Portugal will follow Greece and Ireland to failure

By Desmond Lachman

Published: March 31 2011 12:20


Oscar Wilde famously wrote that to lose one parent may be regarded as a misfortune; but to lose both looks like carelessness. One has to wonder what he might have said about the International Monetary Fund and the European Union. For after effectively losing Greece and Ireland through the standard prescription of draconian fiscal tightening, the IMF and EU look set to lose yet a third country, Portugal.


Indeed, they appear set to do so by prescribing for Portugal the same failed policy approach of savage fiscal retrenchment in the most rigid of fixed exchange rate systems that has had such dismal results to date in Greece and Ireland.


For all of its differences from the Greek and the Irish economies, Portugal shares two common characteristics with those countries. The first is that its public finances are on an unsustainable path as reflected in a public debt to gross domestic product ratio of around 80 per cent, an overall budget deficit of 8 per cent of gross domestic product, and a highly sclerotic economy.


The second is that it suffers from acute balance of payments weaknesses that have been importantly associated with a substantial loss in international competitiveness. Over the past decade, Portugal’s external current account deficit has averaged around 10 per cent of GDP as a result of which its gross external debt has risen to a staggering 230 per cent of GDP.


In recent months, the market has increasingly come to focus on Portugal’s acute economic vulnerabilities making it very difficult for the Portuguese government and banks to fund themselves in the market. Yet despite this market pressure, the Portuguese government has been loath to approach the IMF for financial support.


An understandable reason for this reluctance has been how little the IMF-EU support programmes have done to reduce market interest rates for Greece and Ireland. Indeed, by the end of March 2011, interest rates on Greek and Irish sovereign bonds remained very close to their all-time highs despite the massive IMF-EU financial support packages.


The high interest rates on Greek and Irish sovereign debt imply that the market regards these countries to be insolvent and continues to assign a high probability to these countries’ defaulting. They also imply the continuation of domestic credit crunches in Greece and Ireland that must be expected to exacerbate the adverse effects of sustained severe fiscal retrenchment on these countries’ economic growth prospects.


At the heart of the market’s doubts about Greek and Irish public debt sustainability is a deep scepticism about these countries’ ability to grow their way out of their public finance problems. This is particularly the case considering that continued euro membership precludes these countries from devaluing their currencies to boost exports at a time when deep and sustained fiscal retrenchment is undermining domestic demand.


Since embarking on its fiscal austerity program roughly two years ago, the Irish economy has contracted by over 11 per cent. Meanwhile, between the fourth quarters of 2009 and 2010, Greece’s economy declined by 6.5 per cent and by year-end retail sales were down by around 20 per cent from a year earlier. Even more alarming has been the collapse of Greek tax revenue collections.


The IMF and EU seem oblivious to the literal collapse of the Greek and Irish economies. Instead, as a prelude to an IMF-EU bailout, once the yet to be scheduled Portuguese parliamentary elections are out of the way, the EU is foisting on Portugal draconian fiscal retrenchment. The central component of that retrenchment is to be as much as 5.3 percentage points of GDP in public spending cuts and tax increases within the remainder of calendar 2011. And this retrenchment is to occur at the very time when the country is already experiencing the severest of domestic credit crunches.


One has to wonder how much deeper the economic recessions in Greece, Ireland, and Portugal will have to become for the IMF and the EU to recognize that the countries in the periphery suffer from solvency rather than liquidity problems, that are not amenable to correction by fiscal retrenchment alone in a fixed exchange rate system.


The risk is that, before they do, the electorates in Greece, Ireland, and Portugal will revolt against seemingly endless economic hardship to which they are being subjected for the sake of keeping them current on their debt obligations to foreign financial institutions.


The writer is resident fellow at the American Enterprise Institute


Copyright The Financial Times Limited 2011.