What Went Wrong in Portugal?
Here’s an excerpt of my answer at the New York Times:
In Portugal, the government has adopted steep austerity measures as a condition of its aid package. However, the country’s economy will now shrink because European policy makers fail to understand the dynamics of debt deflation. What they miss is that the Portuguese private sector is highly indebted. When the economy contracts, indebted individuals and companies in an indebted private sector have an overwhelming incentive to save to reduce debt burdens and prevent default and bankruptcy. This means that the private sector will always attempt to increase its net savings position irrespective of the government balance. When government then attempts to move to a net savings position as well by cutting spending and increasing taxes, it is met with cuts in the private sector which still wants to net save and pay down debt. Irresistible force meet immovable object!
The result, then, of government cuts or tax increases when the private sector is indebted and the economy is stalled is debt deflation, as more and more parties cut back, threatened by insolvency due to the decreased economic output.
Read the whole thing here.
Source: What Went Wrong in Portugal, Room For Debate, NY Times