The Reis (2013) paper ‘The Portuguese Slump and Crash and the Euro Crisis’, builds a theoretical macroeconomic model to explain Portugal’s underperformance over the 2000-2007 period, compared to the rest of the Eurozone. This is argued to have been the result of a higher degree of capital misallocation and large pension costs.
Was Portugal in a slump over the 2000-2007 period?
The Portuguese economy had a relatively weak economic performance after it joined the Eurozone in 1999. For example, as Reis (2013) highlighted, the country’s annual growth rate was considerably slower than the rest of the Eurozone. It was one of the only countries where unemployment grew over this time period (see Figure 1). Moreover, this happened during a period of an economic boom in other Southern European countries, supported by capital inflows from the North. Given that Portugal also experienced strong capital inflows during this period, the puzzle is why it did not see equivalent growth.
Figure 1: Portugal experienced slow growth and growing unemployment over the 2000-2007 period.
DATA: Eurostat, Reis (2013). Note*: main trading partner refers to the weighted average of Spain (50%), Germany (30%), and France (20%).
Paper hypothesis: capital misallocation and high pension costs drove the divergence
Reis (2013) develops a theoretical macroeconomic model, which formalises the hypothesis that capital misallocation and high pension costs drove Portugal’s relative weakness. The hypothesis is based on the following indications:
Portuguese banks acted as intermediaries between foreign capital inflows and domestic investments. It is hard to track where exactly they allocated this added capital, but some evidence suggests that it was primarily towards non-productive nontradable sectors. For example, during the 2000-2007 period the retail wholesale sector grew the most in terms of employment, while it remained the most stagnant in terms of productivity. Moreover, Braguinsky et al (2011) estimate that Portugal shifted more towards small-sized firms, partially due to more favourable taxation for them. Such businesses typically fail to utilise economies of scale and their relative growth is another indication of capital allocation to low productivity companies.
Portugal had one of the Eurozone’s most expensive pension programmes, which was the result of two factors. Firstly, the country had one of the highest rates of old-age poverty in the OECD, which led it to impose a minimum pension for everyone. Additionally, during the early 1990s, pension generosity was increased, particularly for public servants, and the added costs materialised from 2000 onwards. In order to deal with the added cost, the country increased its taxation on consumption and labour over the 2000-2007 period, in contrast to most other Eurozone countries. This led to a negative labour supply reaction and lower consumption levels. Moreover, this happened in parallel with a drop in government spending on education, culture, and economic affairs. In fact, Reis (2013) estimates that over 100 percent of the increase in total spending over the 2000-2007 period came from old-age pensions.
Conclusion
The Reis (2013) model for capital misallocation and high pension costs manages to reproduce the prediction of a relatively weak economic performance in Portugal. In my opinion, the fundamental takeaway is the importance of having a mechanism in place which allocates investments to productive sectors. Without this element, it is possible for a country’s productivity to stagnate despite growing investments.
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