Portugal political crisis rooted in drastic economic measures

By Luís Aguiar-Conraria, University of Minho
This article was originally published at The Conversation. Read the original article.

The current political crisis in Portugal has surprised both local economists who know little about politics and international analysts who are ill-informed about the Portuguese economy.

In May, I had the chance to have dinner with the vice-president of a European central bank. He was quite surprised when I told him that austerity was not working in Portugal. All the information he had suggested otherwise.

On Thursday Mario Draghi, the president of the European Central Bank (ECB), declared: “The results that have been achieved [by Portugal] have been quite significant and remarkable, if not outstanding.” Unfortunately, most of this is propaganda. At best, it is only partially true.

Well known problems

Portugal’s main macroeconomic problems are well known: high debt, both private and public, combined with a chronic trade deficit and mediocre GDP growth since 2000.

The country was gradually trying to deal with these problems when the financial crisis and the following economic recession hit Europe. This quickly became a sovereign debt crisis, forcing the Portuguese government to ask for external financial assistance in April 2011. The €78 billion EU and IMF bailout duly happened, but it came with austerity requirements: improve the budget deficit by reducing spending and increasing tax revenues.

There have been some improvements over the past two years: total government spending has decreased substantially, families save more, private firms have less debt and the trade deficit has largely disappeared. But these triumphs were achieved at the cost of a huge recession. The budget deficit to GDP ratio remained almost unaffected and the public debt to GDP ratio dramatically increased.

How to start a recession

Let me provide some numbers. In 2011 — after removing the effect of one-off measures — the budget deficit in Portugal was 7%. The following year, the government raised several taxes and reduced pensions and public wages by the equivalent of two months' income. In the case of public employees, this was already a second reduction.

As a result, the economy went in to recession. Unemployment rose to the unprecedented level of 18%, which forced an increase in spending on unemployment benefits. Tax revenues dropped. The budget deficit did fall, to 6.4%, but not by nearly as much as hoped for.

When reviewing this year’s budget, Portugal’s Constitutional Court ruled that wage and pension cuts for public employees and retirees were unconstitutional, and the cuts were partially offset. At the same time, there was a brutal increase in taxes.

The numbers for the first trimester of 2013 are out: the budget deficit was 8.8% of GDP. The troika – the ECB, the European Commission and the International Monetary Fund – has already relaxed Portugal’s deficit targets twice and will have to do so again.

Demands for more cuts

In sum, it is true that all of the policy measures agreed with the troika, ranging from labour market reforms to spending cuts, were satisfied. Unfortunately, as the recessionary impacts of austerity were severely underestimated, Portugal fell short of the final targets. Instead of acknowledging that the programme failed, the troika demands that the government slashes spending by an additional €4 billion euros (about 5% of public spending).

It is politically impossible to implement such drastic additional cuts. This a country whose GDP has decreased to pre-millennium levels, where unemployment is at an all-time high, and where one half of the jobless are already excluded from unemployment benefits.

There are smoother and more effective alternatives. For example, freezing total government spending for a couple of years (with 2.5% inflation) would amount to a reduction in real spending of 5%.

From economics to politics

All this was fertile ground for the recent political crisis that has seen two major resignations thus far, leaving the government on the verge of collapse.

Economists are often quite oblivious about the political consequences of their policy recommendations. Teams who negotiate bailout agreements should include political scientists, who can assess the political feasibility of what is being agreed upon. A political scientist would know that Portuguese democracy is still young, and that all seven coalition governments the country has had so far fell before the end of their mandate.

On a positive note, in spite of the turmoil, the political system in Portugal is still working. All polls indicate that institutional parties should have no difficulties in forming a government at the next elections.

There may be a way out of this mess. Unlike Portugal, Spain and Italy both benefit from a European Central Bank programme known as Outright Monetary Transactions (OMT), under which the bank purchases sovereign bonds to lower a country’s borrowing costs.

It is not clear whether the economic situation is worse in Portugal than it is in Spain or Italy. What is obvious is that these other countries have more bargaining power, which allows them to receive support from the EU without having to engage in official external financial assistance, with all the strings that comes attached to.

If in the future this kind of support were extended to Portugal, the needed adjustment may become less harsh.

Luís Aguiar-Conraria does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.