OECD on Portugal with a touch of Eurozone criticism

In case you were wondering about the Portuguese economy a recent OECD survey tries to steer you in the direction and although the OECD are undobtedly right in many of their observations the case of Portugal also mirrors how being a member of the Euro does not necessarily help you to achieve those honourful demands of convergence.

Let us see what OECD has to say about Portugal’s economy.

Apparently the data and conclusions are dire;

Following a period of convergence to EU average living standards, the catching-up process has stalled since 2000. Real GDP growth averaged less than 1% between 2000 and 2005 and the on-going recovery remains fragile, with annual growth expected to remain below 2% in 2006 07.
(…)

Thus, Portugal did not take full advantage of the opportunities created by membership in the EU and the euro area to enhance growth on a sustainable basis. Losses in export market shares have been aggravated by the appreciation of the real exchange rate (as measured by Portuguese unit labour costs relative to those in its trading partners), while a real depreciation through greater wage restraint could have been expected (and would have been desirable) in a period of large slack in demand. As a result of economic weakness and lax policies in the past, the fiscal deficit reached close to 6% of GDP in 2005, an unsustainably high level.

Now now, allow me to put my foot down; at least just a bit. The analysis by OECD clearly touches some important points and the solutions offered are probably also admirable in their own right. However, let us scrutinize the argument about Portugal not taking advantage of being a member of the Euro. In a time of economic problems the Euro is not an opportunity for Portugal (or for Italy for that matter) but a major ball and chain on macroeconomic policy choices. OECD highlights this issue by pointing out that the only macroeconomic tool at Portugal’s disposel is to keep wages from rising to increase its relative productivity. I hardly think this would be the solution for Portugal or for Italy for that matter … do you? In the end Portugal is an example of where the Euro has not worked and in this light the demands of convergence and more generally the aspiration and idea that for example Portugal should converge to the rest of Europe becomes a contradiction because the very institutional framework of the Eurozone is a part of the problem.

Clearly, the OECD survey can used to a lot more than a rant about the Euro but this perspective is particularly important in this case I believe. On a more formal note, this is my last post as a guest poster here at AFOE and I should take the occasion to thank the AFOE-team for letting me in for the last couple of weeks. If you want to hear more from me I can be found at my own blog Alpha.Sources, and two collaborative blogs Cultunomics and Demography.Matters.

7 thoughts on “OECD on Portugal with a touch of Eurozone criticism

  1. I think the OECD is on the right lines about Portugal, but perhaps does not go far enough in drawing conclusions.

    “Following a period of convergence to EU average living standards, the catching-up process has stalled since 2000.”

    This is right. Portugal has stopped ‘converging’ and is effectively stuck. This situation is partly obscured by the fact there is very low growth in some other key eurozone economies like Italy and Germany.

    But each case is slightly different, and Portugal’s problems are not globally the same as those of Germany and Italy (although in terms of product mix and having an overvalued currency they are nearer to those of Italy).

    The comparison with the Czech Republic is an instructive one, since (measured in PPP terms) it has now surpased Portugal in GDP per capita. With the current growth differential between the two countries, it will soon also overtake Portugal in terms of dollar value GDP per capita too.

    So what can Portugal do about its situation? Well the first thing to realise is that Portugal is not Iceland. Portugal cannot devalue its currency and raise its interest rates. Being in the Eurozone makes that impossible.

    In language of a bygone age, Paul Krugman used to talk about the eternal triangle:

    http://web.mit.edu/krugman/www/triangle.html

    Now the language of the times may have changed, but in many ways the problems haven’t. Ok, here’s some earlier generation Krugman:

    Why has international monetary discussion become such a matter of euphemisms, evasions, and well-meaning but ineffectual gestures? The deep answer, I believe, lies in the difficulty most officials and even private economists have in facing up to the unpleasant dilemma that is really involved in choosing an international financial “architecture”. This dilemma is not new; on the contrary, the basic story has been the same for at least a century. But for a while a combination of good luck and special circumstances allowed us to forget about such unpleasantness. Now it’s back, and leaders will either have to make hard choices, or find that the logic of events makes those choices for them.

    The essence of the dilemma may be understood by remembering the catechism first suggested by the Bellagio Group, the famous official-academic international talk shop that flourished in the 1960s. In the world according to Bellagio, the problem of choosing an international monetary regime could be summarized as the effort to achieve Adjustment, Confidence, and Liquidity. Exactly what these terms mean is somewhat in the eye of the beholder; but my version goes as follows. Adjustment means the ability to pursue macroeconomic stabilization policies – to fight the business cycle. Confidence means the ability to protect exchange rates from destabilizing speculation, including currency crises. Liquidity basically means short-term capital mobility, both to finance trade and to allow temporary trade imbalances.

    No looking at what has been going on with the IMF over the weekend, I have to say these words continue to ring extraordinarily true, especially the bit about “euphemisms, evasions, and well-meaning but ineffectual gestures”

    Now I say that Portugal isn’t Iceland, but why is this important? Well in terms of the Bellagio catechism cited by Krugman – with the trade-off between Adjustment, Confidence, and Liquidity – we could make the following comparison:

    we could say that the euro has brought Portugal an excess of confidence, an excess of liquidity and a severe lack of adjustment capacity.

    Obviously this is the exact polar opposite of Iceland which now has a lack of confidence, a shortage of liquidity and bags of spare capacity to adjust.

    Possibly wise people in Portugal are now seeing the advantages in being a small island, built on volcanic rock, and stuck out in the middle of the Atlantic.

    So what is left for Portugal? Well obviously what the OECD suggests, as Claus explains:

    “OECD highlights this issue by pointing out that the only macroeconomic tool at Portugal’s disposel is to keep wages from rising to increase its relative productivity”

    Actually perhaps this doesn’t go far enough, as what we are talking about here is a similtaneous reduction in government spending (to correct the deficit) and a *reduction* in real wages, which, if the ECB is in any way succesful in maintaining inflation low in the eurozone, will be all too evident to those who experience it.

    This package has a name: deflation. And it looks like Portugal is now facing several years of economic pain, hardship, low growth and (inevitably, since people won’t simply take all this lying down) political strife.

    Really, this hardly seems to be the diplomatic time to be asking, was all this a good idea in the first place? Sometimes, as I say above, being a chunk of volcanic rock out in the middle of a large Ocean has its advantages.

  2. I don’t think one can really compare Iceland with Portugal

    Iceland is a raw material exporter (fish and energy in the form of aluminium) Portugal isn’t which makes a devaluation for Iceland much easier as export prices remain more sticky for raw materials.

    Average income in Iceland is also much higher than Portugal so they don’t have to fear that their population will move to a richer part of the EU. And i use the word move and not emigrate because the type of jobs that are now open for Portuguese in EU countries are much wider and higher pay/status than traditional emigrant jobs

  3. “I don’t think one can really compare Iceland with Portugal”

    OK, so what do you suggest they should do, since they are evidently in a double bind.

    “Average income in Iceland is also much higher than Portugal so they don’t have to fear that their population will move to a richer part of the EU”

    Ok, but the principal solution being mentioned is to reduce average incomes further (deflation) to make Portugese products more competitive, so this would only make that situation worse.

    If you don’t think you can compare Portugal with Iceland (it was really just the small country comparison I was making), what about Argentina? They were fairly poor, and got into the debt and deflation negative spiral because of a too high currency peg. Do you think these two are comparable?

    My point is structural, that Portugal has too much liquidity, too much international confidence (due to the ECB guarantee), too little real incentive to reform, and too little control over its own economic affairs to allow it to adjust. Meantime, the Czech Republic, which is also poor, but has none of the liabilities which Portugal is saddled with, seems to be doing just fine at the moment.

    The real question is whether all of this is subject to rational investigation or not.

  4. Portugal should follow the Irish lead. Both are former English colonies (Portugal unofficial) on the edge of Europe with the same size (around 5 million) were everybody speaks English (TV is subtitled). So the solution to Portugal’s problem is to be an English speaking tax haven. They have the added bonus of also being a tax haven for Brazil so success is a certainty.

    Wage reduction is not a way out because it would lead to population decrease (i think you can better explain why that is bad) while the wages will still be uncompetitive with Poland.

    Iceland got into debt because it [b]invested[/b] an ungodly amount off money. An investment that makes from a business perspective a lot of sense

    Argentina population is three times larger. Has the highest wages in comparison with its neighbours. Has a large raw materials export and structurally taxed to little. They have nothing in common outside their British-ness.

    Czech is in the center of Europe, a few hours drive from Munich, while Portugal is on the outer edge of Europe.

  5. What was the average interest Portugal paid before it the euro and after?

    Further, what was the total interest payment Portugal made befor the euro and today? And how does that relate to GDP?

  6. “What was the average interest Portugal paid before it the euro and after?”

    I don’t know off hand, but I think this is the point. Certainly it was much higher than today. Much, much higher. The debt load (in terms of the total volume of interest payments, or these as a proportion of GDP) may in fact not have changed anything like as much. But obviously having cheaper interest rates than you can justify in your own right is a double edged sword, and certainly, as we can see, doesn’t induce the structural reforms that these economies need. And of course, if rates were ever to rise substantially, Portugal would have a huge problem servicing all that debt.

  7. In other words, Portugal (and Italy, …) wanted in on the euro because of the easy and cheap credit that comes with being a hard currency country.
    What they didn’t want/expect were the demands on hard currency countries:
    Keep inflation down or you will lose competitiveness and don’t borrow as much as others are willing to lend to you because you will have to pay it back in hard currency.

    They entered a monetary union, but did not adjust their policies to that, partially because there is no incentive from financial markets to do so (until your debt is rated below A-, then you’re screwed).

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