Integration goes bust: Portugal and a history of non-tradables

Miguel Santana

miguel_santana@me.com

Essay for Economics of European Integration

Prof. Dr. Carlos San Juan, Catedrtico Jean Monnet
TA: Jozef Ruzicka
Universidad Carlos III de Madrid
November 2016

Abstract
This paper addresses the issue of misallocation between production of tradable and nontradable goods in Portugal. In particular, it analyses past literature by Bento (2015), Amaral
(2006) and Reis (2013) to infer a connection between the presence of those inefficiencies and
the chronically low growth experienced by this country, as well as its role in the development
of the debt crisis. First, a historical background on the Portuguese economic performance is
given. Then, the above-mentioned papers are analysed. Lastly, main conclusions are derived,
as well as implications for integration theory.

Table of Contents
1. Introduction .......................................................................................................................... 3
2. Background .......................................................................................................................... 4
3. Three Tales of the Portuguese Crisis ................................................................................. 9
3.1. Vtor Bento: A Typical Balance-of-Payments Imbalance Problem ..................................... 9
3.2. Joo Ferreira do Amaral: Lack of Preparedness for Integration ...................................... 10
3.3. Ricardo Reis: A Misallocating Financial System ................................................................. 11

4. Conclusion .......................................................................................................................... 15
5. References ........................................................................................................................... 16

1. Introduction
The effects of the debt crisis in the Eurozone are being felt to the present day. The
peripheral countries only now start showing signals of recovery, but the banks in some of those
countries are still under high stress. Besides, it is not certain whether the latest signals are not
the by-product of a strongly-devised credit cushion by the European Central Bank, implying
that once it is removed, the debt loop will restart1. Therefore, it is still important to assess the
causes of the initial crisis, so that one can evaluate policy responses. Furthermore, the current
wave of Euroscepticism in the EU and protectionism worldwide make it more urgent to
scrutinize the benefits of integration. Hence, in this paper, these two aspects are combined and
a specific country is analysed.
In the case of Portugal, the facts are perhaps more interesting from an academic point
of view: there was no housing boom, the financial system proved to be, at least in an initial
phase, somewhat resilient to external conditions, and it has been experiencing a prolonged
period of anaemic growth. Thus, it allows us to control for those aspects which were present in
other crisis-struck countries. Hence, it seems sensible to turn instead to market fundamentals,
and how they could have influenced the path in Portugal. Here, focus is given to the relationship
of tradables and non-tradables by providing a summary of past literature on the subject, a
decision which, as we will see, seems to be justified by the data.
The paper is structured in two main parts. First, a brief background to Portugals
economic performance since 2000 is provided. Then, the theses of three Portuguese
economists: Vtor Bento, Joo Ferreira do Amaral, and Ricardo Reis, are expounded. Each of
them has a different, albeit potentially complementary view. Here we will see that integration
came also with many thereto absent restrictions. Finally, a conclusion is given with
implications for the desirability of integration.

FT View, October 24 2016, The Eurozone Regains some vitality. Financial Times

2. Background
In the years before the financial crisis, Portugal experienced significantly low growth.
Indeed, as Reis (2013) points out, the period from 2000 to 2012 represents a more severe lost
decade in Portugal than in the historical ones in the United States and in Japan.

GDP per capita (Initial Year = 100)

150
140
130
120
110
100
90
80
70
0

US: 1929-1941

Japan: 1992-2004

EZ 19: 2000-2012

EU 28: 2000-2012

10

11

12

Portugal: 2000-2012

Figure 1 - GDP growth during the lost decades. Sources: Bureau of Economic Analysis (US), Penn World Tables 9.0 (other
countries)

Furthermore, accumulated net capital inflows accelerated until 2011, as shown in Dias
(2014), and by his calculations, total factor productivity exhibited negative growth since 2002.
The computations presented here, based on the approach in Jones (2015), while not so
penalizing towards TFP (it is computed as a differential), do show that the influence of TFP in
income per worker growth was about 40%, while that of the capital-output ratio, a measure of
capital accumulation, accounted for 80%.

Growth Rate of Total Factor Productivity at Constant

National Prices
7%
5%
3%
1%
-1%
-3%
-5%
-7%

Germany

Spain

Greece

Italy

Portugal

United States

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

-9%

Ireland

Figure 2 - Growth of TFP at constant national prices. Source: Penn World Tables 9.0

Contributions

Capital Accumulation Average Hours Worked

TFP

Growth rate of GDP per worker

1,13%

80,91%

-20,77%

40,89%

Table 1 - Contributions to growth of GDP per worker. Sources: AMECO (ajusted wage share), Penn World Tables
(otherwise). See Jones (2015) for an exposition of data involved in these computations.

Real Effective Exchange Rate

Relative to the former EU-15 Portugal (2010=100)

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

105
100
95
90
85
80
75
70
65
60

ULC-based REER relative to former EU-15, double export

weights

Figure 3 - ULC-Based REER relative to the former EU-15. Source: AMECO (2016)

As for the labour market, two measures are worthy of notice. First, as Blanchard (2007)
notes, wages had been growing generally more than productivity, and in a higher proportion
than in the Euro area. The reverse had been true for Germany. In this connection, the ULCbased real effective exchange rate relative to the former EU-15 had been increasing, which
implies a decrease in competitiveness.
Second, human capital indicators for Portugal in 2008 show that the country was
underperforming relative to other developed countries, having the smallest percentage of
population aged 25-64 with at least upper secondary education in the OECD.

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

Portugal
Turkey
Mexico
Brazil
Italy
Greece
Luxembourg
Chile
Iceland
Ireland
Belgium
France
Australia
United Kingdom
OECD - Average
Netherlands
Denmark
EU 22 in OECD
Korea
Hungary
Norway
Austria
Finland
Israel
Slovenia
Sweden
Germany
Latvia
Switzerland
Canada
Poland
United States
Slovak Republic
Czech Republic

Percentage of Population aged 25 to 64 with at least upper

secondary education in 2008

Figure 4 - A measure of human capital. Portugal is well behind other OECD countries.

As for the specific problem of tradables and non-tradables, some empirical results of
past papers are revealing. In Alexandre and Bao (2012), one learns that in the past decades
there has been a substantial shift from the primary and secondary sectors to the tertiary.
Namely, from 1974 to 2006, agriculture saw a 10pp. decrease in the share of employment,
while manufacturing, mining and quarrying, electricity, gas and water supply saw one of 6pp.
This is in stark contrast with construction, which increased its share by 0.6pp., and services,
which increased by 22.4pp. In the latters case, half of this adjustment occurred in the period
from 1986 to 2006.
Amador and Soares (2012) analyse changes in the Herfindahl-Hirschman Index and in
the Price-Cost Margin for the period 2000-2009. There, they find that the most frequent
increases in the HHI, a measure of concentration, occurred in the tradable sector from 2000 to
2004, but from 2005 to 2009 the picture is completely reversed, with 100% of the markets,
gross value added, sales and employment in construction exhibiting increases in this index. For
the non-tradable sector as a whole, markets representing an overwhelming 72% of the
employment increased the HHI (versus 62% in the tradable sector). Since this picture is
attenuated if measured by gross value added and sales, and is reversed if measured by number
of markets, we can conclude that there is a those increase occurred in relatively large firms,
and that these have a smaller relevance in terms of employment than in terms of real economic
output. As for the PCM, the non-tradable sector wins on all fronts, differences also being
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attenuated when measured in terms of number of markets, GVA and Sales. This means that
even though non-tradable markets may not be highly concentrated, they exhibit big mark-ups,
which is a possible sign of abnormal profits, a theoretically equivalent concept to inefficient
allocations.
An interesting approach is conducted by Dias (2014). Here, they develop measures of
total factor quantity productivity (TFPQ) and total factor revenue productivity (TFPR). The
first, by telling us how many units of output a firm can get with one unit of input mix, is a clear
measure of productivity; the second, by measuring revenue instead of units of output, is a
measure of efficiency, since it should be approximately the same in each industry in
equilibrium. Two aspects stand out. On one hand, the left tail of the distribution of TFPQ gets
thicker with time, which reflects a movement towards more inefficient companies. On the other
hand, both TFPR and TFPQ have a much higher variability in the non-tradable sector, and
these two measures are positively correlated which, as the authors state, means that more
productive firms tend to face higher distortions and thus tend to produce less, while less
productive firms tend to overproduce.
After this, the conclusion is quite obvious: workers have moved to jobs where they are
less efficient. This point is made explicitly by Reis (2013). While total factor productivity
decreased by 2.96% from 2000 to 2005 in wholesale and retail trade and 1.77% in community
and other services, the share of employment increased by 17.42% in the former and 24.06% in
the latter. As for the mark-ups, he states that they have decreased 1.42% for wholesale and
retail trade, while they have increased in community and other services.

3. Three Tales of the Portuguese Crisis

3.1. Vtor Bento: A Typical Balance-of-Payments Imbalance Problem
In his 2015 essay, Eurocrisis Another Perspective, Vtor Bento mainly develops an
argument against the policy pursued in the Eurozone after 2008. Even though that is germane
to the present paper, concerned with the causes of and not the response to the crisis, throughout
his paper he reveals what he believes to have been the main driver of the events in 2011.
For Bento, the problem with the Eurozone was, above all, a typical problem of
disequilibrium in the balance of payments of several countries that belong to a de facto fixed
exchange rate regime and to an economic area which, albeit not closed, essentially makes
transactions within itself. He then adds that a sudden change in risk-perceptions by investors
rendered this state of affairs unsustainable. Taking these claims together with the assertion that
the situation in 2014 is, from a macroeconomic point of view, worse than in 2008, and it is
characterized by a double disequilibrium internal (high unemployment) and external
(surplus). Any macroeconomics textbook will say that such a state of affairs reflects an
insufficient domestic demand, one may infer that he has in mind an AS-AD framework,
whereby the financial crisis brought about an asymmetric shock to demand. Furthermore, for
Bento, the Eurozone as a whole was both in external and internal equilibrium in 2008, having
perfectly managed to steer out of the famous Four Zones of Economic Discomfort2
P

A CA-Surplus Country

A CA-Deficit Country

P0
P1

P1
P0

Y0 Y1

Y1 Y0

Figure 5 - An asymmetric shock

See Bentos graphic, Situao Macro da Zona Euro: 2014 vs 2008, and Krugman et al. (2009) for an explanation of the
mechanics.

Now, without assessing any methodological issues potentially arising from the
intellectual device of external equilibrium (which seems to be driven by policy and not by
market fundamentals see Krugman et al. (2009) again), this analysis does rest on the
assumption that all euro economies were in equilibrium in 2008, a premise which may be
untenable given the data above on tradables and non-tradables and the allocative efficiency of
the country. Furthermore, the levels and trends of private indebtedness, together with an
apparent decreasing productivity of labour, support the thesis that the behaviour of the
Portuguese economy in the pre-crisis was not sustainable. A view that goes along these lines
is presented in the next section.
What are the implications of Bentos essay for the effects of integration on Portugal?
First, that countries with relatively less competitive production structures have been absorbing
the surpluses of the European exporting countries; second, such a state of affairs has led to a
chronic inability to cope with asymmetric shocks in the Union; third, without the political
possibility of fiscal transfers, economic integration further deteriorates the welfare of countries
negatively affected by a crisis.

3.2. Joo Ferreira do Amaral: Lack of Preparedness for Integration

In The Economic Impact of Portugals Integration in Europe, published five years
before the Adjustment Programme started in Portugal, Joo Ferreira do Amaral, while
generally agreeing on the problems of a de facto fixed exchange rate regime, expounds a view
that takes efficiency problems into account.
Here, he claims that adhesion had initially caused a general improvement of welfare
due to increasing exports (driven by Spain), foreign investment, and European structural funds.
However, by the 90s decade, the productive structure of the economy was not ready to face
Chinas competition together with Maastrichts factor mobility and financial liberalization; this
all the while it received funds that doubled in amount in 1989 and in 1994. Furthermore, the
upcoming Eurozone required convergence of national currencies, which was only possible, in
the Portuguese case, through an increase in the internal interest rate (inflationary episodes were
recurrent in the past), so that foreign capital demand would increase and strengthen and
stabilize the escudo. Because in this period inflation was still higher than in the rest of the
Eurozone and currency-devaluation-induced competitiveness was not possible, national
companies faced increasing costs and, when interest rates decreased, they turned to non10

tradables; hence the soaring credit demand.

With this in mind, Amaral sees the fundamental problem as one of undue importance
of non-tradables in the Portuguese productive structure. Accordingly, he claims that in order
to have sustainable economic growth, it is necessary that production of tradables increases at
least as much as production of non-tradables. Otherwise, imports increase more than exports
and the country sees itself submerged in growing current account deficits, which end up being
funded with difficulty, interrupting, sooner or later, the growth process. He concludes by
saying that with a common currency there is no essential instrument (currency devaluation)
to balance foreign accounts, and thus an imbalanced economy will have growth ability while
there is indebtedness ability. This means that this process will last while families and
companies are able to borrow.
Note that his view is highly consistent with data: first, the change in the productive
structure of the economy; then, the composition of Portugals exports by technological type
and labour intensity confirm the lack of resources of the country in the 90s3; finally, the
inefficient non-tradable sector was the one that received the highest inflow of resources. Note
as well that this excludes the Balassa-Samuelson effect, for here we are no longer in a perfect
Ricardian world without restrictions. Furthermore, there had been no income convergence
between Portugal and its trading partners. 4
The conclusions of this paper expand those of Bento. While Amaral seems to go for
currency devaluation as the main policy recommendation, it would seem also logic to consider
that a country that is unprepared to face factor mobility and has policy restrictions such as
artificially maintaining a strong currency does not benefit from integration. In this case, we
paradoxically end up concluding that integration, usually associated with economic freedom,
brings about more and not less restrictions to its members. The question thus arises if the
European Union is a good experiment with respect to the general inquiry of evaluating the
goodness of economic integration.

3.3. Ricardo Reis: A Misallocating Financial System

Reis provides a different but complementary insight into Amarals thesis. For him, it is
not only that the Portuguese economy was badly prepared for integration; instead, he argues

3
4

See the European Commissions Memorandum of Understanding (2011), Box 1.

See Samuelson (1964), Asea and Corden (1994) and Reis (2013).

11

that lack of financial deepening, together with financial integration, led to a misallocation of
foreign capital to the national economy, which brought about an inefficiently high level of
production in the non-tradable sector. It is worthwhile to pursue his argument in more detail,
albeit qualitatively, as he expounds it in The Portuguese Slump and Crash and the Euro crisis.
Reis proposes a model where one non-tradable good is produced by a continuum of
entrepreneurs, each with a randomly selected level of productivity. Each entrepreneur can
choose, in each period, to invest in capital or in the financial markets, or to borrow. If the
financial system were not misallocating resources, only the most efficient entrepreneur would
produce with funds being provided by the other firms investments. However, due to collateral
constraints, that entrepreneur is unable to raise enough funds to produce the optimal level of
the good, and thus inefficient firms are able to enter production, depending on whether they
have a level of productivity above or below a threshold that renders them indifferent between
producing and not producing.
The financial system is characterized by a domestic bank which is the only one that is
able to channel funds to non-tradable activity, since it is assumed that these small firms do not
have access to international financial markets. However, if low financial integration exists, the
bank can only seize foreign funds if it offers some of its loans as collateral. Therefore, assuming
competitiveness in the financial markets, a firm-selection curve can be derived by noting that
as the rate paid to inefficient entrepreneurs rises, so does the rate charged to the efficient ones.
This lowers their return, and causes an increase in the threshold level of productivity. Hence,
if one wishes to relate this level with the interest rate on deposits, that is done through a
positively-sloped curve. However, in equilibrium domestic investment must fund domestic
borrowing not covered by foreign capital. Thus, if the threshold level is higher, less loans are
needed and the demand for deposits decreases, which lowers the deposit rate the bank must
pay. Hence, the so-called market-clearing curve is downward sloping. The graphic follows
below.

12

Rate on
deposits

Increase in Financial Integration

Firm-selection
Curve

Market-Clearing
Curve

a1

a0

Threshold Productivity

Figure 6 - Reis' Model of Imperfect Financial Markets

The comparative statics scenario depicted in the graph is one where higher financial
integration occurs, i.e., less collateral to foreign investors is needed on the part of the bank.
This has the intuitive effect that for a given rate on deposits, the rate required from
entrepreneurs decreases and so their leveraged return increases, which in turn decreases the
threshold for production. On the other hand, domestic investment is relatively less scarce,
which lowers its attractiveness and brings about a decrease in the threshold productivity.
Hence, the market-clearing curve also shifts downwards. According to this model, then, a
higher degree of financial integration causes the average level of productivity to decrease.
Crucial in this reasoning is the fact that firms have unchanged collateral restraints (the degree
of financial deepening stays constant) so that the most efficient ones are unable to expand.
On the household side, we have a representative consumer that derives utility from
tradables and non-tradables, but who owns the tradables technology. Since it is assumed that
the tradables sector has perfect access to financial markets, it do not need to recur to the
domestic bank, so that when financial integration is widened, it has no effect. Furthermore, if
one assumes that the subjective discount factor of the consumer is lower than the international
markets discount factor, then the consumer would never save because it would be optimal to
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borrow an infinite amount of funds in absence of a no-Ponzi scheme budget constraint. This
may indeed explain the high amount of private indebtedness.
Reis goes on to empirically analyse the model with successful results. Namely, he
argues that because in other countries, such as Spain, financial integration was accompanied
by financial deepening in the domestic banks, the country experienced strong growth during
the pre-crisis years. In Portugal, on the other hand, with the parameter specifications Reis
introduces, output even falls in the absence of financial deepening together with financial
integration.
If this model indeed holds true, it would be in accordance with Amarals conclusions
that the national economy was ill-prepared for economic integration. It diverges, however, in
that there seems to be no competitiveness-enhancing solution: unless all firms have that same
total factor productivity, it would always be the case that, with imperfect financial markets,
inefficient firms would turn to production while the most efficient firms would be creditconstrained. This is due, of course, to the exogenous nature of productivity in the model.

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4. Conclusion
This paper began with an analysis of Portugals economic data up to the years of the
debt crisis. Here, a pattern of chronic inefficiencies and low productivity is evident through
increasing unit labour costs and even higher nominal wage growth, high price for the nontradables, and misallocations in this sector as measured by the HHI and the PCM. From the
three views here analysed, we conclude there is evidence to support the hypothesis that
Portugals problem is connected to the relation between its productive structure and European
integration.
Although this is common even to Bentos view, he takes a typical Keynesian aggregate
equilibrium view, while the other two authors focus more on the microeconomic foundations
of the problem. In particular, Amaral emphasizes the role of the chronic lack of competitiveness
in the Portuguese economy in causing the disequilibrium in current accounts brought about by
a necessary currency stabilization. To be sure, his policy recommendations do lie in the
existence of an exogenous instrument to maintain firms competitiveness abroad; however, the
link to market fundamentals should not be left unacknowledged. Finally, Reis goes a step
further in connecting these facts with an imperfect financial system in a formal model with
microeconomic foundations. Here, financial integration together with underdeveloped
financial markets causes a decrease in output because the most efficient firms are creditconstrained. Therefore, non-tradables must be partly produced by inefficient firms, which are
strongly affected by sudden stops in capital. Here, as opposed to Amaral, unless firms have
invariant total factor productivity (which we could potentially see as low dispersion in TFPQ
and TFPR above), inefficiencies will always be present at the economy unless capital markets
are perfect.
To conclude, it may be inferred from these findings that integration may not always
lead to an increase in welfare, from both a static and a dynamic point of view. However, it
appears, as said before, that the experience of the European Union is not representative of a
truly free economic area, in the sense that it brought about restrictions on some price-signalling
mechanisms, viz. exchange and interest rates. Therefore, one could only wonder what could
have happened under perfect freedom of these two prices.

15

5. References

Alexandre, F., Bao, P. Portugal (2012). Before and After the European Union - Facts
on Nontradables. NIPE Working Paper Series, 2012/5

Amador, J., Soares, A.C. (2012). Competition in the Portuguese Economy - A View
on Tradables and Non-Tradables. Banco de Portugal Economic Bulletin, Spring 2012,
pp. 41-57

Amaral, J.F. (2006). O Impacto Econmico da Integrao de Portugal na Europa.

Nao e Defesa, Outubro-Inverno 2006 N 115 3 Srie, pp. 113-128

Asea, P. K., Corden, W. M. (1994). The Balassa-Samuelson Model - An Overview.

Review of International Economics, Vol. 2, pp. 191200

Bento, V., February 8, 2015. Eurocrise: Uma outra perspectiva. Observador.

Retrieved from http://observador.pt/especiais/eurocrise-uma-outra-perspectiva/ (Last
Accessed: November 1, 2016)

Blanchard, O. (2007). Adjustment within the euro. The difficult case of Portugal.
Portuguese Economic Journal, 6/1, pp. 1-21

Dias, D.A., Marques, C.R., Richmond, C (2014). Misallocation and Productivity in

the Lead Up to the Eurozone Crisis. Banco de Portugal Working Papers 2014, No. 11

European Commission (2011). The Economic Adjustment Programme for Portugal.

European Economy Occasional Papers, 79

FT View, October 24, 2016. The Eurozone Regains some vitality. Financial Times.
Retrieved from https://www.ft.com/content/3d2e47b0-99ed-11e6-b8c6-568a43813464
(Last Accessed: November 17, 2016)

Jones, C.I. (2015). The Facts of Economic Growth. National Bureau of Economic
Research, Working Paper No. 21142

Krugman, P.R., Obstfeld, M., Melitz, M.J. (2012). International Economics, Theory
& Policy, 9th Ed., pp 522-523. Addison-Wesley.

Reis, R., (2013). The Portuguese Slump and Crash and the Euro Crisis.Brookings
Papers on Economic Activity (SPRING 2013), pp. 143-193

Samuelson, P.A. (1964). Theoretical Notes on Trade Problems. The Review of

Economics and Statistics, Vol. 46 No. 2 (May, 1964), pp. 145-154

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Sources: OECD (2016), Penn World Tables 9.0, AMECO Database (2016), Bureau of
Economic Analysis (2016).

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