The fiscal crisis in Portugal continues

Visitors walk past restaurants on “Pink Street,” a commercial thoroughfare along Rua Nova do Carvalho, in Lisbon, Portgual.  Photo: Bloomberg.
Visitors walk past restaurants on “Pink Street,” a commercial thoroughfare along Rua Nova do Carvalho, in Lisbon, Portgual. Photo: Bloomberg.

The fiscal crisis in Portugal is not over. The structural problems that led to the current situation are likely to remain in place for another generation. They are both economic and political, and without solving them the problem will not end.

First the numbers. The lowest public deficit since 1995 was 3 percent of GDP in 1999 and 2007, while the average from 1995 to 2014 was 5.3 percent of GDP. GDP growth has, on the other hand, been robustly low. From 1991 to 2014 the average growth rate of GDP per capita was 1.13 percent. These two forces generated a rising stock of public debt. In the year 2000 it stood at 50 percent of GDP; 67 percent in 2005; 96 percent in 2010; and around 130 percent of GDP now. Large debt loads are not an issue when interest rates are low. However, one does not really expect rates to stay low forever.

A long term specialization in construction and the access to finance at low interest rates resulted in high debt levels for households and firms, and severe external debt. This did not result in a house price bubble as in other countries, but rather in an increase in the quantity of housing.

One root of this particular outcome can be traced back to the post-revolutionary period of the 1970s, when rents were frozen in a high-inflation environment, and tenant protection was significantly increased. This killed the rental market. The all too common sight of decaying and almost empty historical buildings is a direct result of these laws. Not only that, it made the population immobile with respect to the labor market. Changing housing market laws has been next to impossible ever since, given that tenants vastly outnumber landlords.

A less visible root lies with land use laws. These are for the most part at the discretion of local government and collusion between local politicians and construction interests resulted in wasteful investments and appropriation of rents. This would not have occurred if capital gains from changes in land use were public property, leaving capital gains which do not arise from a political change in land use as private property. They are not hard to disentangle but somehow this issue remains absent from the political debate.

This over-investment in construction did not just create an external balance problem. Before the financial crisis construction absorbed an inefficiently high share of available finance. This created fragility in the banking sector as credit allocation favored high-risk firms and investments. And when the banking sector has a problem, the tax payer has a problem. The recent collapse of several banks in Portugal is a stark witness to this truth. This perverse allocation of credit has only recently been reversed.

The next factor contributing to the fiscal crisis is low productivity. Portugal was the last European country to rise out of illiteracy, and in fact it has not quite done so yet. In 2014 Portugal had only 43 percent of the population aged 24 to 65 with a high school degree, compared to the EU28 average of 76 percent.1 In 1992 this fraction was only 20 percent in Portugal. The necessary expansion of the school system after 1974 required a fast increase in the numbers of teachers. A low quality teaching staff emerged which contributed to low quality education. Vested interests protecting teachers rather than students have made it extremely hard to address this issue and make for a political minefield. We are a generation away from having a properly qualified labor force to face the challenges of a globalized economy. And when we do, they will still be immobile within the country if the housing laws do not change sufficiently.

Next up, the labor market. Recently, young people have been leaving the country straight after university. They find work abroad rather than at home partly because of a dual labor market where often only temporary contracts await them. Firms can hire a worker on a temporary contract for a while, but at some point they are forced by law to use a permanent contract with strong employee protection. Unsurprisingly they choose to let the worker go.

Talented workers will always find a job, but the vast numbers of middle and low skill workers that make up the labor force are subject to these perverse incentives of an inefficient labor market.

Since older and less productive workers cannot be fired unless firms close down, and since firing costs are high, new firms face a hiring challenge which discourages the renewal of the productive landscape. An older generation that has lost its jobs in the wake of the crisis is effectively not employable and it will take a decade for most of these ageing workers to finally leave the labor market. Unemployment peaked at 17 percent and has recently dropped to circa 13 percent in part due to the exodus of the young. It will take a decade to get back to single digits.

The age structure of the population and the pension system are also a key challenge. Portugal has one of the lowest fertility rates in the world, and has been well below the replacement rate for 30 years. Whereas in 1960 the average number of children per women in fertile age was 3.16, in 2013 it was 1.21. The positive aspect of this fact is the emancipation of women out of the traditional role of home makers. The negative side occurs because politically motivated and overly generous pay-as-you-go pension commitments have made the pension system unsustainable. And with an ageing population, cutting pensions is a political challenge. Part of the issue is the incompetent way in which the necessary reforms – recalculating existing pensions to their actuarially fair values and increasing the pension age in accordance with improved life expectancy – have been attempted. A significant part of the problem is the large value of pensions self-awarded by politicians. As their pensions do not change, it is politically very hard to change the others.

Tourists wait to board the No. 28 tram in Lisbon.  Photo: Bloomberg.
Tourists wait to board the No. 28 tram in Lisbon. Photo: Bloomberg.

At the top of the mountain we have governance. Corporate governance is absent. Recently, after running his BES banking group into the ground, Ricardo Salgado has been awarded an annual pension of around 1 million euros. Public governance is worse. Despite plenty of evidence that former Prime Minister Jose Socrates received large amounts of cash from a friend, who by coincidence was awarded large contracts when Socrates himself was in power, it remains extremely uncertain whether it will be possible to convict him of any wrongdoing. Actions which would lead to the end of public life in Denmark are perpetrated with total impunity in Portugal. A not-so-distant episode neatly summarizes the decay in public life. The Parliament, in one of its many window dressing actions, issued a rule that its members with more than a given number of absences without any justification would lose their seat. When a journalist uncovered dozens of Parliament members in that situation, the head of the Parliament at the time, Almeida Santos, played down the regulation and no one lost a seat.

Where will Portugal go from here? Amidst all the chaos, the private sector has been slowly restructuring. Households, firms and government have all undertaken a painful process of deleveraging, which will require another generation. People left the country, firms closed down, new firms are starting, and in the summer of 2015 there were pervasive signs of recovery. In fact, at a different scale, the situation resembles that of Greece before Syriza took power. The bottom has been reached and we are slowly coming out of it. We must now wait to see whether the Portuguese left will throw the country into a new and deeper bottom just like we saw happen in Greece.

With the political left turn ahead, the labor and housing markets will remain an important source of rigidity. The local anti-austerity faction has now come into the mainstream.

However, as Greece as shown, putting your foot down at the negotiating table will result in financial disaster. Public investment is unlikely to work in the best of environments, and in Portugal it is a recipe for disaster. Economics agents should undertake projects only if their return justifies it relative to the market interest rate. Alas, a zero rate is no shelter for Portuguese governments given their proven ability to spend money on projects with visible negative returns. Not only that. As the great Peter Drucker said, what gets measured gets managed. When nothing is measured what is left is empty political rhetoric. And in the Portuguese government, very little gets measured. Borrowing from Tony Blair, Portuguese politicians are masters of the non-falsifiable: “I was convinced these projects had a positive rate of return.”

The basic pillars of good governance, measurement and accountability, are sorely lacking. As I write this, the future is uncertain. Portugal will remain at the knife edge of low growth and high rent seeking for another generation. Those who have the opportunity to do so will leave the country in search of a better life and a pension at retirement age, as indeed many have done in the last few years. Most will find it and never return.



1 Pordata: Retrato de Portugal na Europa, 2015.