Paradigm Lost: The Euro in Crisis

It depends on how quickly and forcefully the government responds. The challenges confronting Spain stem from the same source as those in Greece: a huge misallocation of resources and loss of competitiveness that began with the adoption of the Euro. Spain’s non-tradable sectors—housing, the government, and a broad array of market services—had grown far too big. Spain has a debt-to-GDP ratio that is half that of Greece and has more time and resources to fix its problems. However, its large deficits and the collapse of its post-euro growth model imply that its public debt could—if remedial measures are not taken—follow an exploding path.

Moreover, Spain has to effect a profound structural transformation and it cannot look to a cyclical recovery to reignite growth and reduce its mass unemployment. It must instead unwind distortions that were built up over more than a decade, restore its competitiveness, and reallocate resources to manufacturing and other tradable growing sectors. With currency devaluation not an option, these reforms will only happen if unit labor costs, house prices, and the price of services decline relative to its European partners. A smaller government sector and other far-reaching reforms must kick-start this process, and do so soon. 

The Euro and the Boom

The housing sector’s boom and bust has undeniably defined Spain’s crisis. At its peak, construction value-added reached 17 percent of GDP, compared to a peak of less than half that in the United States. In just ten years, Spain’s housing prices more than doubled, and, at the peak in 2006, Spain started more homes than the UK, Germany, France, and Italy combined, a significant share of which were sold to foreigners.

The housing sector’s boom was only one manifestation of a deeper structural misallocation, however. In the run up to the Euro, interest rates plummeted and confidence soared, leading domestic demand and inflation to rise more than 1.5 times faster than the Euro area average. A European monetary policy that was too loose for Spain reinforced these trends.

Amid this demand boom, the price of all non-tradable activities rose relative to that of tradables (whose price is set in world markets); investment and labor were pulled into these non-tradable sheltered sectors; and wages were bid up higher than in other Euro area members and in excess of productivity. Spain’s manufacturing sector, already small at the start of the process, shrank its share of GDP by 4 percent.

Manufacturing Value Added

Percent of GDP
  2007 Change Since 2000
Germany 24 +1
Ireland 22 -10
Italy 18 -3
Spain 15 -4
Portugal 14 -3
Greece 10 -1
Source: World Bank.

Amid this boom, Spain’s tax receipts swelled temporarily, generating more revenue than expected. As a result, the government was able to rapidly expand spending—by 7.5 percent of GDP from 2005 to 2009—while creating the impression of solid fiscal management and maintaining a public debt-to-GDP ratio that was among the lowest in the Euro area. Though Spain’s government sector is smaller than that of some other large European countries, the government sector’s rapid expansion contributed to Spain’s weak productivity performance.

Rapidly Expanding Expenditure

Increase in Expenditure’s Share of GDP from 2005 to 2009
Germany 0.8
Ireland 14.5
Italy 3.7
Spain 7.5
Portugal 3.4
Greece 6.6

Lost Competitiveness

Even as Spain’s economy boomed, growing almost 1 percent per year more on average than the Euro area from 1999 to 2007, its total factor productivity (TFP) fell behind. Between 2000 and 2008, TFP was essentially stagnant in Spain, compared to average annual growth of 0.9 percent in Germany and 1.4 percent in the United States. Spain’s non-tradables—including post, telecommunications, and transport—fared particularly poorly.

Nonetheless, booming demand led wages to grow faster in Spain than in its partner countries. Since 2000, Spain’s hourly labor costs have consistently outpaced those of the Euro area by more than 1 percent per year. Spain’s labor market rigidities, including a dual labor market that protects permanent workers and their wages, accentuated the rise. Spain’s unit labor costs (ULC), the average cost of labor per unit of output, have risen more than 30 percent since 2000, whereas Germany’s nominal wages have grown roughly in line with productivity.

Relative to the United States and Japan, which both saw ULC in euros decline by more than 20 percent (partly due to euro appreciation), Spain has suffered an even greater competitiveness loss. Though comparable figures are not available for China, enormous labor productivity increases and modest currency changes almost certainly caused ULC in euros to decline there as well.

Over the last decade, Spain’s exports have lost share in world markets but have roughly matched the advance of other Euro area exporters. This perhaps seems adequate at first glance, but is wholly unsatisfactory in reality, given that Spain’s productive capacity surged relative to that of its Euro area partners due to immigration and investment growth, and that its import demand expanded correspondingly.

In fact, exports as a share of GDP fell by 3 percentage points from 2000 to 2008 in Spain, compared to a rise of nearly 14 percentage points in Germany. While Germany grew its current account surplus, Spain’s plunged into deep deficit. In this regard, Spain shared the experience of Greece, Ireland, and Portugal, which also became excessively dependent on domestic demand and non-tradables.

Spain’s deteriorating national balance sheet reflected these trends. The country’s net foreign liabilities reached nearly 80 percent of GDP in 2007, third largest in the Euro area, and loans to households and non-financial corporations grew to more than 200 percent of GDP—more than double their level in 1998.


The Crisis

The Great Recession helped reduce the current account deficit and restore household savings rates, but it also crippled domestic demand and exposed the fragility of Spain’s growth model. Though world GDP is now growing, Spain’s economy is expected to contract an additional 0.4 percent this year. Although Spain’s banking sector weathered the crisis relatively well, its savings banks may see a net drain on capital of 2 billion euros, according to the IMF—nearly 30 percent of their reserves for repossessions—if, as expected, unemployment rises and housing prices fall further.

The massive rise in unemployment—which crossed the 20 percent threshold in April—should be interpreted as part of the unwinding of the structural misallocation, as it reflects not only the effects of global trade’s collapse on manufacturing (which is now recovering) but also the collapse of demand for housing and non-tradable activities generally.
The crisis also exposed the fragility of Spain’s tax base and its unsustainable expenditure increases. In 2009, the fiscal deficit reached 11.4 percent of GDP, comparable to that of Greece and more than double that of Italy. Though the debt-to-GDP ratio remains among the lowest in the Euro area, it is rising more rapidly than in any other country.

What To Do

The collapse of domestic demand has already begun to reverse the imbalances begun by the long euro boom. But the adjustment will not reach the protected sectors—the government, labor markets dominated by “insiders,” savings banks dominated by regional politics, and so on—unless explicit reforms are undertaken. The protected sectors are so important that, if they do not adjust, they will prevent the wider economy from doing so, and the faster prices and wages in protected sectors adjust to the new situation, the smaller the decline in activity needs to be to redress Spain’s imbalances.

The anti-flu medicine is familiar, but the pharmacist has yet to deliver it.

Start with government spending. Though Spain has put forth plans to cut its primary balance (the fiscal balance excluding interest payments) to below 3 percent by 2012, the government’s ambitious austerity plan is not set to kick in until next year, which is too late to preempt contagion from Greece.
Reduce the unit cost of labor.
Spain should aim to recover competitiveness against Germany at the rate it has lost it. Since Germany’s unit labor costs are essentially flat in nominal terms (wages grow in line with productivity), Spain should target a six percent reduction in ULC over the next three years. How to achieve this? A freezing of, or modest reduction in government wages will set a benchmark for wage-setting in the private sector. Rigidities that favor “insiders,” including large severance payments and indexations need to be removed, and greater reliance must be placed instead on social safety nets.   
Encourage reallocation across sectors. Acceleration of other structural reforms will help boost productivity and avoid extreme wage cuts. Broader measures to increase competition in backbone services such as transportation, finance, communications, and energy will help lower their prices and encourage investment in growth sectors such as information technology and clean energy. Forcing a restructuring of savings banks that underpin the real estate market will set the stage for a faster liquidation of the vacant housing stock and a sharper fall in rents and housing prices.

Demand a coordinated effort across Europe. These measures, needed in Spain as well as in other vulnerable countries, will cause deflation unless they are accompanied by more expansionary policy in the rest of Europe. Germany and other surplus countries should commit to stimulating domestic consumption and investment. Meanwhile, the European Central Bank must maintain an expansionary monetary policy for many years, and should explicitly target a lower euro. The G20 should support this course to avoid an implosion of the Euro area, which would threaten the global recovery and could spread to other countries with high and rising public debts.

This plan could, if vigorously executed, and if the global recovery is sustained, lead Spanish exports to rise more rapidly (say, six to eight percent a year in real terms, in line with world trade projections), while domestic demand and imports decline or remain steady. Spain could then complete its structural transformation within three to four years and, with luck, not succumb to the Aegean flu.

Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program. Vera Eidelman is the managing editor of the International Economic Bulletin.