Crisis, by João Firmino

Let me dedicate my first post on this blog to the most Portuguese pressing matter in current times: the crisis. During the last 5 years or so we have employed this word to describe the macroeconomic imbalance of the Portuguese economy.

This, in my perspective (which this post is all about) was ignited by a first exogenous shock called the subprime crisis. Shortly, this shock in the American banking system caused an international disruption of many observables, namely credit and trade, through the economic linkages built during the Great Moderation. But it also led to the disruption of a critical unobservable: confidence. The shut-down of the interbank credit market, after the subprime crisis in America, is a good example of it: worldwide bankers, for a moment, lost all confidence between them and turned to the system security valve: the Central Banks. Either in America or in the Euro Area the respective Central Bank operated a “balance sheet revolution” where loads of money where directed to rebalance the banks’ balance sheets (will this create a liquidity trap, possibly ending in a financial burst? we’ll see…).

On the fiscal side the reaction was to go expansionary. Portugal saw a slight decrease in VAT in 2009 and an increase in public expenditure (we all remember the plan of reconstructing dozens of primary and secondary schools across the country). And indeed the economy recovered somewhat shortly after (see the growth peak started in 2010).

graph joao firmino

Sadly, the 2010 growth peak turned negative again around 2011 which remained so until now. These last two years have been coined as the sovereign debt crisis. This second crisis is intrinsically correlated with the first one, at least, in two ways. First, the classic response of the fiscal policy to go expansionary as a mean to counterweight the decrease of private sector aggregate demand (either domestic and external) led to a worrying explosive debt-to-GDP dynamic, which, per se, increases the chance of default of the Portuguese Government public debt (as perceived in the markets…). Of course markets’ perception of the default chance was inflated by the striking evidence that the Portuguese growth path was a trending-declining one (the above graph clearly shows a negative linear trend in growth since 1996 up to 2011). The second correlation channel with the first crisis is confidence. It is my believe that the subprime crisis not only ended the Great Moderation as it has also debuted the Great Uncertainty period. It is not that hard to concede that the main global financial institutions when assessing the risks of investing in a given sovereign bond they now incorporate the “learned lessons” from the subprime crisis, namely to not take as safe some financial assets as they usually did. In the end, the subprime crisis ignited the expansionary response of the Portuguese Government in a context of anemic structural growth and, in the other hand, it drove the markets from excessive moderation (only this can explain the subprime adventure) to excessive anxiety (only this can explain why Portugal has been in the top 10 most perceived  likely country to default, along with countries which face civil wars, no rule of law and other excruciating phenomena which is not, at all, the case of Portugal).

We all know what followed: panicking markets led Portuguese bond yield curve to invert (almost predicating the end of the world in the very short-run), hence the troika intervention. Shortly after, the devised policies by the Government\troika were put in action leading the country to experience one of the harshest recessions of recent history with the unemployment rate sky rocketing side by side. Those policies aimed to “adjust” the Portuguese economy to tackle the structural negative trend noted above, but through a rather weird mix of short-term and long-term policies, highly contradictory. My point of view is that the Government\troika program had two main goals: 1) correct the “structural” economy, i.e. invert the long-term decline trend in GDP growth; 2) control the public debt dynamic, i.e. avoid default in the process. Some policies seemed to go the right direction: control of rent-seeking contracts (PPPs), effort to make the transportation state-owned companies less of a burden, the cost rationalization of the National Healthcare System and the privatizations done to attract foreign capital. What is incredible, in my opinion, is the set of measures that sent us to a negative spiral of recession: the cut of disposable income (either through increased taxation – VAT, income tax… and the cut of wages, namely in the public sector). Not have these measures only created economic contraction in the short-term, as it also endangered the public debt control as well as the structural economy correction. Especially when they are set up in an economy where the majority of agents are current disposable income-dependent (call them rule of thumb consumers) and the measures are itself uncertain toward the future.  And by uncertain toward the future I mean in the sense that when announced by the Government we all get the feeling that much worse measures will come in the future. Now, this sense of harsher future coupled with indefinite harsher future (which are two completely different things) produces a cumulative effect on consumers’ perceived permanent income which in turn contributes even more to decrease domestic private demand (about two thirds of aggregate demand). Summing up, the “consolidation” measures are killing aggregate private demand, either through squeezing rule of thumb consumers or through building up fear toward the future to those other consumers that were not that dependent of current lower disposable income (i.e. they could have not decreased so much their demand if they believed that their incomes would be decreasing in a predictable way). This over increased contraction in private demand, coupled with the tightening of public expenditure and with the not so much relevant increase in exports explains the spiral recession we currently live in, where the consolidation measures produce less economic activity, less taxation, more unemployment and increased social benefits expenditures (all in the opposite direction of the so desired consolidation), which in the end may jeopardize the benefits of the structural reforms as these are not felt given the dimension of the short term contraction. And we know that structural reforms that take, by definition, longer periods to be felt, may fade away as public opinions press policy makers to go other, shorter term, directions because “in the long run we are all dead”.

What can we do then to overcome the Crisis (mix of different crisis as explained above)? This is the logic question that follows after the story I presented to you and the one that finalizes the post. Well, firstly, let us do a State Budget not for one single year, but for the remaining period of adjustment. This could prevent the uncertainty regarding the short term future path of incomes, thus avoiding excessive demand contraction out of pure fear of that uncertain future rather than sounder economic reasons. By the way, this should be accompanied with Constitutional Court advising (cheaper than contracting some private lawyer office) to avoid the time consuming Constitutional checking process, which in my opinion is used for political blackmailing purposes between many of the current political actors.

Let us tie the interest payments on the troika loans to the evolution of the economy. For example indexing such payments to a given threshold positive growth of exports and of GDP. This could alleviate the short term harshness of the consolidation measures (as negative rates of growth would imply no interest payments), hence increasing the probability that the structural reforms are socially doable. This could be a naïve proposal if not for my believe that the main mandate of the troika program is to consolidate the public debt through structural reforms, from which follows that for the best interest of troika’s program success is then the rapid change of economic performance of Portugal which can only be threatened and delayed by such rigid interest payments obligations.

Finally, let us promote what can be called the internal devaluation. In face of the fact that we cannot devaluate our own currency to foster net exports, we can try to do so by rearranging the taxes that we (still) control. For example let us benefit those firms that invest in new capacity or hire new workers with long-term contracts with a lower social security contribution or a lower income tax. This could be compensated by increasing some green-taxes or financial transactions’ taxes. This way we would be promoting durable factor absorption (either labor or capital) and making the total operating costs lower, thus allowing the firms to price-compete in the international markets.

Of course the set of measures that I present here should not be seen as strictly-to-be-followed polices, but as ideas to be discussed. What I believe as being fundamental is to regain confidence in two fronts: 1) domestically, by coming up with policies that deliver a credible way to correct the structural problems of our economy and 2) externally, to make us to be regarded as able to pay our debts (which we all want to do…right?).

About the author, João Firmino is a first year student of the Research Masters in Economics at Nova SBE. He holds a BSc. in Economics and a BSc. in Management. His areas of interest include Growth Economics, Short-term Macroeconomic Fluctuations, Public Economics, Economic History and History of Economic Thought.



  1. each time i used to read smaller content which as well clear their motive, and that is also happening with this article which
    I am reading at this place.

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