The Economy of Portugal and the European Union.pdf

8/10/2019 The Economy of Portugal and the European Union.pdf

1/34

Accepted Manuscript

Title: The Economy of Portugal and the European Union:from High Growth Prospects to the Debt Crisis

Authors: Werner Baer, Daniel A. Dias, Joao B. Duarte

PII: S1062-9769(12)00045-2DOI: doi:10.1016/j.qref.2012.06.002Reference: QUAECO 684

To appear in: The Quarterly Review of Economics and Finance

Received date: 12-4-2012Accepted date: 14-6-2012

Please cite this article as: Baer, W., Dias, D. A., & Duarte, J. B., The Economy of Portugal and the European Union: from High Growth Prospects to the Debt Crisis,Quarterly Review of Economics and Finance (2010), doi: 10.1016/j.qref.2012.06.002

This is a PDF le of an unedited manuscript that has been accepted for publication.As a service to our customers we are providing this early version of the manuscript.The manuscript will undergo copyediting, typesetting, and review of the resulting proof

before it is published in its nal form. Please note that during the production processerrors may be discovered which could affect the content, and all legal disclaimers thatapply to the journal pertain.
http://localhost/var/www/apps/conversion/tmp/scratch_2/dx.doi.org/doi:10.1016/j.qref.2012.06.002http://localhost/var/www/apps/conversion/tmp/scratch_2/dx.doi.org/10.1016/j.qref.2012.06.002http://localhost/var/www/apps/conversion/tmp/scratch_2/dx.doi.org/10.1016/j.qref.2012.06.002http://localhost/var/www/apps/conversion/tmp/scratch_2/dx.doi.org/doi:10.1016/j.qref.2012.06.002


2/34

Page 1 of 3

A c c e p t e

d M a n u

s c r i p t

80

Highlights

Economic performance of Portugal from the fast growth of the late 1980s and early1990s to the current recession.

Causes: slow productivity growth, disconnection between productivity and wagescontinued external and public deficits;

Three areas for improvement: justice system, education and public administration.


3/34

Page 2 of 3

A c c e p t e

d M a n u

s c r i p t

81

THE ECONOMY OF PORTUGAL AND THE EUROPEAN UNION:FROM HIGH GROWTH PROSPECTS TO THE DEBT CRISIS1

by

Werner Baer a, Daniel A. Dias a,b , and Joao B. Duarte a

a University of Illinois at Urbana-Champaignb CEMAPRE

Abstract:This paper documents some of the recent economic history of Portugal,since its accession to the EEC, to the adoption of the Euro and morerecently to the financial and economic crisis. In the first part of the paperwe show the economic performance of Portugal during the last 25 years tillnow, from the fast growth of the late 1980s and early 1990s to the currentrecession. We point out some of the reasons for this trajectory slowproductivity growth, disconnection between productivity and wages,continued external and public deficits and choose three areas that mustbe improved in order to reverse the current downward spiral justiceneeds to be more effective and faster, education needs to improve itsquality and distribution across the population, and the publicadministration must become more efficient.

1. Introduction

When peripheral countries join rich countries to form a customs union,

which also becomes a monetary union, they may be tempted to make use

1 Corresponding author: Werner Baer, Department of Economics, University of Illinois at Urbana-Champaign, Email: [email protected] , Telephone: +1 217 333 8388.

Keywords: Portugal; European Union; Core and Periphery; Debt Crises; Structuraladjustment; Competitiveness; Imbalances.


4/34

Page 3 of 3

A c c e p t e

d M a n u

s c r i p t

82

of perceived opportunities. Using some of the latter might be called

responsible, while others might be called irresponsible. In the case of

the European Union the responsible use of opportunities was the transfer

of resources to the peripheral countries for the purpose of building up the

countrys infrastructure (Baer and Leite, 2003). Also responsible would

be the use of these resources to improve the productivity of various sectors

of the economy.

The irresponsible use of opportunities consisted of the government of

the peripheral country to borrow from the rich country in order to finance a

rapid rise in social benefits, which were not related to productivity. In the

case of the European Union, funds were abundant and cheap as creditors

from Europes rich countries (mainly banks) had the perception that there

was little risk in lending to countries that were in the same currency area

and with no restrictions on capital flows.

The expectation, of course, was that the peripheral country would be

able to service its growing debt because its GDP would also increase and

therefore the country would be able to generate more resources to at least

pay the interest on the debt stock. And to fulfill this expectation, the

peripheral country would have to produce trade surpluses (perhaps


5/34

Page 4 of 3

A c c e p t e

d M a n u

s c r i p t

83

combined with an inflow of direct foreign investments). Finally, to be able

to produce trade surpluses, the expectation was that productivity in a

number of sectors would rise to such an extent that the peripheral country

would become competitive abroad.

As we shall show in this article on Portugal, one of the peripheral

economies of the European Union, this good scenario did not occur.

2. Expected performance of Portugal within the Euro

The last fifteen years of the 20 th century brought about institutional

developments which seemed to promise a bright economic future for

Portugal. The country entered the European Union in 1986, joined the

Exchange Rate Mechanism (ERM) of the European Monetary System in

1992, entered the European Monetary Union (EMU) in January 1999, and

began circulating the euro on January 1, 2002. In addition, the EU

committed itself to transfer resources to its peripheral economies to

build up their infrastructure, which would facilitate their integration with

the more advanced European economies. All members of the EMU were

committed to observe strict fiscal discipline, keeping budgetary deficits to a

maximum of 3% of GDP.


6/34

Page 5 of 3

A c c e p t e

d M a n u

s c r i p t

84

Given fiscal and monetary stability, with open borders, no exchange rate

risk, and a labor force whose earnings were substantially below the EU

average, it was expected that many European and non-European

multinationals would make substantial investments in Portugal. All these

factors would contribute to high rates of growth, which in the long-run

would allow the country to attain the quality of life of Europes more

advanced economies.

3. Disappointments

All these great expectations for the Portuguese economy were not

fulfilled. This claim can be corroborated using many statistics. We start by

showing in Table 1 the average yearly growth rate of GDP as well as some

of its components between 1996 and 2013, for some selected years, where

the last three years of the series are forecasts provided by Eurostat. The

economic growth of the Portuguese economy greatly decreased in the early

2000`s. The average yearly growth rate of GDP in the second half of the

1990s was 4.22%, while the yearly growth rate in the first decade of the

21 st century was only 0.61%. Gross capital formation as a percent of GDP

declined from a yearly average of 27.2% in the second half of the 1990s to

23.7%; and public investment also declined (see Table 1). In this Table, one


7/34

Page 6 of 3

A c c e p t e

d M a n u

s c r i p t

85

also notes a large difference in the export/GDP and import/GDP ratios, the

latter being always larger than the former.

It is interesting to note that the expected higher levels of investment

due to lower interest rates and lower inflation rate did materialize, but only

for a very short period of time. In 1999, when Portugal joined the EMU,

gross capital formation increased to 27.3%. However, in 2002, when the

Euro started circulating, it had already gone down to 25.6%, reaching 23%

in 2005, which is below the level reached nine years before, when interest

rates were much higher.

Table 1 - GDP and Unemployment

1996 1999 2002 2005 2008 2009 2010 2011 f 2012 f 2013 f

GDP real growth rate 3.7 4.1 0.8 0.8 0 -2.9 1.4 -1.9 -3 1.1

Final consumption ofhouseholds

63.4 61.9 61 62.8 64.8 63 63.9 Na Na Na

Final consumption of generalgovernment

17.7 18.1 19.7 21.1 20.1 22.1 21.6 20.6 18.7 17.4

Gross fixed capital formation 23.6 27.3 25.6 23 22.5 20.6 19.8 18 16.9 17.1Exports 27.2 27.1 27.6 27.7 32.4 28 31 35.3 38.1 40Imports 34.4 37.4 35.9 37.1 42.5 35.4 38.2 39.5 38.6 38.7External balance of goods andservices

-7.2 -10.3 -8.3 -9.4 -10.1 -7.4 -7.2 -4.2 -0.5 1.3

Unemployment rate 7.2 4.4 5 7.6 7.6 9.4 10.8 Na Na NaSource: Eurostat. With the exception of GDP real growth rate and unemployment rate all indicators are measured as % ofGDP. Superscript f refers to forecasts.


8/34

Page 7 of 3

A c c e p t e

d M a n u

s c r i p t

86

The unemployment rate reached its lowest level in 1999 after several

years of steady decrease, but it increased substantially in the subsequent

10 years (more than doubled). This fact is obviously correlated with the

reduction of gross capital formation in the country.

Table 2 - Balance of Payments (% of GDP)

Current Account Financial Balance

Total Goods Services Earnings Transfers TotalDirectInvest.

PortfolioInvest.

OtherInvest.

CapitalBalance

Errorsand

Omissions

1996 -4.1 -8.1 1.2 -0.7 3.6 3.1 0.5 -1.3 4.6 1.9 -0.9

1997 -5.9 -9.2 1.2 -1.1 3.3 3.7 0.2 0.5 4 2.4 -0.21998 -7.1 -10.8 1.5 -1.2 3.3 4.2 -0.8 -0.5 5.9 2 0.91999 -8.7 -12 1.5 -1.3 3 7 -1.6 2.9 5.9 2 -0.32000 -10.4 -12.9 1.7 -2 2.9 9.3 -1.3 -0.9 11.5 1.3 -0.22001 -10.3 -12.4 2.2 -2.9 2.8 9.1 0 3.4 6.2 0.9 0.32002 -8.3 -10.5 2.4 -2.3 2.1 6.7 1.5 2.9 3.2 1.4 0.12003 -6.5 -9.4 2.5 -1.6 2 4.4 0.4 -3.6 3.6 1.8 0.22004 -8.4 -11 2.7 -2 1.9 6.8 -3 0.5 8.3 1.5 0.12005 -10.4 -11.9 2.5 -2.5 1.5 9.1 1 -0.2 7.5 1.1 0.12006 -10.7 -11.5 3.1 -3.9 1.6 9.5 1.9 2.4 4.2 0.8 0.42007 -10.1 -11.3 3.9 -4.1 1.5 8.5 -1 5.9 3.1 1.2 0.3

2008 -12.6 -13.4 3.8 -4.5 1.4 11.1 0.8 8.5 1.7 1.5 02009 -10.9 -10.6 3.5 -5.2 1.3 10.3 0.8 8.9 0.5 0.8 -0.32010 -9.9 -10.4 3.9 -4.6 1.3 9.1 4.4 -5.6 10.7 1.1 -0.3Source: Pordata.

Another source of disappointment is the external sector of the

Portuguese economy. As can be seen in Table 2, Portugal`s economy

suffered from high current account deficits during the entire period.

Moreover, even though real GDP growth declined, the current account


9/34

Page 8 of 3

A c c e p t e

d M a n u

s c r i p t

87

deficits remained high. Some explanations for this event are discussed in

the next section.

Also worth noting is that despite the expected large investments by the

richer countries of Europe as consequence of Portugal having joined the

euro, direct investment was very low.

The disappointing performance of the Portuguese economy can also be

noted in its fiscal accounts. Table 3 shows that Portugal never complied

with the EUs rules regarding fiscal deficits, in particular, running a fiscal

deficit below 3% of GDP.

Table 3 - Government Budget (% of GDP)

1996 1999 2002 2005 2008 2009 2010Total Revenue 38 38 39.2 39.7 41 39.7 41.6 Growth rate 0 3.2 1.3 3.3 -3.2 4.8

Total Expenditure 42 40.9 42.2 45.6 44.8 49.9 51.3 Growth rate -2.6 3.2 8.1 -1.8 11.4 2.8

Net Borrowing 4.5 2.7 2.9 5.9 3.7 10.2 9.8

Primary Balance 0.3 0.2 -0.2 -3.4 -0.6 -7.3 -6.8

Deficit 4.5 2.7 2.9 5.9 3.6 10.1 9.8Source: Eurostat.

The fiscal failure was largely reflected in the rapid growth of Portugals

net external debt, which went from 22.5% of GDP in 1999 to 84.2% in 2010,


10/34

Page 9 of 3

A c c e p t e

d M a n u

s c r i p t

88

as shown in Table 4. This is associated with the high current account deficits

faced by Portugal`s economy in the same period, which indicates that the

investments, consumption and public expenditure made at that time were

mainly financed with external borrowing. This is also confirmed by the

financial balance, which averaged 7.7% (see Table 2).

Table 4 - Portugal`s Debt Position (% of GDP)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Gross external debt 101 132 146 154 162 165 178 187 197 203 226 229 Growth rate 30.8 10.8 5.5 5 1.8 8.1 5.3 5.3 3.1 11.3 1.3

Net external debt 22.5 33.2 45.8 48.9 41 42.1 49.5 55.9 64.6 75.6 85.2 84.2 Growth rate 47.2 38.1 6.8 -16.3 2.7 17.7 13 15.5 17 12.7 -1.2Source: Bank of Portugal, BPstat.

4. Main causes of the disappointing economic performance

There are several factors that explain, or at least help understanding,

why Portugal had such a disappointing economic performance in the last

two and a half decades. In this section we analyze four of these reasons,

the most relevant in our view, and conjecture how each one of them

impacts the short-run and the long-run future of the country.

a) Lack of Productivity growth


11/34

Page 10 of

A c c e p t e

d M a n u

s c r i p t

89

In the first decade of the 21 st century Portugal experienced economic

stagnation or even a reversal of its economic convergence process with

respect to the major European economies. One of the reasons behind the

slower GDP growth is weak productivity gains. As can be seen in Table 5,

during the 90`s, labor productivity grew on average 3.8% and 3.5% in the

first and second half of the decade, respectively. However, after 2000, it

slowed down substantially, to the point of having no growth between 2007

and 2009. Interestingly, between 2009 and 2010 labor productivity grew

again at rates similar to those observed during the 90s. One possible

explanation for this increase in labor productivity may be the sharp

increase of the unemployment rate during this period.

Table 5 - Labor productivity annual compounded growth rate

Period1990-1995

1995-2000

2001-2007

2007-2009

2009-2010

Portugal 3.8 3.5 1.4 0 3.2

OECD Total NA NA 1.9 0.1 2.1Euro Area NA NA 1.2 -0.5 1.2

Source: OECD database.


12/34

Page 11 of

A c c e p t e

d M a n u

s c r i p t

90

1. The change in productivity can be broken down in its components in order to isolate theeffects of structural change due to changes in the sectorial employment structure, following theso called shift-share technique.

The first component of productivity growth ( structural effec t) corresponds to the impact of achange in the sectorial employment structure . And the second component of productivitygrowth ( within-sector effect ), is obtained by calculating productivity growth rate holdingsectorial employment shares constant.

A shift-share analysis 1 done by the OECD Economic survey (2010)

shows that structural change of the economy was the main force behind

labor productivity growth at the beginning of the 1990`s, as labor moved to

high productivity sectors (examples of these are telecommunications,

banking and tourism). This process decelerated markedly after 1995,

despite the fact that Portugal`s economy had clearly not yet completed the

structural change process. During 1995-2000, the within-sector growth rate

picked-up, which compensated for the decline in productivity gains arising

from structural change. However, after 2000, productivity growth within

sectors also slowed. As a consequence total productivity growth declined

dramatically.

Although in the first decade of the 21 st century productivity growth in

Portugal was low, it was still higher than the average for the Euro zone,


13/34

Page 12 of

A c c e p t e

d M a n u

s c r i p t

91

2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.

reducing the productivity gap from 59% in 2001 to 57% in 2010, as shown

in Table 6. At the same time, the opposite process happened relative to the

OECD, increasing the gap from 52% to 54%, comparing the same years as

before.

able 6 - Productivity Indicators

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

roductivityevels (euros per

our worked)Portugal 12.6 13 13.4 13.7 14.3 14.3 14.3 14.5 14.5 14.8 14.9 15.5 15.3 15.5 16Euro Area Na Na Na Na 34.5 34.9 35.3 35.6 36 36.4 37.1 37.5 37.4 37.1 37.5OECD Total Na Na Na Na 29.6 30.1 30.8 31.5 32.3 32.8 33.3 33.8 33.8 33.9 34.6

roductivityrowth rate

Portugal 4.5 3.7 2.9 1.9 4.4 -0.1 0.2 1.1 0.4 1.7 0.6 4.1 -1.5 1.6 3.2Euro Area Na Na Na Na Na 1 1.2 0.8 1.1 1.2 1.7 1.2 -0.2 -0.8 1.2OECD Total Na Na Na Na Na 1.7 2.1 2.3 2.6 1.5 1.5 1.6 0.1 0.1 2.1

roductivity GapEuro Area Na Na Na Na 0.59 0.59 0.59 0.59 0.6 0.59 0.6 0.59 0.59 0.58 0.57OECD Total Na Na Na Na 0.52 0.52 0.54 0.54 0.55 0.55 0.55 0.54 0.55 0.54 0.54

urce: OECD database. The productivity gap is measured as one minus the productivity levels of Portugal relative to theoductivity levels of the zone of interest (in this case Euro Area or OECD Total).

Overall, the productivity performance of Portugal over the period is

worrisome, given the fact that the productivity level is very low when

compared to the Euro or OECD. Hence, there was and there still is plenty of

room for the improvement of productivity. Indeed, if Portugal s economy is


14/34

Page 13 of

A c c e p t e

d M a n u

s c r i p t

92


to start converging again with the major European economies of the EU,

reducing the productivity gap between Portugal and the rest of Europe

must be a top priority for Portugal. As we shall discuss in the next sub-

section, the poor performance of labor productivity in Portugal during the

last 20 years did not have to lead the country to the financial crises that it

is currently experiencing such financial crisis could possibly have been

avoided if the returns to labor had followed more closely its productivity.

Likewise, Portugal could be facing the same financial problems even if it

had had a continued and robust increase in productivity the same reason

presented above applies here. Between these two possible situations the

latter is clearly preferred as the country could regain competitiveness, and

thus fix its financial problems, by forcing nominal wages to grow slower

than productivity. Unfortunately for Portugal, given the slow growth of

labor productivity, this real adjustment will have to be made through

nominal wage cuts as changes in growth rate of productivity are normally

very slow moving.

b) Loss of Competitiveness


15/34

Page 14 of

A c c e p t e

d M a n u

s c r i p t

93


The economic boom of Portugal that lasted until 2000, led to an

overvaluation of labor as described by Blanchard (2007). Productivity

growth did not accompany the rise in the nominal wage, and as a direct

consequence, Portugal`s unit labor cost increased. More importantly, the

latter was larger than the increase of unit labor costs in the Euro zone and

the OECD - Portugal`s unit labor cost growth rate averaged 2.73%, while in

the Euro zone and in the OECD it was 1.38% and 2.55% respectively (see

Table 7). This process accounted for a loss of competitiveness which

contributed for the deterioration of the current account deficit. Hence, the

overvaluation of labor is crucial to understand the imbalance in the

Portuguese external accounts.

Table 7 Competitiveness (Growth rates)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Nominal Wage 6.5 5.6 3.8 5.7 5.4 4 3.2 3.3 2.2 3 1.5 4.4 3.5 4.3 1Productivity 4.5 3.7 2.9 1.9 4.4 -0.1 0.2 1.1 0.4 1.7 0.6 4.1 -1.5 1.6 3Unit Labor cost

Portugal 4.3 4.1 4.3 2.9 4.5 3.5 3.1 3.5 0.8 3.7 0.6 0.8 3.1 3.1 -1Euro Zone 1.8 -1.4 -0.1 1.8 1 2.1 2.3 2.1 0.7 1.3 1 1.3 3.4 3.9 -0OECD 3.9 4 3.8 3 2.8 3.3 1.6 2.1 0.8 1.6 1.9 1.8 2.8 2.5 N

Source: OECD database.

It is important to mention that even if Portugal had not lost so much

competitiveness against the Euro zone economies and/or the OECD


16/34

Page 15 of

A c c e p t e

d M a n u

s c r i p t

94


countries, it could still be facing financial and economic difficulties even

though, these should be less severe than the difficulties the country was

facing at the beginning of the second decade of the 21st

century. This is so

because Portugal does not compete directly with the main economies of

the Euro zone. That is, the product mix (textiles, footwear, and furniture) of

Portugal, to some extent, is orthogonal to the product mix of the main

European economies. This is no longer true if we compare the (traditional)

product mix of Portugal with the product mix of some emerging economies

where labor costs are just a fraction of the labor costs in Portugal, and the

productivity differences are not sufficiently high to allow Portugal to

continue being competitive in the usual industries (in this respect, see

Felipe and Kumar (2011)).

c) Structural Bottlenecks

Analyzing in a more general perspective, it is important to mention

that Portugal has severe structural bottlenecks. In order to enhance

general economic performance, the country needs to make reforms in: a)

justice, b) education and c) public administration. In general this is a true


17/34

Page 16 of

A c c e p t e

d M a n u

s c r i p t

95


statement for any country and so it is somewhat vague. However, we will

make an effort to show why in the Portuguese case this is indeed not only

needed, but also crucial for the countrys development.

i. Justice

Most economic activity, if not all, is based on contracts

between economic agents. The less risky, or in other words, the

more enforceable contracts are, the more activities/transactions

will take place. Therefore, it is in the best interest of any modern

economy to have a Justice system that is as efficient and cost

effective as possible. Unfortunately, in the case of Portugal, the

Justice system is neither cost effective nor efficient. That is, not

only is the Justice system in Portugal very costly for the quality of

the service that it delivers, as it is very inefficient and ineffective. To

illustrate the effectiveness problems of the Justice system in

Portugal, we present in Figure 1 the average duration of some types

of civil proceedings between 1993 and 2009. Figure 1 shows several


18/34

Page 17 of

A c c e p t e

d M a n u

s c r i p t

96


facts regarding the speed of the Portuguese courts and how it

evolved over time. On the positive side, we see that between 1993

and 2009 the average length of bankruptcy processes declined from

45 to 5 months.

Even without a comparison with other countries, this is a very

positive indicator. The problem is that such evolution was

Figure 1: Average length of some terminated civil proceedings.

0

5

10

15

20

25

30

35

40

45

50

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

M o n t h s

Divorces and separations Corporate Bankruptcy Civil responsibility

Debt Evictions Claim of ownership

Source: Pordata

not observed in any other types of processes. For example, in 1993

eviction processes took on average 18 months to be concluded and

in 2009 it was taking more than 20 months. In this case not only the


19/34

Page 18 of

A c c e p t e

d M a n u

s c r i p t

97


indicator in 2009 is very negative, as it is worse than what it was in

1993. Another example of negative performance of the Portuguese

Justice system is the time it takes to solve a debt related case. In

1993 it took around 8 months, and in 2007 it was taking 41 months.

In this case there was an improvement between 2007 and 2009

(the average duration of a lawsuit dropped from 41 months to 18).

Another indicator that is worthwhile looking at is the so called

court congestion rate. The court congestion rate is the ratio

between the total numbers of proceedings pending at the

beginning of the year, by the total number of cases solved during

the year. This indicator shows the ability of the court system to

keep up with the flow of processes. The results for Portugal are

presented in Figure 2.

Figure 2: Court congestion rate in Portugal for different courts


20/34

Page 19 of

A c c e p t e

d M a n u

s c r i p t

98

0%

50%

100%

150%

200%

250%

1990 1994 1998 2002 2006 2010

Courts of Justice Supreme Court of Justice Appelate Courts

Supreme Administrative Court Constitutional Court

Source: Pordata

The figure above shows that, with the exception of the courts

of justice, in all other types of courts there was an improvement of

the congestion, i.e., courts were either able to complete more

proceedings during the year or the number of new proceedings

decreased. The only case where the congestion rate deteriorated

during the period 1990-2010 was for courts of justice, which are in

charge of processing the vast majority of cases. This is a truly

worrisome indicator because it shows that in Portugal the speed at

which Justice works is increasing instead of slowing down.


21/34

Page 20 of

A c c e p t e

d M a n u

s c r i p t

99

If Portugal wants to become a more competitive economy,

either through internal initiative or through attraction of foreign

direct investment, it must resolve the problems in the Justice system.

Portugal needs more investment and more entrepreneurship. Having

an inefficient Justice system it will not help in achieving this goal.

The fact that the Justice system in Portugal is not able to provide

proper property rights protection is a major barrier to

entrepreneurial activity and this is something that Portugal needs if it

wants to have a growing and prosperous economy.

ii. Education

The low educational coverage and the low quality of education

are at the heart of the Portuguese low productivity levels. Hence,

education is a major bottleneck in the Portuguese economy.

One way to illustrate the contribution of education to

Portugal`s labor productivity gap is to compute the changes in labor

productivity induced by changes in the composition of labor, from


22/34

Page 21 of

A c c e p t e

d M a n u

s c r i p t

100

the current situation to a simulated scenario in which the structure

of the working-age population is the same as in a reference country.

This is done at the same time that group-specific employment rates

and average working-time are kept at their current levels.

This exercise was done for OECD countries in Boulhol (2009), with

the US taken as the reference country. According to the results of the

study, Portugals hourly productivity would be 14.4% higher if its

working-age population had the same level of education as the US.

Also according to that simulation, education would explain

approximately 25% of Portugals GDP per capita gap vis--vis the

United States.

This study is a quantitative example of how the Portuguese

educational gap is associated with the Portuguese productivity gap

with the OECD average.

It is interesting to make a distinction among the causes of the

educational gap. The first cause is the low coverage of the

Portuguese educational system when compared to the OECD

average. And the second cause is low overall quality of the


23/34

Page 22 of

A c c e p t e

d M a n u

s c r i p t

101

educational system. However, it is important to note that there is a

large variance of the educational quality in Portugal.

In terms of coverage, in the Programme for International

Student Assessment (PISA) 2009, the percentage of the population in

the age group 35-44 years with at least upper secondary education in

Portugal was 28.7%, while the same indicator for the OECD average

was 75.9%. Also, according to PISA 2009, the quality of education is

still very low. The scores in reading and mathematics are below the

OECD average.

Portugal has increased the coverage in the recent decade, but

the quality has not increased at the same pace. According to OECD

(2010), a major handicap for Portugal has been the very low starting

point in terms of educational attainment and literacy of its

population. A fifth of all 15-64 year-olds were illiterate in the mid-

1970s and less than 5% had completed upper secondary education.

The low starting point made it difficult to find qualified teachers

when the education system expanded. At the same time, the low


24/34

Page 23 of

A c c e p t e

d M a n u

s c r i p t

102


educational background of the parents has also limited the potential

achievements of children.

The educational bottleneck is a major challenge for the

Portuguese economy because the expenditure on education as a

percent of GDP is already equivalent to the average expenditure in

OECD countries and therefore the problem is not the low amount of

resources allocated to it. The problem in education is of inefficient

utilization of resources and of poor distribution of these resources.

Hence, improving the education system is, in part, linked to the

improvement of the Portuguese public administration. The main

challenge for the Portuguese educational system is to improve the

quality of education, mainly in the worst schools, and reduce the high

levels of school dropout 2. This effort will translate into a better


25/34

Page 24 of

A c c e p t e

d M a n u

s c r i p t

103

overall education quality at the same time that it reduces the

inequality of the educational system and increases the overall quality

of the labor force.

iii. Public Administration

The Portuguese public sector is considered very inefficient

when compared to other Euro zone members. This can be clearly

seen in Afonso et al (2005). These authors construct public sector

efficiency (PSE) indicator that is an average of other seven

constructed indicators that are parts of public sector output, i.e.,

education and administration are two of these two indicators.

The PSE for Portugal was 0.86, while the Euro zone average

was 0.92. Also, when just looking at the public administration

efficiency indicator, we find that Portugals score is 0.56, while the

average of the same indicator for the Euro Zone is 0.82. This result is

not surprising when one analyzes more deeply the Portuguese public

administration structure and management. In order to illustrate

more clearly this point we use a simple example - the number of

public municipalities. While there are too many municipalities in


26/34

Page 25 of

A c c e p t e

d M a n u

s c r i p t

104

Portugal, there are also too many employees in each municipality for

the amount of public service needed. So while the first is a problem

of structural inefficiency, the second is a problem of public

management inefficiency.

Table 8 shows that government effectiveness in Portugal is not

far away from major economies in the EU. Hence, the real problem in

the public sector is of inefficient resource allocation rather than final

public output.

Table 8 Government EffectivenessIndicator (2009)Country Score (-2.5 to 2.5)

France 1.44

Germany 1.48Greece 0.61Portugal 1.21Spain 0.94

United States 1.39

Source: World Bank.

However, this public sector inefficiency is a large cost to the

Portuguese economy, as more resources could be used in private

sector while keeping the public sector output at the same level.


27/34

Page 26 of

A c c e p t e

d M a n u

s c r i p t

105

d) Moral Hazard - Living beyond its means

Portugals membership in the EU and the Euro area provided its

policymakers and politicians the illusion that it was possible to reach

consumption levels of its richer partners prior to reaching productivity

levels which were equivalent to that of its partners. The moral hazard was

present on both the borrower and lender sides. The borrowers saw access

to cheap credit with no devaluation risk, while the lenders saw no danger of

losses due to devaluation or default.

The moral hazard behavior can be observed in Table 9. As already

noted previously, the public deficit was above the required 3% of GDP in

the entire period we are examining (its yearly average was 4.7% in the 1996

2000 period, rising to a yearly average of 5% in the 2001-9 period, and

reaching 8.6% in 2009).

In Table 9 we can see that despite the poor economic performance of

Portugal, social expenditures increased sharply, indicating that there was a

convergence with the richer economies of the EU in terms of benevolent


28/34

Page 27 of

A c c e p t e

d M a n u

s c r i p t

106

government. In fact, the increase was such that Portugal`s level of social

expenditures was similar to two reference countries of the EU`s rich

economies, France and Germany.

Table 9 - Selected Social Expenditures Indicators (as % of GDP)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

HealthPortugal 7.8 7.8 7.7 8 9.3 9.3 9.3 9.8 10.1 10.4 10.1 10 10.1

France 10.4 10.2 10.1 10.1 10.1 10.2 10.5 10.9 11 11.1 11 11 11.1 Germany 10.4 10.2 10.2 10.3 10.3 10.4 10.6 10.8 10.6 10.7 10.6 10.5 10.7

Education Portugal 5.3 5.4 5.4 5.4 5.4 5.6 5.5 5.6 5.3 5.4 5.3 5.3 4.9 France 6 6 6 5.8 6 5.9 5.9 5.9 5.8 5.7 5.6 5.6 5.6 Germany Na 4.6 Na 4.5 4.5 4.5 4.7 4.7 4.6 4.5 4.4 4.5 4.6

Pensions Portugal 9.7 9.6 9.7 9.7 10.1 10.5 10.9 11.4 12 12.3 12.6 12.6 13.2 France 13.5 13.5 13.4 13.4 12.9 12.9 13 13.1 13.1 13.2 13.2 13.3 13.6 Germany 12.7 12.8 12.8 12.8 13 13.1 13.3 13.5 13.4 13.3 12.9 12.4 12.3

Social protection benefitsPortugal 17.7 17.4 17.7 18 18.7 19.3 21 21.7 22.3 23 23.1 22.6 23.2

France 29.1 28.9 28.5 28.4 27.7 27.8 28.5 29 29.4 29.5 29.3 29 29.3 Germany 28.3 28 27.9 28.2 28.3 28.4 29 29.4 28.7 28.6 27.6 26.6 26.7

Source: Eurostat.

Figure 3: Domestic credit as % of GDP and nominal interest rate.


29/34

Page 28 of

A c c e p t e

d M a n u

s c r i p t

107

Source: Constructed by the authors using interest rate of OECD database and domestic credit of Bank ofPortugal BPstat.

At the same time, Figure 3 indicates that the public sector was not

the only one living beyond its means. The cheap credit was also available to

the private sector. Hence, despite the average annual wage increase, the

high consumption pattern of the period was also financed.

To put it in a nutshell, the access to cheap credit and the low risk of

devaluation created the conditions for a fast increase in the countrys

standard of living. The question is whether Portugal`s economy could afford

this process in the long run. Given the economic performance of Portugal,

the answer was clearly negative. However, the moral hazard behavior of


30/34

Page 29 of

A c c e p t e

d M a n u

s c r i p t

108

both parties sustained this illusion to a level in which the external debt is at

high risk of not being repaid.

5. Conclusions

In the last 25 years Portugal experienced a unique set of

opportunities after becoming member of the EEC and more recently one of

the countries sharing a common currency, the Euro. One of the advantages

of joining the EEC was the initial access to large quantities of money that

could be used to modernize the economy at no cost. That is, the country

would not have to repay these amounts of money flowing into to the

country. More recently, after the introduction of the Euro, Portugal had

access once again to large quantities of capital at a very low cost. In this

case, any inflows to the country in the form of external debt had to be

repaid at some point in the future.

Despite the unique set of opportunities to become a modern and

competitive economy, Portugal never took proper advantage of these

opportunities. Instead it wasted them and, even worse, it compromised the

future significantly for not having used all the resources it had available to


31/34

Page 30 of

A c c e p t e

d M a n u

s c r i p t

109

improve its long term growth perspectives. As a consequence of this

wasting of opportunities, Portugal was in a very serious financial crisis

(2011/12), which seriously compromised the long term perspectives of the

country and its people.

If things were not bad enough, Portugal, in additional to the financial

problem, also has an economic problem. That is, Portugals overall low

productivity and lack of competitiveness make it very hard to grow out of

the financial crises. Because Portugals economy is not sufficiently

competitive, in order to solve the financial crisis it needs to make very

harsh and politically costly adjustments. Namely, a sharp reduction of

public expenditure on wages and pensions, elimination of some inefficient

public institutions, alienation of non-performing public enterprises, higher

taxes, etc. Such adjustments will create severe social tensions as these will

lead, at least in the short run, to an increase of unemployment, reduction

of disposable income for families and reduction of firms profitability, which

in some cases will lead to bankruptcies. An important question is therefore

how much of this austerity is going to be politically feasible?


32/34

Page 31 of

A c c e p t e

d M a n u

s c r i p t

110

Assuming that Portugal is able to impose these measures and with

that solve the financial crisis, the country still has one big problem to solve

which is its long run economic growth. Several measures aiming at

improving competitiveness are part of the agreement signed between

Portugal, the International Monetary Fund, the European Commission and

the European Central Bank. Some, if not all, of these imply that certain

established interests will have to give up some of the benefits they

currently enjoy (the justice system and the public administration are two

examples). Such transformations also have big political costs which may be

too large for any government.

Another alternative is to leave the Euro and with that regain full

control of monetary and fiscal policies. There is no doubt that leaving the

Euro will have a big upfront cost as it would cause the entire banking

system to collapse 3, a large devaluation of the currency which would lead

to a very high inflation with all its negative consequences. Whether the

long term benefits compensate the initial costs of leaving the Euro is a

question that is almost impossible to answer. For instance, would Portugal

leave the Euro and use that buffer to make the necessary adjustments to


33/34

Page 32 of

A c c e p t e

d M a n u

s c r i p t

111

3- The risk of devaluation could lead to a run on the Portuguese banking system. At the same time, withthe devaluation, banks would have more difficulty to pay their debts that remain denominated in Euros.These constitute some of the obvious reasons why the banking system might collapse.

become more competitive, or, would that just be a way of avoiding having

to make the necessary transformations?


34/34

A c c e p t e

d M a n u

s c r i p t

112

References

Afonso, Antnio, and Schuknecht, Ludger and Tanzi, Vito (2005), Public

sector efficiency: An international comparison, Public Choice,Volume 123, Numbers 3-4, 321-347 .

Baer, Werner, and Leite, Antnio P. N. (2003), The economy of Portugalwithin the European Union: 1990 2002, The Quarterly Review ofEconomics and Finance , Volume 43, No. 2.

Blanchard, Olivier (2007), Adjustment within the euro. The difficult case of

Portugal, Portuguese Economic Journal , Vol. 6, No. 1.

Boulhol, H. (2009), The Effects of Population Structure on Employmentand Productivity, OECD Economics Department Working Papers No.684.

Felipe, Jesus and Kumar, Utsav (2011), Unit Labor Costs in the Eurozone:The Competitiveness Debate Again, Levy Economics Institute ,working paper No. 651.

OECD (2010), OECD Economic Surveys: Portugal 2010, OECD Publishing .

Documents

The Economy of Portugal and the European Union.pdf