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As Athens burns after two years under an International Monetary Fund (IMF) – European Union (EU) adjustment program, one has to hope that Lisbon is paying attention to the Greek drama. Since, in order to cure Portugal’s chronic budget and external current account deficits, the IMF and EU are now prescribing for Portugal the very same policy mix of draconian fiscal austerity and structural reform as they did with such dismal results in Greece. Forewarned by this experience, Portugal could avoid Greece’s horrible fate if it were to draw the right lessons from the Greek experience.
The first lesson that Portugal should derive from Greece’s experience is that severe budget austerity in a currency union is a sure recipe for the deepest of economic recessions. Without the benefit of its own currency to devalue to promote its external sector, the severe fiscal austerity imposed by the IMF on Greece exerted a hugely negative shock to the Greek economy. Indeed, over the past two years, under the weight of a massive dose of fiscal austerity, the Greek economy contracted by over 12 percent while its unemployment rate skyrocketed from 7 percent at 2009’s end to over 20 percent at present.
“Portugal could avoid Greece’s horrible fate if it were to draw the right lessons from the Greek experience.” - Desmond LachmanThe lesson that budget tightening in a currency union is all too often the precursor of the deepest of economic recessions would seem to be particularly pertinent to the present Portuguese economic conjuncture. The IMF is now requiring Portuguese spending cuts and tax increases, in 2012 alone, of as much as 6 full percentage points of GDP. And it is doing so at the very same time that there are the clearest signs of an already weakening Portuguese economy, a deteriorating external environment, and a domestic credit crunch. Little wonder then that the Portuguese Central Bank has already been forced to acknowledge that Portugal’s economy will shrink by more than 3 percent in 2012. A second fundamental lesson that Portugal would do well to draw from the Greek experience is that deep economic recessions are antithetical to either the re-establishment of budget balance or to the stabilization of the public debt ratio. Indeed, by eroding the country’s tax base, a collapsing Greek economy has kept Greece’s budget deficit at close to 10 percent of GDP despite two years of major tax increases and public spending cuts.
More disturbing still, the collapse of the Greek economy has contributed importantly to the relentless rise in the Greek public debt to GDP ratio from 110 percent at the start of its IMF program in May 2010 to around 160 percent at present. This lesson would appear to be particularly pertinent to Portugal since that country starts with an underlying budget deficit of close to 8 percent of GDP and a public debt to GDP ratio that is already on a trajectory to climb to over 120 percent by 2013.
A third lesson that Portugal might usefully learn from Greece is that delaying debt restructuring in the case of an insolvent country only compounds the eventual debt restructuring process when it eventually occurs. It does so by affording the private sector the opportunity to reduce its share of the country’s overall sovereign debt at the expense of the IMF, the EU, and the European Central Bank. Those latter institutions are all highly resistant to the notion of affording any debt relief themselves. As a result, whereas a 30 percent write down of Greece’s privately held sovereign debt might have restored Greek fiscal sustainability in May 2010, some two years later, after massive IMF-EU lending, Greece is now obliged to seek a 70 percent write-down in the present value of its privately held debt in order to restore any semblance of public debt sustainability.
Yet another lesson that Portuguese policymakers might draw from the Greek experience are the advantages of having the overwhelming majority of one’s sovereign debt covered by domestic rather than international law. This advantage deprives a country’s foreign private creditors the option of resorting to the American or English courts to dissuade a country from unilaterally changing the terms of its sovereign debt contracts. To its detriment, Greece has only now started exploiting this advantage by threatening to retroactively legislate collective action clauses into its debt instruments as a means to coerce recalcitrant creditors to “voluntarily” accept a 70 percent haircut.
Perhaps the most basic of all lessons that Portugal should learn from Greece is the futility of an insolvent country adhering to an IMF-EU austerity program that precludes debt restructuring and currency devaluation. If it is inevitable that a country will in the end be forced to restructure its debt, it is best that such a restructuring be undertaken early while the overwhelming part of a country’s debt is still in private hands and still subject to the country’s domestic law. This would seem to be clearly preferable to putting the country through the most wrenching of recessions only to find that in the end the debt cannot be repaid.
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