Don't Let Me Stop You: Portugal

Last month we traveled to Lisbon on a business trip. The Portuguese I met were warm and friendly to foreigners, and the part of the city where I was staying seemed to be booming. There was a lot of construction going on, and much had been done previously for Expo 98. A large shopping center, named for Vasco de Gama, was full of stores and customers.

Appearances can be deceiving, especially on a short visit when you don't speak the language. Matthew Kaminiski reports in the Wall Street Journal, in this (unfortunately) subscription-only link. The Portuguese economy is not healthy:

"Arriving here, my first thought is that the mood must be brightening. New EU-subsidized highways crisscross the land. Shabby and a bit backward on my last visit, Lisbon now looks no different than any other European capital -- no, better.

This first impression is wrong. Why it is so tells a lot about European 'unification' and its limitations. 'The Portuguese are now very pessimistic, all negative,' says Rui Constantino, chief economist at Santander Negócios Portugal. 'The infrastructure has changed [in the last 15 years] but in the mind, there hasn't been enough change. This country really needs to be shaken up.'

Portugal isn't supposed to be in this deep a funk almost a generation after joining the European Union. Next door, Spain thrives. After a troubled decade or two in the EU, Greece recently got its act together. The 'New Europeans,' those 10 new countries who joined a year ago, are shaking up the club. Not Portugal."

Simply joining the EU and/or adopting the Euro is not sufficient to produce economic health. The problems are rooted in government taxation and spending policies.

"It's all about the policies. A generation ago, Ireland invested heavily in education. Portugal didn't. In the last decade, Spain carried out a second wave of economic reforms, principally to straighten out the budget and loosen up labor market regulations. Portugal's rulers opened the spending spigots.

The hangover from the 1990s party won't pass quickly. As Portugal met the Maastricht criteria to join the euro zone, interest rates converged with the rest of the Continent. The Portuguese people and government felt richer than they in reality were. The borrowing craze took household indebtedness as a share of disposable income from under 50% in the early 1990s to over 120% today.

The then-Socialist government directed spending at job-creating public works and threw the budget deep into the red. In 2001, the fiscal deficit hit 4.1%, breaching the Stability and Growth Pact limits and bringing EU censure (back then, those rules were enforced). Today, the fiscal deficit is 6.2% and the government eats up half of GDP. In the last decade, Portugal grew without improving productivity or building the foundations for future development. As one former finance minister quipped, 'We spend like the Germans, but we produce like Moroccans.'

This debt-induced consumption came to a brutal halt when the global economy imploded in 2001. In the years since, the world has recovered, but Portugal hasn't. The infrastructure built up in the 1990s -- the pride of the EU structural aid program -- stands around underused. What good are all these highways when there aren't enough trucks moving cargo on them?"

It's not possible for a country to borrow, spend, and devalue its way to prosperity, although there are no shortage of governments willing to try that route and stay on it until they drive off the cliff. Mayor Abe Beame of the New York City default springs to mind.

Massive government spending on "infrastructure" projects can create the illusion of prosperity, but if the projects aren't economically sound on their own merits the illusion vanishes when the smoke clears. Since government spending is always based on political rather than economic considerations, there is little chance of a real rate of return from such "investments."

"The work force is one of Europe's least well-educated. The country also produces too many sociologists and not enough engineers. The labor market isn't flexible nor are wages competitive. The judiciary and bureaucracy are notoriously slow: to start a business, expect to wait a month alone to gain government permission to use your preferred name. The tax system is too complicated."

Without knowing any more than this, we'll bet that tax rates are too high, as well. It's noteworthy that Ireland also cut taxes as they were "investing" in education.

"The current Socialist rulers are raising the retirement age to lessen the load on the budget. In response, retired military officers and their families went out on the streets. While Mr. Frasquilho credits the Socialists for standing up to vested interests, he thinks Portugal really needs to embrace eastern European-style 'shock therapy,' a blend of fiscal tightening, deregulation and liberalization.

With everyone so glum, one finds it hard to imagine a 'Portuguese miracle.' Yet it is equally puzzling why this beautiful nation isn't flourishing. Portugal's comparative advantages lie in tourism and services, cork and (yes) plastic moulds -- enough for a country of 10 million. 'We can't rely on consumption anymore to grow,' says Mr. Andrade. 'What we need is a different growth pattern based on global competitiveness.' No one but the Portuguese themselves can make this happen."

We'll also reiterate that "fiscal tightening" must be in the form of government spending cuts and restraints not tax increases that would further damage the productive parts of the economy. Couple that with deregulation and liberalization of the economy, and we could be talking about a "Portuguese Miracle" in ten years.

Technorati: Portugal, economics