State Space Models

All state space models are written and estimated in the R programming language. The models are available here with instructions and R procedures for manipulating the models here here.

Friday, June 14, 2013

The Mystery of Why Portugal's Economy Has Performed So Poorly.

Matthew O'Brien recently wrote a piece for the Atlantic titled "The Mystery of Why Portugal Is Doomed". The reasons given in the piece are all essentially recitals of the conventional wisdom on economic development and, although each point might make sense in and of itself, the actual causes are simpler to understand and less complicated. From the graph above (real GDP in US$ from the World Data Bank) the economy in Portugal experienced an economic bubble after it joined the EU in 1999 and the bubble popped in 2007 as a result of the Subprime Mortgage Crisis. The bubble can be clearly seen in the dynamic attractor plot above (the dashed red line is the dynamic attractor path and the other dashed lines are the 98% bootstrap prediction intervals). Before going into more detail, let's review the conventional wisdom.

Matthew O'Brien lists the following problems with the economy of Portugal:
  • Between 2000 and 2012, Portugal's economy wasn't growing fast enough. To prove this case, GDP per capita in Portugal from 2000-12 is compared to the USA 1929-41 (the Great Depression) and Japan 1992-2004 (the Lost Decade). The comparison supposedly supports the conclusion that "this wasn't the case of the bust erasing the boom, because there was no boom". But this is certainly a logical non-sequitur since these economies and time periods really have nothing to do with each other (more about the supposed "non-boom" and a-historical comparisons later).
  • Portugal's Immature Financial Sector. After Portugal's entry into the EU, the financial sector "...misallocated the foreign capital that poured in to low productivity, non-tradeable sectors like wholesale and retail trade. In other words, it wasted money on things that never had a chance of paying off." This argument is rejected because German Banks in Portugal also made "bad bets". Bankers making bad bets sounds consistent with bubble behavior which seems inconsistent with the "non-boom".
  • Portugal's Small Business Culture, Too Much Corruption and Regulation. Portugal and all of Southern Europe supposedly have too many small "mom-and-pop" businesses that stay small to fly under the radar of a corrupt government. The conventional wisdom: if small-and-medium-sized-enterprises (SMEs) play too big a role in the economy, the economy can't grow and take advantage of economies of scale. The article correctly rejects this explanation because it has been true for most of the late 20th century and hasn't changed much recently.
  • Portugal Has To Fix All The Structural Problems.  Here the article trots out the laundry list of conventional criticism of Southern European countries: labor market inflexibility (they need to fire more workers), difficulty starting a business (too much red tape), and legal problems (inability to enforce contracts). "After all, Portugal's stagnation between 2000 and 2008 shows that adequate demand isn't sufficient in the face of these deep problems--but it is necessary. That's why Europe needs to stop insisting on punishment as the path the prosperity." What seems more interesting about the period after 2000 when looking at the graph above is why the bubble was able to stay inflated for so long?
In the end, the article concludes that Portugal's economic performance is a "puzzle". What creates the puzzle, I would argue, is illogical comparisons and arbitrary lines (explicitly or implicitly) drawn on graphs.

The starting point for all the consternation about Portugal is the counterfactual assertion that Portugal should have grown more rapidly. The counterfactual assertions can be conveniently summarized by drawing lines on graphs (the solid red lines with arrows in the graph above) projecting rapid future growth based on strong periods of (bubble driven?) economic performance.  Portugal should have taken-off after the mid-1990s (Dot-com bubble), or after 1999 (EU bubble, "I contend that the European Union itself is like a bubble." George Soros, June 2, 2012) or after 2007 (Subprime Mortgage Housing bubble). Something must have been preventing the take-off into sustained growth implied by the red-line counterfactuals and the usual culprits are trotted out to affirm the conclusion.

None of the red-line "take-off" extrapolations have anything to do with the capabilities of Portugal's economy but rather with the implications of neoclassical economic growth models. Unfortunately, Portugal's economy is not correctly described by the unrestrained exponential growth embedded in such models. Portugal's growth is slowing because the economy is moving toward a steady state. To understand these issues, which are very different from the conventional wisdom, will require a comparison of the neoclassical growth model to the PT20 state-space model of Portugal's economy (the model used to generate the dynamic attractor path in the plot above) and a more detailed discussion of macroeconomic analysis underlying the conventional wisdom, to be covered in future posts.