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Comments and Discussion

From: Brookings Papers on Economic Activity
Spring 2013
pp. 194-210 | 10.1353/eca.2013.0007

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Comment by Olivier Blanchard

This paper by Ricardo Reis makes two contributions. The first is to provide a formalization of an important theme, namely, that financial opening without financial deepening can be counterproductive. This theme has been around for a while and has led in particular to a rethinking of the role of capital controls, but I have not seen it formalized before. The simple analytical structure offered by Reis is elegant and user friendly. This is the part of the paper I like most.

The paper's second contribution is an interpretation of the Portuguese slump through the filter of this model. Here I am less convinced. I am willing to believe that higher capital flows indeed led to some mishandling and some misallocation of resources. But I am skeptical that this is one of the major factors in the Portuguese tragedy.

Reis focuses on the period 2000-07. As he emphasizes, taken on their own, the facts of that period in Portugal are indeed puzzling: large capital flows, low interest rates, but little or no growth. Ricardo offers a tentative resolution to the puzzle: misallocated capital flows led to decreasing productivity, in particular in the nontradables sector.

I believe, however, that there is no puzzle. By choosing 2000 as the starting date, Ricardo starts the story in the middle. The full story, which starts circa 1995, is in fact quite straightforward. Its main elements are summarized in my figure 1, which plots Portugal's unemployment rate and the ratio of its current account balance to GDP. The story has three chapters.

The first chapter, which starts in 1995 and ends in 2000, is the story of the boom. It is shown in the first panel of figure 1's triptych. The proximate causes of the boom are clear: a sharp decrease in the interest rate (as shown in Reis's figure 4), reflecting the steady decrease in perceived country risk in anticipation of Portugal's entry into the euro area, and expectations of sustained growth, again from adoption of the euro. The implications are equally straightforward: strong demand and sustained growth, the latter running at an average of 4 percent per year, leading to a decrease in the unemployment rate from 7.5 percent to 4 percent, together with an increase in the price of nontradables, increased demand for tradables, and a large increase in the current account deficit, from rough balance in 1995 to 10 percent of GDP by 2000.


Click for larger view
Figure 1. 

Current Account Balance and Unemployment Rate in Portugal, 1995-2013

The second chapter—the focus of most of the paper—which starts in 2001 and ends in 2007, is the story of the slump. It is shown in the middle panel of figure 1. As the start of the euro does not lead to the hoped-for growth miracle, Portuguese households and firms revise their expectations, and private demand slows down. The textbook adjustment process suggests that this should lead to a decrease in the price of nontradables, a shift in consumption toward nontradables, a shift in production toward tradables, and a decrease in the current account deficit. This does not take place, however, partly because countercyclical fiscal policy props up demand and output—the budget deficit remains high, at around 5 percent of GDP—and partly because of nominal wage and price rigidities. Indeed, nominal wage growth continues, in excess of productivity growth (which is low), leading to a further real appreciation and a current account deficit that remains around 10 percent of GDP.

Under this interpretation, large capital inflows and slow growth are not surprising. Growth is slow because of the slump, but the current account deficit remains large, implying, as a matter of identities, large capital inflows to finance it. One obvious question is why foreign investors continue to be willing to lend at such low rates, despite the mounting risks. As we know, the question is relevant not only for Portugal, but also for many of the other countries in the euro area's periphery. And the answer, unsatisfactory as it is, is that investors often ignore or understate risks until they suddenly wake up and demand...



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