Sunday 14 July 2013

The biggest challenge

The crisis that I described in my previous post is still far from being solved. The president asked for the three institutional parties to reach an agreement. Since nobody knows what is going on in the President’s head, it is impossible to predict what he will do if such an agreement is not met.
Anyway, the biggest challenge that the new government will face for the next year is to cut 4.7 billion euros (about 2.85% of GDP) in public spending. Such a drastic cut seems like the wrong thing to do.
If this number is correct, then the 4.7 bn cut would lead to a contraction in GDP of 5.7%. This contraction in GDP, by itself, would cause the debt to GDP ratio to increase by 7 percentage points (from 125 to 132%). Additionally, the recession would also lead to a decrease in tax revenues. If tax revenues dropped by 3.3 bn then the budget deficit would decrease by 0.6 percentage points.*
In sum, if these cuts were to be implemented, Portugal, whose GDP is already at pre-millennium levels, would face a huge recession. Unemployment, which is already at an all-time high, would explode. The only benefits would be a decrease in the budget deficit by less than 1 pp. together with an upsurge in the debt to GDP ratio. This is just silly.
Given this, I would say that the biggest challenge that the new Government, whatever its form, will face is to convince the troika that this additional cut is simply stupid.

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


  1. I agree that it is silly to ask Portugal to cut even more at this stage. But I think it is also silly to expect that the troika will suddenly be magnanimous and say that Portugal does not have to cut any more. For the international community in general and the IMF in particular, Portugal is getting what it deserves after many years of mismanagement: Too many expressways, too many stadiums, too many unproductive public servants (and I know that there are many more good ones), and so on.
    Portugal's current crisis should be seen as a great opportunity to finally do the structural reforms everyone knows Portugal needs but no one has the courage to implement...

    1. It is politically impossible to implement such cuts

    2. and without cuts it is impossible to lower taxes.

  2. This comment has been removed by the author.

    1. Two points:

      1. The following assumption: "Second, nominal wage and price rigidities are raised, increasing
      the average contract duration by around 80 percent. (page 14)"

      So in bad time rigidities increase???? And from table 2 we see that this increase is responsible for a multiplier increase in the cuts case, as it has no impact in the taxes multiplier.

      So a policy of cutting costs and decreasing rigidities would work (in this model).

      2. The 3 year multiplier is quite different than the impact multiplier. In the taxes increase it keep the economy below the initial steady-state, as the cuts would almost return to the steady state. So a government cut can produce results 4 years after implementation (just before the next election :) - Table 1 and 2.

      P.S: Do not take the previous points as an endorsement of the cuts. For that I would have to believe in these kind of models, and although I do not refut them I am not a pious believer.

    2. "decreasing rigidities would work"
      Well, of course. In any DSGE model if you remove rigidities, the economy will reach the steady state very quickly. In particular, the Ricardian equivalence kicks in and therefore, the budget spending multipliers will have (almost) no relevance.

      "The 3 year multiplier is quite different than the impact multiplier."

      Naturally, these are short-run effects. This is why these types of multipliers should not be a guide to long-run policy. However, in the current situation, when we are facing a serious recession, this short-run analysis is crucial.

    3. Elaborating on one of Pedro's points, you're making it sound like there is no trade-off, that this cut is simply stupid. But if you extend your analysis to years 2 and 3 there is a positive impact on the debt to GDP ratio, because both GDP and tax revenues recover. Specifically, debt to GDP would rise 7 pp in the first year like you say, but it would fall 6 pp in the second year and fall another 5 pp in the third year. And it would keep falling another 2.85 pp per year going forward. You are right that the short-run matters, but there is a real trade-off to consider.

  3. Let me say:

    1. For those that are not economists (and to some economists, as well) and might be at odds with the Ricardian equivalence:

    2. My argument was not how a DGE models works. My argument is why the authors consider that rigidities increase? They do not provide any sound story for that. Actually, we can get stories for both:

    a. Let's say, if government cuts spending and fire people, more people will be unemployed and less people will be unionized therefore the "market power" of unions might in fact decrease and so rigidities decrease (the way the model gets the rigidity is through union market power). [Story that could be easily modeled in a DGE model]

    b. In normal times people have less information about economy and so people work more on "rule of thumbs" laws. In crisis people have more information and, as they are hit by the crisis, re-evaluate their decisions, and are more prone to adapt and change. This will also reduce rigidities. [This is more from the heterodox view of the economy, namely from behavioral economics, and as such, harder to translate to a mathematical economic model]


    c. In normal times the adjustments are done without changing the nominal wage, so just the differential between inflation and wage change will adjust the economy. In bad times, we need to readjust the nominal wages, people are more contrary to that. So rigidities increase. Actually this is more a non-linearity than a change [This would mean a kink in the reaction function, so would not be diferentiable anywhere and therefore much harder to build it mathematically speaking - harder, but not impossible, there is a lot of literature about nominal rigidities. anyway can be modeled as a change just for comparison].

    d. In crisis there is more social upheaval, so any adjustment is harder, so rigidities increase.

    There are, of course, more stories, but I just want to pick, for each case, one story from the traditional new macroeconomics and one from a more heterodox view.

    But... "find that economic crisis in the form of higher unemployment rates tends to reduce LAMRIG" (page 4).

    The two central points in the multipliers change in BP paper are the labor market rigidity and financial frictions. If we change their assumptions of how these two things change we can get a different result.

    Just saying, I am not criticizing your position, actually I agree with what you say.

    But we need also to advance with solutions:
    1. Tax increase?
    2. Government cuts?
    3. Debt restructuring?
    4. Pure default (total or partial)?

    I would go for the third with some of the second (tied with decrease of bureaucracy and faster justice -easier to say than to do) and the reverse of the first.

    Final note: If the paper of BP has accurate multipliers an increase in tax and an increase in governments spending would improve our financial situation on the first year, but not on the third...

  4. Há que considerar que o corte de 4,7 mil milhões envolve diversas rúbricas que "multiplicam" de forma diferente sobre os seus efeitos sobre o PIB. Por memória salários, aquisição de serviços, e prestações sociais. Ocorre que de facto os maiores cortes incidem sobre as áreas com mais impacto no PIB.
    De resto 2012 foi uma confirmação clara desta teoria. Um acentuado corte naquelas rúbricas acabou por ter um impacto menor no deficit, por força da forte contração que provocou na economia.

  5. The question is not being framed correctly: it's not about IF we do fiscal consolidation, it's about WHEN. The current fiscal path is unsustainable.
    And even if you take these multipliers as a given - these are theoretical results coming from a model heavily geared towards producing high multipliers - and accept that consolidation would be more costly now than later on, there is at least one strong reason to do it now, and it can be summed up in three letters: OMT.
    If Portugal qualifies for OMT next year, it will be a huge boost. Having the ECB as effective lender of last resort will keep sovereign yields down and essentially eliminate the risk of a new panic. This will give the government a lot more fiscal space to maneuver, and because banks hold a lot of sovereign debt it will help repair bank balance sheets (which are a major cause for the higher multiplier to begin with).
    Why is fiscal consolidation now so important? Look at the recent behavior of interest rates. To qualify for OMT Portugal needs to regain market access, and for this we need interest rates to stay low enough. The political crisis caused a spike in interest rates, and at these levels there is no way we can regain access. Right or wrong, the market seems to be telling us to stick to the plan. That our credibility is not high enough to be able to delay consolidation. We should hear the message, because wasting the chance to qualify for OMT would be a disaster.