What Went Wrong in Portugal? Portugal Is the Next Greece



Compared to Europe’s other ailing states, Portugal did everything right. It adopted steep austerity measures in exchange for international aid, but now nearly a year later, Portugal’s economy is shrinking and the nation is struggling to repay its debts. What went wrong

Portugal Is the Next Greece

 Edward Harrison is a banking and finance specialist at the economic consultancy Global Macro Advisors. He is also the principal contributor to the financial Web site Credit Writedowns.


Europe is on the wrong path because its prescription for the sovereign debt crisis, so-called expansionary fiscal consolidation, is a failed economic paradigm. The thinking has been that sacking government workers and cutting government spending would eliminate the budget deficit in countries like Greece and Portugal and, therefore, restore market confidence in their sovereign debt. The reality has turned out to be quite a bit different. Instead of reduced debt loads, we are witnessing higher government debt burdens as the reduced economic output from cutting government is met with cuts in the private sector. If Europe continues on this path, the euro zone will break apart entirely with unpredictable political and economic repercussions.

Europe is wrong to focus on budget deficits; the bigger problem is private indebtedness.

In Portugal, the government has adopted steep austerity measures as a condition of its aid package. However, the country’s economy will now shrink because European policy makers fail to understand the dynamics of debt deflation. What they miss is that the Portuguese private sector is highly indebted. When the economy contracts, indebted individuals and companies in an indebted private sector have an overwhelming incentive to save to reduce debt burdens and prevent default and bankruptcy. This means that the private sector will always attempt to increase its net savings position irrespective of the government balance. When government then attempts to move to a net savings position as well by cutting spending and increasing taxes, it is met with cuts in the private sector which still wants to net save and pay down debt. Irresistible force meet immovable object!

The result, then, of government cuts or tax increases when the private sector is indebted and the economy is stalled is debt deflation, as more and more parties cut back, threatened by insolvency due to the decreased economic output. Europe must understand that Greece is not a special case. Rather it is the leading edge of a debt deflation, which risks claiming Portugal as its next victim. Put bluntly, Portugal is the next Greece.

To their credit, the ratings agencies and the International Monetary Fund have all voiced disquiet with this policy response in Europe. In fact, in each of the last rounds of sovereign credit ratings downgrades, Standard & Poor’s and Moody’s wrote that they had downgraded several countries in Europe in part because the austerity-centered approach was making matters worse. The ratings agencies indicated that Europe must turn toward more pro-growth policies if it is to have any hope.

The bottom line is this: Europe is fixated on the wrong problem, budget deficits. The bigger problem in most of Europe is private indebtedness and financial sector leverage. If Europe wants to fix its problems, it must address this indebtedness, and that requires a lot more than endless rounds of fiscal austerity and budget cutting.