Portugal in the Eurozone during the pandemic

The pandemic has brought about a severe economic crisis and, naturally, governments have been called upon to address the problems caused by that economic crisis. Nevertheless, Eurozone governments must comply with Eurozone rules and, in this sense, are constrained in their action. Most notably, their scope for fiscal action has limits, and monetary and exchange rate policies are completely outside their remit. Opponents of Eurozone membership will argue that Portugal would be better equipped to fight the crisis if it could make use of a broader range of economic policy instruments, namely, somehow exert control over the exchange rate.

What did the pandemic do to Portugal’s exchange rate, i.e., to the euro’s exchange rate? I will take January 30 as representative of the pre-pandemic “normal”. January 30 was the day when the World Health Organization (WHO) declared that there was a Public Health Emergency of International Concern. Before that day, international concern about the new virus was still relatively minor. Between January 30 and March 11, which was when the WHO characterized Covid-19 as a pandemic, the euro appreciated against most of the currencies for which the European Central Bank (ECB) publishes reference rates. The exceptions were the Japanese yen, the Hungarian forint, and the Swiss franc. However, in all these three cases, the depreciation of the euro was modest by historical standards. On the other hand, during that period, the euro appreciated significantly against many of the remaining currencies. For example, 4.6% against the UK pound, 6.7% against the Norwegian krone, 6.9% against the Canadian dollar, 12.9% against the Brazilian real, 15.5% against the Mexican peso, and 16.8% against the Russian rouble. Appreciations of the euro versus these currencies, with these magnitudes over such a short period, are rare events. The euro appears to have been viewed as a safe haven in the context of a most unusual crisis. In fact, since March 11, the euro has made further gains against most currencies (as well as against the three initial exceptions).

In the usual context, an exchange rate depreciation signals the need to lower domestic production costs in order to stimulate exports, reduce imports, and balance the external accounts. Opponents of Eurozone membership attach great value to this mechanism. Indeed, they often complain about Portugal being bundled together with a strong economy such as the German, and not being able to use the exchange rate to compensate for the existing structural differences between them. I am inclined to think that one advantage, possibly the most important, of Eurozone membership is actually the fact that it imposes a framework for policy-making that reduces the likelihood that national authorities will overuse or misuse discretionary measures. Note that, in my view, an institutional framework that leads to, Ulysses-style, tied up hands is not desirable either, as the Covid-19 crisis itself has shown: ECB’s flexibility regarding the purchase of public debt has been important to keep the financial markets calm.

In addition, in the context of the Covid-19 pandemic, the foregoing interpretation of the exchange rate depreciation (lower domestic production costs in order to balance the external accounts) is probably misleading. Given the restrictions on social life and economic activity imposed by governments – with a view to “flatten the curve” or even suppress the virus – and all the uncertainty about how the crisis would (and will) unfold, it seems unlikely that a price movement induced by an exchange rate depreciation would have been able to direct resources towards new and better uses. Instead, an exchange rate depreciation would more likely be signalling a lack of confidence in the government’s ability to tackle the crisis, given its complexity. In these circumstances, the exchange rate depreciation has probably acted as an additional factor compounding the crisis, especially in those countries burdened with foreign debt. Membership of the Eurozone is likely to have saved Portugal from similar problems.