Can Spain Survive Inside the Euro? Of course.

By: Angel Ubide, Tudor Investment Corporation and CEPS

The story of EMU has so far been marked by two opposing events: the dramatic recovery in competitiveness in a "core" country, Germany, who entered EMU at an overvalued real exchange rate owing mainly to unification, and the similarly impressive loss of competitiveness of some of the "periphery" countries, such as Portugal or Spain, which now display very large current account deficits.  The road to the recovery of competitiveness in Germany has been wage moderation. Since 1996, when German labor costs were estimated to be about 20% overvalued, German wage inflation has regularly underperformed the EU average. Several years later, Germany has recovered its competitive edge and it is now gaining export share - sometimes at the expense of its EU neighbors, with important consequences for the EU business cycle.

The large and rising current account deficit of Spain seems to have become the poster boy of how bad things can get as a result of euro area membership, and has led many commentators to suggest that Spain would be a perfect candidate for exit from the euro. We believe that this view is wrong and that it grossly exaggerates the risks, as we attempt to show in this note.  
 
The German experience was dictated by the idiosyncrasies of the country, an open economy with a strong comparative advantage in capital intensive sectors and where the business cycle has always been export led. Thus, wage moderation was the obvious solution to the problem, problem which had largely been caused by a wage and exchange rate shock to start with.  
 
The case of Spain is rather different. The rapid increase in the current account deficit (at well over 7% of GDP is the highest in the OECD), in a setting of fiscal stability - the fiscal accounts are in surplus of above 1% of GDP - is the result of the very rapid growth in domestic demand over the last several years (the Spanish economy has been running at a growth rate about 1.5 points higher than that of its neighbours). The reasons for this increase are varied, but two stand out: (1) the drastic - and permanent - decline in real interest rates that ensued the entry into EMU; and (2) the rapid acceleration of house price inflation – supported by higher incomes, immigration, and strong foreign demand - and its very powerful transmission through monetary policy to consumption as a result of the very efficient and competitive banking system - where almost all mortgages are at variable rates and where innovative financial products allowing ample mortgage equity withdrawal have been developed.  In an environment of still high unemployment and rigid employment and service sector regulations, excess demand has translated into job creation and higher wage and goods inflation - the inflation differential with respect to the EU has accumulated 9 percentage points in the last 5 years - at the expense of productivity growth, which has been flat in recent years. In addition, the rapid growth in real estate construction has led to a sharp increase in its share of GDP since 1999.
 
 Why did this happen? The answer is perhaps obvious: because Spain did not run its own monetary policy and, with a fiscal situation already in balance - and sizable fiscal surpluses being very difficult to achieve for political economy reasons - had no cyclical policy tools at its disposal. Thus, a very loose cyclical policy stance led to rapid goods and house price inflation. Coupled with an appreciating exchange rate and a disappointing productivity performance, the composition of growth tilted ever strongly towards domestic demand and away from the external sector - as the export shares stagnated and the real exchange rate deteriorated more than 10 percentage points with respect to Germany since 1999.  The widening current account deficit is the summary of all these events.
 
But does it matter? To some extent, as we argue below, but certainly not as much as many commentators suggest. Clearly, inside a monetary union the question of funding of the current account becomes irrelevant, so that is not the worry. The worry is that the current account deficit is signaling deeper cyclical and structural problems which will have to be tackled.  The three critical ones are the necessary slowdown in domestic demand to solve the overheating problem, the necessary reform in the wage bargaining process to solve the endemic over-inflation of the Spanish labor market, and the necessary liberalization of goods and services markets to help boost productivity growth.
 
The cyclical outlook looks a bit exhausted, after more than a decade of very robust growth. Housing market inflation is poised to slow down. Immigration has accelerated in recent years, adding as much as 1 percentage point to an otherwise near flat population growth in the last few years, but it cannot continue at this pace ad infinitum for obvious social reasons. As these two key drivers of growth eventually stabilize by their own dynamics, private consumption and residential investment will slow down.

In thinking about what will support growth if these two sectors slow down, one can lay out a rather gloomy scenario. What will take the place of consumption and housing? The answer should be private investment and the external sector. But for the external sector to regain its weight, competitiveness has to improve. Given the short term rigidity in productivity growth, wage moderation is the only option, potentially depressing even further private consumption. And this would happen in a context where real wage growth has already been moderate, trending down and being even negative in recent years (partly explaining the robust employment growth). Thus, how is domestic demand going to sustain growth during the long adjustment process if real wages have to fall further and the wealth effect vanishes?  Something similar applies to private investment, which is driven by accelerator dynamics. With an outlook of declining domestic demand growth and unclear competitiveness, why would companies increase their domestic investment? In fact, Spanish companies have been diversifying abroad in order to better cope with this possible scenario, and many of the large Spanish companies now derive a large share of their profits outside Spain. One solution to the competitiveness problem has been to follow a strategy of pricing to market, which is possible due to their high profitability, but it is clearly not a viable long term solution – and certainly does not lead to higher domestic investment. Clearly, the only cyclical answer is an increase in the fiscal deficit, and Spain is well positioned for this with its current surplus – and it should try and increase it before the downturn arrives.  The virtue of the Stability and Growth Pact recommendations – balance or small surplus - may show for the first time when the Spanish economy slows down, by providing plenty of room for the automatic stabilizers to work.

But this is only a scenario, not the most likely outcome. The outlook may thus not be as bright as the past 15 years, but it needn’t be the gloom and doom that many commentators forecast. In fact, there is an important floor to the predicted housing downturn. Housing starts are running at around 750,000 units, but demographics suggest that the sustainable rate is as high as 500-525,000.  Using standard elasticities, calculations show that a 30% reduction in housing starts in 2007-08, which would restore the level of starts towards a more sustainable level, would only shave about 0.5 percentage points of GDP growth per year – just a dent for an economy growing at over 3%. Critically, the very high elasticity of imports would offset, through an improvement in the external sector, the negative impact on activity and consumption of the housing correction. In addition, public construction is expected to accelerate as long term infrastructure plans are implemented, offsetting part of the correction in private consumption.  Furthermore, as corporate profitability is maintained thanks to the external diversification of the Spanish corporate sector, employment need not decline drastically, thus providing support to personal income – as it is happening in the United States. Completing this benign scenario, the Spanish financial sector seems to be in a very strong shape as far as provisioning and capitalization is concerned (see the most recent IMF Financial System Stability Assessment) and therefore the risk of a credit crunch induced by financial sector problems is slim.  And through the development of very advanced mortgage products, it provides multiple options for the management of cash flows at the household level that should allow for efficient consumption smoothing.  In other words, as the United States example shows, the correction can happen in a gradual manner even with a stable exchange rate.  

The structural problems are more worrisome, but are unrelated to monetary union: productivity growth must increase and wage dynamics must be modified to reduce unit labor cost’s growth. In today’s globalized economy, Spain cannot afford a growth model that is based on low productivity employment growth. The solutions are well known: (1) eliminate the anachronistic catch up clause in the wage negotiation framework to allow better matching of wage growth and productivity growth and eliminate nominal wage inertia; (2) adapt the labor market institutions to protect workers, not jobs, by allowing higher churn through  easing  hiring and firing restrictions for the insiders – the outsiders, the young and unskilled, already have rather precarious labor market conditions, but the insiders still enjoy very high levels of protection – improving the assistance to the unemployed and the incentives for work search; (3) and further liberalize the goods and services markets, especially services, to foster productivity growth – it is critical to remember that productivity growth improves mainly through the entry of productive firms and exit of unproductive firms, not through improvements in existing firms.  If the education levels of the population – low by OECD standards according to the PISA study - are increased at the same time, the outlook will look bright.

These are long term issues that will not have any clear impact on today’s current account deficit. But the recent experience shows that they can be critical to survive in a currency area where exchange rate management is not possible, where cycles are likely to be asynchronous because of the sharp differences in the transmission mechanism of monetary policy, and where the losers of the competitive race could be condemned to long periods of stagnation. In fact, one wonders if the current global environment of high competitive global pressures and offshoring to emerging markets, together with the strength of the euro as a result of its increasing global role as a reserve currency, will not lead EMU countries to beggar-thy-neighbor policies via wage deflation that permanently depress European consumption. In fact, it seems that the recent strength in German exports is taking place at the expense of its European neighbors. If this is the case, cyclical policies, and especially monetary policy – either through lower-than-otherwise interest rates or a weaker exchange rate that “coordinates” the individual depreciations -  may end up having to be geared towards supporting demand in the “loser” countries while adjustments in the real economy take place at a slow and asynchronous place.   

Concluding, the evolution of the Spanish economy provides a good testing ground for the internal dynamics of a monetary union.  A slowdown will probably occur, but it need not be as sharp as many commentators predict nor require exiting the euro area to resolve it. And, when it happens, it will probably vindicate the rational of the “close to balance or small surplus” provision of the Stability and Growth Pact.  

 

The author is the Director of Global Economics at Tudor Investment Corporation, Washington DC

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