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)00045-2
DOI: doi:10.1016/j.qref.2012.06.002
Reference: QUAECO 684
To appear in: The Quarterly Review of Economics and Finance
Received date: 12-4-2012
Accepted 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
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Highlights
Economic performance of Portugal from the fast growth of the late 1980s and early
1990s to the current recession.
Causes: slow productivity growth, disconnection between productivity and wages
continued external and public deficits;
Three areas for improvement: justice system, education and public administration.
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THE ECONOMY OF PORTUGAL AND THE EUROPEAN UNION:
FROM HIGH GROWTH PROSPECTS TO THE DEBT CRISIS
1
by
Werner Baer
a
, Daniel A. Dias
a,b
, and Joao B. Duarte
a
a
University of Illinois at Urbana-Champaign
b
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 more
recently to the financial and economic crisis. In the first part of the paper
we show the economic performance of Portugal during the last 25 years till
now, from the fast growth of the late 1980s and early 1990s to the current
recession. We point out some of the reasons for this trajectory slow
productivity growth, disconnection between productivity and wages,
continued external and public deficits and choose three areas that must
be improved in order to reverse the current downward spiral justice
needs to be more effective and faster, education needs to improve its
quality and distribution across the population, and the public
administration 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: wbaer@illinois.edu, Telephone: +1 217 333 8388.
Keywords: Portugal; European Union; Core and Periphery; Debt Crises; Structural
adjustment; Competitiveness; Imbalances.
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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
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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.
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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
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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 of
households
63.4 61.9 61 62.8 64.8 63 63.9 Na Na Na
Final consumption of general
government
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 17.1
Exports 27.2 27.1 27.6 27.7 32.4 28 31 35.3 38.1 40
Imports 34.4 37.4 35.9 37.1 42.5 35.4 38.2 39.5 38.6 38.7
External balance of goods and
services
-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 Na
Source: Eurostat. With the exception of GDP real growth rate and unemployment rate all indicators are measured as %of
GDP. Superscript f refers to forecasts.
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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 Total
Direct
Invest.
Portfolio
Invest.
Other
Invest.
Capital
Balance
Errors
and
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 -0.2
1998 -7.1 -10.8 1.5 -1.2 3.3 4.2 -0.8 -0.5 5.9 2 0.9
1999 -8.7 -12 1.5 -1.3 3 7 -1.6 2.9 5.9 2 -0.3
2000 -10.4 -12.9 1.7 -2 2.9 9.3 -1.3 -0.9 11.5 1.3 -0.2
2001 -10.3 -12.4 2.2 -2.9 2.8 9.1 0 3.4 6.2 0.9 0.3
2002 -8.3 -10.5 2.4 -2.3 2.1 6.7 1.5 2.9 3.2 1.4 0.1
2003 -6.5 -9.4 2.5 -1.6 2 4.4 0.4 -3.6 3.6 1.8 0.2
2004 -8.4 -11 2.7 -2 1.9 6.8 -3 0.5 8.3 1.5 0.1
2005 -10.4 -11.9 2.5 -2.5 1.5 9.1 1 -0.2 7.5 1.1 0.1
2006 -10.7 -11.5 3.1 -3.9 1.6 9.5 1.9 2.4 4.2 0.8 0.4
2007 -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 0
2009 -10.9 -10.6 3.5 -5.2 1.3 10.3 0.8 8.9 0.5 0.8 -0.3
2010 -9.9 -10.4 3.9 -4.6 1.3 9.1 4.4 -5.6 10.7 1.1 -0.3
Source: 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
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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 2010
Total 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 9.8
Source: 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,
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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 -1.2
Source: 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
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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
Period
1990-
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 2.1
Euro Area
NA NA 1.2 -0.5 1.2
Source: OECD database.
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1. The change in productivity can be broken down in its components in order to isolate the
effects of structural change due to changes in the sectorial employment structure, following the
so called shift-share technique.
The first component of productivity growth (structural effect) corresponds to the impact of a
change in the sectorial employment structure. And the second component of productivity
growth (within-sector effect), is obtained by calculating productivity growth rate holding
sectorial 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,
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help 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.
Table 6 - Productivity Indicators
Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Productivity
levels (euros per
hour 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 16
Euro Area
Na Na Na Na 34.5 34.9 35.3 35.6 36 36.4 37.1 37.5 37.4 37.1 37.5
OECD 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
Productivity
growth 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 3.2
Euro Area
Na Na Na Na Na 1 1.2 0.8 1.1 1.2 1.7 1.2 -0.2 -0.8 1.2
OECD 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
Productivity Gap
Euro 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 0.57
OECD 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
Source: OECD database. The productivity gap is measured as one minus the productivity levels of Portugal relative to the
productivity 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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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 1.4
Productivity 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 3.2
Unit 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 -1.3
Euro 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 -0.7
OECD 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 Na
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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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 21
st
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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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
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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.
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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
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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
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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
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2- Programs along the lines of the Educational Territories of Priority Intervention implemented in 2005
help to reach this goal. However, the program itself should be evaluated to ensure its effectiveness.
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
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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
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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 Effectiveness
Indicator (2009)
Country Score (-2.5 to 2.5)
France
1.44
Germany 1.48
Greece 0.61
Portugal 1.21
Spain 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.
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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
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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
Health
Portugal 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 benefits
Portugal 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.
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Source: Constructed by the authors using interest rate of OECD database and domestic credit of Bank of
Portugal 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
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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
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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?
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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
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3- The risk of devaluation could lead to a run on the Portuguese banking system. At the same time, with
the 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?
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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 Portugal
within the European Union: 1990 2002, The Quarterly Review of
Economics 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 Employment
and 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.