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?

Private Debt Becomes Public

Daniel Gros is the director of the Center for European Policy Studies in Brussels.

Portugal’s policy makers are understandably confused by the reaction of the markets to their heroic efforts to cut the budget deficit in the face of a rapidly contracting economy. The risk premium on Portuguese government bond has risen to double digit levels while it has fallen for everybody else, except Greece.

But the problem of Portugal is not fiscal policy. It is the excess consumption of the private sector, which for more than 10 years now has become used to spending much more than its income. This can be seen in the large current account deficits the country has run (over 10 percent of G.D.P. for more than 10 years). Their cumulative effect is now a net foreign debt worth more than 100 percent of G.D.P.

In Greece the excess consumption was financed by the government, and as a consequence most of the foreign debt was owed by the government. A fiscal adjustment coupled with a cut to the government debt thus addressed the core of the problem for Greece. Not so for Portugal. In this country the excess consumption was not financed by the government, but by banks, especially branches and subsidiaries of Spanish banks in Portugal.

This is also the reason that, despite the strong fiscal adjustment, the external current account of Portugal is still in a large deficit.

At first sight one is tempted to say: so what? Why should the markets worry if Portuguese households continue to consume on credit? As long as the government gets its accounts under control, the risk premium on government debt should decline. However, markets factor in a simple lesson learned from this crisis: excess private debt becomes, in the end, public debt. The losses that Portuguese banks are likely to experience when their customers cannot repay their debt as the economy spirals downward will in all likelihood become public debt – just as in Ireland and Spain. What matters in the end is the total debt (public plus private) of the country.

This presents the authorities in Lisbon with a particular challenge: they must not only get their fiscal accounts under control, but also reign in their own banking system to ensure that consumption falls to a level compatible with income. This would require another fall in (private) consumption of more than 10 percent and would be highly unpopular. But if this is not done the country cannot succeed in its adjustment.

For European policy makers, the fate of Portugal is crucial because they have solemnly declared that Greece is a “unique and exceptional” case. But if they do not recognize that excess private consumption is the real problem in Portugal, they might soon have another country that will need debt forgiveness.