Free Lunch: Sketches of Spain

Spain has been gaining attention as it keeps notching up some of the fastest growth in the eurozone, to the point of usurping Ireland’s status as “star pupil” of the monetary union’s official policy prescriptions. With national elections looming, the Spanish government is keen to insist that the austerity-with-reforms orthodoxy it implemented is bearing fruit.

The economist Simon-Wren Lewis has recently picked up my colleague Matthew Klein’s diagnosis of Spain from a few months back. That diagnosis stands as well today as then, and it documents the many ways in which Spain’s economic situation has improved. The country has turned the trade balance from a large deficit to a solid surplus. What is more, it has done so through strongly growing exports, not just falling imports. The Spanish private sector’s outstanding debt has come down significantly, and the overall debt — including the growing public debt — is decelerating.

Both Klein and Wren-Lewis rather treat Spain’s success, such as it is, as a rather backhanded compliment. The country still has far to go before it can be discharged from the economic recovery ward; witness in particular its shocking unemployment rate. For Klein and Wren-Lewis, Spain’s incomplete success is a vindication of the conventional story: Spain has done more or less as well as it could do, given the strictures of the eurozone, and that is far from good enough. 
“It’s hard to imagine what [Spain] could have done differently during the boom,” writes Klein, to stop the debt bubble and the economic overheating that set the country up for a crash. Well, one answer is even tighter fiscal policy — not just the actual surplus it ran but a very big surplus. Wren-Lewis suggests the reason it didn’t happen was because the eurozone was obsessed with deficits, so once that was eliminated, it was thought nothing more was necessary. He argues that within a monetary union, a better measure of the economic cycle is local inflation — which in Spain was much higher than the eurozone average — and that fiscal policy should be set to control it.

This might seem a bit like replacing one eurozone fetish (the deficit) with another one (inflation), but the point that fiscal policy could and should have been more countercyclical is well taken. There were other things too that Spain could have done differently, such as stronger “macroprudential” limits on private borrowing. Philippe Martin and Thomas Philippon have demonstrated this alone could have prevented 4 percentage points of the 12 per cent fall in employment from 2008 to 2012; the same benefit as a more conservative boomtime fiscal policy.
What about after the crisis, rather than just before it? Klein says the “normal response would be to let the currency float while defaulting on some foreign debt”. Instead it was necessary to cut wages and prices, an “internal devaluation”. Wren-Lewis agrees. Both seem to say that what we are seeing in Spain is that internal devaluation works, but slowly and painfully. That is why Wren-Lewis wants stronger countercyclical fiscal policy.

He is right about the conclusion, but the argument is less convincing. For, in fact, Spain did not achieve an export boom through internal price devaluation, as Francesco Saraceno points out in a new blog post. So how do you boost your exports when you can’t devalue your currency? Saraceno sensibly suggests non-price competitiveness factors; ie changes that make the exporting sectors more productive even without changes in prices and wages. Better infrastructure, for example — which by itself may require more not less public spending — or structural reforms that make it easier for exports to expand (but not by cutting labour costs). While unit labour costs have come down in Spain, that is all due to increased labour productivity. Anecdotally, an important reason seems to be that it has become easier to employ people in the most productive activities.

This touches on the important difference between the flexibility with which prices go up and down, and the flexibility with which quantities respond. The eurozone debate focuses almost exclusively on the need for prices (and most importantly the prices of currencies and of labour) to be flexible enough to adjust to disruptions. But unless the mechanisms for allocating and moving capital and labour are flexible too, the expected boost to exports may not materialise even if exports become more “competitive” (in a price-related sense). There is a good case to make that this has happened in Greece and the UK, both countries that improved their international price competitiveness significantly in the crisis, without exports picking up as hoped.

Conversely, if resources can move flexibly between sectors and activities, then the inability to devalue may not be as big a problem as is often thought. That may be the real lesson Spain is sketching out before our eyes.

Source: Financial Times