenting myself.

Well, according to this study commissioned by the European Commission, Portugal behaves quite well with a VAT gap of 4%. The VAT gap (the gap between actual and theoretical revenues) is not a direct measure of fraud, just an upper bound. For details I defer the interested reader to the report that covers the period 2000-2006. The time series dimension is of some interest as it is probable that the gap increases during recessions. In any case, international markets should welcome Portuguese diligence.

This little pig went to the market, the others...

See here, and also here.

The end of Europe as we know it

The eurozone is in a deep crisis, which will have serious consequences for the Portuguese and for the European Union. In the beginning of the sovereign debt crisis, Greece, Portugal and Ireland owed thousands of millions of euros and the problem was theirs, i.e., they would have to correct their imbalances through austerity measures. In the current stage of the crisis, Spain, Italy, Belgium and France owe millions of millions of euros, and the debt crisis is now also a problem for the creditor countries – and the final word in the solution of the eurozone crisis is theirs.

Since the beginning of the sovereign debt crisis, several commentators have expressed the hope that surplus countries agree to three measures. First, to change the orientation of the ECB towards a more expansionary monetary policy. Second, to adopt themselves expansionary fiscal policies, which would stimulate imports of goods produced by deficit countries. Finally, countries such as Germany could also take measures to increase wages and thus further stimulate demand. Associated to this view is the idea that a permanent solution to the structural fragility of the euro is the creation of a “European government” that would collect taxes and distribute subsidies and other public expenditures at the European scale. This government would put into work a mechanism of “automatic stabilization” in the eurozone: when Portugal is in recession, as is the case, and Germany is in an expansion, taxes collected in Germany would pay, for instance, unemployment subsidies in Portugal. By definition, this European government would be financed by euro-bonds.

In that scenario, the countries currently in crisis, which implemented economic policies incompatible with the stability of the euro, would determine the economic policy of the wealthier countries and of the ECB. This solution is very unlikely to be accepted by most Germans and Central and Northern European peoples, who would most likely prefer to let the indebted countries default. This would lead to the end of the euro and also of the European Union as we know it; at the very least, the number of member countries would be significantly reduced. A period of economic, social and political chaos would follow, with abrupt falls in standards of living, accompanied by the resurgence of international tensions. This process would have unpredictable consequences, unthinkable in pre-crisis Western Europe. As for Portugal, after the chaos, it would probably return to its pre-European integration status: a poor and peripheral country, politically unstable.

However, eurozone countries may still choose alternative solutions, involving more active ECB policies and/or greater fiscal coordination, which we group into two scenarios.

In the first scenario, during the next few years, the ECB (and the EFSF) intervenes resolutely and in large scale in the sovereign debt market, buying debt issued by European countries with funding problems. At the same time, the countries in trouble successfully implement fiscal consolidation programmes, possibly aided by some form of soft restructuring of their debt. In a few years, investors regain some confidence in those countries and the ECB and the EFSF may stop buying public debt issued by them. At that time, the eurozone will return to the normality of its first years, but with higher spreads for less credible countries.

However, this solution has two problems. The first problem is that it does not guarantee that the behaviour of governments will change so as to avoid a repetition of the crisis – the moral hazard problem remains, and may even worsen in this context. The second problem is that the change in the behaviour of the ECB will hardly be accepted by the German public opinion. Clearly, financial markets do not believe this solution will work, a feeling deepened by the erratic behaviour and the lack of consensus among European leaders. The proposals to revise the stability and growth pact, namely through the establishment of automatic sanctions, are a way of trying to bypass this problem. But, if the stability and growth pact failed, why should one believe that the new proposals will be more effective (even assuming that they are accepted by all countries, which cannot be taken for granted)?

In the second scenario, the European countries reach a political agreement to reduce, if not eliminate, the probability that the eurozone faces a crisis of this kind. The measures include (besides ECB intervention and soft restructuring) a transfer of budgetary powers to a European entity designed by Central and Northern European countries. This entity is committed to presenting balanced budgets for each country under its supervision. National authorities may choose the level and composition of public expenditure, and the type of taxes. The intervention of that European entity in the budgetary process will guarantee that the budgetary targets are met, as it will be able to impose the measures required to correct deviations. For deficit countries, this solution should imply the continuation of austerity, with the goal of reducing the weight of public debt. The refinancing of debt and the financing of temporary deficits might employ euro-bonds, as a way to alleviate austerity.

This solution eliminates the moral hazard risk through a transfer of powers to a more credible entity. However, this would certainly be met with opposition from important sectors within eurozone countries, which would view it as a loss of sovereign powers and a submission to stupid rules (which in any case would be very hard to define).

Last Tuesday’s meeting between Angela Merkel and Nicolas Sarkozy suggests that European leaders are moving from the first to the second scenario. If none of these solutions work, the collapse of the euro, followed by European Union chaos, especially in peripheral countries, will become inevitable.

(with Pedro Bação)

The Ministry of Finance report on fiscal devaluation

The Portuguese Ministry of Finance has posted a report on the implementation of a fiscal devaluation in Portugal.

I wish to make a few comments:

1. The authors should state that the report is preliminary. The report does not contain any conclusion, therefore, in its current form, it is still incomplete and preliminary.

2. The report is acknowledged to be a patchwork of views of four different institutions (Bank of Portugal, Ministry of Finance, Ministry of the Economy and Employment, Ministry of Solidarity and Social Security). While a list of all four different stances is a useful starting point, the final document must find a coherent and unique position on the matter. After all there is only one entity that must fiscally devaluate, Portugal.

3. The structure of the document appears to be biased against the fiscal devaluation.

3.1. The first quarter of the study consists in a detailed description of the social security's financing sources. It is useful to know these details, and there is a lot of interesting information (see below Remark in 3.3). It is important to know which laws should be abrogated and/or changed if the government implements the reduction of the social security contributions paid by employers. The chapter ends with a comparison between Portugal and EU's fiscal revenues structures and states that Portugal relies more heavily than the rest of EU on indirect taxation (read VAT) and less on social contributions (paid by employers). These numbers are obviously influenced by the composition of aggregate demand and income shares. For example, in Germany private consumption (basically the tax basis for VAT) is around 56% of GDP and in the Netherlands private consumption is 45% of GDP. In Portugal private consumption is around 64% of GDP. I would imagine this section as an appendix and not as the initial chapter of the report.

3.2 The second section which addresses the macroeconomic effects (the core of the matter) of the fiscal devaluation is short. The evaluation is performed using a dynamic stochastic general equilibrium (DSGE) model developed at the Bank of Portugal. Two similar DSGE models developed by the ECB and the European Commission have also been used to confirm the results. Personally I believe that these models are very useful for theoretical guidance but should be complemented by more empirical approaches for a more robust quantitative evaluation of the suggested policy. [For the more analytical inclined readers : in the technical description of the macroeconomic effects, a neat identification of short term effects (fiscal devaluation), medium term effects (firm entry in the tradable sector) and long term effects (new steady state due to possible non neutral shift in aggregate labor demand and labor supply) is absent, which makes the quantitative results difficult to interpret].

3.3 The third section is the central part of the report and describes a menu of options to implement the measure. The benchmark measure, the only one that can be labeled as a fiscal devaluation, is the reduction of the payroll tax across all sectors compensated by an increase in VAT (and/or a decrease in public expenditure). The report correctly identifies the main weakness of the measure in the market power of the non-tradable sector (Remark: I noticed that in Table 3 Section1, a large non-tradable industry, or network industry, such as Telecommunication pays a payroll tax of 7.8%, as opposed to the general rate of 23.7%. Given that such a company-industry will not see its payroll tax being reduced the above weakness does not apply).

The alternatives suggested are not fiscal devaluations but could be labeled as :
a) Incentives to job creation (low payroll tax only for new jobs) ;
b) Export oriented Industrial policy (payroll reduction in export industries);
c) Tradable (?) oriented industrial policy (reduction of payroll tax only for lower wages).

3.4 The last page and a half is concerned with the financing of the payroll tax reduction. The last sentence briefly mentions that if the measure is implemented, the necessary fiscal revenues will have to be found by increasing the lower VAT rates. Obviously the financing of the reduction in the payroll tax is a (the) key aspect for the implementability of the measure. After all, who would disagree to lower labor costs if the sustainability of the social security system was secured? This is the section I would have expected the government to put more (all) efforts in order to reach an educated opinion on how much revenues an increase in the lower VAT rates could generate (0.5% of GDP, 1% of GDP, 2% of GDP…4% of GDP?).

As a final remark: I am confident international observers would welcome a report in English (only the executive summary and a technical appendix by the Bank of Portugal are in English), especially if the government plans to convince the troika not to implement the measure or to transform it in a different policy.

On the Economic and Budgetary Impact of Fiscal Devaluation in Portugal

Abstract
In this paper we show that fiscal devaluation, of the most dis puted issues in the current policy debate in Portugal, has the technical capacity to stimulate employment and investment and increase GDP while improving the foreign account position. More importantly, as this has been a point ignored in the debate, it can significantly contribute towards budgetary consolidation. Here

How much will the new Greek bailout cost private bondholders?

Ricardo Cabral © VoxEU.org: On 21 July 2011, the Council of the EU agreed to a second bailout for Greece. The deal was predicated on “private-sector-involvement”. This column explores what this actually means. It estimates that the haircut for private bondholders may well be one-third of the figure initially proposed. It stresses that such uncertainties could spell more trouble for Greece and Europe as a whole.

You shall foster competitiveness

Euro area leaders face demanding tasks. The high level task is the requisite to concur on the analytical model of the currency area. The more practical task is the need to dampen the imbalances generated by relative cost misalignments of the participating countries. To adress the latter, leaders can choose from a collection of solutions ordered by the degree of economic and financial integration that individual members wish to pursue. Unfortunately the identification of what member states wish cannot be defered to the next european election (2014). As of today, european leaders have agreed or announced measures (my reading could be biased) to:

1)Improve financial markets and banks stability mainly through the EFSF

2)Strenghten real convergence through the Euro Plus Pact adopted last March

Regarding 1), leaders should enhance the quest of stability with a movement towards further financial and banking integration. I will not engage this argument but point the interested reader to this lucid analysis.

Regarding 2), leaders should be more ambitious on the instruments and instutions needed to achieve the desired level of policy coordination.

Let me change scale somewhat abruptly, and focus on the first policy commitment of the Euro Plus Pact, namely “to foster competitiveness”. The text agreed by the European head of states says that the assessment of competitiveness adjustment needs will be based on “unit labour costs (ULC) for the economy as a whole and for each major sector.” A precise identification of competitiveness as ULC is useful and necessary as it permits to adopt concrete policy measures.

The competitiveness of an economy is a multidimensional idea and economists have constructed several different indices to measure it. This multidimensionality necessarily leads the different indexes to exhibit different patterns. Some commentators interpret negatively the observed difference in the dynamics of these indexes. Their argument is that, if different measures of competitiveness exhibit different patterns, they must lead to different conclusions. Therefore these indexes of competitiveness, such as ULC, are flawed and cannot provide guidance to the unidimensional objective of promoting export growth. I will not dispute that measures of Real Effective Exchange Rate (REER) based on different deflators and/or weights exhibit “unsatisfactory” behavior. However, I believe, the above reasoning on the heterogeneous behavior of the indexes, does not consider the dimensionality of the idea of competitiveness.

I am more concerned by a subset of commentators, who build on the possibly contradictory pattern of the different REER, and shift the focus from relative costs misalignment to composition issues. In simpler words they argue that if Portugal has a trade deficit, it is not because its relative costs are high but because it produces the wrong goods. I bypass the economics of this argument, but I am curious to know what type of good is not produced in Portugal (exclude military submarines). Consider the following thought experiment. Assume Portugal was part of an exchange rate mechanism instead of a currency area. Would we expect a nominal devaluation to improve the trade balance? If the answer is yes, I would defend that trade deficits have more to do with cost misalignment than type of products. (Even after acknowledging the “this time is different” echo in light of China & co access to the WTO.)

The Euro plus pact correctly focuses on intra-european competitiveness. Eurozone members are obviously free to improve their trade balances vis-a-vis the rest of the World. However they must consider that their trade balances respond much more to change in relative costs and external demand within the currency area (“long-term price elasticities for intra-euro area exports appear to be at least double those for extra-euro area exports” ). I could not find estimates of Portuguese elasticites for intra-euro and extra-euro exports. It would be useful to have them.

Let me end with a digression. During the last two years, commentators have changed the designation of euro members that could not anymore access financial markets from “southern” to “peripheral”. I find this labebling both imprecise and misleading. We should relabel the so called peripheral countries as current account deficit countries and the so-called core countries as current account surpluses countries.

Caixa Geral de Depósitos

Quite surprisingly, the appointment of a new administration for the state-owned banking corporation CGD has emerged as priority. CGD operates in a highly regulated industry. The Bank of Portugal is the regulator. CGD is the largest bank in Portugal. The government selects the one who regulates to manage the one who is regulated. Economists call this the revolving door problem in regulation. Hundreds of papers in the economics of regulation and public choice address the perverse effects of the revolving door behavior in politics. Nobody in Portugal, but literally nobody seems to be worried about it. Remarkable! More remarkable when there have been accusations of regulatory failure against the Bank of Portugal (due to BPN and BPP scandals a couple of years ago).

Dynamic inconsistency again

In a famous paper, Kydland and Prescott (1977) show that when policymakers announce a low-inflation policy, agents will expect high inflation, as long as the marginal cost for policymakers of additional inflation in the future is low compared to the marginal benefits of pushing output temporarily above its normal level. The reason this happens is because the policymakers discretion to change policy in the future makes the announcement of a low-inflation policy not dynamically consistent (equivalently, it is not subgame-perfect).
I could not help thinking about this issue when I read yesterday’s statement by the heads of state or government of the euro area and EU institutions, which stated in point 6 that regarding private sector involvement Greece “requires an exceptional and unique solution” and in point 7 that “all other euro countries reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments”.
Didn’t the Greek government commit in the past to fully honour their responsibilities? Nevertheless, yesterday’s agreement requires private sector involvement in terms that some consider a selective default. If Merkel thinks that the political cost of not involving the private sector is too high now, why should markets believe that Germany will have a different view if Portugal needs additional EU financing sometime in the future?

Do the right thing

So here we are, at (another) potentially decisive Eurozone summit. There's little need to go into what's at stake. Growing numbers of decision-makers (including notional ones) have alluded to this, and countless column inches have been devoted to the burgeoning Eurozone crisis. Churchill used to say that "Americans can always be counted on to do the right thing... after they have exhausted all other possibilities." Perhaps today will be a good test of the applicability of the Churchillian aphorism to us Europeans also.

Portugal is not Greece, the US are neither Greece nor Portugal, but there are similarities

Wage productivity gap again

I didn't show the figure below in my earlier post, because I really don't know how to import it and make it readable. But I believe it illustrates quite well the main ideas, so I do it now:

1. Wage-productivity gaps are observed in building construction and agriculture: reality or fiction (decreasing informality...)?

2- In any case, for manufactures, services and the economy as a whole (total), deviations are not significant

3 - Prices/ULC in services increased faster than in manufactures. The later are linked to PPP. The increase in the former explains the RER appreciation: once again, Pn/Pt is the issue , not wage productivity gaps.

To this, I could add a figure showing that on average wages in services are higher than in manufactures.

Thus, the challenge is to convince workers (and unemployed) to accept a lower pay while moving from services to manufactures.

The macroeconomic addjustment will be impaired not only by the economic climate, which is not investment-friendly, but also by any incentives unemployed may have to wait and see, rather than to accept an immediate move to a less friendly production environment.

The Importance of Being Euro

Lady Bracknell. Now to minor matters. Are your parents living?
Jack. I have lost both my parents.
Lady Bracknell. To lose one parent, Mr. Worthing, may be regarded as a misfortune; to lose both looks like carelessness.

Oscar Wilde, The Importance of Being Earnest

In this initial post, I would like to share a recurring thought. In pondering about the current crisis, I am often reminded of the above exchange in Wilde's The Importance of Being Earnest. Yes, I know that the Portuguese situation has its own very particular (perhaps even peculiar) national dimensions - just like the Greek and Irish crises have their own domestic specificities, echoing Tolstoy's oft-quoted dictum about each unhappy family being unhappy in its own way. Yet I find myself invariably returning to Lady Bracknell’s response above. To paraphrase Wilde, if losing one (Greece) could be considered misfortune on the part of the Eurozone, to lose three really does look like carelessness. With another two or three (Italy, Spain, maybe even Belgium further down the road?) edging towards the brink, it seems that Europe has yet to fully realise the political importance of being Euro.

More on wage-productivity gap

Like Miguel Lebre de Freitas in the post below, I have also been exploring the Campos e Cunha hypothesis for Portugal's stagnation. And I am growing increasingly convinced. Miguel gives you some numbers: here is the one plot that makes the point for me, where TOT are terms of trade, RER-ULC is the real exchange rate using unit labor costs against 35 developed economies from the AMECO database, and REC-CPI is the real exchange rate using consumer price indices from the CPI database.

Could bank deposits be used to fund sovereign debt?

Probably yes (available also in my webpage with additional footnote. Sorry, in Portuguese only).

Too much talk about economic growth

It seems to me that this government is going to commit the same mistake of the former one by conveying the message that resuming economic growth is the way out of the crisis. It is not. Economic growth will not resume in the short run and the debt crisis demands very short run domestic solutions. All the talk must be focused on the adjustment of expenditure, private and public. However, passing on that message is very hard for political leaders and for a people that have lived (and were educated) in an age of prosperity and high public spending growth.

Wage-productivity gap: where is it?

The problem with exports is not wages being too high in tradables. On the contrary, the evidence is that wages have evolved quite in shape with productivity, especially in manufactures. The problem is about to convince workers and unemployed to move from services, where wages are higher, to manufactures, where wages are lower.

INTRO

Competitiveness is a rather complex concept. In a broad sense, it refers to the extent to which a nation provides economic agents with (socially-aligned) incentives to produce and invest. For a moment, however, let’s focus on a narrow concept of competitiveness, related to wage costs. In particular, let’s stick with a definition proposed by Olivier Blanchard (2007), who refers to competitiveness as the inverse of unit labour cost (ULC) in tradable goods sectors relative to the corresponding world value.
In its influential paper, Blanchard (2007) argues that competitiveness in Portugal deteriorated significantly since the mid-nineties. According to the author, this reflected a misalignment between wages and productivity growth, which caused profitability in tradable goods sectors to shrink. However, Blanchard did not provide evidence supporting the claimed loss of competitiveness. The author showed that economy-wide ULC increased in Portugal faster than in the EU15, but he did not distinguished tradable goods (T) from non-tradable goods (N). The European Commission (2011) goes along with the same argument: “Since the introduction of the euro, Portugal has experienced significant real exchange rate (REER) appreciation vis-à-vis its trading partners, due to wage growth largely outstripping productivity advances (Graph 3)”. However, Graph 3 in the document only displays economy-wide real exchange rate indexes…
In a contrasting view, Campos e Cunha (2008) argues that “there is no room to claim a loss of competitiveness (...)” (p.158). The author points out that, in a small open economy, the real exchange rate and aggregate demand are two sides of the same coin. As it is well known, in a well functioning economy, an aggregate demand expansion translates into higher N-prices, while T-prices are bounded to remain unchanged. This causes a real exchange rate appreciation that has nothing to do with wage-productivity gaps. Fagan and Gaspar (2007) illustrate the argument is in the context of an endowment economy where, by definition, there is no such a thing as competitiveness.
Competitiveness and the real exchange rate do not necessarily go along.

FORMAL

To illustrate this, let’s look at the real exchange rate index based on nominal unit labour costs. By definition, ULC=W/a, where W refers to the compensation per employee (“nominal wage”) and a refers to Gross Value Added at constant prices per worker (“productivity”). Now, assume that the production function is a Cob-Douglas with labour-output elasticity equal to b and let Z be a variable measuring the wage-productivity gap: Z=ba/(W/P)=bP/ULC. When computed in terms of a base year (the constant b disappears) the index 1/Z is labelled Real Unit Labour Cost (RULC) or “real wage gap”. In a frictionless economy, Z=1. In a world with frictions, in face of a wage push, firms may opt to maintain a higher level of employment than that implied by the textbook wage-productivity rule. When this is so, the producer margin shrinks (Z<1).
Using the definitions above, the real exchange rate index based on nominal unit labour costs (RER-ULC) becomes ULC/ULC*=(P/P*)(Z*/Z). This means that RER-ULC accounts for two effects: wage-productivity misalignments (Z*/Z) and the increase in the relative price of non-tradable goods (P/P*). In a well functioning economy there are no wage-productivity misalignments, so Z=Z*=1. Still, unit labour costs may increase relative to abroad, whenever non-tradable good prices increase relative to abroad. This means that we can hardly rely on RER-ULC as an indicator of competitiveness. Competitiveness a la Blanchard is accounted for by the component (Z*/Z) and in the proportion corresponding to tradable goods, only.

EVIDENCE

Returning to Portugal, we now look at the data. In Table 1, se see that between 1995 and 2010 there was a

Openness, internal devaluation and competitiveness

One is entitled to ask if the "internal devaluation" will lead to an improvement in Portuguese's competitiveness given the recent euro-appreciation trend.

First, with respect to the euro-appreciation, given the growing importance of intra-euro are trade for Portugal (> 65% of exports), such phenomenon is not expected to severely damage the trade balance.

Secondly, internal devaluation should be coupled with crucial structural reforms (including the labour market) such that we assist to an emergence of new economic activities. In particular the MoU is highly reliant on opening up the nontradable sector to competition to decrease rent-seeking behaviour and encourage profitability in the tradable sector. The emphasis should then be on export-led-growth rather than specific sectors, which may, at the beginning, naturally favour those with strong(-er) comparative advantages.

Thirdly, internal devaluation can take the form of i) planned fiscal devaluation (as suggested/endorsed by our co-blogger Francesco) which basically adjust relative prices by simulating a currency depreciation; ii) a (further) compression of nominal wages (despite not ideal, may still be necessary); iii) a push for increasing competition (resulting in smaller prices of domestically produced goods).

Regardless of how it is going to be implemented, the timing and correct design of an internal devaluation strategy should take into account its social impact and the existing room for manoeuvre (in terms of available measures) in face of the already large fiscal adjustment in progress...

All in all, the above points together with no increases in the minimum wage (as envisaged by the MoU) should contribute to zero growth in unit labour costs (ULC). This combined with sensible projections for trading partners should imply an important cumulative depreciation by 2016.

Moody's lazy screw up

Moody's has really taken a beating in the last few days in Europe. Their hard to understand, sudden, and dramatic downgrade of Portuguese debt has had people, from the FT and policymakers all the way down to blogs and facebook accounts, calling Moody's analysts names that range from incompetent to dishonest.

I don't agree, since I tend to see Moody's as a serious company that does a good job with often little information in tough circumstances. But the downgrade of Portuguese debt in 4 ratings to junk on Tuesday, is far from its best moments. Actually, it is a moment that the people there should be embarrassed about: it is hard to avoid the conclusion that, at least, they are lazy.

The downgrade decision was justified by Moody's on two accounts. First, the low growth of the Portuguese economy, the high budget deficit, and the political uncertainty on the government's ability to change things. But, these problems are years-old news, and nothing in the past week made them look worse. In fact, with recent elections giving 80% of the vote to parties that are committed to the IMF program, and the announcement of a surprise tax hike, the news has been moderately positive on those concerns. The only backing I can find for this Moody's argument is the revision down of growth forecasts and poor numbers on government spending in the first quarter. But these are week-old news. So, at best, Moody's analysis are right, but lazy, taking weeks to digest simple news.

Second, Moody's points to the new plan to "voluntarily" restructure Greek debt, and the suggestion that this plan could be offered to Portugal's creditors as well. This makes a lot of sense to me, although the Sarkozy plan is very far from likely being adopted. As Alvaro puts it below, it puts the blame of the downgrade squarely on the EU's too-frequent grand announcements and retreats. But if this European shock justifies a 4-level downgrading of Portugal, how can it not involve an even modest change in outlook for Ireland, Spain or Italy? Again, the only explanation that I can come up with is that Moody is being lazy, and will downgrade those ratings too but only in the next few weeks, when it gets around to it.

A downgrade a week or two earlier I could understand; a downgrade later for a group of European countries, including Portugal, would be a gamble, but hey that's forecasting. A downgrade last Tuesday just seems like laziness.

Incomplete information is a fact of life. Poor economic models are a trap for anyone who ventures into forecasting. But laziness is an embarrassing attribute for people monitoring credit.

More on this in Portuguese in today's Expresso.

Domestic extraordinary measures are not a solution for our structural problems

The adoption of extraordinary measures has become an ordinary behavior of Portuguese governments. The most recent example was the extraordinary income tax announced last week. The events of this week have shown that extraordinary measures are not a solution for the structural problems of the Portuguese economy. There are two aspects to this. First, the markets clearly do not believe that these measures are enough to tackle those problems. Second, to the Portuguese people they convey the idea that the problems are, like the measures, temporary and thus the measures fail to put in motion the process of adjustment of expectations (and behavior) that the seriousness of the problems demands – therefore confirming the beliefs of the financial markets.

Structural measures are therefore required. The unsustainable current account deficit is a reflection of the structural problem of the Portuguese economy. It embodies the disconnect that exists between the structures of consumption and production. Devaluation would be the obvious (easy and non-structural) solution outside a common currency area. Absent this possibility, a significant cut in wages has been suggested as a means to restore the competitiveness of Portuguese firms.

A structural measure that would have the same competitiveness effect as a 7% wage cut would be to eliminate, permanently, the 14th wage payment, for both workers and pensioners. Beside the competitiveness effect, this measure would reduce public expenditure permanently. It should also have an impact on expectations, bringing the behavior of Portuguese consumers closer to our economic possibilities and sending a clear message of commitment to the financial markets and to the European Union (i.e., Germany), on top of the commitment to the memorandum of understanding.

Finally, except for legal problems that would have to be dealt with, this is simpler than other measures that would introduce additional complications into our fiscal system, with uncertain effects on the structure of incentives, such as the much discussed reduction in payroll tax. It should also be noticed that other structural measures, such as those in the memorandum, will take a long time to produce effects – if they do.

This kind of measure should be implemented from 2012 onwards. The Portuguese households should be given time to adjust their consumption plans. Obviously, such a measure will deepen our recession. But there is no way out of our problems without a serious recession, except if the Germans accept to pay the bill for our past excesses. Given the events in Greece, this would appear quite extraordinary.

Ich bin ein Grieche!

To fight the North American ones, more and more politicians are suggesting the creation of an European rating agency. It seems that they are not aware of the several dozens of rating agencies that are spread around the world, including Portugal.

Anyway, if there is going to be a new European credit rating agency, I propose that this new rating agency uses the Greek alphabet instead of Latin. Therefore, instead of aaa we would have ααα, or βββ instead of bbb, and so on and so forth.

Misquoting Kennedy, one would say: “Two thousand years ago the proudest boast was civis Romanus sum. Today, in the world of freedom, the proudest boast is 'Ich bin ein Grieche!'... All free men, wherever they may live, are citizens of Greece, and, therefore, as a free man, I take pride in the words 'Ich bin ein Grieche!'”

Moody’s decision was correct…

… if one accepts the ratings agencies’ view that the debt rollover involving private creditors proposed for Greece should be considered “default”. Given that the consensus seems to be that Moody’s decision is absurd, I feel I must explain my previous post and the previous sentence. Considering that:
1. The Portuguese “program entails important risks” (see the IMF’s staff report, page 23, available here), “in particular, refinancing risks”;
2. If the program fails to deliver the results projected, additional official financing will be necessary; i.e. there is an “important” probability that Portugal will need new financing from the European Financial Stability Facility (EFSF), which implies approval from all the Eurogroup governments;
3. It is very likely that France and Germany will apply the principles of the latest Greek program to all future EFSF financing, requiring private creditors to rollover their debts, an event ratings agencies consider to be “default”.
Then, there is “very likely” an “important” probability that an event called “default” will occur, regarding Portuguese debt. That is exactly what a junk rating means, that there is a important probability of default.
This also means that Portugal’s downgrade has nothing to do with Portuguese fundamentals, but it is related to the fact that France and Germany are requiring private creditors to rollover their debts.

Growth and Employment "Trackers"

The growth and employment "trackers" (see footnote for technical details) give a sense of the dramatic decline in economic activity and employment following the last economic crisis and its tepid recovery (particularly in the labour market) in Portugal between 2000-Q1 and 2011-Q1 (from here up to 2015-Q1 the trackers are based on forecasts - grey shade).

The profile of GDP growth forecasts are somewhat in line with what the new Minister of Finance (Vitor Gaspar) has recently said: “Portugal is expected to have 9 terms of consecutive negative growth” (see here).

Source: author’s calculations based on OECD data.

According to these estimates we shall have “contraction at a moderating rate” until around mid 2013 and only then we should begin growing below trend at a moderate rate. Perhaps we won’t go through another “lost decade”, but we are certainly expected to experience at least half a decade of negative, stagnant or moderate growth (at best). More reassuring, might be the case of employment if the “right” structural policies are enacted and put into action such that the “job-destruction” process is reversed and productivity and competitiveness improved. (Note, however, that projections shouldn't be viewed as an exact science but solely as an indication as to where the economy is expected to move based on a number of mathematical and statistical assumptions.)

Footnote: The trackers are constructed using a univariate fitted Structural Time Series Model with unobserved components over the period 1970Q1:2011Q1 allowing for a stochastic trend, cycle and seasonal and estimated by maximum-likelihood via the Kalman filter. Forecasts are then obtained up to 16 periods ahead and the classifications represented in the figure are based on the behavior of a centered 4-quarter moving average.