What we are seeing in Portugal is an increase in reform fatigue. Of course, this had been brewing for quite some time in view of the protests but now it has led to clear signs of corrosion in the governing coalition. As in any peripheral country, the constituent parties are probably constantly making a calculation of what would serve them best. There may be a strong reason to remain in the coalition even though it takes unpopular measures because near term elections may result in a significant fall in a party's share of the vote to the benefit of more populist parties. However, at some point a party may decide its interests are served best by defecting. Openly doing so may increase their share of the vote.
The fundamental reason why Europe is still in the mess it finds itself in today is that, from the start, politicians have failed to recognize that this is a common problem and that all parties involved share a responsibility for having created it and for solving it. To be concise, rising borrowing and current account deficits in the periphery would not have been possible without corresponding rises in lending and current account surpluses in the core. For too long, the latter part of the region has regarded the crisis as the result of peripheral profligacy which in their view could only be solved by severe fiscal belt-tightening and structural reforms. Because of severe market pressure, the core countries were forced to concede to providing some form of bridge financing via the EFSF/ESM and Portugal is benefiting from this.
It is abundantly clear now that the single minded focus on fiscal tightening and the simultaneous implementation of structural reforms comes at a huge economic and social cost which at some point may become too big to bear for any given country. It would have been far better if the Troika had severely diminished the degree of peripheral fiscal tightening in recognition of the fact that these are very much self-defeating in an environment where the private sector is deleveraging, credit supply is very tight and exports are hindered by slow DM growth and competitiveness problems. Doing so would also have made the structural reforms, which are very necessary, more socially acceptable. Also, more attention could have been paid to explicit core reflation and a much easier monetary policy stance.
Of course, all this is now being slowly recognized by EU policymakers as evidenced by the increase degree of lenience towards cyclically induced deficit target misses. Nevertheless, a lot a damage has already been done to the economy and social cohesion in the periphery. The current rise in yields does not pose an immediate direct threat to Portuguese public finances as Portugal is in a Troika program until H2'14. However, it does pose an indirect threat because it tightens domestic financial conditions and could lead to tighter credit supply to the extent that the domestic banking sector has to take a hit on its domestic bond holdings. This would have a depressing effect on near term growth and hence also private and public debt sustainability.
A near term solution needs to come from Portuguese politics where the situation remains fluid. In all this one must bear in mind that Portugal is not yet under the ECB's OMT umbrella because it is in a full Troika program. The game plan was probably to take Portugal back to the market with an ESM credit line as a backstop next year in which case the country would have become OMT eligible. Also, it is important to bear in mind that Portugal has a lot more goodwill in European circles than Greece had because it has been a "good citizen" until now as the country has complied with both fiscal and structural reform targets. If push comes to shove, a European solution to the current market turmoil will probably be found but only after the pressure has increased further both form a political and a market point of view. As was the case in Greece, one cannot exclude the possibility that PSI will be part of that solution. It all depends on whether the rest of the region believes that the firewalls against contagion will be strong enough this time around.
Image By Andrés Monroy-Hernández from Cambridge, USA (DSC01221) [CC-BY-SA-2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons
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