This is a study on the origins of the crisis of the Portuguese economy by Ricardo Reis of Columbia University worth reading, published in March 2013. Reis-Slump-Crash

Reis explains the slump in the Portuguese economy from 2000 to 2007 as a result of two shocks: (i) large capital inflows that followed the entry of Portugal into the Euro zone with the “underdeveloped” financial markets of the Portuguese economy, and (ii) the increase in taxes due to past commitments to old-age pensioners. He dismisses three other causes sometimes given for the slump: (a) trade shocks associated with the expansion of China, (b) discretionary state spending in goods and services, and (iii) labor market rigidity.

In our view, there was a boom after the entry of Portugal to the EU with large capital inflows that fuelled housing and general credit boom starting with the accession to the EU (1986), and ending in 2000. A model that captures the boom was built by Fagan and Gaspar (see footnote 2). The boom was also fed by large expenditures taken or sponsored by the state. All indebtedness levels increased dramatically in 1986-2000. The stop of the real estate boom and the high level of household level led to a stagnation in consumption and house investment after 2000. The slump was seriously aggravated by a massive misallocation in the continuing capital inflows channeled to nontrabales with low productivity (construction of infrastructure and other state sponsored expenditures as well as retail and wholesale trade). Why? The main reason was that they were sheltered from international competition, regulated with secured high margins or the loans were guaranteed by the state (zero weight in the solvability ratio of banks). The sudden stop that started with Greece and then extended to Ireland and Portugal was a result of the heightened awareness by investors of the levels of indebtedness in these economies and the threat that they would not be able to pay their debts.

Our main criticism of the paper is that the periodization that Reis adopts is arbitrary, and to better comprehend what really happened in the country we should extend the analysis at least to the 1990s. In this case, the traditional model of boom and slump of large capital inflows explains most of the facts. Presenting rates of change of several indicators starting in 2000 without a judgment about its levels can lead to erroneous interpretations.

Another common mistake is to say that there was no housing boom in Portugal. Using AMECO data, Spain had a boom in 1999 to 2008 with the accumulated investment in dwellings over GDP of 77%, Ireland had a boom in 1998 to 2008 with 113%, and Portugal had a boom in 1987 to 1999 with 89%. In all cases the investment ratio collapsed after the boom to levels below the pre-boom numbers. Most commentators use house prices to document the cycle, but there are no reliable price statistics to follow these phenomena, at least for Portugal. When the house construction boom stopped in Portugal there were about 400 thousand houses unoccupied (for a 10 million population).

Reis builds a model with two sectors: tradables and nontradables. Credit is allocated to the nontradables sector through the banking sector that collects funds domestically and abroad and allocates them subject to collateral constraints, typical of a financial frictions model. Because capital is misallocated and taxes increase, the exchange rate appreciates and the nontradables sector expands with the economy slumping. Otherwise there would be a boom like in Ireland and Italy.

Capital inflows resulted from the reduction in the risk premium to the economy. The large inflows from North to South Europe (plus Ireland) were a Euro phenomenon, not specific to Portugal. The differentiation of risk across Euro countries is yet not well understood. A number of policy makers from these countries continue to insist that interest rates for all Euro countries should be the same (common currency area). If short term interest rates in money markets should be similar, credit rates should reflect the risk and liquidity associated with each debtor. Thus, a government bond of a high debt state should have a higher risk premium. The inverse that prevailed from around 1997 to 2008 is abnormal.

The author proposes some evidence, based on TFP estimates of the KLEMS data base, that there was misallocation of resources because the sectors that expanded (community services, real estate and wholesale and retail trade) had the largest decrease in TFP and rising markups. But all sectors show a decrease in TFP: the misallocation was more widespread. E.g. the high rents in energy and telecommunications was documented by the Portuguese Competition Authority. Our book “Economia Portuguesa” gives evidence of the extremely low rates of return of the PPPs.

Both in Greece (with the Olympics of 2004)[1] and Portugal (with the World Expo of 1998 and Euro soccer championship of 2004) there were also large public expenditures with evidence of high costs and low returns. See “Economia Portuguesa” (chapter 11) for evidence.

The role attributed to tax increase seems overplayed since the ratio of taxes over GDP only increased by 1.7% in 2000-2007. It also looks overplayed the increase in 3.3% of the pensions of old-age. More important was the increase in discretionary spending through the public enterprises and infrastructure construction (Mateus A., Boom and a Long Slump in a Small Economy of the Euro Zone: the Portuguese case, 2012[2]). The author refers “en passant” the role of PPPs saying that the impact on public debt will come in the future. But here we study real economy impacts (not financial flows) and the impact of these investments was high. The numbers in this table are difficult to ignore (from Mateus above):

Table 4: Total Public Investment (GFCF in percent GDP)

Source: INE, National Accounts and author’s estimates

On labor market rigidity the author argues that the marginal worker affected by the slump is a fixed-term contract which is quite flexible. According to Reis, the permanent contracts of the average worker are substantially rigid but they contribute to the (level!) of low productivity of labor force in the country. However, the contribution of this factor vis-à-vis others like the low level of human capital needs to be investigated.

The literature on sudden stops of capital inflows explain a boom in consumption followed by a crash, but the country did not have a consumption boom in the 2000-2007 period. AS we documented above, both levels of consumption and construction in housing (particularly stock of houses) were quite high in the starting year, thus, the increases afterwards were modest. From 1986 (date of entry to the EU) to 2000 private consumption increased at an average annual rate of 7% compared with 1.4% in the 2001-2007 period. Similarly, public consumption also increased much faster in that period (4.3% against 1.4% in the 2001-2007). The large investment in housing was fuelled by the large increase in household indebtedness (debt over disposable income increased 4.2 times to 77%, and further to 114% in 2010).[3] In fact, it was common for Central Bank and governments of the late 1990s up to the crisis to dismiss the existence of any disequilibria saying that that indebtedness had a counterbalance in the raising assets of households and that external deficits did not matter in the context of the Euro area. We think that a better story is the traditional boom slump model, with a long delayed bust (should the sudden stop not have happened already at the beginning of the 21^st century?) and the sudden stop was delayed to after the global crisis of 2007-2009, like in the other Euro crisis countries.

There are systemic and idiosyncratic factors for the Euro and Portuguese crisis. Reis models some specific factors that contributed to the slump. It is particularly interesting in Reis model that the low net worth of Portuguese firms deepened the slump. Similarly, it would be an increase in net worth that would lead the country out of the crisis. The same would need to happen in the household sector. The problem is how net worth will increase since it is clearly an endogenous variable.

The existence of a large mass of inefficient firms in operation in all sectors of the economy and the financial constraint on other small and medium enterprises that operate below the optimal scale because of lack of collateral for borrowing is attributed to underdeveloped capital markets. These characteristics of the Portuguese statistical distributions of enterprises are well known, but we think that the reasons for these distributions are also due to lack of labor and capital mobility, as well as typical family enterprises in developing economies. We also think that bureaucratic, regulatory and fiscal factors (a la Sotto) linked with informality are crucial to explain those distributions.

Is the credit channel to SMEs really that important to explain the slump? Let us look at the distribution of loans by use. Comparing credit allocation by sectors in 2007 compared with 2000 there was a 10 pp increase in the share of construction and real estate, and 6 pp in manufacturing and 4 pp in trade. It confirms the movement away from tradables, but not for the expanding sectors he identifies. Those movements were even more pronounced if we compare 2010 with 1987 with a decrease of 28 pp in manufacturing and increase of 21 pp in construction and real estate, which is consistent with the housing boom of 1987-2000 magnified with the infrastructure and other public sector expansion in the same period and intensified in 2000-2010.

According to Reis the crux of the matter was that the massive capital inflows in the Euro area were intermediated by the banking sector into inefficient firms in the nontradable sector. But there is even no increase in output and employment in nontradables because the raise in taxes leads to a fall in supply of labor. Is most of the increased in unemployment due to the destruction of firms lacking demand/credit/competitiveness or because workers do not want to work as hard (the supply side effect)? The author distinguishes the Portuguese economy from Greece, Spain and Ireland stating that it has a more undeveloped capital market, an assumption which we question. First, Greece never had an intermediation level similar to Portugal, and Spain had a similar financial system. The Irish market is clearly more developed due to the influence of the City of London and the large presence of multinationals, but instead of searching for some structural factors it can be simply argued that the housing boom was a decade later in the cases of Spain and Ireland, relative to Portugal, and that the expansion of the state sector as well as the state sponsored projects were larger in the case of Greece and Portugal. Moreover, there were also large capital inflows in the 1990s to Portugal, if the same structural characteristics prevailed in the economy, why there was a boom and not a slump?

This is an interesting work that represents a serious work for rationalizing the slump of the Portuguese economy and worth studying in detail. It makes a contribution to the study of capital market imperfections and its macroeconomic impact. But we think that the origins of the crisis in Southern states should be searched in political economy, combined with risk misperception factors that are common to a number of financial crisis (not alone the 2007 global crisis).

Two external factors

Portugal entered the Euro with the first group of countries – the founding members. The exchange rate had been almost fixed since 1994, but the irrevocable rates were determined in about one year previous to the start, although the last rates (rounded to the last digit) were determined in the eve of January 1^st, 1999. These were the years of the peak of the credit and investment boom, culminating in the Expo of 1998. The last priority of the government was to question the exchange rate of entry, although this was a major decision for the country. But there were two clear signs of overvaluation. The first was the climb in unit labor costs since the late 1980s, the second was the increasing current account deficit.[4] According to our estimates we entered with about a 10-15% overvaluation.[5] This was very serious because it was a once for all effect. Reis dismisses this factor in the slump of the first decade of the 21^st century, saying that the economy would have adjusted. However, it is not quite that easy. It is right if we have a fully flexible model with rational expectations. However, there are important rigidities in the product and labor markets well known by economists that will make the adjustment long and generates significant unemployment in the medium term. This adjustment was delayed because of the discretionary investment and current expenditures sponsored or undertaken by the state, plus the continuing capital inflows. Just to refer one rigidity: the collective bargaining of wages that take place still nowadays in large sectors, with a zero bound nominal wage change. Since inflation rates were quite low, it was difficult for real wages to adjust. It is interesting that there were other mechanism at work to adjust the labor market. In the 1990s there was a large influx of illegal emigrants from Eastern Europe (mainly Ukraine and Moldova), and also from Portuguese speaking Africa, probably in the order of tens of thousands, a large part to the construction sector. These flows reverse themselves in 2000-2010 period as labor market conditions deteriorated relative to the originating economies.

Another important factor was the enlargement of the EU to Eastern Europe that coincided with globalization, rise of China in world markets and liberalization of trade in textiles. Reis also dismisses this factor because it affected also other countries that did not have the slump. However, if we believe that there are rigidities in capital and labor markets, capital is immobile in the short to medium term, and it takes time for labor to readapt its skills, then the shock that started in the 1990s would reverberate throughout the 2000-decade. All estimates done of the impact of the enlargement to the East pointed to Portugal as the country that would lose more (See Economia Portuguesa the chapters on integration and spatial economy). One example was the automobile sector. When Ford-Volkswagen signed the contract for building a factory of Auto-Europa in the late 1980s the plans were to produce 400 thousand vehicles. When it started to operate in the 1990s it never went above 150 thousand. I still remember a conversation with the head of the research of the Central Bank of Austria telling me around 1994 that Auto-Europa would be the last automobile factory built in Portugal. Most of the future investment in this sector would take place in the square of Czech Republic, Slovakia and Hungary because of agglomeration economies, proximity to the German markets and availability of skilled labor at low wages. He was right.

What is the relative contribution of the capital inflows, discretionary spending by the state, overvaluation of exchange rates and value chains in FD? It is difficult to disentangle. That is way we need general equilibrium models, preferably dynamic and with some disaggregation, in the footsteps of Reis contribution.

Abel Mateus

April, 21^st, 2014

[1] The Olympic park and staging of the games cost 9 Billion Euros (Bloomberg Business Week, August 2012). A new airport (a PPP with the state and German construction companies) and metro system linking the airport to the city were also built, to a total cost of about 20-30 Billion Euros, equivalent to 10 to 15% of GDP. Greece also carried out a large road construction program: they absorbed about 60% of the structural funds.

[2] Please see some of our papers on the Social Science Research Network (SSRN) at:  http://ssrn.com/author=1223260.

[3] A model capturing the boom was built by Fagan and Gaspar, Adjusting to the Euro Area: Some Issues inspired by the Portuguese Experience, European Central Bank, 2005. See our comments on this paper in Economia Portuguesa, pg 382.

[4] The deficit was dismissed as relevant by the authorities because we were in a currency union, (who bothers about the deficit of Texas or Alabama? Was frequently said by the highest officials) and because changes in statistical methodologies obscured the right numbers.

[5] It is difficult to disentangle the impact of the excess credit growth in that number.