Portugal’s Best Way out of Economic Stagnation: Institutional Reform of the Eurozone

Abstract

Since the creation of the Economic and Monetary Union (EMU), the Portuguese economy has exhibited real divergence vis-à-vis the wealthier Eurozone countries, tremendous current account imbalances and a sharp increase in foreign indebtedness. We argue that the causes of the underperformance and of the external imbalance of the Portuguese economy in the last decade were excessive private consumption growth fuelled by historically low nominal and real interest rates, steep increases in oil prices, rising relative unit labour costs vis-à-vis other Eurozone countries, and fierce competition from China and Central and Eastern European Countries affecting Portugal’s traditional exports. We discuss the different macroeconomic policy options currently available to the Portuguese government and conclude that, in the face of the terrible short-term economic hardships that Portugal would face were it to withdraw from the Eurozone, the best way forward for it is to join forces with other peripheral Eurozone countries in order to push for institutional reform of the EMU along the following lines: replacement of the Stability and Growth Pact by ceilings on the current account balances of individual Eurozone countries; a temporary increase in inflation to (say) 5 per cent to allow for a more rapid decrease in relative unit labour costs in Eurozone countries exhibiting current account deficits; implementation by the ECB of asset-based reserve requirements on Eurozone banks; issuance of Euro-bonds to fund credit towards Eurozone countries facing liquidity crisis, and empowerment of the ECB to purchase these bonds.

This paper was presented at the Conference titled ‘The Greek and Euro Crisis’ held at the University of the Basque Country, Bilbao (Spain) on 17 December 2010 and at the 8th Conference on ‘Developments in Economic Theory and Policy’ held also at the University of the Basque Country on 30th June 2011. The authors would like to thank Philip Arestis for kindly inviting them to participate in both Conferences. They also wish to thank participants in the Conferences and the editors of IPPE for their useful comments and suggestions. Of course, the authors are responsible for any remaining errors.