A Portuguese Lesson for Britain's Euroskeptics

British euroskeptics have been predicting the demise of the euro since before the single currency was even launched. For 25 years, they have been warning that it is doomed to failure, that it is a "burning building with no exits."

Its supposed imminent collapse was one reason why some Brexiters said it was essential that Britain quit the European Union. Others argued that the only way for the eurozone to save itself was to turn itself into the superstate of euroskeptic nightmares, complete with mutualized debt and fiscal transfers, riding roughshod over national sovereignty.

That narrative has suffered many setbacks over the past few years, and last week it suffered another when Standard & Poor's restored Portugal's sovereign debt rating to investment grade, triggering a sharp rally in its 10-year bonds and driving the yield down to 2.53%, the lowest since January 2016.

This marked another important milestone in the country's recovery from a severe financial crisis that forced Lisbon to seek a bailout from the rest of the eurozone and the International Monetary Fund. With Portuguese growth expected to hit 2.8% this year and unemployment back to around 9%, one of the weakest links in the eurozone looks increasingly secure.

From an economic perspective, it's puzzling why British euroskeptics, who mostly claim to be conservatives, should be so neuralgic about the euro. Conservatives typically believe in sound money, that the key to prosperity is finding ways to boost productivity, not via gimmicks such as devaluation, deficit spending and loose money.

Indeed, during the coalition government years, many British conservatives berated Chancellor George Osborne for abandoning his tough fiscal targets too quickly and criticized the Bank of England's money-printing. Yet when they look across the Channel, these critics suddenly discovered their inner Keynesian, blaming all the eurozone's misfortunes on an inability to devalue and spend borrowed money.

In fact, Portugal has achieved the kind of turnaround of which British conservatives can only dream. The country turned a budget deficit of 9% in 2012 into a deficit of just 1.5% in 2016, compared with a U.K. budget deficit in the year to March 2017 of 2.4%. It turned a current-account deficit of 6% into a surplus of 0.7%, compared with a U.K. current-account deficit of 4.4%. And Portugal has grown its exports as a percentage of gross domestic output from 29% to 45%, compared with just 28% in the U.K.

It has done this without the help of a devaluation, let alone fiscal integration or debt mutualization. Instead, Portugal owes its recovery in large part to determined supply side reforms -- as was also true of the even more impressive turnarounds in the fortunes of Ireland and Spain.

The reason that British conservatives failed to spot this eurozone recovery is that they aren't, in fact, as conservative as they think. Seared into the British political memory is the repeated failure of successive governments to maintain the value of sterling against gold in the 1920s, the dollar in the '60s and '70s and the deutschemark in the '90s. The lesson the British establishment drew from economic history -- in particular the recoveries that followed the decision to abandon the gold standard in 1932 and quit the European Exchange Rate Mechanism in 1992 -- is that currency flexibility is the key ingredient to economic success.

But it should now be clear, not least from failure of the two big plunges in sterling in 2008 and post-Brexit last year to deliver the expected recoveries in the U.K.'s current account position, that this was the wrong lesson.

The key to the recoveries that followed the devaluations of 1932 and 1997 wasn't so much the fall in the exchange rate but the dramatic easing of credit conditions, constrained by the mechanics of the gold standard and by the high interest rates needed to defend sterling in the ERM, rather than the value of sterling.

The reason the eurozone didn't collapse like the gold standard, as British euroskeptics insisted it would, was because it managed to keep credit flowing, thanks to a common central bank that provided enough cheap liquidity to enable countries to achieve an orderly deleveraging.

That isn't to deny that mistakes were made during the euro crisis that made the crisis for countries like Portugal worse than it needed to be.

It took too long to fix the problems in the eurozone banking system, which meant that despite the action of the European Central Bank, the flow of credit was still impeded. This was compounded by inefficiencies in national insolvency regimes, which continue to delay the restructuring of bad debts, acting as a further drag on the credit flows.

The ECB was also too slow to spot the deflationary consequences of structural overhauls designed to restore competitiveness by reducing relative prices including wages. As a result, real interest rates remained growth-sappingly high until the ECB belatedly launched its quantitative easing program.

Nor would anyone claim that either Portugal or the eurozone is yet out of the woods.

Portugal's very high levels of public and private bad debt leave it vulnerable to a shock despite its improved growth outlook. Like many eurozone countries, it needs to further boost its productivity if it is to remove all doubts about its long-term debt sustainability.

Nonetheless, Portugal's recovery is a reminder that the euro's collapse isn't inevitable and that it's survival need not depend on the eurozone turning itself into a superstate -- just as the U.K.'s continuing imbalances are a reminder that a flexible currency can be a curse if it allows governments to duck hard decisions.

(END) Dow Jones Newswires

September 20, 2017 18:55 ET (22:55 GMT)