Luis M Linde: Reflections on the crisis in the Spanish economy and its
European context
Address by Mr Luis M Linde, Governor of the Bank of Spain, at the Spanish Medical Surgery
Academy, Madrid, 31 January 2013.
* * *
Mr President, distinguished members, ladies and gentlemen,
It is a pleasure and a privilege for me to participate in this ceremony marking the
appointment of new members, all the more so given my own honorary nomination.
I much appreciate the invitation by the President of the Academy, Professor Ortiz Quintana,
a friend of mine, albeit only for a little over 50 years. It gives me the opportunity to share with
you some reflections on the crisis the Spanish economy is undergoing and its European
context.
A particularly severe crisis
Certain parallels can be drawn between the work of those of us who attempt to understand
the causes of economic crises and how to treat them, and that of doctors, who seek to
understand illnesses and how to cure or alleviate their effects.
Almost invariably, economic crises contain common elements, meaning that each new
outbreak reveals problems that are familiar to us and which we have already learned to treat
in the past. Not infrequently, however, these old and well-known viruses are accompanied by
singular characteristics, which put to the test our diagnostic capacity and our ability to devise
new treatments. And crises, like illnesses, are also more or less acute, may overlap one
another and may have interconnecting feedback loops, with the consequent increase in risks
to the health of the patient or, in this case, of the economy.
Viewed from this perspective, the current crisis in Spain is very serious. It has seen the
confluence of different tensions and problems, which tend to exacerbate one another and
make diagnosis and treatment more complex. And, as a particularly worrying characteristic,
its social, institutional and political dimensions go beyond those of previous crises.
The constraints arising from Monetary Union membership
To understand the situation facing the Spanish economy, I must first briefly explain how the
mechanisms of economic adjustment work in a monetary union and what the consequences
are for economic policy management.
First and foremost, in my opinion, the fact that Spain is part of the European Economic and
Monetary Union has been and will continue to be an enormously positive factor for our
economy. As a founding member of the euro, Spain has benefited over the 13 years the
single currency has been in place from conditions of economic stability which, most probably,
would not have been possible outside monetary union, and which have led to an
improvement in our standard of living that the current difficulties should not let us forget.
Yet that should not mask the fact that belonging to a monetary union entails a series of
constraints or commitments which, among other things, involve the necessary adaptation of
economic agents' behaviour and of the means of pursuing economic policy.
In a monetary union, the control of two essential instruments usually at hand to combat
crises passes to a supranational level and, therefore, they cease to be available to meet the
specific needs of the member countries: both very short-term interest rates - the key tool
used by a central bank when setting its monetary policy - and the exchange rate have been
set in the European Monetary Union, since 1 January 1999, on the basis of the aggregate
situation of the area as a whole. They cannot be managed to serve the specific needs of any
national economy. It is the national economies that have to be in a position to live with the
standards set for the whole.
National authorities retain control of the other economic policies, which remain under their
responsibility; however, the proper functioning of the area evidently requires that their
handling should observe specific common principles, preventing misalignments in one
country from prompting imbalances in the rest, or from destabilising the monetary union as a
whole.
The way in which these common principles have been implemented has differed depending
on the specific economic policy tool in question. Thus, for instance, fiscal policy coordination
mechanisms have been the focus of particular attention, with monitoring and surveillance
procedures to avoid excessive budget deficits (of over 3% of GDP) and high public debt
proportions (over 60% of GDP) coming into play. Indeed, these thresholds, along with the
procedures for their prevention and ultimate correction, took the form in 1997 of an
agreement known as the Stability and Growth Pact.
In contrast, the rules for coordinating "structural" policy (e.g. those governing the workings of
the labour market or the markets for goods and services) were fairly lightweight as a result of
their broader scope for application and of the difficulties involved in setting common
objectives. Also, in the area of financial regulation and supervision policies, countries
continued to enjoy a high degree of independence.
The limitations of the monetary union's adjustment mechanisms
As events have shown, the constraints imposed by the institutional framework were not
powerful enough to ensure the appropriate response by national authorities in the face of
potential slippage from the stability levels required.
It was hoped that the very fact of monetary union membership would activate sufficient
response mechanisms. Among these potential mechanisms, particular importance was
accorded to the so-called "competitiveness channel", which works as follows: when an
economy's inflation rate stands systematically above the average for the rest of the area, the
very loss of competitiveness involved - or, what amounts to the same, the relative rise in the
cost of output in that economy - tends to reduce demand-side pressures and ease the
tensions on prices that led to the initial slippage. However, for this channel to work
economies should, inter alia, be adaptable and sufficiently flexible, something which, for
social and political reasons, is evidently not easy to achieve.
It was also thought monetary union membership would prompt greater discipline in economic
policy management. It was assumed that, if a Member State's management of the economic
instruments available to it was inadequate, the subsequent adverse effects on its growth and
employment-generating capacity would lead international investors to demand greater
returns for investing in the country, or even to freeze such investment. The subsequent
tightening of financing conditions would discipline economic agents and ultimately redress
economic management. But this mechanism did not work because financial markets, rather
than punishing divergences, instead financed excesses, contributing to exacerbating
tensions.
Unsurprisingly, then, the crisis has called into question the consistency of the institutional
arrangements underpinning the euro. The solution would involve a reformulation of the initial
project, geared to fuller integration.
The adaptation of the Spanish economy to the euro was incomplete
Turning now to the Spanish economy, our adaptation to the new rules of play derived from, or
imposed by, monetary union has been insufficient and belated.
Our membership of the euro area compelled us to desist from long-established practices
among economic agents who regarded exchange rate devaluation as the "normal" means of
resolving the problems of competitiveness caused by inflation and did not consider fiscal
discipline as vital for maintaining economic growth.
True, in the years before we joined the euro area, we took steps to adjust economic policy
rules to a low-inflation environment and set in train some reforms so it would function more
flexibly. Two factors were particularly important in achieving this goal. First, the anchoring of
inflation expectations, which required fulfilment of the price stability convergence criteria. And
second, in the area of budgetary policy, the enactment in 2011 of an initial Stability Law
laying the foundations for preventing excessive budget deficits.
The transition to Monetary Union was also easier because the peseta/euro conversion rate
agreed in 1999 was quite competitive as a result of the devaluations which had taken place
between 1992 and 1995 during the functioning of the European Monetary System. However,
those devaluations were a clear sign of the difficulties awaiting countries that make exchange
rate commitments if these are not accompanied by price and cost discipline.
In the first ten years of membership of the euro area, Spain enjoyed a long phase of growth
in an environment in which monetary policy, with relatively low interest rates, was highly
expansionary. This period saw rapid increases in the standard of living and in economic
welfare, as reflected by the rapid rise in GDP per capita, which in 2007 edged above the
average of that of the countries then comprising the euro area. This achievement largely
reflected very labour-intensive growth.
The insufficient adaptation to the euro gave rise to significant imbalances
However, the expansion in those years 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% 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
macroeconomic 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% of GDP in 2007 to a deficit of
more than 11% of GDP in 2009, and, in addition, the severe job destruction over the last five
years has raised the unemployment rate to over 25% 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.
To overcome the crisis further reforms are needed at the national and European levels
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.
To conclude: you ask me what my prognosis is (not surprisingly, given who you are). I think
you will understand if I reply that I still reserve my judgment. But, it was significantly worse a
few months ago. I believe that the patient can of course be cured, must continue to take the
prescribed medicine and should not be out on the town at night.
Many thanks, again, to the Academy and the President for your invitation and to all of you for
your attention.