Welcome

Welcome to this new blog, which hopes to find a small role in widening and deepening students’ interest and understanding of economics. There are lots of good economics blogs out there, so what’s the point of another one?  I have no good answer to that question, except to say that I will aim to write primarily for business students (and interested non-economists) and will try to capture the “the big picture” of economic developments. I will also pay special attention to the Spanish economy, seeing as that is where we are, but without ignoring the wider macroeconomic issues and debates that are now raging. To avoid reinventing the wheel, I will include appropriate links to articles/blogs which explain what I want to say. I welcome any comments, queries or suggestions which can help generate an exchange of views.

This first post will provide a brief overview of what is wrong with the Spanish economy. The first part of the story is well known: Spain experienced ten-year economic boom between 1997 and 2007, driven largely by cheap and plentiful credit, soaring confidence, and mass immigration. The boom was particularly visible and notorious in the housing market, where prices tripled in ten years, encouraging massive overbuilding. The housing bubble burst in 2007, leaving a stock of about one million unsold homes and a trail of bankrupt developers:   non-performing bank loans soared, undermining the solvency of the country’s financial system. The story is not very different to what occurred in Ireland or, for that matter, in the United States.

To understand the challenges now facing Spain, two further features of this period need to be understood. First, Spanish productivity – measured in terms of output per worker (or output per hour worked) -scarcely improved (see OECD http://dx.doi.org/10.1787/818262068028). That is, the perceived rise in prosperity was not sustained by an underlying improvement in economic efficiency. Second, demand was sustained by credit flows from abroad (that is, growing foreign debt). In 2007, the deficit on Spain’s current account (essentially the difference between exports and imports) stood at €10.4bn, equivalent to 10% of GDP. That is, Spaniards on aggregate were spending and investing 10% more than they were producing: in simplistic terms, Spain was living well beyond its means. This was not a problem during the good times, as foreign creditors happily and blindly provided financing to an economy which appeared to be one of Europe’s main success stories.

Once the global credit crisis erupted in August 2007, however, international financial flows seized up and private capital stopped flowing into Spain. The economy, which had come to depend upon foreign credit, faced a brutal contraction. The ensuing economic recession, bad as it has been, would have been far worse were it not for the action of the European Central Bank (ECB), which created emergency lending facilities that allowed Spain’s banks  continued access to “foreign” credit.  However, ECB loans are not a long-term solution to Spain’s difficulties.

So where does Spain go from here? A main objective must be to reduce the country’s current account deficit and dependence on foreign capital. To do this, Spain must increase its exports and/or reduce its imports. To do this, the Spanish economy must become more competitive.  From a macroeconomic perspective, there are three routes to increased competitiveness:

• Historically, the easiest and most widely-used option is a currency devaluation, which makes exports cheaper and imports more expensive. But Spain no longer has its own currency. To go along this route, it would need to leave the euro
• A second option is to hope and pray that your main trading partners become less competitive. This could be achieved if countries such as France and Germany experience higher inflation than Spain (helped by more public spending and a looser ECB monetary policy). This would not be a bad outcome for Spain, but cannot be the basis for policy-making
• The third option is what is known as an “internal devaluation”, namely that Spain gets cheaper relative to its trading partners, which requires a cut in unit labour costs. This is the route that Spain is now trying to follow. However, this tends to be an extremely slow and painful way of restoring competiveness, and can easily generate social and political instability because it is usually associated with cuts in wages.

So Spain faces a very unattractive menu of macroeconomic options. At this point, the main policy priority must be option 3, but without a narrow focus on wage cuts, which is a pessimistic and ultimately self-defeating route to prosperity. The objective should be to reduce unit labour costs by increasing productivity, thereby circumventing the need for wage cuts. How can productivity be improved? That can be the subject of later posts. But innovation – finding new and better ways of doing things – should play a key role.