Driving too fast?

“you’re driving too fast…you went straight past the curve and you never go back…driving too fast…the road was a blur and it all turned to black…driving too fast… hang on to the wheel, I think you’re going to crash…” (Rolling Stones)

In the neoclassical growth model developed by Bob Solow and Trevor Swan, one learns that countries that start off with a low level of physical capital (infrastructure, machines, etc) will grow faster than better-endowed countries and eventually catch up, provided they get access to the same technology and share similar features (savings rate, fertility, etc). Convergence within much of ‘Old’ Europe in the last 75 years and, right now, that of ‘New’ Europe with the ‘Old’ (per capita income in the Baltics has grown by 50% since joining the EU four years ago) are illustrations of this. The issue not raised in Solow, however, is whether catching-up too early, too fast can be problematic. In a recent article, the IMF Senior Representative for Central Europe and the Baltics takes the example of Portugal to warn Baltic states to ‘avoid the portuguese trap’: since EU accession in 1986, Portugal enjoyed impressive growth rates until 2000, after which the Portuguese economy has slowed down considerably, without converging to the EU-average per capita income. His argument: “large wage increases, fueled by unrealistic expectations, which exceeded productivity growth and undermined Portugal’s competitiveness.” Olivier Blanchard agrees. So, what happened to Portugal and what are the lessons to be learnt?

TWO PHASES OF THE PORTUGUESE ECONOMY:

Blanchard identifies two phases of the Portuguese economy: 1995-2001 and 2001 onwards.

(1) From 1995-2001, there was a steady decrease in unemployment and a rapidly growing current account deficit [i.e. the deficit of exports over imports]…

The proximate cause was participation in the ERM and in the construction of the euro. With the reduction of inflation, the elimination of country risk, and access to the euro bond market, Portuguese nominal interest rates declined from 16% in 1992 to 4% in 2001; over the same period, real interest rates declined from 6% to roughly 0%.

Combined with expectations that participation in the euro would lead to faster convergence and thus faster growth for Portugal, the result was an increase in both consumption and investment. Household saving dropped, investment increased.

(2) Since 2001, a steady increase in unemployment, and a continuing current account deficit. With low unemployment, nominal wage growth was substantially higher than labor productivity growth, leading to growth in unit labor costs higher than in the rest of the euro area. Starting in the early 2000s, the future turned out to be disappointing:

(i) Higher labor productivity growth did not materialize.

(ii) Lower growth and thus lower import demand should have led to a decrease in the current account deficit. But this was largely offset by a continuing increase in relative labor costs.

In an earlier paper in 2002, Blanchard and Giavazzi suggested that it was natural for Portugal to run a wide current account deficit, in line with the Solow-Swan growth model:

To the extent that they [Greece and Portugal] are countries with higher rates of return, poor countries should see an increase in investment. And to the extent that they are the countries with higher growth prospects, they should also see a decrease in saving. Thus, on both counts, poor countries should run larger current account deficits…wediscuss whether countries such as Portugal and Greece should worry and take measures to reduce their deficits. We conclude that, to a first order, they should not.

But in 2006, Blanchard had a different opinion:

Should the government [of Portugal] have aimed to limit the size of the boom and the size of the current account deficit through tighter fiscal policy? With hindsight, the answer is surely yes.”

STRUCTURAL PROBLEMS:

The comparison between Portugal and Ireland is striking. Ireland, which joined the EU earlier in 1973, still enjoys sustained economic growth and low unemployment rates and has long outpaced the EU average. GDP per capita in Portugal is only 52% of GDP per capita in the top five EU members. Is this yet another example of the triumph of economic liberalism over large, inefficient governments?

It is true that Ireland has succeeded because it has made high school and college education free, made corporate taxes low, simple and transparent, it actively seeks out global companies, it has opened its economy to competition, speaks English and keeps its fiscal house in order. It has used EU aid to increase investment in the education system and physical infrastructure. Portugal, on the other hand, has been spending relatively little on education and R&D (by OECD standards), has high levels of employment protection which induce high unemployment, etc. A McKinsey study in 2005 on the Portuguese economy blames (1) the informal sector for allowing small inefficient firms to survive, and preventing economies of scale from being exploited (2) zoning and licensing rules, limiting the number of large scale developments and hence economies of scale. But, according to this report, two-thirds of these structural factors can be corrected through economic policies (eg. changing labour laws, changing zoning regulations, etc).

These structural factors can explain why Portugal has not converged to EU levels. After all, the Solow-Swan economic growth framework predicts that convergence is absolute only when countries use their resources wisely. On the other hand, the reasons why Portugal slowed down recently could be due to business cycle factors: excessive expectations coupled with the inability to undertake a competitive devaluation because of the use of the Euro. From these factors, not even Ireland may be able to escape as the Irish property market is now showing clear signs of a slump. The Portuguese economy, on the other hand, has shown signs of recovery in 2007 and the Bank of Portugal projects 1.8% GDP growth in 2008 and 1.8% in 2009, close to the EU average.