Growth rates constrained by internal and external imbalances and the role of relative prices: Empirical evidence from Portugal

Thirlwall’s Law (Thirlwall 1979) considers that growth can be constrained by the balance-of-payments when the current account is in permanent deficit. The Law focuses on external imbalances as impediments to growth and does not consider the case where internal imbalances (budget deficits or public debt) can also constrain growth. The recent European public debt crisis shows that when internal imbalances are out of control they can constrain growth and domestic demand in a severe way. Recently, Soukiazis E., Cerqueira P., and Antunes M. (2012) developed a model – hereafter the SCA model - that takes into account both internal and external imbalances but where relative prices do not play any role on the pace of economic growth. The aim of this paper is to extend the SCA model by relaxing this assumption and introduce explicitly relative prices in it. The model is tested for Portugal which recently fell into a public debt crisis with serious negative consequences on growth. It is shown that our new model makes a significant improvement in predicting actual growth in Portugal. Our empirical analysis reveals that Portuguese growth is balance-of-payments constrained and that policies aiming at reducing external imbalances and changing the share of imports and exports towards trade equilibrium will help the economy to grow faster. Competitive devaluations and lower cost for financing the economy are also important stimulus to growth.