I
stated yesterday that I thought the IMF jumping ship on the current fiscal plan could be a bellwether of change in direction for the Eurozone’s crisis response. Last week we saw Italy’s Mario Monti
announce a surprise change to low income earners tax rates while cutting the planned VAT increase and even Angela Merkel has
stated that tax cuts are on the way in order to spur growth across the zone. I note, however , that both Schauble and Merkel are
defending their current position on Greece, but Ms Merkel’s recent visit to Athens demonstrates there is probably further compromise coming once the final Troika report is delivered.
That good news has been somewhat offset by Sweden’s Finance Minister reportedly claiming that it is “most probable” that Greece would leave the monetary union within six months. Obviously I am also still very concerned about the implementation of counter-productive policy in the Eurozone, but at least there appears a hint of change on the horizon. Unfortunately however that good news doesn’t appear to extend to Portugal who now appear to be making the same policy mistakes we’ve seen since the crisis began.
As I
explained again back in September, the current IMF/EU response framework is for nations to internally devalue with the aim of making countries more internationally competitive which will eventually mean current account surpluses can be used to pay down the existing debts. But this plan has some serious problems:
The basic premise of European policy is to tighten government budgets in an effort to drive down deficits. In the absence of a current account surplus in order to maintain a level of national income this requires an expansion of private sector balance sheets. If this does not occur then the most likely outcome is a slowing of internal demand and therefore a slowing of imports. This in turn should drive the balance of trade towards positive territory, but at the same time lower overall GDP.
Falling GDP leads to falling national income, which in the absence of real across the board wage deflation means more unemployment and therefore slowing government revenues which, as I’ve said previously, leads to a self-defeating process of re-newed cuts to government budgets.
So in essence this whole process becomes a struggle between the balance of the external sector, real wages and unemployment and this is the dynamic we have been witnessing in much of the periphery over the last 18 months. What I have noticed recently is that the adjustments in periphery nations balance of trade has been seen by some as a sign of recovery, which in part it is, but ultimately what is required is a sustained current account surplus.
This issue, as I also explained in that post, is that the initial side-effect of this policy implementation is rising unemployment and falling industrial production which obviously have upper limits, in a democracy more so.
Overall the basics of this plan is to restructure the economy to get the external account in surplus within a time-frame that the entire thing doesn’t blow up due to social and political unrest. Obviously writing off foreign debts would be a very quick way of helping this adjustment take place ( as with Iceland ) but for reasons of their own the Northern creditors of Europe think this is a bad idea and have been slowly jawboning the southern debtors into legally binding programs.
The problem is that Greece, Spain and Portugal certainly appear to be reaching the upper limits of what their citizens will endure but these countries are yet to reach external surpluses because there existing debt burdens are still too large. In other words the EZ has spent the last 2-3 years dismantling their existing economic structures but so far they have little to show for it. In fact by most macro-economic metrics these nations are far worse off, and therefore by definition so are their creditors.
As I
have explained before what we tend to see when a nation reaches these limits is an attempt to implement even stricter fiscal tightening in the misguided belief that the problem has been that they’re just not trying hard enough:
If a country’s current account deficit is structural then these efforts are very dangerous because this can easily develop into a damaging feedback loop. The loss of income through the external sector leads to a loss of income in the private sector, this then drives the stronger desire to save, meaning government revenues fall further. This inevitably leads to calls for higher taxes, which once again drain income from the private sector … and around we go. The result of this dynamic is a rise in unemployment, therefore national production and income, meaning once again the government sectors revenue decline while private sector spending and investment fall further.
And so the most likely outcome of further tax rises is that the government’s revenue will actually fall, not grow, meaning government sector debt actually grows, not shrinks, all the while the nation’s wealth ( social and economic ) deteriorates via continuing external sector deficits, a growing idle labour force and, increasingly, emigration.
Once a country reaches this point, the options are relatively limited and in the case of Europe we have seen these nations given greater amounts of credit in order to stave off default. It is obviously self explanatory that this is simply adding to the problem because by doing so the external account of the nation goes deeper into deficit. In the absence of some new external stimulus, the inevitable outcome is eventually outright default which is exactly what we have seen, and will likely see again, in Greece. But Spain and Portugal, and possibly Italy, are on Greece’s path.
Each of these economically troubled nations has different economic, political and social circumstances, differing levels and compositions of debt, and are all at different stages in the crisis. But at a high level the problems are basically the same and we have witnessed their issues steadily grow over time . Last month I
noted that Spain had reached the point where it had begun to once again increase taxes which signaled to me it was about to take another leg down based on the dynamic I explained above.
Unfortunately overnight
I read that we are about to see the same from Portugal:
The Portuguese government was all set to push ahead on Monday withmassive tax rises in a draft 2013 budget just two days after mass street protests against further austerity. The new measures, a condition of debt-rescue funding, are known to target income tax, pensions, and unemployment and sickness benefits.
….
The list of the new measures to satisfy EU-IMF debt rescue conditions will go from a cabinet meeting to parliament later on Monday.
Finance Minister Vitor Gaspar has already revealed the main thrust of the budget and what he termed an “enormous” increase in taxes, notably by means of reducing from eight to five the number of bands for income tax.
A surtax is to be introduced, and payments for pensions, unemployment and sickness benefit will be reduced. The changes to the tax banks will have the effect of raising income tax on the lowest incomes from 11.5 percent to 14.0 percent.
Tax on the middle income band ranging from 20,000 to 40,000 euros ($25,870-$51,740) per year will rise from 35.5 percent to 37.0 percent.
The rate on incomes above 80,000 euros will rise from 46.5 percent to 48.0 percent. This nearly halves the level at which the top rate applied previously, from 153,000 euros.
The increases could worsen a recession in Portugal. Official data suggests that the economy could shrink by 3.0 percent this year with the unemployment rate being close to 16.0 percent.
This is a preliminary announcement so there is a possibility of backtracking on some components but the message is clear. The Portuguese government is going “all-in” in order to meet it’s obligations under the emergency program even if the end result is a worsening economic outlook.
I would have hoped that a change in policy response would have come in time to save Portugal from this sort of economic suicide, but it appears now that this may not be the case.
