Friday 8 July 2011

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.


  1. @alexandre

    you say other measures have "uncertain effects on the structure of incentives"...


    - the transmission mechanism that permits a wage cut to have a positive effect on competitiveness is ...
    ... identical (the same) to the transmission mechanism at play for a decrease in the cost of labor to improve competitiveness. No difference.

    Furthermore decreasing wages has pros and cons, here one con:

    - a decrease in the wage increase the real debt burden of households

    this does not happen with the fiscal devaluation

  2. Francesco,
    uncertainty concerning the payroll tax is such that no one knows the way it is going to be implemented.
    A major difference between the two measures is that cutting the 14th wage payment reduces public expenditure and the present value of future pensions.
    A recession and an increase in households debt burden is unavoidable (that an increase in taxes to compensate the decrease in the payroll tax would also increase).
    In a different context I would prefer your proposal.

  3. Interesting ideas.
    Personally, I think the most important structural reforms needed are (i) the increased flexibility in the labour market (including the ability to easily make redundant many thousands of unproductive public servants who currently have no incentive to work hard and therefore don't, many of whom earn way above European standards) and (ii) the medieval judicial system which at the moment helps law breakers and penalizes law abiding firms and individuals.
    Cutting the 14th wage is, I believe, more than justified given the circumstances (here in the UK we only get paid 12 months) but unless it is seen as permanent it will not change expectations and therefore behaviours.