The Portuguese Slump and Crash and the Euro Crisis

than the United States during the Great Depression and less than Japan during its lost decade. This paper asks why this happened, with a particular focus on the slump between 2000 and 2007. It describes the main facts of Portugal’s recent economic history, evaluates some possible explanations for its dismal performance, and proposes a new hypothesis based on the misallocation of abundant capital flows from abroad. I put forward a model of credit frictions to show that if financial integration exceeds financial deepening, productivity will fall, generating a slump as relatively unproductive firms in the non-tradables sector expand at the expense of more productive tradables firms. This explanation can also potentially account for the similarities and the differences between Portugal on the one hand, and Ireland and Spain on the other, during this period, and for some features of the crash in Portugal after 2010. Writing 10 years after the introduction of the European common currency, the vice president of the European Central Bank, Lucas Papademos, stated unequivocally that “the euro has been a resounding suc-cess ” (Papademos 2009, p. 16). The euro was by then a reserve currency, and inflation was stable and on target. Economic growth in the euro area had not fallen relative to the previous two decades, and employment had increased significantly, while capital markets had become more integrated, and southern Europe had benefited from sustained low interest rates. Papademos (2009) further argued that the countries within the euro area had been better protected from the financial crisis of 2007–08 than others in the European Union. Yet even before the global financial crisis, there were warning signs about some of the countries in the euro area. One of the more pressing alerts came from the small country of Portugal and was brought to the attention of economists and policymakers in a notable article by Olivier Blanchar