A few thoughts on Portugal and the Euro

Consensus exists on what should be the present and future path of the the Portuguese economy. Portugal needs to reach a state of sustained current account surpluses and simultaneously reabsorb a large number of unemployed while deleveraging the balance sheets of the Households, the Government and the Corporations (see Figure 1).

Where we see opinions differ vividly is in the actions to implement this path. One end of the opinion spectrum thinks that Portugal should exit the euro, regain monetary policy autonomy, stay in the common market with a devalued escudo and restructure national liabilities. The other end believes that structural reforms coupled with a medium-term consolidation anchored in a coherent euro membership will rebalance and relaunch the economy. 

The pro-euro-exit narrative follows the textbook description of a devaluation. Real wages will fall, the real exchange rate will depreciate. This will favour temporarily (2-3 years?) employment and the tradable sector. Yes but... economies have evolved faster than textbooks and supply chains, increasing the import content of exports, have likely changed the importance of the nominal exchange rate in determining the trade balance. Portugal is no different and is highly integrated with other producers in Spain, Germany Italy and France. Its energy trade balance is negative (although has improved).  Not so sure a nominal devaluation would improve significantly the trade balance (lower labor costs will help). In any case, even with a national currency, the most likely exchange rate arrangement with the rest of the common market would be a fixed or managed exchange regime that de facto will subordinate national monetary policy to the ECB. The extra degree of freedom, which is more a fraction of a degree of freedom, would be that Portugal could change the central parity (value) relative to the euro. One certainty is that financial markets will reflect this possibility in higher interest rates. All assets and liabilities denominated in euro (and other currencies) that do not include the contingency of a change in denomination (if they exist) will see their value increase in terms of the new currency.  Given the large negative investment position, strongly biased toward debt, Portugal will need to restructure its liabilities. The restructuring would also be reflected into higher interest rates. The capacity to attract foreign investment will decrease. Finally the exit from the euro and the permanence in the common market is not an option contemplated by the treaties and will have to be negotiated with the rest of the EU members. Would it be a temporary exit with a subsequent medium term strategy to attain the conditions to be part of the euro at a later date, or would it be a change of course towards a more standalone posture vis-a-vis Europe and the World? This uncertainty will imply a disorderly period and diminish any positive effects of the devaluation. 

It is also true that the adjustment within the euro is difficult. It requires well functioning markets and a coherent currency area. By well functioning I mean markets that permit adjustment through the demand-supply mechanism and deliver competitive outcomes. Ireland for example appears to have better functioning markets than Portugal. This did not protect Ireland from the consequences of a tremendous financial shock but helped to quicken the adjustment relative to Portugal. (see Figure 2) The policy prescriptions to improve labor markets functioning are reforms that increase job flexibility and maintain workers protection. Fairness suggests to address both legs, flexibility and protection, simultaneously. The policy prescriptions for better functioning goods markets are to increase competition in the non-tradable and networks sectors. We need to recognise that scale and some market power can be a source of R&D and innovation especially in the ITC and energy sector. If this is the case, the creation of integrated pan-european markets in the network industries can break national resistance to better competition (which is very strong),  allow sufficient scale for innovation and simultaneously permit European countries to operate on a level playing field by facing similar telecommunication and energy costs. This is the solution the euro area has adopted with the Banking Union to ensure that firms face similar competitive conditions in crucial inputs such as financial services and credit. The latter goes beyond the competition argument as it also aim at improving the transmission of monetary policy across the euro area. When fully implemented, Portugal like the other periphery countries, will see credit supply conditions improve and be at par with other euro members. Improving competition in the network sectors will help the rebalancing towards the tradable sector. It might not be sufficient to reabsorb sufficiently rapidly the large number of unskilled unemployed. (Can we find non-resident resources to reabsorb the unemployed coming out of the construction sector by finding resources to repair and maintain the existing stock of houses?) To be credible (in the sense of having a positive probability of success), the deleveraging and consolidations processes cannot be made unconditional to the state of the economy. They need to be designed around sound measures of structural unemployment and potential output level and growth. (For example some measures put the structural unemployment rate in Portugal at approximately 13% based on a non accelerating nominal wage model: nominal wages do not decrease therefore the unemployment rate is structural. Assume just for a moment that nominal wages never decrease, then there is no upper bound to the structural unemployment rate measured with this model.) Fiscal consolidation must also be made progressive to have as low as possible recessionary effects and ensure social cohesion and fairness.

A note on the euro. Yes we lost the possibility to devalue against other euro members. But was it really such a bonanza to devalue in the past? (read this older post). Yes the nominal convergence started in the mid 1990's towards German rates caused a boom that the periphery was not capable to channel towards higher productivity capital. Portuguese 10 years government bonds went from 11.8% in 1995q1 to 4% in 1999q1. But German interest rates on Bunds went from 7.4% to 4% in the same period: there were (and are) forces beyond the euro at play. Yes some euro zone members do not fully accept that to a current account deficit must correspond a current account surplus. And now the euro-area has the largest current account surplus in the World. With a fairly high unemployment rate. One certainty: international imbalances require international cooperation. Another certainty: inter-nations imbalances within a currency area require its members to have coherent policies.

Figure 1 (click to enlarge)

Figure 2 (click to enlarge)