When the euro was “physically” introduced on January 1st, 1999 a new world of endless possibilities seemed to be emerging for participant countries. With the introduction of a single currency across European Union countries, a brand-new single and more transparent market was expected leading to a strong economic and political integration with more competitiveness and subsequently overall growth across all member countries. However, “A single currency to work over a region with enormous economic and political diversity is not easy” (Stiglitz, 2016:8) and although for a while everything went according to the original plan, huge problems arose after the 2008 financial and economic crisis. This article aims at understanding what were the constraints imposed by the euro as a common currency when having to respond to the financial crisis in Portugal, namely the costs of losing one very important tool: either exchange rate or monetary policy.
In the run up to and following the introduction of the euro, Southern European countries could borrow at lower interest rates than before, since they were at that moment considered less risky and the European Central Bank ran several anti-inflationary policies. Hence, there was a large inflow of capital to these countries (Feldstein 2012). Despite this, data reveals lower productivity growth in the Southern European Union countries when compared to the rest. Studies suggest that this was due to the boom in construction and to the movement from tradable to non-tradable sector, characterized by slower productivity growth (Benigno and Fornaro, 2014; Reis, 2013). Authors such as Gopinath et al. (2015) have also suggested that lower productivity might be due to a misallocation of capital which led to lower total factor productivity. Since the introduction of the euro, Portuguese GDP has only grown three years above 2%. Through almost two decades, the growth rate of Portugal has mostly been around zero or one percent, and even negative in some years (-2.98% in 2009; – 4.03% in 2012). Only in 2014 did the economy began recovering, reaching a 2.8% growth in the first trimester of 2017 (1). As for the unemployment rate, it increased since 2008, reaching 16.2% in 2013, the third largest in the European Union, higher than what had been seen in many years, following Greece and Spain (2). Portugal’s interest rate reached 10,5% in 2012 the 2nd highest, after Greece (3).
Monetary policy is a helpful tool in solving external and internal issues that Portugal has given up when decided to join the common currency. On the one hand, it can be used as a current account stabilizer. As to fix external deficit, a country might use currency depreciation or devaluation. For that, banks must intervene by issuing currency or decreasing interest rates. The decrease in the interest rates will have two consequences: on the one hand, it will increase the demand for foreign currency, thus increasing its price and subsequently depreciating home currency which is the aimed effect; on the other hand, it will result in a capital outflow, the more one decreases the interest rate, which may have a big impact in the economy since foreign investment will fall substantially. That said, any institution with the authority to perform such operation should be very careful as not to force too much the depreciation but rather let it happen naturally.
In addition, monetary policy can be used for correcting inflation – the primary goal of the European Central Bank. If inflation is expected to rise, countries might increase interest rates as to drive demand for goods and services down (making access to credit harder) and hence soften the inflationary pressures. However, increasing interest rates drives demand for home currency up which will drive its price up and result in an appreciation. This appreciation though, if excessive, might harm the countries competitiveness and hence worsen its current account. Not to forget though, that this topic has been given a lot of attention from the ECB and hence it is not the major problem.
Furthermore, this tool can be used as an economic growth booster as well as a measure to fight unemployment. By decreasing interest rates, banks are facilitating access to credit and therefore promoting consumption and investment which accelerate the economy. Also, through open market operations, i.e. buying debt to commercial banks in return for money, monetary policy increases banks liquidity which might be responsible for an increase in loans to families and companies. If Portugal was not in the Eurozone, it could attempt at solving any of these mentioned problems by using money as a tool. With a common currency however, there is only one common monetary policy which means that, when faced with asymmetric shocks, there will be a common answer thus not all economies will have their needs satisfied.
Without the euro, Portugal could have an essential instrument to stimulate economic growth: the exchange rate. Portugal could compete in prices with Germany, for instance, through a devaluated currency. With the euro, it’s stuck competing with much stronger and much less devastated economies. In this sense, there was a failure in creating institutions that would overcome this. Also, despite being always negative, there is a significant fall in the current account from 1996 till 2009. By 2013, it reaches its highest level and afterward decreases a bit again (4). Consumption has decreased in these years meaning that the increase in the current account is not only due to an increase in exports but above all to a decrease in imports (5).
Some economists, such as Alesina, Barbiero, Favero, Giavazzi, and Paradisi (2015, January), a reference for Troika, believe that countries can still benefit from the same effects of a currency devaluation (increase in external competitiveness) through a decrease in nominal wages – austerity. In their opinion, by reducing salaries, companies can decrease their production costs and subsequently their prices, thus increasing competitiveness with foreign countries. I believe that the Southern European Union countries recent experience has shown several flaws of this assumption. First, because a fall in prices through this mechanism is a fall in all prices, not only on tradable goods’ prices (as it would happen with currency devaluation). As a matter of fact, housing prices fell drastically between 2009 and 2013 which corresponds to an asset devaluation, characteristic of a period of crisis (6). This means that the overall economy becomes worse, whether internally or externally and therefore, an income effect will occur, which will be responsible for a general reduction in consumption, as we saw between 2011 and 2014 (see (5)). On the other side, a currency devaluation incites investment in tradable goods sector, since imports become a higher burden. This can have a positive structural effect on the external position of the country, meaning that it will become more competitive before its foreign rivals.
Finally, unlike what was used as an argument in favor of the introduction of the euro, joining a big currency union while being less productive than most member countries did not lead to economic convergence but rather to increase external dependence, worsening the current account deficit. In the Eurozone, when a country imports more than it exports, which is the case of Portugal, a domestic shortage of money tends to occur, requiring borrowing from abroad and hence an aggravation of the external debt. Also, since borrowing has limits, lender countries will keep on lending up to the point where they do not longer consider the borrower country to be solvent and then a sudden stop becomes imminent. At that point, the borrower hits bankruptcy, as it happened with Greece and almost with Portugal, and ends up stuck with a big external debt and no means of liquidating it. If Portugal and Greece had opted out in first place, most likely they wouldn’t have benefited from these borrowing opportunities and hence they wouldn’t have increased their debt up to the levels that they did. Despite week, without the euro these countries wouldn’t most likely have the economic performances that they did. Nevertheless, they wouldn’t be forced to pay an enormous external debt along with absurd interest rates and restrictions to all its policies, including fiscal and monetary. Therefore, they had to surrender to Troika’s requirements as to be conceived a bailout.
Throughout this article, a few arguments were presented on how the euro constrained the Portuguese economy, especially during the period of the financial crisis. Nevertheless, it is relevant to mention that these are merely assumptions and it is impossible to know for sure how it would have been if the Escudo had remained as Portugal’s currency. In fact, not joining the euro always entailed the risk of having to face very high interest rates during the early 2000s, while all the other countries would be benefiting from low interest rates since Portugal was never considered very reliable. This would have represented difficulty in obtaining financing and no capital flying in. Joining the euro has increased price transparency, since it is now easier to compare prices among the European Union and has abolished currency uncertainty. Still, the main issue here seems to be the failure in creating institutions that would overcome these obstacles, namely protecting less strong countries at least during an adjustment period. Putting countries like Portugal, Spain or Italy at the same level as Germany, Austria or even France is at least irresponsible and is at the source of the problems that the Eurozone countries have faced. The European Union faces now the challenge of having to restructure its institutions, making them stronger, more egalitarian and solidary, as all common projects should be, to overcome these problems and in this way, assure a long lasting common currency.
Macroeconomic Analysis NovaSBE Frederica Mendonça, 3688
References:
Stiglitz, Joseph E. (2016) The Euro: How a common currency threatens the future of Europe, W.W. Norton & Company
Ferreira do Amaral, João (2013, Abril) Porque devemos sair do Euro, Lua de papel
Ferreira do Amaral, J. Louçã, F. (2014, Agosto) A solução Novo Escudo, Lua de papel
Gopinath, G. Kalemli-Ozcan, S. Karabarbounis, L. Villegas-Sanchez, C (2015, 28 September) Low interest rates, capital flows, and declining productivity in South Europe (Acessed 30th November 2017)
Data: The World Bank & OECD
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