Portugal in Peril

That simple yet forceful American proverb “if you’re in a hole, quit digging” summarizes the European economic crisis quite well. The problem is, Europe’s welfare-statist politicians just won’t stop digging. Consider the latest stunt by Portugal’s uber-statist chief socialist:

Portugal’s opposition Socialist party spooked financial markets and pushed up the government’s cost of borrowing after it demanded Lisbon renegotiate the terms of its bailout deal with Brussels. The news came as Fitch became the third ratings agency to strip France of its AAA rating, to AA+. In Portugal, the Socialist leader, António José Seguro, said he was ready to discuss a pact with the prime minister, Pedro Passos Coelho, but any coalition needed to agree that austerity measures agreed with Brussels had failed.

Leading financial investors have adopted the same attitude to austerity as the leadership of the EU-ECB-IMF troika. They all appear to be under the delusion that austerity eventually, somehow, somewhere will bring a country back to growth, full employment and prosperity. So far, with Greece in its fifth year of austerity, the exact opposite has happened.

This does not mean that Mr. Big Socialist knows the path to a successful recovery for the Portuguese economy. All he will do is stir up some political trouble and cause yet more uncertainty as to where Portugal is heading:

“We have to abandon austerity politics. We have to renegotiate the terms of our adjustment programme,” Seguro told parliament. “The prime minister has to recognise publicly that his austerity policies have failed.” The political turmoil has already forced Lisbon to request a delay in the eighth review of the bailout by its creditors, initially due to start on Monday, until the end of August or early September. The delay drove up yields on Portuguese government bonds, which determine Lisbon’s borrowing costs, with 10-year yields surging 90 basis points to 7.87%.

This is junk-bond territory. Portugal is stuck there, and will remain stuck there for as long as they remain committed to the fiscal self-destruction program known as austerity. To make matters worse, the only alternative currently floating around on the political scene is a return to the same old socialist welfare-state spending that brought about this crisis in the first place. That will bring about more political instability and social unrest, in addition to the political general strike on June 27. The Guardian again:

Greece is braced for a general strike next week while Portugal faces the collapse of its coalition government and a general election next year. The president, Anibal Cavaco Silva, threw Portugal into disarray this week by refusing to allow the premier to heal a rift in the ruling coalition with a controversial cabinet reshuffle, calling for a cross-party agreement to last until the end of the bailout programme in June 2014, to be followed by early elections.

The bailout program is the supply of funds from the EU to the Portuguese banks, to keep those from collapsing. As a condition for this money the Portuguese government is forced to try to close its budget deficit with harsh austerity measures. The only result is a deeper depression of the economy, as austerity drains more resources from the private sector while giving less back. Government grows bigger while suppressing more of the productive sector of the economy – precisely the wrong recipe.

What Portugal needs is more investments by private businesses and more consumer spending. Neither can happen under austerity. But in a country like Portugal it could not have happened before that either. This is a nation whose economy has been stuck in zero growth for the better part of a decade, while its welfare state has slowly but relentlessly bled the private sector to death. It was only a matter of time before a recession would push the Portuguese economy over the cliff.

Let me stress that point again. The cause of the current crisis was not the global financial turmoil. The financial institutions of the world could have handled that turmoil, were it not for the fact that banks in, e.g,  Europe were busy lending excessively to morbidly obese welfare states. About the time when the financial crisis broke out those same welfare states were beginning to have problems with their piles of debt. Yet instead of structurally terminating entitlement spending, i.e., instead of surgically removing fiscal fat from the economy’s overburdened bones, Europe’s politicians continue to defend their big governments at any cost.

The result: banks lost their low-risk anchors and needed bailouts to stay afloat. Governments were now forced to rescue their own creditors, a rather absurd process that has become a perpetual financial machine. Portugal, again, is a prime example. Reports Business Week:

The European Central Bank’s funding to Portuguese lenders rose to the highest in seven months in July. ECB lending increased to 50.2 billion euros ($67 billion) from 49.4 billion euros in June, the Lisbon-based Bank of Portugal said on its website today. Central bank funding to Portuguese banks peaked in June 2012 at 60.5 billion euros and was at 52.8 billion euros in December.

What Business Week does not report is that the financial institutions own about the same amount of Portuguese government debt. consider these numbers from Eurostat:

Portuguese debt held by financial institutions
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Euros, millions 14,120 12,765 12,976 13,908 12,426 14,061 22,993 45,235 50,243 58,304
Percent of total debt 18.0% 15.2% 13.7% 13.8% 12.0% 12.5% 16.4% 28.1% 27.1% 28.5%

The banks’ ownership of Portuguese government debt is hair-raisingly close to the amount that the ECB is lending those same banks. (We are making the perfectly reasonable assumption that Portuguese financial institutions hold Portuguese debt.) As the Portuguese treasury bonds fell to junk status in 2012, the financial institutions found their portfolios listing heavily to the high-risk side.

The effects of the Portuguese government’s over-indulgence in debt were exacerbated by the fact that those institutions had increased their share of the country’s government debt from 12 percent to 28.5 percent in five years. While the government was doing everything to erode its credit worthiness, it sold almost 46 billion euros worth of new, increasingly unreliable debt to banks.

This is an important background to the current turmoil on the Portuguese political scene. First the government builds an unsustainable welfare state; when the private sector can no longer deliver the taxes needed to pay for that welfare state, government goes out and borrows excessively to fund it; as soon as the banks have handed over tens of billions of euros for supposedly safe treasury bonds, the over-spending welfare state blows a big hole in its own credit worthiness.

Now the ECB is holding those same banks under the arms by lending them almost exactly the same amount of money that they in turn had invested in government junk bonds. Meanwhile, the budget deficit is the only thing that has survived unscathed through this entire process. Impervious to austerity, the deficit continues to haunt Portugal’s legislators and force the Portuguese people deeper and deeper into an economic situation the country will never recover from.

Unless, of course, they do away with the welfare state and open their country to the fresh winds of economic freedom. Which, of course, will not happen. Instead, I fear, Portugal will go the same way as Greece, with increased influence of totalitarian parties in their parliament, and eventually an attempt by those same parties – in some absurd coalition or a mad solo run for power – to “save” the country. It is hard today to predict exactly what that would mean, but do expect a secession from the European community, the reintroduction of a national currency, a formal or informal termination of parliamentary democracy and central planning attempts as a disastrously erroneous way to prevent an inevitable economic disaster.

Only Capitalism and economic freedom can save Europe. Both are well known, but neither is well liked in Europe today. Let’s hope that will change.