Will Portugal be first to abandon the euro?

Rafael Pampillón. Professor. Instituto de Empresa

23 December 2003

If present imbalances continue, Spain’s neighbor could be the first country forced to give up the euro. The author suggests ways Portugal can avoid an untimely exit from the Eurozone

The woeful state of Portugal’s economy is striking: high inflation, negative GDP growth, rising unemployment and a hefty external deficit. Since the last devaluation of the escudo, in 1995, prices have risen 9 percent, more than the eurozone average. The reasons are many and varied: from increase in oil prices in 2000 and terrible weather that destroyed harvests in 2001, to the euro’s introduction in 2002 and then forest fires in 2003. But perhaps most important have been soaring production costs (particularly labor costs rising faster than productivity) and a clearly erroneous budgetary policy.

The persistent public deficit has given a markedly expansive character to fiscal policy and heightened inflationary tensions. In March 2002, the center-right won the general elections over the Socialists, ending a two-term period of left-wing government. The major problems they inherited were the public deficit and the external deficit. What’s more, in 2002, the EU activated its early-warning system because Portugal had failed to reduce the public deficit as its government had proposed to that body. Greater inflation means loss of competitiveness, and the Socialists under Antonio Guterres did not take advantage of the more favorable economic situation between 1998 and 2000 to make strides toward budgetary discipline. A shame, for it would have been much easier then than now.

A cooling of the world economy followed the explosion of the technological bubble and the uncertainty generated by the attacks of Sept. 11. These events put the brakes on global economic growth, and Portugal was no exception. Yet, while Spain continued its process of convergence with the euro area, Portugal initiated a sharp deceleration phase that led it to 0.4 percent growth in 2002, far below the meager 0.9 percent registered in the eurozone last year. For 2003, Portugal expects negative growth, while Spain is forecasting growth far above the eurozone average.

What can explain such differences between the two economies? As Alberto Nadal has pointed out in these pages, the answer is found in their budgetary policies. While Spain took advantage of the expansive cycle to get its public accounts in shape, lower taxes, rationalize expenditure and reduce indebtedness, Portugal increased public expenditure and failed to reduce its deficit.

[*D Measures for 2004 *]

Unfortunately, the Portuguese government has proposed inflationary budget measures for 2004, with a 3.8 percent deficit in public accounts, which yields 2.9 percent for public administration as a whole. This means it will just be able to comply with the Stability and Growth Pact criteria. The goal should really be budgetary balance, which is the best way to achieve price stability and boost long-term growth. Corrective measures, no matter how painful, must be carried out on the expenditure side, since there is no longer sufficient margin for increasing revenue from direct taxation, and indirect taxation risks reviving inflationary tensions. This happened in 2002, with the raise in VAT rates.

It is unlikely that Portugal will make substantial progress in its fight against inflation unless it undertakes budgetary consolidation. Controlling inflation is highly important for economic growth: it boosts the competitiveness of firms and accelerates growth, as well as employment, thanks to increased exportation. However, Portuguese inflation has – traditionally – always been above the EU average, In order to compensate this continual loss of competitiveness, successive governments opted for devaluation of the escudo. The problem arises when an inflationary, small, open economy (one facing competition from foreign producers) cannot offset the loss of competitiveness with devaluations, since it no longer has its own currency to devalue. In such a situation, the only way to guarantee economic development and achieve sustained employment growth is through price stability. Otherwise, Portugal shows all the signs of being the first country which will be forced to desert the euro.

Survival of Portugal’s economy within the eurozone depends, to a large degree, on its success in controlling inflation. In the absence of an exchange-rate policy, competitiveness and external balance only prove possible through price stability; and this can be achieved solely by restrictive fiscal policies, boosting competition and structural reforms. The problem is more serious than in the past, since there is no escudo to depreciate. If the government continues adopting expansive budgets, with the consequent inflationary chaos, the only other alternative, if it wishes to regain competitiveness, will be to voluntarily forsake the euro – although, evidently, that would not be a wise road to take.


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