31 January 2013

Bank of Spain/Linde: Reflections on the crisis in the Spanish economy and its European context

Spanish expansion was based on a pattern of household and corporate spending which, driven by the property sector boom and by cheap and easy credit, systematically exceeded the economy’s productive capacity. This imbalance has been at the root of the difficulties of the Spanish economy since the international financial crisis began. First, demand-side pressure led to significant pressure on costs, margins and prices, which tended to grow systematically faster than those of our European partners, with a notable  worsening of our external competitiveness. This was not at all consistent with the decision to forgo the exchange rate as an economic policy instrument.

Second, the lack of sufficient domestic output to meet domestic demand had to be increasingly covered by imports. This caused a sizeable imbalance in our foreign trade, as reflected by the balance of payments, which in 2007–2008 ran a deficit of around 10 per cent of GDP. At the same time, the financing of this process required huge flows of funds which, given the insufficiency of domestic saving, had to be met by turning to foreign saving, channelled to Spanish households and firms by credit institutions. Behind this whole process lay a real estate sector growing at an excessive pace in terms of both houses built and house  prices. The excessive surge in construction was unquestionably fuelled by low interest rates and the practically unlimited supply of financing provided by foreign saving.

The sound fiscal performance by the Spanish economy before the crisis, between 2005 and 2007, masked the actual situation of public finances which were distorted by extraordinary revenue of a strictly temporary nature, linked to the exuberant real estate sector. These  abundant inflows discouraged the adoption of the necessary public expenditure rationalisation and control measures needed in both central and regional government.

In short, the path followed by the Spanish economy in those years brought about substantial macro-economic imbalances which crystallised in, among other things, a large external deficit and a sudden sharp rise in total external debt, both of which reached highs in 2007–2008. Finally and inevitably a far-reaching adjustment took place, unfortunately amid the turmoil of  the international financial crisis. On top of all this, in the middle of the recession, Spain’s public finances worsened markedly from a surplus of nearly 2 per cent of GDP in 2007 to a deficit of more than 11 per cent of GDP in 2009, and, in addition, the severe job destruction over the last five years has raised the unemployment rate to over 25 per cent of the labour force. The labour market was also subject to certain illusions during those years. The enormous growth in the construction sector lay, without a doubt, behind the major immigration flows, and this strong population growth drove buoyant consumption and, by extension, the increase in activity and employment in all sectors, delaying the reforms that would have led to a more balanced adjustment between wages and employment.

However, it should also be noted that the size of the imbalances that built up in the Spanish economy was not only a consequence of insufficient adaptation to the conditions and restrictions of euro area membership. They are also related to the deficient functioning of the disciplinary mechanisms with which the euro area is equipped and the fragilities inherent in its institutional design and its system of governance. Hence, the Spanish crisis is closely related to the euro crisis, and overcoming it also depends on Europe’s ability to respond to the institutional problems of the Monetary Union.

Aside from the important role that the solutions being considered in the European Union to better control budget deficits must play, overcoming the recessionary tendencies experienced by the Spanish economy since 2008 requires the correction of some structural features that hinder its ability to adapt. The fall in employment, which has been much greater in Spain than in the other euro area countries during the crisis, is largely explained by the insufficient adaptation of labour conditions. Indeed, wages and prices continued to grow as if no significant cyclical change had occurred. The labour market reform has addressed the serious distortions that have existed in this area for decades. Their effects on wage moderation have already begun to be noted and, although the improvement in terms of job  creation is taking longer, I have no doubt that it will materialise, if the possibilities opened up by the reforms are fully harnessed and completed.

The sharp deterioration in public finances since 2008, which only began to be corrected seriously in 2012, has unavoidably required the implementation of severe and unpopular austerity measures and reforms. Despite their initially restrictive impact, they are vital for restoring confidence in the sustainability of our public finances and for normalising our access to international financing, which is essential for our exit from recession and for the  resumption of growth in the euro area. Great efforts are being made, involving significant sacrifices from broad sections of society; but they will eventually bear fruit and help to absorb the mass unemployment that is currently Spain’s most serious problem.

To overcome the deterioration in solvency stemming from the economic crisis and the end of the unsustainable growth in construction and related lending activity, part of the banking sector has required an extensive clean-up, restructuring and recapitalisation. The main thrust  of this process is already well-advanced, and this is having positive effects on the ability of our banks to raise funds abroad. Its completion will be a fundamental step in the recovery of confidence, activity and employment.

We can affirm that the tensions experienced by the Spanish economy over the last 18 months have begun to abate, as a result of greater confidence in both the ability of the euro area to reform and in the adjustment drive of our economic policy. The deep-seated change in our trade balance, which will be manifest in a significant balance of payments surplus in 2013, is the prime example of the adjustment under way in the Spanish economy and of the competitiveness gains that are materialising.

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