CHAMPAIGN, Ill. - A new paper co-authored by a pair of University of Illinois economists says increasing resource misallocation in Portugal contributed to at least 15 years of sluggish economic growth - a conclusion that also could explain the poor economic performance of similar peripheral European Union countries in the lead-up to the eurozone crisis of 2009.
Daniel A. Dias, a professor of economics at Illinois, and Christine Richmond, a professor of agricultural and consumer economics at Illinois, found that deteriorating efficiency in the Portuguese economy was responsible for shaving off about 1.3 percentage points from the country's annual gross domestic product from 1996 to 2011. The finding is significant, since the Portuguese economy during the period only grew an average of 1.5 percent per year, the researchers say.
"You would expect a lot of growth in a country like Portugal, given the funds and resources that were channeled into it during that period of time," Dias said. "But what we actually found was a significant source of lost opportunity for the country."
According to the paper, the Portuguese economy between 1995 and 2001 underwent a structural transformation in the run-up to the introduction of the euro, shifting away from a manufacturing-based economy to a service-based one.
However, this came at the expense of competitiveness and higher indebtedness, the researchers say. By 2010, the interest rates on long-term Portuguese government bonds started rising, mirroring those of debt-riddled Greece.
To investigate whether a change in allocative efficiency may have contributed to the poor economic performance in Portugal, Dias and Richmond studied firm-level data from 1996-2011 on the evolution of resource misallocation in the Portuguese economy.
They found that within-industry misallocation in Portugal almost doubled during that time, with those results primarily being driven by the service sector, which encompasses construction, ground transportation, transportation support services (e.g., road and toll-road management and maintenance), general support services (accounting, law and market research) and the wholesale of food and drinks.
"We observe a high concentration in just five industries of the service sector, which accounts for 72 percent of the total increase in resource misallocation," Richmond said. "Their levels of misallocation are significantly higher and increased much faster than those found in both the manufacturing and agricultural sectors."
"As more capital was coming into the country, it was being allocated less efficiently," Dias said. "That's important because 10 to 15 years later, there's a big burden of debt to pay and no economic growth to show. And that's something that could very well happen to other countries that happen to be in a similar situation to Portugal, like some of the new eastern European countries that are trying to get accepted into the European Union."
The authors say their paper is the first to use service sector data to study misallocation's effect on a country's economic growth.
"Economists haven't done much work on the service sector, so we feel that we're contributing something big," Richmond said. "Our results suggest that economists who are restricting their attention to the manufacturing or agricultural sector are likely to underestimate the importance of misallocation for the economy as a whole."
"One thing we learned is how the service sector is so much less efficient at allocating resources than manufacturing," Dias said. "Manufacturing in Portugal is about as efficient as manufacturing in France, which is about as efficient as the U.S. But we have no similar comparison for services or non-tradable sectors."
Financial integration of the EU ostensibly would improve resource allocative efficiency, facilitate risk sharing and boost economic growth. But that hasn't necessarily happened for some southern and peripheral European countries like Greece, Ireland, Portugal and Spain, the so-called "GIPS" of the eurozone. Those countries have experienced stagnant or declining productivity and a loss of competitiveness, despite large capital inflows in the decade preceding the onset of the 2009 crisis, the researchers said.
"Greece was a sexier case in a way, because there were just so many blatant problems there," Richmond said. "Portugal is a smaller country that's not on everyone's radar, and their problems weren't as blatant as Greece's problems."
Can the story of Portugal help economists understand what happened in the other troubled EU countries? Possibly, Dias and Richmond said.
"We knew that in both Spain and Ireland, the big problem was construction," Dias said. "Portugal has flown almost completely under the radar. But according to our calculation, it was construction that most contributed to this big decline in allocative efficiency. Twenty-five percent of our estimate comes from construction. So even though construction is not a big contributor to Portugal's GDP, it's very important in terms of production."
The research also is important if other eastern European countries - Slovenia, Latvia and Estonia, among them - seek to join the EU.
"In the run-up to those countries joining the EU, they get access to EU money to bring them up to a European level," Richmond said. "They would have the same potential problems that Portugal had - all this money coming in, how do they spend it properly? How can they put it to work in the best way to boost growth, but not end up in a Portugal situation? Some of the eastern European countries have had their share of problems, and all of them are at risk of falling into the same trap."
Their co-author was Carlos Robalo Marques of the Banco de Portugal.