Portugal's Successful Recovery from the Euro Crisis

Speech by Eurogroup President and Portugal’s minister of finance, MÁRIO CENTENO From sick man to poster boy: Portugal’s successful recovery from the euro crisis

European Economic Policy Forum

18 DE MARÇO DE 2018, CENTER FOR EUROPEAN STUDIES

HARVARD UNIVERSITY

Dear Chair, Professor Peter A. Hall,

Dear Professors,

Dear Students,

It is a pleasure to be here at the Center for European

Studies of Harvard University. It’s good to be back and to see so many familiar faces and places. I cherish the memories of the time I spent here as a PhD student back in the late nineties. And I have learned so much from colleagues, professors, all friends.

Harvard taught me how to think of economics and politics together. At Harvard I had the privilege to meet colleagues with the same interests, but also those who read different papers. I was truly enriched by that experience. And, I may say, my interest in Politics and Economics remains intact.

Although politics has been stealing me probably far too much time lately…! But that too I learned here. I was always inspired by so many examples of Harvard Professors and Alumni that served in office. That sense of mission called me in, when a chance to govern my country in a dire situation was offered to me.

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I’m doing my share of serving. I come here today as alumni, as a Minister of Finance and a President of the

Eurogroup. I will share with you today my government experience.

David Cutler always urged us in seminars to start by answering the question: why should I care about this? Well before you raise this question, let me tell you why.

Portugal has had a successful recovery from the euro crisis. It is a good story of an economy reforming and benefiting from it.

And for those with an eye on the political science dimension, it is also a breakthrough for political alliances in Southern European countries coming from the left.

The Portuguese economy and society have endured a difficult period of adjustment. The kind of adjustment that occurs, hopefully, only once in a lifetime.

We are still working to ensure a happy end to this story but it is looking pretty good so far.

This is a story of a small open economy in the context of a wider integration in a single currency area, with a degree of shared sovereignty.

From a political economy perspective, the process of adjustment depends on a triplet: reforms – expand the supply, increase potential growth; the business cycle and fiscal policy, feed the reforms with some demand; and time, which in economics means patience, the opposite of populism. Patience is a key ingredient for a successful implementation of reforms and the State is the main supplier of such precious asset.

This triplet was not always taken on board in the European economic policy debate. In a sense, ideologically, this debate was a revival of Jean Batiste Say famous result, known as the Say’s Law: all supply creates its own demand.

But we all know that Jean Batiste was not right.

Europe focused too much on the first dimension of the triplet and woke up rather late to the need for the whole set policies. Arguably, it did not do so until Mario Draghi’s famous statement “whatever it takes”.

In fact, Europeans came to believe that reforms were everything, and they arrived late to a solution for the financial crisis. That also increased the burden on national reform agendas.

Let’s then focus on Portugal.

Let’s start with a gloomy scene setter. After a decade of very low growth, in 2011 Portugal was mired in a deep recession and was blocked off markets.

I’ll explain how we got there. I will then proceed to explain in some detail how Portugal turned around. Finally, I will talk you through the challenges we have before us.

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To start with, how did Portugal became what so many called a sick man in Europe?

Let me take you back to Portugal in the early 2000.

Portugal joined the EU in 1986. A small-closed economy with very poor human capital, the country struggled to catch up with its European peers.

While the US was experiencing the Century of Education, as

Larry Katz and Claudia Goldin dubbed the 20th Century, in

1982, only 2% of private sector workers were college graduates.

While in Massachusetts education is mandatory until the age of 12 since the late XIX Century, in Portugal we traveled though the XX Century with 3 years of mandatory education (and for men only).

In 1986, strong public investment and domestic demand became prominent and were met by a European willingness to finance them. As a result, private debt increased remarkably.

From 1995 to 2001, household debt rose from 52% to 118% of disposable income and non-financial corporate debt from 81.5% to 149.8% of GDP.

The demand boost acted as a growth catalyst (3.5% per year on average between 1995-2001), and pulled down the unemployment rate (from 7.1% in 1995 to 4.0% in 2001).

In my last year as a PhD student at Harvard, I presented a paper on self-employment in Portugal. It stroke the audience that the unemployment rate was as low as the one in the best performing US states by then: 3,8%.

However, this was not a sustainable path as, for example, the current account balance deteriorated from -0.1% of

GDP in 1995 to -10.4% in 2001.

Thus, in the 2000s, while other European countries experienced high growth rates, the Portuguese economy flattened. Between 2001 and 2008, the country grew at an average rate of 1%.

Why did this happen?

First, domestic demand weakened, both in terms of consumption and investment.

Second, the admission of China to the World Trade

Organization in 2001, and the enlargement of the European

Union to Central and Eastern European countries in 2004, raised new challenges. These came on top of weakening external competitiveness.

Third, during this period, Portugal borrowed vast amounts from abroad, which the domestic financial sector appears to have misallocated, by channeling these foreign capital inflows to relatively unproductive non-tradable sectors.

When the 2008 global crisis came, Portugal was vulnerable.

The country’s economy could not cope with rising spreads and interest rates. This generated both a sovereign debt crisis and a banking crisis.

Remember that the first reaction of Europe (and the US) to the crisis was to boost demand, but there was no fiscal space in some countries (Portugal included) to finance it.

So they entered into rising (sky-rocketing) fiscal deficits and public debt (a 10% deficit in 2010 and more than 100% public debt since that date).

The results were dramatic. Portugal was forced to turn on the EU and the IMF for financial assistance, and that was doomsday. We entered into panic mode.

GDP fell 7.9% and employment declined 13.4%.

Unemployment surged to 17.5% in 2013. Nearly 500,000 people emigrated between 2011 and 2014 - the largest emigration rate the country had experienced in 50 years.

The Labor market contracted for 14 quarters in a row.

That’s only comparable to countries experiencing a war!

(as was actually the case for Portugal in 60s, with the colonial war in Africa).

Portuguese bonds were downgraded to “junk”.

So, as you see, the crisis was not kind on Portugal.

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Today the script has changed. Today Portugal is on the news again, but for good reasons.

The economy has picked-up in a sustained way since the second half of 2016, accelerating further to a 2.7% growth rate in 2017. This is above European Union average.

Investment and employment increased twice as much as the EU average, while unemployment fell to 8% (its lowest level since 2008). More interestingly, the unemployment rate of prime-age individuals (25-54) was 5.7% in 2017.

The labour force has been expanding again since the 4th quarter of 2016.

On the fiscal front, we reached a fiscal deficit of 0.9% in

2017. Public debt decreased 4.3 p.p., the largest drop in

20 years, and is now at 125% of GDP – still very high.

The good economic results translated into policy and financial recognition: we exited the corrective arm of EU

SGP and regained investment-grade rating for our bonds.

With all this, can we dub Portugal a “poster boy” of

Europe? I do believe Portugal’s recovery provides a good example for Europe.

When explaining how the economic situation evolved I stated that Portugal was catching up in terms of human capital with the rest of Europe.

Portugal is still dealing with a large stock of low-skilled workers, but is posting a very positive flow. From the 2% of college graduates in 1982, we are now at 20%.

Remember the element of patience I have mentioned in my introduction?

Reforms introduced following the EU accession in education and training started to pay-off only decades after their implementation. But we know that there is still a long way to go.

We’ve only recently dealt with the challenges posed by the financial sector. We were truly late beginners on that.

But one single measure of success is that in 2016/2017 we were the only European country to be able to attract banking capital from all over the world (the US, China,

Africa and Europe).

Challenges, of course, remain. I’ll come back to these later on.

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The national efforts only make sense if properly framed in the Euro Area reform process. I believe that the discussion

on Euro Area reform can also benefit from some comparisons with the US Monetary Union.

Note that the institutional landscape in Europe is much harder and incomplete compared to the US.

Also note that income convergence in Europe still lags that witnessed in the US. If you take the income distribution of each of the two monetary areas (EU and US) you conclude that: income inequality is larger in the US; but inequality between countries/states is much larger in Europe.

A plot of the income distribution in the US stacking states on top of each other results roughly in the stripes of your national flag; while in Europe, the result is a totally skewed distribution, with low income countries representing a disproportional share of low income

Europeans.

If a policy is designed to the median income in the US it spreads all states roughly equal. In Europe, it will result in a quite different impact across countries.

The Euro is a currency still in its infancy. But it is developing fast and has proven very resilient. A few years after being born it faced a major global crisis. Not only it survived, but it grew stronger.

Let’s briefly recall what we have achieved at the Euro Area level, both in institutional and economic terms.

At the institutional level, we pooled common resources together to establish the European Stability Mechanism, a body to support Member States facing financial difficulties.

We also reinforced our common rules on macroeconomic and fiscal policies in the euro area. This was important to bring more coherence between 19 different policies. Our

efforts are producing results: the annual fiscal outrun of

Euro Area member states is more aligned than ever before.

Very importantly, we set up a common regulation and supervision of financial institutions and of financial markets.

And we are enjoying economic growth.

We are in the 20th consecutive quarter of growth in the

Euro Area. We have been witnessing steady job creation and growing investment. We have a positive external position. Today, the Euro Area is seen as an engine of global growth. The Euro proved its role as a political project. Citizens and firms back in Europe never lost faith in their currency even in hard times (74 percent back the euro, the highest in many years).

The reform process is not yet over. The US took several decades, since the period of Hamilton to complete its banking union. We need to follow suit.

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What does the future bring for Portugal and Europe?

I have highlighted two main engines of the structural change of the Portuguese economy: human capital and external competitiveness.

We have more quantity and more quality in our schooling system. Our students have now above average results in the OECD PISA tests. Beating US, Germany and even some northern countries’ students.

The current account has been in surplus for the past six years now (the first time in many decades).

Several factors play into this. I would like to highlight the fact that Portuguese exports have been climbing the quality ladder. And gaining market share.

The fiscal front still requires attention.

The Portuguese debt is very high. Our aim is to reduce public debt to 102% of GDP by 2022. Belgium did it between 1995 and 2005, we can also make it.

The financial sector has also to return to full health. More will have to be done to fully restore credit flows, notably by further reducing the level of non-performing loans.

But Portugal is not isolated from the rest of Europe.

Every single member state of the Euro Area will only reap the full benefits of the Euro if the financial union, which comprises a banking and a capital markets union, is implemented.

In Europe we need to be ambitious and to defend the completion of the banking union. This is so because in the

Euro Area, unlike in the US, financial fragmentation is a major concern. This increases costs for everyone. Unlike in the US, citizens and firms still face major hurdles to find financing across state borders. This limits growth potential.

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I have conveyed to you the path Portugal has made to recover from the crisis in order to illustrate how reforms take time to produce results.

Portugal was perceived as a sick man of Europe. Indeed it had severe imbalances, but elements of reform were already present before the crisis.

Nowadays Portugal is perceived as a poster child for economic adjustment. Indeed success is evident but

challenges remain. I’ve shown how decisive reform in key areas – on the financial sector and on the fiscal stance – can produce positive results. I have also cautioned that those efforts must be sustained over time given the magnitude of the task they represent.

In my final words let me go back to my days at Harvard. I have learned here, as a student, to be detailed in my research. I have learned the value of good, reliable and verifiable data. As such, now as a policy maker, I always pursue the same method. When deciding policy we should base our options on hard data. No leaps of faith or perceptions. But with a faith in action and in alternatives.

When coming back to my alma mater I want to pay tribute to the lessons learned here. And, believe me, I do my best to keep up with the lessons I learned at Harvard.

Thank you.