The Portuguese Economy

Abstract

By the end of the last millennium, Portugal looked like a promising country in Europe, flooded by a wave of optimism and self confidence seldom felt since the country led Europe to all the corners of the world during the XV and XVI centuries. Coming from organizing a major international event in 1998, the Universal Exhibition, which had attracted as many visitors as its entire population, the country was already preparing for another major event, having been chosen to organize the European football cup. The new generation coming out of the universities faced much brighter prospects than their fathers, having born into a stable democracy after the fifty dark years of dictatorship which made the country one of the most illiterate in Europe. The economy had been rapidly converging to European levels since 1985, just before becoming a member of the EU, unemployment was low, by European standards, interest rates were low and it had been admitted into the first group to adopt the euro. But the dawn of the new millennium uncovered major economic frailties. Productivity growth slowed sharply. Large current account and budget deficits emerged. Portugal faces a serious problem of competitiveness, hidden by decades of continuous currency devaluation, but now emerging with the euro. On the contrary, due to inflation rates above the EU average, in the seven years since the euro inception in 1999, the real effective exchange rate has grown by 14.2 percent. For a better understanding of the current situation, it is helpful to look at the past developments. In the post-war period, the Portuguese economy was influenced by three major events, with a profound impact on economic structures: the revolution of 1974, EEC membership in 1986, and euro adoption in 1999. The Marshall Plan, after the second world war, is regarded as the main trigger for a change in international economic relations, originating the movement of European economic integration in the late 1950s: in 1957 the Treaty of Rome is signed and three years after, the European Free Trade Association (EFTA) is created, of which Portugal was a founding member, opening the country to trade. A further step towards economic integration was taken in 1972, by signing a trade deal with the European Economic Communities (EEC). Economic openness was soon followed by democracy. With a bloodless military coup in 1974, Portugal emerged from almost half a century of dictatorship. After a decade of some political instability, the country joined the European Communities in 1986, together with its neighbour, Spain. By then, the country’s GDP per person was just above half the average European level and in the following years this figure increased quicker than in any other EU member in the first years of membership. In 1999, it was one of the eleven countries adopting the euro at its launch. Portugal is a good case study for the potential benefits and main risks of monetary integration. Ever since adopting the euro, its growth rate has been dismal, well below the EU’s average, unemployment increased, and budget and current deficits soared, a situation which have proven extremely hard to invert. It has been very difficult for the Portuguese economy to adjust to the rules of the monetary union and the wider globalisation phenomenon. Low productivity and high costs leave domestic firms vulnerable to competition from the new EU countries and Asia. An under-financed education system, very low spending in research and development, and shattered self-confidence levels do not help in keeping expectations up. Unit labour costs have increased relatively to the European average during the 1990s, and have been emphasized as a major source of the problem. In a monetary union, there are only two available solutions to reduce unit labour costs relatively to the other members: lower wage growth or higher productivity growth. The latter solution is obviously more attractive but the former seems faster in the short run. The problem is that, with already low wage growth during the last few years, this solution effectively requires a decrease of nominal wages (Blanchard, 2006). The catching-up process of real convergence with the EU has stopped and was even reversed in recent years. During the first years of this century, growth rates well below the EU average led relative per capita income to the levels registered in the beginning of the 90s. With low and sluggish productivity, it will be extremely difficult to prevent the negative effects of an aging workforce on GDP per capita.