Final, 1 September 2002

Portugal´s European Integration:

the good student with a bad fiscal constitution

Jorge Braga de Macedo

Portugal ’s experience with international economic interdependence began under a corporatist regime keen on fostering economic and political integration with African and Asian colonies constrained private initiative while political freedom was constrained by the absence of multiparty democracy. Probably because of the lack mutual political responsiveness with major members of the North Atlantic Treaty Organization, let alone of the Organization for European Economic Cooperation (now OECD), the experience was largely ignored. The same is true of membership in the European Free Trade Association (EFTA) in 1960, even though it paved the way for a free trade agreement with the European Community (now EU) in 1972.

With the 1974 Revolution, mutual political responsiveness emerged but there was a strong reversal in economic interdependence. In addition to the 1973 oil crisis, civil strife followed the attempt to introduce soviet-style economic planning in the 1976 constitution. The rigidity inherited from the corporatist regime was compounded by the widespread nationalization of heavy industry and banking, together with agriculture in the southern part of the country, and by successive balance of payments crises. As a consequence, the democratic regime accommodated substantial macroeconomic instability, a combination not observed since the aftermath of the 1910 Revolution.

The prevailing idea was that European integration would serve as an "insurance" against dictatorship rather than against the voracity of vested interests inherited from both the corporatist and the soviet-style regimes. Pressure towards greater reliance on market mechanisms and better governance in a public sector frozen by a constitutional ban on privatization was largely external, especially from the interventions of the International Monetary Fund (IMF) in 1977 and 1979. While the success of EU accession in 1986 and especially of the first Presidency in early 1992 brought to the fore the view of Portugal as a good student of European integration, prior experience with OECD and EFTA should not be neglected. The government elected in late 1995 made it a political imperative to join the eurosystem in 1998 while distancing itself from the good student view, seen as excessively deferential towards Community institutions. Whatever the meaning of good student of European integration, membership in the eurosystem signaled the "limits of external pressure".

Over five decades, international economic interdependence helped bring about macroeconomic stabilization and liberalization - except in what concerns neighboring Spain, whose free trade agreement with EFTA in 1979 implied incipient trade relations with Portugal. A particular outcome of the simultaneous negotiations for EU membership of Portugal and Spain between 1977 and 1985 has been resistance to increased bilateral integration. On the eve of the 1999 general elections, the government jeopardized the good student reputation by threatening to veto a merger between a Spanish and a Portuguese bank. The veto was lifted after winning the election, albeit with a minority government. The good student appeared to return for second EU Presidency in early 2000, but only to face new elections and a budget crisis in 2002.

The importance of geographical limits to external pressure notwithstanding, those rooted in fiscal history present a greater threat to the good student reputation. To be sure, constitutional aspects are not usually looked at in connection with the euro but they are certainly determinant in Portugal, where the constitution included a ban on privatization from 1976 until 1989 and fiscal institutions have been impervious to reform over an even longer period. This suggests bad relations between the state and the population involving both taxes and transfers: the good student has a bad fiscal constitution.

After this introduction, the paper contains three sections. Section 2 describes the role of monetary and fiscal policies in the regime change which culminated in the entry of the escudo into the Exchange Rate Mechanism of the European Monetary System (ERM). The ERM code of conduct - an informal convergence instrument - is shown to have made Portugal a good student of macroeconomic stability. The ERM also helped deal with neighboring Spain in a multilateral framework. On the contrary, the experience of the eurosystem has been one of divergence.

Section 3 defines a fiscal constitution where government expenditures only stop growing under threat of balance of payments crisis and focuses on how such a bad fiscal constitution favored financial repression during the EFTA years. The ability of banks in protecting their role as implicit tax collectors remained until after the restoration of full currency convertibility and the creation of a single market in financial services. Consequently, as argued in section 2, the good student fell victim to the euro hold-up.

The conclusion suggests that credibility in the eurosystem is not likely to be restored without overcoming the current budgetary crisis. Different policy areas need specific reform efforts, otherwise they stall. Overcoming the budgetary crisis will thus imply changing the fiscal constitution by improving budgetary control and completing the tax reform initiated in 1989. A more hopeful implication is that flexible integration - of which the ERM is na example - may help Portugal become a good student again.

When primary government expenditure is too high in relation to the taxpayers' ability to pay, as happened in planned economies and in many emerging markets, macroeconomic instability inevitably follows. Taking the form of excessive deficits on the balance of payments and on the government budget, macroeconomic instability calls for both a multiannual fiscal adjustment strategy (MAFAS) and a pre-pegging exchange rate regime (PPERR). Stabilization helps real and financial liberalization, along with other structural reforms.

As described in Bill Branson et al (2001; also Branson's contribution to my 2001 with Daniel Cohen and Helmut Reisen), the PPERR avoids the "inconsistent trio" of fixed exchange rate, free capital movements, and independent monetary policy by freeing monetary policy to be targeted on external balance, represented by a suitable reserve position. The MAFAS then sets fiscal policy to maintain internal balance, as represented by a low rate of inflation.

The durable achievement of nominal convergence requires wage and financial moderation and the government has a leadership role in negotiating both wage settlements and benchmark operations in international financial markets. In turn, macroeconomic stability is required for sustained economic growth and real convergence.

The convergence record determines policy credibility, because it suggests whether policy reversals are likely or not. Under divergence it is difficult to muster the electoral support for structural reforms, even though they are most needed to resume convergence. This applies to Portugal, who achieved a remarkable degree of convergence, both nominal and real, in the decade following EU accession then diverged after qualifying for the euro.

Portugal’s experience also shows that nominal convergence does not guarantee real convergence. In fact, the reticent liberalization of exchange controls by the Central Bank maintained interest rates too high during the 1991/92 global recession. This made Portugal’s recession in 1993 much more severe than it need have been, with resultant real divergence in 1993 and 1994, the end of structural reforms and the election of a new Prime Minister in 1995.

Nevertheless, when compared with other experiences, namely those of the Nordic countries, Portugal’s financial liberalization was remarkably problem-free. No banks failed and there was no sudden surge in careless lending even though the Central Bank had no experience with supervising competitive banking activity. As detailed in section 3.2., banks, whether private or nationalized after 1974, had hitherto always been closely regulated, with nominal credit limits and effective barriers to entry.

The major difference between Portugal’s liberalization and that of the Nordic countries was that Portugal’s took effect in an economic downturn, when bank’s were in a cautious mood, concentrating on recovering outstanding debt rather than exploring new lending opportunities. By contrast, the Nordic countries liberalized their banking regulations in an economic boom and banks rapidly stretched their limits of prudent lending. The lesson is that the authorities should not wait for a "favorable" economic climate to liberalize – if anything, it is better to do so in an economic downturn when decision-makers are more cautious.

The remainder of this section describes moving the escudo into the euro as the outcome of the gradual change in Portugal’s economic regime towards price stability and currency convertibility which took place from 1989 to 1992, leading the authorities to accept the ERM code of conduct in conditions of high volatility - only to neglect fiscal discipline when enjoying an interest free ride in the run-up to the euro.

Two years after the July 1987 general elections secured a majority government for the Prime Minister in power since mid 1985, the two main aprties agreed to amend the constitution and allow state-owned enterprises to be privatized. This signalled the beginning of a process of gradual domestic liberalization which still continues. In September 1989, the escudo entered the ECU basket at a rate of 172.

With hindsight, this marks the beginning of the change in the economic regime, which eventually would move the escudo into the euro. Two kinds of measures define the change. Some, like a constitutional amendment reversing the 1976 freeze on privatization, were public but their relation to financial liberalization was not immediate. Other measures like the MAFAS presented to the Commission services were relevant but not public. In spite of these measures, neither the government nor social partners saw ERM membership as imminent. The cabinet was reshuffled shortly after the 1989 local elections, further delaying public awareness of the ongoing regime change. A Foreign Exchange Law where criminal charges were replaced by fines had been approved in the fall of 1989 and was heralded by the Minister of Finance as a major reform.

The crawling peg policy (in existence since the IMF intervention of 1977) was replaced sometime in the spring of 1990 by a shadowing of the DMark, known - but not officially acknowledged – as the hard escudo policy. Since, like the shadow MAFAS of 1989, the new exchange rate regime was not announced publicly, it couldn’t be interpreted as a PPERR. But a very low level of unemployment coupled with a strong upward pressure on public sector wages led to strong inflationary pressures and to the appreciation of the real exchange rate. Moreover, the fear that financial freedom would threaten monetary control and the soundness of the banking system was ingrained at the Central Bank. Decree law 13/90 of January 8 allowed the Central Bank to reinstate several controls, which remained under Decree law 176/91 of 14 May, in spite of the principle of freedom stated in article 3.

The Foreign Exchange Law gave the Central Bank competence to issues avisos (regulation notices signed by the Minister of Finance) where capital controls could be introduced or relaxed. On 21 May, the first aviso was used to introduce an interest free deposit of 40% of loans contracted abroad (except when the operation related to financing of current transactions) and a prohibition of forward purchases of escudos between resident and non-resident banks (forward sales were still not allowed). The controls were reinforced before the general election (aviso 7 of 5 July 1991) with explicit reference to the threat to monetary and exchange rate policy that was posed by excessive capital inflows. The tightening of controls was supposed to help prevent inflation from accelerating while the associated increase in the cost of servicing the public debt was looked at with benign neglect.

While shadowing the DMark, so as to fight inflation, the Central Bank was accumulating dollar deposits earning 5 %, while paying 20 % on the escudo debt being issued to mop up the resultant "excess" liquidity. Under credible shadowing no exchange rate changes are expected so that this translates into a 20% rate in dollars. Foreign exchange reserves more than doubled from 1989 to 1991, with disastrous consequences for the Central Bank’s operating results. The existence of exchange controls allowed banks to delay adjusting to a single market in financial services and the combination of a shadow MAFAS with a shadow PPERR remained until July 1990, when a National Adjustment Framework for the Transition to Economic and Monetary Union, known as QUANTUM, was proposed.

After the 1991 elections confirmed the parliamentary majority, a convergence program combining MAFAS and PPERR with capital account liberalization (called Q2 to stress the continuity of the gradual regime change) was submitted to the ECOFIN Council and discussed in the Portuguese Parliament. In spite of Q2, the decision to request entry of the escudo in the ERM was a genuine surprise. On the weekend following the approval in parliament of the 1992 State Budget - the government applied to join the ERM at a rate of 180 escudos agreed upon at a special cabinet meeting on Friday afternoon.

The EU response came from the Monetary (now Economic and Financial) Committee whose members were acting as personal representatives of the then twelve minister/governor pairs who meet with the Commission in the so-called informal ECOFIN. Even though there was a precedent with sterling, the prior declaration of a parity generated great resistance among several members. Under the alleged fear that, on the eve of the British general election, the announced parity of 180 might induce a speculative attack against sterling, a parity closer to the market rate was sought. Finally, the notional central rate of 178,735 - that is the one prevailing since the entry of sterling in October 1990 - gathered consensus.

After the cabinet meeting the Minister of Finance had briefed the social partners and the following week ERM entry was debated in parliament. Nevertheless the rule-based exchange rate regime which culminated the gradual change in economic regime was neglected at home. The ERM code of conduct required full convertibility and the Central Bank - who managed the derogation to the 4^th Brussels directive negotiated by Greece and Portugal until 1995 - hesitated to accept that such derogation should expire in 1993 or 1994 (which is when Greece finished its liberalization), especially because currency convertibility would lessen monetary control.

The ERM crises were felt by the lira and sterling, which left the grid on 17 September, 1992 when the peseta also realigned but the escudo did not. The opinion in financial circles was to stick to DMark shadowing and deny "geographic fundamentals". Exporters, on the other hand, were sensitive to the bilateral rate with the peseta and had been pressing for a devaluation of the escudo relative to the peseta. In the event, the realignment of 23 November was matched and those on 14 May 1993 and 6 March 1995 were followed in part, without ever facing the loss in financial reputation associated with initiating a realignment.

The acquisition of financial reputation during ERM turbulence is reflected in weekly measures of exchange rate volatility between the DMark and the escudo. Using a technique of analyzing changes in the variance of the exchange rate first applied to the US stock market, probabilities of the volatility of the weekly exchange rate from January 7, 1987 until December 30, 1998 are reported in Tables 1 and 2 for a specification with five volatility states. During the period preceding the widening of the bands in August of 1993 the results remain essentially the same, even though a rise from the "very low" to the "low" volatility state is observed in the last weeks before the creation of the euro.

The period begins with the last accession to the ERM before the crisis and includes some of the realignments involving the peseta and the escudo. The restoration of full convertibility was announced on 13 August 1992 and the Central Bank agreed to have controls renewed for shorter and shorter periods: in Table 1, the probability of the "very high" volatility rises to 94% the following week but returns to the previous level of 79% until end of September. The few instances of "very low" volatility in Table 1 show instead massive intervention by the Central Bank shortly before the November 1992 realignment.

Full convertibility was restored on 16 December 1992. There is no effect in Table 2, and no instance of "artificial stability" either. Given that the financial reputation of the country was not fully established, this serves as an illustration of the power of the ERM code of conduct as a convergence instrument. The implications of convertibility were twofold. First, allowing for greater banking competition. Given the soundness of the banking system (at least in relation to what happened in the Nordic countries), this implied a tighter supervision than the regulators could muster. Second, lowering money market rates even if it meant letting the escudo slide towards the middle of the 6% ERM band. Better banking supervision, namely in enforcing greater transparency in effective rates being charged on credits, would lead to a decline in the cost of credit without the need to change the stance of monetary policy. Flexibility within the top of the band would reflect the benefit of the ERM code of conduct relative to DMark shadowing.

In the turbulence that followed ERM entry, the lack of credit familiarity with Portugal had to be overcome. Yet, international borrowing was still associated to situations of looming payments crises rather than with the promotion of the nation’s credit abroad. Moreover, exceptionally high foreign exchange reserves were not used to boost the Treasury’s credit rating: Portugal’s external debt issues had been assigned a rating of A1 by Moody’s Investors Services in late 1986 and A by Standard and Poor’s two years later. The divergence between the two agencies remained until late 1991, when Standard and Poor’s upgraded to A+.

As soon as the currency was fully convertible, therefore, a strategy of making the Treasury known in international markets was designed, involved a planned return to international borrowing, successively in yen, marks and dollars. Standard and Poor’s decided the upgrading of Portugal’s foreign debt to AA- in May 1993, even though the previous upgrade had been decided less than 18 months earlier. International investors were ready to believe then that economic policy in Portugal would retain a medium term orientation also; this was the first such rating move since Ireland had been upgraded in 1989. Once again, the strategy was ignored domestically. Shortly after the global dollar issue of September 1993, the deterioration in tax revenue collections, whilst keeping non-interest expenditure at the nominal amount included in Q2, increased the deficit and had a much greater impact domestically than the credibility earned abroad.

The central rate the escudo kept after the realignment of the peseta in March 1995, around 196, reached without increasing short and long term interest rates showed a greater benefit of ERM membership for Portugal than for Spain. While the accumulated real appreciation of the escudo may have been perceived as excessive by export-oriented firms and the government may have been sensitive to their pressure, it was certainly less than that of the peseta - who had joined the ERM as far back as 1989. In any event, testing the ERM parity of both currencies made sense when there was accumulating evidence that the recession was hitting their domestic economies.

Quarterly data on capital flows confirm that external credibility was achieved in late 1992 and remained almost as unperturbed by subsequent peseta realignments as it had been by the domestic turbulence of March 1993. In sum, had the decision to join the ERM been delayed, the escudo would have been unable to join the ERM in time to meet the EMU criterion of two years’ membership. It would have trailed with the Greek drachma outside the parity grid, rather than accompanying the peseta inside. Foregoing the ERM code of conduct would certainly not have helped the government sell stability at home.

The MAFAS retained in the Revised Convergence Program (PCR) approved with the 1994 State Budget kept the nominal ceiling on non-interest expenditures from Q2 but adjusted the deficit for the revenue shortfall. This was well accepted by international investors who heavily oversubscribed a global bond issue of one billion dollars in September 1993 and by the Monetary Committee who approved the PCR in November. A cabinet reshuffle was announced shortly before the December local elections, but economic policy remained consistent with the PCR. In early 1994, a global bond issue in ECU was received with the same success as the previous one. Yet the government's call for lower interest rates, while directed at a domestic business audience, had foreign repercussions. In this context, an Austrian news agency reported rumors of a military coup in Portugal. While entirely groundless, the story led to a renewed attack on the escudo - but without any lasting increase in volatility. Differences on banking supervision led to the replacement of most of the Central Bank board in June 1994. This drastic move was well accepted, for - just like in March 1993 - it was understood that the tension did not originate in monetary policy.

As the ERM code of conduct moved the escudo into the euro, the Treaty on European Union and the Banking Law (Decree Law º 298/92 of 31 December), which introduced the single market in financial services and called for greater supervision and competition, appeared to consolidate macroeconomic stability under convertibility, to which the Central Bank fully adjusted. Further changes were introduced to the statutes of the Central Bank to make it more independent from the government, to introduce some accountability in parliament and to improve the regulation and supervision procedures.

Another reflection of the continuity of the MAFAS was that the PCR proposed in 1993 extended the expenditure ceilings into 1997. The PCR remained the basis for the excessive deficit procedures until a Convergence, Stability and Growth Program from 1998 to 2000 was approved by the ECOFIN in May 1997. It was followed by a Stability and Growth Program for 1999-2001 shortly after the escudo joined the euro at a rate of 200,482. The MAFAS continued listing structural reforms, especially in the public administration but unfortunately dropped nominal ceiling on non-interest expenditures.

Portugal’s regime change remained misunderstood by public opinion until after the general elections in October 1995. Aside from domestically generated disturbances that obscured the significance of the change, the combination of recession and system turbulence must be recognized. The lack of credit familiarity with Portugal would have been bad enough for firms and citizens in tranquil periods. In the turbulence which followed ERM entry it was of course much worse and may have contributed to slow down the learning process.

This lesson reinforces the need for balance in the rising economic interdependence and mutual political responsiveness, which Portugal lacked over the last five decades with respect to OECD, EFTA and even EU - except as good student of macroeconomic stability. Moreover, the role of domestic and international media in spreading news about financial reputation to citizens should not be underestimated. It has certainly been far more striking in the reversal of mid-1999 due to the pre-election refusal of a merger between a Portuguese and Spanish bank than it was in 1990-91 when television was still a state-owned monopoly.

While some oscillations in the integration path are explained by political and social variables, macroeconomic indicators like productivity and relative prices of goods and factors tell the same story, once account is taken of the succession of exchange rate arrangements. Thus, wage increases and long-term interest rates converged and diverged before they converged again to the EU average. Wage and financial immoderation certainly contributed to obscure the significance of the PPERR for firms, trade unions and the general public before joining the ERM and after 1995. In 1997, the expectation of euro entry ensured financial moderation, though wage moderation was reversed and reached the 1996 level of about 3% in 2000-01.

The rise in unit labor costs in relation to the eurozone average is reported in chart 1, which also depicts the substantial changes the Spring 2002 forecasts by the European Commission introduced with respect to the ones presented in Winter 2001. Relative unit labor costs deteriorated after the last ERM realignment, from a rate of about 1% p.a. in 1996/97 to a rate of over 2.5% in 1998/2001. To compare, the rate of deterioration in 1993/95, at the time of ERM turbulence, was about 2% p.a. The trend was so dramatic that there was a warning from the Central Bank governor in early 2001.

Meanwhile, successive revisions of the budget deficit for 2001 culminated in a recommendation by the European Commission, issued on 30 January, 2002 "with a view to giving early warning to Portugal in order to prevent the occurrence of an excessive deficit". The ECOFIN decided against making the recommendation because of the commitments of the outgoing government but a new Stability and Growth Program is to follow the revision of the 2002 State Budget by the new government.

Meanwhile, the surge in non-interest expenditure diverged from the EU average, as illustrated in chart 2. In addition to explaining how divergence followed convergence, this state of affairs hurts corporate governance and the fight against corruption. Section 3 shows how the bad fiscal constitution reversed the monetary and fiscal policies of the good student.

The financial moderation desired by the government when joining the ERM in 1992 turned out to be more difficult to achieve than anticipated. One indicator of such moderation is the spread of long term interest rates relative to Germany, and its decline after qualifying for the euro is evident from chart 3.

The decline of some ten percentage points in inflation rates – and interest rates – in the early 1990’s gave government expenditures an interest free ride equivalent to about five percentage points of GDP in the late 1990’s. In this sense, nominal convergence brings with it the risk of giving a temporary illusion of fiscal discipline. The credibility of the MAFAS/PPERR was not fed by additional measures of a microeconomic and structural nature, designed to enhance the competitiveness of production and therefore sustain the catching-up process. Indeed, the greater volatility observed in chart 3 after the December 2001 local elections suggests that investors remain quite aware of the threat that political instability poses to public sector reform.

Public administration has remained incapable of reforming itself in areas such as justice, home affairs, social welfare, education and others. The absence of structural reforms is especially grave in what pertains to the enlarged public sector and the discretionary regulation of private enterprise. The MAFAS/PPERR was a decisive signal of the change in economic regime even though, in the last ten years, the (general and local) election cycles have hindered the implementation of public sector reform.

The national economy is still more open on the trade than on the capital account, but this changed fast due to both large FDI into Brazil in the late 1990s and large outflows after entering the eurosystem. It is unclear whether government policy mattered, as the instruments were available since 1992. Nevertheless, among cohesion countries, Portugal was set to gain the most from the single market from 1995 to 2010. The opportunity for structural change afforded by euro was lost and with it the improvements in fiscal discipline and structural reforms. The macro situation became unsustainable shortly after qualifying for the euro, with a current account deficit reaching 10% of GDP. Private credit also rose to 140% of GDP, with limited effects on capital accumulation. Worse yet, structural reforms went into reverse gear, with a punitive tax reform and indulgent public sector wage negotiations.

The neglect of the ERM code of conduct after qualifying for the euro made for an unfavorable business environment, which led to an acceleration of outward direct investment. As the business internationalization drive was not accompanied by reform in tax administration, justice and decentralization towards municipalities, let alone social security and public health, it eroded the legitimacy of integration. Portugal was perhaps in a unique position in that it was able to meet the euro criteria without any fiscal adjustment. Since the opportunity for sustained structural change afforded by the euro and the associated interest free ride has heretofore been lost, Portugal has become a victim of the euro hold-up.

If national governments avoid taking unpopular measures because they fear loosing the next election, then populism and nationalism interact in a perverse way. The common good is dissipated. If joining the euro stalls structural reforms, the national economy would become less competitive as a production location in the global economy. An interest free ride, together with EU structural funds, is harmful when it makes social groups more voracious. This is what Portugal's fiscal constitution brought about.

The fiscal constitution includes the institutions enforcing the social contract and thus incorporates various exchange rate regimes, monetary standards and state revenues. The concept of fiscal constitution shows the deep causes of unsustainable fiscal policies, which prevent the benefits of a stable and common currency from materializing. Deficient tax administration has undermined the social legitimacy of taxes as a means to provide for the common good.

It also prevented the reform of public administration from being initiated, let alone carried out, until the government elected in early 2002 and the Central Bank discovered a grossly excessive budget deficit for 2001. Since the previous crises had involved the balance of payments, there are still those who doubt an excessive government budget deficit qualifies as financial crisis and would rather call it a legal nuisance. Nevertheless, the interruption of convergence with EU standards of living may last long enough to discredit such a view.

In Portugal, domain revenues associated with the overseas trade monopolies and collected mostly in Lisbon were more significant than those associated with income taxes, levied since 1641. Centralized revenues were easier to administer and they helped maintain monetary stability in the face of recurrent military expenditures,. However, growing domain revenues gradually narrowed the domestic tax base and divorced taxpayers from transfer recipients. Both of these features came to characterize the fiscal constitution of the 1700s; unfortunately they remained even after the apparent economic prosperity of these times disappeared. In the late 1700s, the combination of foreign and then civil wars, monetary instability and collapsing revenues stunted Portugal’s economic development.

The 1820 liberal revolution was associated with the loss of social confidence and financial reputation, making the taxation of capital and the redistribution among social groups difficult. Civil rights were seen as inimical to monetary stability, so that political and financial freedom clashed until the gold standard brought nominal and real convergence with what is now the EU average from 1854 until the 1891 financial crisis. Exit from gold standard initiated a period of maximum divergence, which lasted until the postwar European integration boom. The preference for hidden taxation included the one achieved through inflation and excess borrowing by the state (my 2001 with Alvaro Ferreira da Silva and Rita Martins de Sousa).

Through exports and through migrant remittances, European growth was crucial for the national economic growth. The effects of rising economic interdependence on society, let alone on the polity, were not as simple. Even when expectations of improved standard of living were realized, the isolation of the political regime made the absence of mutual political responsiveness as conspicuous as the consumption of the middle class. Moreover, export- and remittance-led growth reinforced the discrimination between taxable capital on the one hand and informal capital and labor on the other.

It turns out that neither the redistributive revolutions of 1910 and 1974 nor the ensuing political instability changed the fiscal constitution much. EFTA allowed Portugal to develop an export base in manufacturing but without any significant product differentiation. This is why Portugal was sometimes called a "pajama republic". But the preference for hidden taxation was exacerbated by the revolutions and macroeconomic instability prevailed in their aftermath. In the early 1980s, for example, the inflation rate reached over 20% the EU average.

This rigid fiscal constitution discriminated against "informal capital" and also against labor. In other words, banking, monetary and exchange rate policies supported the discrimination against labor evident in the drop in real wages from 1977 to 1985.

Even though the state is supposed to promote the common good of the population, taxes are viewed as a common resource, whereas expenditures on goods, services and transfers benefit particular social groups. Each one of these groups therefore tries to earmark tax revenues to expenditures or transfers that it can benefit from. The fiscal constitution defines the earmarking process. Social groups are then like a kind of capital that is taxable by the state and can be redistributed through the budget to the benefit of other social groups. Very different tax and transfer mechanisms, including implicit or explicit earmarking procedures, are then associated with a certain level of net taxes, or primary budget deficit. This ultimately reflects the constitution, electoral rules, and other related (even informal) practices of the polity. Together with a number of contextual and informal elements, the high level rules which make up the fiscal constitution determine the actual workings of the policymaking system (i.e., is the Judiciary independent, is the bureaucracy professional, are legislators policy-oriented, etc.) and include the overall functioning of the political system.

The rigidity of the fiscal constitution prevented European integration from balancing mutual political responsiveness with economic interdependence. Public and private interest groups seeking transfers from the state and thereby holding on to the tax base took advantage of European structural funds. The whole process reinforced some of the interests vested in state intervention. Excessive regulation was pervasive both during the corporatist regime (Royo, 2002) and after the 1974 Revolution. In fact, the effectiveness of the resistance of public and private interest groups to broadening the tax base or to tightening the link between taxpayers and transfer recipients has been so remarkable that the fiscal constitution could be described as "get out of my tax!"

As it describes relations between the state and the population involving both taxes and transfers, the fiscal constitution includes the institutions enforcing the social contract and thus incorporates exchange rate regimes, monetary standards and state revenues. Policies can be seen as lower lever rules that regulate the behavior of economic agents; for instance a policy that defines tax bases and tax rates. The rules that determine who has the power, under what procedures, to legislate on tax bases and tax rate, are intermediate level rules and high-level rules are those that determine how intermediate level rules are determined.

Reforms in lower lever rules (like tax reforms) and intermediate level rules (like privatization, or granting independence to the central bank) leave high-level rules unaffected, even though they heavily condition not only the choice of lower rules but also the details of implementation and effectiveness of those lower level rules. For example, the capacity that the political system has to enforce certain rules, to make intertemporal commitments, is perhaps more important than the "title" of the policy in intermediate level rules (such as "public enterprises" versus "regulated private utilities"). Tommasi (2002) applies this view to Argentina, arguing that the inability or unwillingness of powerful social groups to cooperate has enormously raised the political transactions costs of intertemporal cooperation in Argentina. The same insight comes from Portugal's fiscal constitution, which has remained unchanged through the years of the good student, the decades of international economic interdependence and the centuries of earmarking taxation.

Where control of corporate behavior through mergers or take-overs is restricted (and banks are more regulated), firms tend to be committed to their group’s commercial bank, which in turn adopts a more flexible approach and a longer-term view than would be possible in highly competitive and unregulated financial markets. A consequence of the fast economic growth and the excessive financial regulation of the 1960s was therefore that industrial groups needed more finance for their activities than the commercial banks were able to provide. Tight regulation of credit - with ceilings established on an individual bank basis - made it essential for an emerging industrial and financial group to avail itself of a commercial bank.

Most of the seven ‘family’ groups were indeed called by the name of their respective commercial bank. Because of the close links of these groups with the government, the competitive fringe of new conglomerates did not manage to bring about industrial and financial restructuring. Had this fringe been successful, thriving firms might have been able to shop around for more attractive sources of funding, but the financing of the export enclave of small manufacturing firms did not operate in this competitive way. Most firms outside groups were also deprived of the option of borrowing abroad and had to finance their long-term investment through own resources or revolving short-term loans. The oligopoly situation of the seven groups, together with the comfortable external position, explains why non-monetary financial intermediaries failed to develop.

Because of their diversified earnings, large industrial and financial groups do not require a financial market for investment. In the 1960s the managers of the commercial banks at the core of these conglomerates were nurtured in a type of financial intermediation where most of the operations were internal to the group. As the groups could do without a financial market, after the nationalization of 1975 they probably took the same view of the nationalized sector as a whole. The closing down of the stock market, shortly after the revolution, reinforced this perception. At the same time, the abnormally high levels of gold and foreign exchange reserves changed the nature of financial intermediation. Urged by revolutionary politicians to put banks ‘at the service of the people’, the managers saw those reserves as collateral against which the nationalized enterprises were borrowing. But when there is imperfect monitoring of projects by banks, a rise in collateral makes borrowers more likely to default. To compensate for this decline in the expected return of a loan, the bank selects riskier borrowers and projects, which cause expected bank returns to fall. To avoid a fall in profitability, the bank will prefer to ration credit, even if there are no macroeconomic disturbances.

When credit ceilings on private firms are binding, rationing is exacerbated. In an inflationary environment, where every borrower, especially the government, faces negative real interest rates, the constraint on private credit may be very strong. Financial repression made private firms more dependent on bank credit at a time when retained earnings were low and there was no substitute in the stock or bond markets. The heavy dependence of firms on bank credit made the financial system more fragile because banks did not expect some of the debts would be repaid. This reinforced the lack of incentives for creditors to monitor borrowers. It it thus no surprise that after the stock market was revived in 1987 it attracted mostly firms with insufficient retained earnings and with low collateral.

During the expansion of 1981-82, with high wage inflation and controlled prices, profits and retained earnings fell. When interest rates were raised in 1982, the adverse selection effect towards riskier borrowers (who are less reluctant to pay higher rates) was probably offset by a less binding constraint on credit ceilings. This allowed banks a better mix of borrowers and projects, but, in so far as deposit rates were administratively fixed, higher lending rates only increased the intermediation margin. Arrears and bad debts accumulated, peaking at 15% of credit to non-financial enterprises and individuals in 1986. At the time non-performing loans were three times as large as the equity of commercial banks. Bad debts fell to about 11% of credit in early 1989, but the figures would be much higher for the nationalized banks, which were also saddled with the need to provide for their staff’s pensions.

Paradoxically, the role of nationalized banks in collecting hidden taxes through excessively wide intermediation margins may have helped stabilize the system. The hidden taxes were passed on through their forced purchases of public debt. In addition, since nationalized banks were acting as tax collectors, depositors were confident that the state would bail them out. The implicit tax imposed on borrowers and depositors in the banking system widened the normal intermediation margin to bring a ‘revenue’ peaking at almost 10% of GDP in 1982, falling to close to 4% in 1987.

Ten years after the great nationalization the government finally authorized new entrants, both domestic and foreign, into the banking sector, even though some of them were direct competitors of the nationalized commercial banks. The new banks avoided holding public debt instruments other than Treasury bills, which had just been introduced, and were reluctant to lend to the troubled state-owned enterprises. This meant that they were less exposed to bad debts. The contrast between ‘clean’ and ‘tainted’ banks might have prompted depositors to run on the riskier banks but, once privatization was allowed, the state bought the bad debts of nationalized banks. To the extent that depositors believed that ultimately the state would bail out the nationalized banks, this was indeed the appropriate measure. The consequent increase in public debt was in part be offset by the proceeds from the privatization of most of the state-owned enterprises that were nationalized in 1975. Also, "bad" debts turned out not to be so bad, as assets appreciated during the boom which followed. At the same time, the growth of private commercial banks had a stronger effect on banking competition than the mere increase in the number of players would imply. Nevertheless, banks continued to serve as implicit tax collectors until after financial liberalization was achieved.

The resistance to the cross border merger was also a reflection of interests vested in the fiscal constitution, exacerbated in this case by the traditional fear of Spanish domination. The Prime Minister went as far as to say on television "we are not a banana republic!" and vetoed the deal, only to accept it a few months later after winning the elections. As mentioned at the outset, trade between Portugal and Spain began as a by-product of Spain's free trade agreement with EFTA and its growth was the effect of EU membership. Because of the geographical proximity, Spanish imports and investment continue to be resisted, especially in agriculture and banking.

To pursue a defensive strategy with respect to one partner and remain cooperative with respect to others is consistent with the ambiguous responses to external liberalization which prevailed before the good student phase. It is also equivalent to preferring implicit taxation, a habit which stems from financial repression. The habit of implicit taxation is also visible in the resistance to a broader domestic tax base and to budgetary procedures stemming the growth of primary expenditures. The time it took to introduce personal income taxation is yet another example of the resilience of a fiscal constitutions favoring certain social groups.

The first attempts at income taxation were made before the 1974 Revolution and several governments attempted to implement the call to that effect included in the 1976 constitution. Nevertheless, the new taxes on individuals and corporations were not introduced until 1989 - the year when the economic constitution was amended to allow for privatization. Since 1989, several attempts at pursuing tax reform, especially in what pertains to administration, have failed. The most visible reversal occurred in 2001, with respect to an attempt at taxing capital gains, as it led to the replacement of the Minister of Finance, who at the time also held the Economy portfolio. It might even be said that the merger after the 1999 elections of the Ministries of Economy and Finance, two agencies with opposite views of the budget process, only helped solve the reversal in EU policy associated with the veto of the cross border bank merger.

The issue of tax reform was also debated, and the Prime Minister from 1985 to 1995 suggested a "tax shock" involving a reduction in direct taxes matched by an increase in the value added tax and expenditure reduction. The consequences of such packages vary with the specific measures involved but Alfredo Marvão Pereira and Pedro Rodrigues (2002) find no scenario where the tax shock comes close to being self-financed. Moreover, in spite of steady state gains in GDP levels, private welfare falls in the cases which do not involve lower government expenditure. A compensatory increase in indirect taxation would have to be substantial and permanent.

Quite aside from the resistance to tax reform, the fiscal constitution exacerbates the deficit bias and threatens the role of Minister of Finance in dampening the "common pool" problem, at least in a democratic government. Budgetary procedures have scores comparable to Spain, much better than Greece but substantially below Austria (Branson et al 2001). The strategic dominance of the Minister of Finance is associated with strong majority governments between 1985 and 1995. The clear preference for credibility until the qualification for the euro in 1998 was accompanied by increases in primary expenditure.

One reason for the trend illustrated in chart 2 is that, in the minority governments between 1995 and 2002, removing the responsibility for public administration from the Ministry of Finance to the office of the Prime Minister weakened the strategic dominance of the Ministry of Finance, so that the deficit bias was not resisted and the semi-presidential regime became more unstable than with the reform-minded majority governments of 1987/95, even though the President of the Republic and the Prime Minister belong to the same party.

The experience of combining the Ministry of Finance with a spending ministry was short lived and culminated in the approval of emergency measures for expenditure reduction in Spring 2001. This allowed the promised tax reform to be postponed while expenditure control became even harder to apply in the deteriorating external environment following the September 11 attacks on the United States. While the pressure of increased transfers coming from redistribution objectives interacted with the falling tax revenue, public opinion became alarmed at the deteriorating fiscal situation and fears of EU sanctions for breaching the Stability Pact began to be voiced.

In the 17 December, 2001 local elections, the opposition won the major cities and the Prime Minister resigned. General elections were called for March 17, 2002 and in the electoral campaign successive calls for fiscal consolidation were made by economists on both sides of the political spectrum. The changes in the 2002 State Budget brought about by the new coalition government and the public sector reform it initiated have met with fierce resistance on the part of trade-unions and opposition parties. Nevertheless, the strategic dominance of the Minister of Finance is ensured by the fact that she is also Minister of State, that the Ministry recovered the responsibility for public administration and that it seems to be in a better position to control local and regional administrations.

Portugal’s European integration has revealed both convergence and divergence, nominal and real. Since 1997, inflation in Portugal has exceeded the EU average every year, while real convergence has been slowing down each year since 1998, actually turning negative in 2000 and with both real and nominal divergence expected to increase until 2003. One of the major gains of financial liberalization, the significant decline in real interest rates permitted Portugal to be the only eurozone country to meet the convergence criteria without enacting any major curtailment of government expenditures.

After adopting the PPERR/MAFAS and earning credibility abroad, Portugal was in a unique position: it could join the euro without fiscal adjustment. In other words the fiscal convergence criteria were not binding for Portugal. The risk of this interest free ride is that nominal convergence can give the illusion of fiscal discipline via the fall in real interest rates. Instead of using the interest free ride to finance the transition costs of needed structural reforms, the government defeated in the March 2002 general elections used that margin to fund populist measures like a price freeze on gasoline prices, increased transfer payments and large increases in the number of civil servants. On the other side, procrastination relative to unpopular reforms was so pronounced in Portugal that it led to a stagnating economy and higher inflation. By not taking care of the needed structural reforms when they had the opportunity, the Portuguese authorities laid the ground for having both nominal and real divergence.

Original membership in the eurosystem may have suggested to the government that the experience of Portugal was an unqualified success, relative to Greece. Yet, inflation may not have been fully eradicated in Portugal, where it is currently higher than in Greece. Put in another way, the credibility of Portugal’s MAFAS/PPERR must be fed by additional measures of a microeconomic and structural nature, designed to enhance the competitiveness of production and therefore sustain the catching-up process. Structural measures need to be taken at all levels of government, so that cities and regions also benefit from the newly acquired financial reputation of the sovereign.

Belonging to the eurosystem only prevents a currency and a public debt crisis. Instead, bank credit remains largely domestic and the current boom could be suddenly reversed. If that happened, there may not be a spectacular crisis but the current belated attempt at limiting public expenditure growth is likely to have to be pursued over the long haul. Just when the international environment would require more security, Portugal may find itself exposed to a lasting divergence with the EU and with Spain. Policy credibility turns out to be more important than proximity to EU markets in attracting "right" FDI, as corruption discourages FDI and favors bank loans (Shang Jin Wei, 2000).

The benefits of a stable and common currency do not materialize when fiscal policies are unsustainable. Moreover, deficient tax administration undermines the social legitimacy of taxes as means to provide for the common good. There is no substitute for domestic reform and in Portugal the first priority is to change the fiscal constitution which has proved resilient to the political, social and economic changes brought about by 15 years of European integration.

The negative effects of the euro hold up are all the more lamentable since the ERM is an example of flexible integration. Given the complexity of the EU institutional architecture, successful flexible integration schemes such as the euro have a "snowballing" effect which applies both to the other three current EU members and to prospective ones. The issue of building effective governance at the EU level hinges not only on the existence of the European common good but on the specifics of the public good to be provided and on the transactions costs involved. When the benefits of the public good are exclusively for the members who finance it, then the free ride problem is not as serious as it is with respect to common resources like the tax base. This is behind the success of the ERM or the Schengen agreement which are based on a mutually accepted code of conduct and also behind the failure of tax harmonization (Alkuin Kolliker 2000).

By itself, the euro cannot change the fiscal constitution. Different policy areas need specific reform efforts, otherwise they stall and affect each other in a negative way. The good student of macroeconomic stability fell victim of the euro hold-up because of its bad fiscal constitution. The good student must now change its fiscal constitution and reconstruct its financial reputation. Since flexible integration was made easier in the Nice Treaty (Richard Baldwin et al 2001), Portugal may have a chance to become good student again.

References

Baldwin, Richard, Erik Berglof, Francesco Giavazzi and Mika Widgren, Nice Try: Should the Treaty of Nice be Ratified? Monitoring European Integration 11, CEPR: London, 2001

Branson, William, Jorge Braga de Macedo and Jurgen von Hagen, Macroeconomic policy and institutions in the transition towards EU membership in Central Europe towards Monetary Union: Macroeconomic Underpinnings and Financial Reputation, edited by Ronald MacDonald and Rod Cross, Boston: Kluwer Academic Publishers, 2001

Correia, Isabel, Consumption taxes and redistribution, Banco de Portugal mimeo, December 2001.

European Commission, The Economic and Financial Situation in Portugal in the Transition to EMU, European Economy special reports 1997

Kolliker, Alkuin Bringing together or driving apart the union? Towards a theory of differentiated integration, preprints aus der Max Planck Projektgruppe Recht der gemeinschaftsguter Bonn 2001/5

Macedo, Jorge Braga de, Luís Catela Nunes and Francisco Covas, Moving the escudo into the euro, CEPR Discussion Paper October 1999

Macedo, Jorge Braga de, Álvaro Ferreira da Silva and Rita Martins de Sousa, War, taxes and gold: the inheritance of the real, in Transferring Wealth and Power from the Old to the New World, edited by Michael Bordo and Roberto Cortes-Conde, Cambridge: Cambridge University Press, 2001.

Macedo, Jorge Braga de, Daniel Cohen and Helmut Reisen, editors, Don´t fix don´t float, Paris: OECD Development Centre Study, September 2001

Macedo, Jorge Braga de and José Braz, Portugal's euro holdup, presented at a seminar at the Polish National Bank, 21 de March 2002

Pereira, Alfredo Marvão and Pedro Rodrigues, On the impact of a tax shock in Portugal, College of William and Mary mimeo, March 2002

Royo, Sebastián, Still the Century of Corporatism? Corporatism in Southern Europe. Westport, CT: Greenwood Publishing/Praeger, 2002.

Tommasi Mariano, Crisis, Political Institutions, and Policy Reform: It is not the Policy, it is the Polity, Stupid, Annual World Bank Conference on Development Economics – Europe June 2002.

Tornell, Aaron and Philip Lane, Are Windfalls a Curse? A Non-representative Model of the Current Account, Journal of International Economics, February 1998, pp. 83-112.

Tornell, Aaron and Philip Lane, The Voracity Effect, The American Economic Review, March 1999, 22-46.

Wei, Shang-Jin, Negative Alchemy? Corruption and Composition of Capital Flows, OECD Development Centre Technical Paper no. 165, October 2001

(from the entry to the first realignment)

Source: Macedo et al. (1999), updated

(Numbers in parenthesis after date refer to difference with original when larger than or equal to 5%)

(from the first realignment to the widening of the bands)

Date		Smoothed probabilities
		Medium	High	Very high
12/02/92		0%	96%	4%
12/09/92		0%	93%	7%
12/16/92		0%	90%	10%
12/23/92		0%	84%	16%
12/30/92		0%	88%	12%
01/06/93		0%	87%	13%
01/13/93		0%	92%	8%
01/20/93		0%	93%	7%
01/27/93		0%	95%	5%
02/03/93		1%	95%	4%
02/10/93		1%	94%	6%
02/17/93		0%	89%	11%
02/24/93		0%	92%	8%
03/03/93		0%	93%	6%
03/10/93		1%	94%	5%
03/17/93		3%	95%	3%
03/24/93		3%	94%	2%
03/31/93		5%	93%	2%
04/07/93	(5)	6%	91%	3%
04/14/93	(6)	7%	89%	4%
04/21/93	(6)	7%	84%	9%
04/28/93	(6)	7%	75%	18%
05/05/93	(5)	6%	56%	38%
05/12/93		0%	10%	90%
05/19/93		0%	0%	100%
05/26/93		0%	1%	100%
06/02/93		0%	0%	100%
06/09/93		0%	0%	100%
06/16/93		0%	2%	98%
06/23/93		0%	4%	96%
06/30/93		0%	4%	96%
07/07/93		0%	4%	96%
07/14/93		0%	0%	100%
07/21/93		0%	0%	100%
07/28/93		0%	0%	100%
08/04/93		0%	44%	56%

Source: Same as Table 1