Saturday, 3 November 2012

Why the IMF therapy is not working in Portugal

The IMF repeats in Portugal the ostrich policy of not recognizing what is fundamentally wrong with its adjustment approach in the Euro Area. In its 5th review of the Portuguese program it states that “authorities have made good progress in reducing macroeconomic imbalances … But after a strong start, the program has entered a more challenging phase … a large and durable fiscal gap has emerged due to a shift in the composition of output from domestic demand to less-taxed net-exports”.

Despite the initial Portuguese external disequilibrium being milder than the Greek or Irish, I anticipated that the program was likely to fail because it had been undertaken reluctantly, too late, with too little and it was too soft. Moreover, its management was weak, incompetent and erratic partly because the Troika was desperate to have a success story and it had in Portugal a Finance Minister – Victor Gaspar – that was seen as one of their men. So, all tough measures (e.g. reducing the number of municipalities and monopolistic rents) were abandoned or reversed. For instance, fiscal consolidation which was to be implemented by 2/3 of expenditure cuts and 1/3 of revenue measures failed completely with the expenditure hardly slowing down and the revenue collapsing.

By now the IMF had to agree to extend its program for one more year and to grant some waivers, while it is already busy working on another package that will inevitably result on more time and more money. This will only raise the Portuguese external debt to new heights without any visible improvement in its economic growth.

Just as a reminder, note that the Greek debt path under IMF management, which started in May 2010 with a general government debt equivalent to 115% of GDP and was supposed to peak in 2012 at 149%, at the start of the second IMF bailout in June 2012 had already reached 165% and is expected to peak at 171% in 2014. For comparison, in Greece the total net external debt rose from 87 to 107% of GDP between 2009 and 2012 while in Portugal (external debt, excluding FDI and reserves) rose only from 98 to 99% of GDP. However, the portion owed by the government increased from 64 to 95% of GDP, degenerating into a sovereign debt crisis.

In a recent post we called the current IMF (Troika) adjustment program for Portugal a pyrrhic victory because, when compared to previous programs, it had doubled the cost of external adjustment in terms of output loss. We identified as the main culprit a weak foreign trade multiplier. So, the key question is why isn´t the trade multiplier working now as it did in past programs? As we calculated the multiplier effect by assuming a constant income elasticity of demand for imports the explanation must be accounted for by a sluggish international economic growth and or changes in relative prices (terms of trade).

In fact, the growth of the world economy accounts for a small portion of the reduced multiplier effect, since the OECD was growing at 6% during the first two programs but recently it has been growing at only 4.3%. So, the majority (71%) of the blame for the smaller multiplier effect lies in a weak export performance because of lower price elasticities and adverse changes in the terms of trade. Since recent estimates show that the export price elasticity remains low (0.42) and statistically is not significantly different from zero, the core explanation must lie in the terms of trade.

The Portuguese terms of trade did not deteriorate enough to drive a higher level of economic activity because of an irresponsible fiscal policy of indirect tax increases that caused a futile destruction of businesses in the non-tradable goods sector and the failure to confront the powerful lobbies in the energy and transport sectors that hamper the tradable goods sector. This trend in the terms of trade is clearly visible in the following chart.

The persistence of domestic inflationary forces despite an increase of 3.5 percentage points in the unemployment rate which reached 15.5% can only be the result of market rigidities compounded by fiscal mistakes.

The program of fiscal consolidation was not only inefficient, but foolish and poorly sequenced. Instead of targeting the preservation or a small rise in revenue, through the broadening of the tax base and selective competitive tax cuts, combined with substantial cuts in subsidies and other wasteful forms of spending it did the reverse. In terms of sequencing, instead of beginning with spending cuts, followed by a broadening of the income tax base and cuts in corporate taxes it did the reverse. It raised indirect taxes first at the expense of external competitiveness and is now promising a massive increase in income and corporate taxes for 2013 to be followed by spending cuts in 2014, thus perpetuating unnecessarily the current recession for at least another two years.

In conclusion, the program left untouched all the cancers blocking the growth of the Portuguese economy listed in this blog long ago as being: irresponsible recourse to PPP financing, large rent-seeking privatized monopolies, extensive subsidization of energy, environment, technological and other self-serving mafias, too many, too inefficient and too indebted State enterprises for the exclusive benefit of their managers, unions and bankers, a financial sector who suckles on public financing, the uncontrollable spending of the health and social security sectors, the destruction of a professionally independent public service, dysfunctional fiscal and judicial systems and generalized recourse to off-budget operations and creative accounting. Indeed, it made things worse through mismanagement. So, without changing course, Portugal is condemned to more than a decade of slow growth and unbearable indebtedness and sooner or later it will have to default or ask for debt forgiveness for the first time since 1892.

As a Portuguese I am saddened to see my beloved country ravaged by an incompetent government in collusion with useless international organizations at the mercy of an unholy alliance of heartless Teutonic European mandarins, predatory Chinese and Angolan dictators and dubious Latin American business interests. This is the end result of 80 years of state capitalism in Portugal.

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