Portugal’s transition to the euro:the Treasury and the Bank

Jorge Braga de MacedoFEUNL and NBER

to be presented at a conference on Central Bank Communication, Decision-

Making and GovernanceWilfrid Laurier University, April 28, 2009

Political vs. financial freedom• As a European Commission official dealing with transition

economies in the early 1990s, I observed that the Ministry of Finance tends to be weak in Soviet type systems, certainly compared to the Gosplan. The first provisional government after the April 25th revolution featured a Minister for economic cooperation rather than for finance.

• Three decades later, the power of the Minister of Finance over the budget remains the lowest and the budgetary process the most fragmented in the EU.

• Political freedom and financial freedom are seen as inimical, instead of complementary. Future policies and their sustainability are neglected in policy discussions, while the rights and guarantees that democracy is supposed to provide today feature prominently in the current electoral debate.

• The fiscal constitution has not managed to resolve conflicts between political and financial freedom. After denying the former in the name of financial stability, the latter continues to be seen as a threat to democracy. This lasting ambiguity has led to defensive responses to European integration.

No economic and political synchronicity• The European Free Trade Association allowed Portugal to

develop an export base in manufacturing (“pajama republic”) before joining the EU in 1985.

• The process did not balance mutual political responsiveness with economic interdependence.

• The fiscal constitution prevented transfers to labor and “informal capital”. Public and private interest groups seeking transfers from the state and thereby holding on to the tax base took advantage of EU structural funds, reinforcing the redistribution of “taxable capital” to these groups.

• In a CEPR book on “unity with diversity in the European economy”, I argued in 1990 that the only credible measure to end the direct financing of the Treasury by the banks would be an agreement among the Central Bank, the Ministry of Finance and the spending ministries on a plan of deficit reduction involving both expenditures and revenues, and perhaps including tax reform.

• The agreement proved impossible even between the Treasury and the Bank!

Lessons from Portugal’s regime change• Little did I know I would try to do just that by embedding the

1992 budget in a convergence program a few weeks after I was sworn in as Minister of Finance. The budget was consistent with a wage and price agreement based on a target of 8% and the escudo joined the wide band of the EMS in April.

• The complementary package of macroeconomic and structural policies failed because the new currency regime required budgetary control – rather than excessive primary expenditure and state-led wage inflation.

• The mind set of inflation was rooted in a civic culture which pits political freedom against financial freedom, and democracy against hard budgets. Governments have been unable to reign in public expenditure because budgetary procedures have not been reformed.

• The ability of the banking system in protecting their role as implicit tax collectors also reflects a fiscal constitution where primary expenditure does not stop growing until a budget crisis erupts. Reform procrastination reversed the demand-led boom and led to a decade of real divergence with respect to the EU average.

Power over the government budget• In addition to the currency regime, the fiscal constitution reflects

the formal and informal rules governing the drafting of the budget law (formulation), its passage through the legislature (adoption) and its implementation. It distributes strategic influence among the participants in the macroeconomic policy process and regulate the flow of information.

• Around 2000 a survey was carried out in the European Union, according to which the Minister of Finance’s power over the budget has the lowest score in Portugal. As the Table shows, in Sweden the implementation phase is not carried out by the Ministry of Finance.

• Updates of these scores, based on work carried out by the European Commission and the IMF were published in Economic Policy 2008. In the Figure, Portugal’s score is equivalent to the absence of a numerical rule until it improves marginally in 2002. The EU 27 average is constructed to be zero. The problem has not gone away.

Power of Minister of Finance in the three phases of the budget

Countries\Phases Formulation Approval Implementation

Min (Portugal) 0,1 0,3 0,5

Greece 0,1 0,8 1

Average EU15 0,5 0,7 0,6

Min (Sweden) 0,4 0,5 0

Max (UK) 1 0,9 1

Fiscal rules in Portugal, Sweden and UK 1994-2005

-1,00

-0,50

0,00

0,50

1,00

1,50

2,00

2,50

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

SE UK PT

A gradual regime change towards convertibility

• A gradual regime change towards currency convertibility began with the 1989 amendment to the 1976 Constitution allowing a reversal of the nationalizations without due compensation which followed the 1974 revolution and was completed in 1992.

• The lesson from phase 2 of EMU is that you need to float in order to fix. Portugal’s external credibility was reached end 1992 with full convertibility and a rating upgrade in early 1993. This was confirmed after the widening of the bands in August 1993, even though another realignment was going to take place before the creation of the euro, bringing to four the totals of realignments of the peseta involving at least partly the escudo.

• Markets believed before voters did. Why? No constituency for globalization. Paranoia Europe vs. Africa.

• The Figure shows the reversal of regime change in 1990-91 (reform of public sector wage grid and controls on capital inflows, wage and financial moderation).

Long term interest rate differential relative to Euroland (% p.a.)

0,0

2,0

4,06,0

8,0

10,0

12,014,0

16,0

Contagion between escudo and peseta in a model with variable

correlations and volatility states determined by the interest differential with Germany

Effect of differential on probability of currency going from high to low volatility

Correlation varies with escudo

Correlation varies with peseta

Escudo-0,2 -0,2

Peseta0,3 0,4

Correlation low volatility

0,7 0,6

Correlation high volatility

0,7 0,8

Perverse expectations effect

• When the two currencies were in the ERM, an increase in the interest rate differential when Portugal is in a crisis state lowers the probability of exit from the crisis, a “perverse expectations effect” which does not obtain if Spain raises the interest differential.

• These results qualify previous analysis about interventions when fundamentals were seen as determinant in the wide band period. Taking into account the correlation between the two Iberian currencies reveals that fundamentals in Spain affected Portugal but the converse was not true.

• The correlation between escudo and peseta does not change with escudo volatility but it jumps from 0,6 to 0,8 when the peseta goes from low to high volatility.

Political and financial instability

• “Geographic fundamentals” suggest that for the escudo to always follow the peseta would have prevented any positive differentiation, whereas ignoring the peseta would not have been credible. Thus remaining outside of the ERM during the turbulent period would have been likely to exacerbate contagion, or require a drastic tightening of capital controls instead of their dismantling.

• The euro did not change the fiscal constitution and reforms continued to stall. Even before breaching of Stability Pact in 2002, Portugal became a victim of the “euro hold up”.

• There is no evidence that the drachma might have a similar contagion problem, so that ERM entry for the drachma was not as urgent as it was for the escudo.

• Dynamics of bipolar executive (Head of State vs. Head of Government) have been source of political instability, especially serious when enhanced by disagreements on reform design.

References• Unity with Diversity in the European Economy: The

Community’s southern frontier, edited with C. Bliss, Cambridge University Press, 1990;

• Productivity and Growth in Portugal, edited by M. Pinho, Lisboa 2002;

• M. Hallerberg, R. Strauch and J. von Hagen, The design of fiscal rules and forms of governance in European Union countries, European Central Bank Working Paper Series, No. 419 / December 2004;

• The Ladder of Competitiveness how to climb it, O. Causa and D. Cohen Paris: OECD, 2006;

• A comparative view on reform complementarities, Revue d’Économie Politique, vol 117 (4), July August 2007;

• Competitiveness and convergence in Portugal, GEE Papers, Ministério da Economia e da Inovação, 2007, nº 4.

• Growth, Reform indicators and Policy complementarities (with J. Oliveira Martins), Economics of Transition, 2008;

• Tied to the mast? National Fiscal Rules in the European Union, X. Debrun et al., Economic Policy, April 2008.