The severity of the current Portuguese crisis results from a mixture of internal and external factors. After an initial boost in the second half of the 1980s fuelled by EU membership and some significant market-oriented internal reforms, Portugal gradually became dependent on EU financial transfers and the easy money provided by decreasing interest rates. The combination of a political and intellectual climate of strong opposition to market oriented policies with the rent-seeking opportunities provided by EU integration proved to be a lethal combination for the Portuguese economy.
In this context, the new centre-right Portuguese government faces a tremendous – some would say overwhelming - challenge. So far, the most prominent measure has been the announcement of a new tax increase on income, which will take the form of an extraordinary one-off tax of 50% on the extra one month’s salary workers receive as a December bonus. The new government has also announced its intention to accelerate the privatisation programme and the end of ‘golden shares’ in several major utilities companies. Most of the public spending cuts announced so far have been largely symbolic, so expectations are naturally high in this regard.
Even though the tax increase was not totally surprising given the very difficult context, it was very disappointing since it fails to invert the previous path of trying to consolidate the budget by capturing more and more receipts from the economy. If Portugal is to improve its situation the focus needs to shift quickly to real and immediate reductions in public spending. Simultaneously, the country needs to greatly improve its competitiveness and that can only be done through policies that promote greater economic freedom. Portugal’s rankings in the economic freedom indexes suggest there is great room for improvement in this regard.
The recent downgrades by rating agencies have not helped but their importance is overestimated since ratings have tended to follow the markets rather than lead them. In Portugal’s case, the downgrade also has little short term effect given that the country is for the most part out of the debt market and the ECB will apparently continue to accept Portuguese debt as collateral. In any case, the general backlash against rating agencies should be regarded as a very bad sign because it looks like national governments and European institutions are targeting them as a scapegoat for their own failings.
It is true that conflicts of interest exist in the operation of rating agencies and that the market is concentrated, but the current oligopoly of rating agencies is itself largely a consequence of the regulatory framework. And creating new national or European public rating organisations will greatly increase conflicts of interest, rather than reduce them.
More important for the viability of the euro is the news coming from Spain, which also faces rising interest rates and increased distrust from international creditors. Portugal’s Iberian neighbour presently has somewhat stronger macroeconomic fundamentals and also better growth potential when compared to Portugal. However, Spain also had a much greater real estate bubble and faces a tremendous unemployment problem. Furthermore, given the size of the Spanish economy, it may simply prove too big to bailout.
In this scenario, the increasing political pressures on the ECB to pursue a more expansive monetary policy are the greatest threat to the eurozone. The political temptation to finance public spending through debt monetisation is always strong and it will increase even further if the trend for centralisation of economic policy at the EU level continues.
If the situation does not start to improve rapidly, particularly in terms of budget consolidation, the only alternative to further centralisation may well be abandoning the euro. Leaving the euro would make it easier for the Portuguese and Spanish governments to solve their budget problems through currency devaluation. However, in addition to almost certainly leading to a default on debt denominated in euros, this would also imply a brutal cost for the population and the social situation in the country would deteriorate.
At the European level, having more monetary competition (which doesn’t necessarily mean abandoning the euro) and less policy centralisation would be preferable, but in the present context the desire to be in the eurozone continues to have some important positive influences in terms of policy making for countries such as Portugal and Spain. This is, of course, a very risky bet in the context of a single currency, since it assumes that the ECB will be able to maintain a relatively sound monetary policy despite all the political pressures to do otherwise. For Portugal and Spain, the scenario of staying in the monetary union is far from bright but the consequences of abandoning it could conceivably be even worse.
This text is adapted from an interview given by the author to Ángel Martín. The full interview (in Spanish) can be read here.