Spain, and how the Eurozone has to get real about countercyclical policy

Matthew Klein has a good account of how Spain’s macroeconomic fortunes are improving, but only from a very bad place. I’m not that knowledgeable about the Spanish economy, so I cannot add any detail. However I do want to pick up on one point, which he and others (including Martin Wolf - see below) have made, which I think is wrong and misleading.

Before I do that, I just want to make a general point about the current recovery. At its heart it is export led, which is exactly what you would expect. Just as this post which compares Greece to Ireland shows, the Eurozone does have a natural correction mechanism when a country becomes hopelessly uncompetitive as a result of a temporary domestic boom (whatever its cause). The mechanism is a recession and what economists call ‘internal devaluation’: falling wages and prices. The problem with this correction mechanism is that, on its own, it is slow and painful, particularly when Eurozone inflation is so low.

So the key question is what could Spain have done to avoid having such a painful period of correction. The cause of the problem was the excess private sector borrowing of the pre-crisis period, and the associated capital inflows. This was part of an unsustainable property boom that led to a large current account deficit and rising inflation. (I liked the point that Matthew Klein made about how export orientated firms have recently increased their borrowing. Extra borrowing is not bad if the investment is sound.) What could Spain have done to cool things down? As Matthew Klein points out, Spain already had some sensible macroprudential monetary policies, and it seems likely that more of the same would not have been enough.

Which brings us of course to fiscal policy, and it is here that so many commentators go wrong. They say, correctly, that Spain’s problem was never a profligate government. They say, correctly, that the actual budget was in surplus from 2005-2007. Of course the relevant number is the underlying (cyclical adjusted) balance, and the IMF now thinks that shows a persistent although small deficit. But as Martin Wolf points out, again correctly, the IMF in 2008 thought very differently. As I have said many times in the case of the UK, ex post numbers for pre-crisis cyclically adjusted deficits can be very dodgy because of the depth and persistence of this recession.

The mistake everyone here makes is to judge the appropriate fiscal policy by the size of the deficit. That is like saying that a bigger fiscal stimulus in the US in 2009 was impossible because the deficit was already very large. For an individual country in a currency union the deficit is not the appropriate metric to judge short term fiscal policy. Unless there are very good reasons for believing the economy is too competitive, the appropriate metric is national inflation relative to the Eurozone average. From 2001 to 2007 the GDP deflator (the price of domestically produced goods) for the Eurozone as a whole increased at an average rate of just over 2%. In Spain it increased at an average rate of nearly 4%. 2% excess inflation over 7 years implies a 15% loss in competitiveness. So forget the actual budget deficit or any cyclically corrected version, fiscal policy was just not tight enough.

I have been told so many times that for Spain to have a tighter fiscal policy before the crisis was ‘politically impossible’. If that really is true, then Spain has little to complain about when it comes to the subsequent recession. If you cannot do any better, you have to leave the natural correction mechanism to do its slow and painful work. But I suspect what is ‘politically impossible’ is in part a reflection of the Eurozone’s flawed Stability and Growth pact itself, which focused entirely on deficits.

It seems more than likely that the existing monetary but not fiscal/political union is here to stay for some time. Many in Europe’s political elite plan to move quickly to greater union (see Andrew Watt here), but there are serious obstacles in their path. The current system can be made to work better, and strong countercyclical fiscal policy is an obvious part of that. Combining this with medium term deficit reduction is technically trivial. Just how many years and recessions does it take before what is obvious textbook macroeconomics can become politically acceptable?