March 27, 2007
The pain in Spain will follow years of rapid economic gain
Do current account deficits matter inside a monetary union? The answers are “no” and “yes”: no, because there cannot be a currency crisis; and yes, because there cannot be a currency crisis. Where unsustainable divergences in competitiveness emerge, adjustment occurs largely through changes in relative nominal costs, particularly of labour. The bigger the required adjustment, the greater the pain.
The challenge posed by divergent competitiveness inside the eurozone has been widely discussed for the case of Italy. But Spain is even more interesting. Spain, unlike Italy, has been an enormous economic success; Spain, unlike Italy, has a huge current account deficit; Spain, unlike Italy, has enjoyed a vast construction boom. But Spain, this time like Italy, has low productivity growth and deteriorating external competitiveness.
The question, then, is not whether adjustment will happen, since it is sure to do so. It is how it will happen.
The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free.
Olivier Blanchard: I think Martin has put his finger on the most important issue confronting the euro area, the age-old issue of adjustment within a common currency area.
We can get a glimpse of the problems Spain is likely to confront by looking at two other countries.
The first one is Germany: The boom due to reunification led to an appreciation. It took nearly 15 years of low growth (1 per cent lower than that of the euro area on average), high unemployment, and very low wage growth, to re-establish competitiveness, and trigger an export-led expansion.
The second one is Portugal. The anticipation of a productivity boom and a sharp decrease in interest rates led to a boom in the second half of the 1990s. The boom led to an appreciation. The hoped for productivity boom never materialised. Internal demand decreased, while external demand suffered from lost competitiveness. As a result, Portugal has been in a slump since the early 2000s. Wage growth is low, but productivity growth is dismal, and so competitiveness is not improving. The current account deficit is very large. A reasonable guess is that it will take many more years for Portugal to get out of its hole.
Is Spain different? In some ways yes. The expansion was, for the most part, a healthy one. Yes, it was triggered by housing demand, and some of it may have been excessive, but on the supply side, it came with a decrease in the natural rate of unemployment. So, despite the enormous decrease in the unemployment rate, inflationary pressures were limited. But they were still there, and Spain has lost competitiveness. When the housing boom comes to an end, internal demand will decrease, external demand will be low, and Spain will go into a slump.
Can it get out of it easily? Probably not. Policy makers in Spain point to the fact that the fiscal position is strong, so they can use fiscal policy to sustain demand. This would however be the wrong tool (although I am sure it will be used). What is needed is an increase in external demand, not internal demand. Boosting internal demand will simply delay the adjustment, not eliminate the need for it. Can competitiveness be re-established fast? This would take either negative nominal wage growth, or a productivity boom, or both. Negative nominal wage growth is not in the cards in Spain. On the productivity front, one may be a bit more optimistic. Productivity growth has been dismal, probably because of the need to accommodate the enormous increase in the labour force. One may hope that, now that this is done, productivity growth will go back to normal or better. I hope it does. But the most likely scenario is for a long slump.
There is a more general point here. What happened to Germany, to Portugal, and probably to Spain, is likely to happen to other euro countries in the future: A boom in internal demand, leading to an appreciation, leading to a long and painful adjustment (a pattern I have called this “rotating slumps” elsewhere). In this context, we should be thinking hard about three issues:
Were these exceptional shocks, due to transition to the euro, never to be seen again? While we may not see the likes of the reunification shock again, my belief is that country-specific shocks will continue to happen. They surely do across US states in the United States.
Is there a role for fiscal policy? I think the answer is an emphatic yes. In the case of Portugal or Spain, using fiscal policy to reduce the demand for non-tradables, and thus limit the appreciation, would, in retrospect, have been very smart. We need to be ready for the next time. We are not.
Can more be done? I think so. Aggregate wage flexibility can, in principle, solve these problems. A larger increase in wages in Portugal would have limited the boom, and a larger decrease now would shorten the slump. Should it be achieved by running unions into the ground, as some suggest? I think not. I believe the answer is in better dialogue and bargaining between unions and firms at the national level (think of the Wassenaar agreement, as the source of the turnaround in the Netherlands in the 1980s). There is a long way to go.
Posted by: FT Forums | April 1st, 2007 at 3:39 pm | Report this commentGuillermo de la Dehesa: As the only Spaniard, I think, in the FT Economists’ Forum, I feel obliged to make a few comments on Martin’s brilliant article on “the pain in Spain”.
I agree with most that Martin says about the need for adjustment in the Spanish economy. Spain has been in a boom for more than 13 years growing at an average of 3.5 per cent and it seems like if it is going to continue to do so, in 2006 and 2007. According to very recent the Spain’s IMF Article IV report, it agrees with the growth estimates by the Spanish government for 2007 and 2008 about growing at the present potential GDP growth of 3.25 per cent on average for both years. It is the longest period of high growth in many decades.
The problem now, as Martin says, is not if it needs to adjust - that it is absolutely certain - but how and when it is going to adjust; or, which is the same, if Spain is going to make a soft landing or end up in a recession, as it did in 1993, and if it is going to happen in 2009, in 2010 or in 2011.
Let me explain the reasons for this persistent growth boom, which is the result of the following factors in chronological order:
First, it is the consequence of Spain joining the euro. As soon as the peseta exchange rate risk disappeared, two things happened: short and long term interest rates came down from 13.3 and 11.7 per cent respectively in 1999, to 2.2 and 3.4 per cent respectively in 2005; and a new wave of direct, portfolio and real state investment came from the rest of the eurozone.
Second, it is also the consequence of the effects of the ECB necessarily “one size fits all” monetary policy. As it uses the weighted harmonised CPI of the eurozone as a medium term reference target and the GDP weight of Germany, France and Italy is much above 50 per cent of the total eurozone GDP and therefore their rate of inflation is determinant for the ECB monetary policy stance.
During most of the last eight years these three countries have tended to be the lowest growth and lowest inflation large eurozone members while Ireland and Spain have been the highest growth and highest inflation peripheral member countries. The same level of interest rates set by the ECB tended to be too high for low inflation members and too low for high inflation members. As a consequence, Spain’s real interest rates have been either negative or neutral for the last five years, provoking both a consumption boom and a housing boom, among other things.
Third, when the first “once for all” factor of started to have a slowly decreasing impact on growth, then a third shock came to help (at least temporarily) Spanish growth. Foreign population (mainly immigrants) has increased from 1 per cent of total population in December 1999 to close to 11 per cent of the total population, in December 2006. That is an inflow of more than 4 million people in seven years!
This large inflow of immigrants, all of them at working age, with very high participation rate and total flexibility both functional and geographical, together with a large increase in the participation rate of young Spanish women, have increased the flexibility of the traditionally rigid Spanish labour market and have produce a persistent and large wage moderation in most sectors of the Spanish economy.
The other side of the coin is that labour productivity growth has been much lower, not only because of the lower capital-labour ratio resulting from that large migration inflow which is working mainly in labour intensive sectors, but also by the effect of a large percentage of fixed term and part time labour contracts within total employment, because some of the employment growth has also been the result of the emergence of a large number of workers coming from the underground economy (whose output was already partly registered), as well as from new employment accounting rules by the Statistics Institute.
As a matter of fact, immigrants have on average a higher average skill than the average of total Spanish population but a lower one that the average of the Spanish labour force. Thus, Spanish companies have been able to find not only a lower cost of financing their activities but also suitable and cheaper workers (that they could not find previously in both the services and construction sectors) and to enjoy a moderate wage growth, so as a result, they have also been able to compensate for the lower productivity growth and for the necessary loss of profit margins in order to be able to compete by exporting to both the eurozone and the rest of the world. These factors have resulted in the largest increase in Spanish employment since the sixties. More than one third of all eurozone employment growth in the last ten years has been contributed by Spain.
Moreover, there are some issues raised by Martin that need some qualifying.
First, it is true that 8 per cent of total investment goes into housing, but in the last four years total investment has been around 30 per cent of GDP, the level of emerging economy and surpassed only by Estonia within the EU. Moreover an increasingly larger part of this investment is going into equipment and technology, given that many companies have been increasing its production capacity, mostly in the services sector.
Second, it is also true that Spanish households have increased their debt service-disposable income ratio and that the present and future increases in interest rates by the ECB are going to have a negative impact on that ratio, but, at 9 per cent, it is still lower than in most countries of the eurozone. If it is measured in terms of stocks, instead of flows, total liabilities as a percentage of total net wealth Spain’s ratio (at 11 per cent) is the lowest of the eurozone, after Italy.
Third, it is true that, within the eurozone, currency risk turns into credit risk, but it is not doing so, at least for the time being, since countries as Portugal and Greece with very high budget and current account deficits and high levels of debt show bond spreads that are very close to those of France or Germany. Spanish spreads are the same as Germany is spite of such its large current account deficit.
Fourth, it is true that Spain has been losing competitiveness and that its technological capacity in tradable goods is still weak and that its current account deficit is huge and may go up, at the end of 2008, to even 10 per cent of GDP, but all this deficit is generated by the private sector and not so much for a fall in its savings rate (like that of the US) but by a larger increase in its investment rate than in the savings rate.
Moreover, inflation differentials with the rest of the eurozone are coming down. In 2007, it is expected to go down to 2.4 per cent, from 2.9 per cent in 2006.
Fifth, the consolidated general government budget deficit has been in balance or in surplus for more than five years and public debt to GDP is less than 40 per cent of GDP. Therefore, the government can act anti-cyclically in case of a slowdown in the economy. For instance, it can help the construction sector developing public infrastructures when housing starts will go down. Moreover, construction companies are investing heavily in other countries to diversify their home risks and investing in other sectors no correlated with their own activity and with better prospects such as energy.
Finally, labour productivity growth per employed person is stating to grow at a faster rate (0.8 per cent in 2006) and it is expected to go above 1 per cent in 2007. Nevertheless, total factor productivity is only slightly positive and not showing a clear recovery.
Posted by: FT Forums | April 2nd, 2007 at 10:46 am | Report this commentMartin Wolf: I want to thank Olivier and Guillermo for superb comments on last week’s column.
I am certainly not going to disagree with Guillermo on the details of Spain’s economic experience. He is pretty well the world’s leading expert, after all. But I have three comments.
The first is that it is an open question whether the fact that the borrowing is being done by the private sector is decisive. The issue, as I suggested, is whether its members understand the implications of a shared rush into borrowing against property.
The second point is that the credit risk I was discussing was private, as well as public. I agree entirely with Guillermo that the credit risk spreads on public sector risk are remarkably small in the eurozone. But even if the public sector is solvent, the private sector may ultimately get into difficulties.
The third point is that the fact that the public sector is solvent and so may be able to spend anti-cyclically may not help much if the need is rather to restore competitiveness through a large depreciation of the real exchange rate. To be honest, I don’t see how Spain is going to achieve that over anything less than a decade.
Olivier’s broad comments are why I was sure that it was wise for the UK and good for the eurozone that it did not join. It takes a strong political commitment to endure the pain of a long period of competitive disinflation. That commitment the UK has always lacked. Even in some of the more enthusiastic countries, it may be difficult to maintain the political commitment to membership of the eurozone through year after year of grinding competitive disinflation.
I would also like to add a point to Olivier’s discussion of wage flexibility. I think there are two solutions, as he does: radical liberalisation or intelligent co-ordination. Either way it would make sense for labour contracts to have an amount for base pay and a sizeable amount for variable pay on top (perhaps as much as 10 per cent of total pay in a good year). Then, whenever the economy was doing badly, variable pay would be slashed. Moreover, whenever that happened, there should also be no growth in real base pay. That way competitiveness would be restored by the cuts in variable pay and the stability of base pay could continue until the economy recovered. That would make the improvement in competitiveness permanent. Something like this is needed if the eurozone is to work in the long term, since, like Olivier, I expect divergence in competitiveness to be an enduring feature of the currency union.
Posted by: Martin Wolf | April 2nd, 2007 at 7:02 pm | Report this comment