Miguel Fernández Ordóñez: What should be done during the
macroeconomic adjustment phase in Spain?
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at a
Lunchconference organised by El Correo de Andalucía, Seville, 25 September 2008.
* * *
Since August last year the world's developed economies have been convulsed by two very
severe shocks: the rise in oil and other commodity prices and the outbreak of financial
turmoil that has reached dimensions that nobody could have imagined initially. The increase
in commodity and oil prices seems to be easing, and yet the events of recent weeks suggest
that, as regards the turmoil, we are probably experiencing the most significant financial crisis
since 1929.
There are already numerous reports by domestic and international agencies (IMF, OECD,
Bank for International Settlements) analysing the causes and consequences of the situation
the industrialised economies are currently going through. At first it was thought that the
repercussions of the financial crisis would be concentrated in the US economy. Then it was
considered that other industrialised economies in which debt, the external imbalance or the
property boom may have been important, like the UK, Spain, Ireland and New Zealand,
might also be affected, while other countries would remain beyond the contagion. But this
has not been the case. The effects have reached all countries. As we have just seen with the
release of Q2 European growth figures, countries with large external surpluses such as
Germany, have also posted a very weak economic performance. As a result, today, unlike a
few months ago, nobody is defending the possibility of certain European economies
decoupling from what is happening in the United States.
As you can imagine, the Spanish economy has not been able to remain unaffected by these
processes. In fact, our country, which had been building up certain imbalances, in the form of
rapid growth of household and corporate debt and, consequently, of a large external deficit,
had already embarked upon a smooth correction from mid-2006. However, global events
have accelerated and intensified this adjustment, even though, from the viewpoint of the
financial system, Spanish banks have had absolutely nothing to do with the causes of the
financial crisis. They have not generated doubtful assets like US banks have, nor have they
invested in these assets like many European Banks have. However, the financial crisis has
not only affected the institutions that generated these toxic products or invested in them but,
by inducing financial market breakdown, has spread to all institutions. For Spain, this means
that the adjustment process must now take place in the presence of much more difficult
conditions in the financial and international environment than we have enjoyed during the last
decade.
That said, the Banco de España has pointed out on a number of occasions that some of the
adjustment we are experiencing is an inevitable part of economic developments, which will
allow correction of the imbalances that had been accumulating during the upswing. Indeed,
their continuation would have entailed an increase in the vulnerability of the Spanish
economy and the eventual correction would have been even more severe. Cyclical upswings
followed by downswings are a normal feature of all economies, although the fact that Spain
has recorded high growth rates without interruption for fourteen years may have led agents
to forget the existence of this type of cyclical disturbance.
Before addressing the central theme of my speech, it would be useful to answer the question
why the industrialised countries have suddenly found themselves in such a complicated
situation. Part of the answer (the other part being the regulation and supervision failures in
many countries) relates to the strong increase in corporate and household debt in numerous
countries in recent years, which led, in the presence of highly favourable financial conditions,
to a significant appreciation in the value of financial and real assets. Some economists and
institutions have argued that monetary policy was too lax and that central banks should in
future pay attention not only to inflation, but also to other financial developments, such as
credit, when taking their decisions. In some cases, these favourable financial conditions were
harnessed to expand residential and productive investment (as in Spain), while in others
consumption was also boosted by the ready availability of financing, leading to a spectacular
reduction in household saving ratios, as in the United States. The excessive financial
expansion was also accompanied by a reduced perception of risk by investors and
intermediaries, contributing to spending growth and the leveraged buyout boom. This
situation was gradually changing as central banks tightened their monetary policy, but the
most radical change took place from the summer of 2007, when the turmoil led to a rapid and
substantial reassessment of the risk of financial instruments and a sudden standstill in many
segments of the money and capital markets. There then began a process of deleveraging,
the opposite of the one that took place in the previous years of this decade, in which debtors
are striving to rebuild their balance sheets, while investors exercise the greatest prudence in
choosing where to place their savings.
During the stage of strong credit growth, the Spanish economy accumulated certain
imbalances, linked to the fact that (residential and capital) investment exceeded national
saving. However, Spain has preserved a number of very important stabilising factors, such
as the balanced budget, to which I will refer later. Also, as I have mentioned in detail in other
speeches, Spanish banks were not involved in the financial innovation operations that,
through the creation of highly sophisticated instruments, lie at the source of the current
financial crisis. This means that our institutions are in a somewhat more solid position to face
the new stage than those of other countries.
Today I am going to reflect on what I consider that different economic agents should do
during a macroeconomic adjustment phase like the one we are currently experiencing in
Spain. It seems to me that it would be useful for us all to understand what is happening and
what we can do to get through this phase at the lowest possible cost. Admittedly each agent
has a different degree of freedom of action, but it is important to remember that it is not only
the authorities (governments, parliaments, the ECB, etc.) who can help our economy to
return to a high growth path as soon as possible.
* * *
To start with, I should like to point out that the most important thing is not to fall into the
temptation of adopting policies that try to avoid the adjustment, since that would only prolong
it and prevent the economy rebuilding the foundations for fresh growth.
It is understandable that firms for which oil is an important input should appeal to
governments to reduce the cost of energy through some mechanism, such as subsidies or
lower taxes, as likewise it is understandable that businessmen and financial institutions that
can no longer obtain low-cost, long-term funds on the market think that the State could
provide them with larger volumes of financing and on better terms than the market. It is vital
that governments and parliaments reject these temptations, not only because of the possible
budgetary repercussions, but also because it is essential that economic agents adapt to the
new realities, however painful these may be. This is even more important when these
realities, like the price of oil and the availability of funds on international financial markets,
are global phenomena that even countries larger and more powerful than our own have been
unable to influence.
Thus, the aim should not be to isolate the Spanish economy and protect its agents from the
various shocks that we have suffered in recent quarters, but rather to facilitate the
adjustment process, permitting changes in relative prices (energy, labour costs, mark-ups)
and the reallocation of resources across sectors to take place with a high degree of flexibility.
Another approach that must be ruled out is short-termism. In general, economic policy should
be designed in all situations from a long-term viewpoint, because many important measures
(I dare say the most important) are structural, and these are the ones that tackle the
economy's fundamental problems. It is understandable that, when faced with a stream of bad
economic news, like at present, public opinion calls for rapid reactions and that the
temptation to focus on short-term measures increases. Such proposals are also based on
the idea that structural measures only have medium and long-term effects, and are therefore
inappropriate for a period of economic weakness. This is not true. Evidence shows that,
apart from their medium-term effects, structural reforms may have significant favourable
effects in the short term, in so far as their introduction may make agents more confident that
the foundations for growth are being made more solid and flexible. Such an improvement in
expectations may also help to bring forward certain spending decisions, such as investment
projects aiming to exploit the new opportunities that these structural changes may give rise to
in the future.
Now is therefore the time to stress the essential role played by the institutional framework
and policies that provide incentives to facilitate economic adjustment. In this respect, as I
have already mentioned, obviously not all agents have the same degree of responsibility
when facing a period of difficulty, the authorities being the main agents responsible for
shaping this combination of positive incentives. Given that the decisions of the private sector
(households and firms) depend significantly on the institutional framework and incentives,
their role in the adjustment (especially that of households) is highly constrained by the
framework in which they operate.
This is perhaps the main thing that the authorities should take into account in their response
to a period of economic difficulties, both when managing budgetary policy and when
designing their regulatory and market-organisation policies. It is necessary to analyse, at all
times, whether the policies proposed provide the appropriate incentives for agents to adapt
to the adjustment, increasing the probability that the economy will return to a growth path in
the medium term.
In the case of monetary policy, it is essential that it should be completely geared to the ECB's
mandated objective of keeping inflation at very moderate levels, and in this respect I think
that the ECB is fully complying with its task. It would have been very negative if the European
Central bank had fallen into the temptation of forgetting its objective of containing inflation,
attempting to alleviate the painful adaptation by households and firms to the very substantial
increases in commodity and oil prices that we have experienced. Fortunately, there is
complete confidence that the ECB will ensure that inflation returns to its target level, and this
is helping to somewhat reduce the uncertainty surrounding the financial system, growth and
other variables.
In the case of budgetary policy, one positive element of the Spanish case is its favourable
starting position. This is based on the notable budget surpluses recorded in recent years and
on the sustained decline in the ratio of government debt to GDP to 36%, a very low figure in
comparison with other developed countries. This initial situation has made it possible for
automatic stabilisers (i.e. the reduction in revenues due to the slowdown and the increase in
spending on unemployment as a consequence of the rise in the numbers of unemployed) to
be allowed to operate freely, providing a significant counter-cyclical component in the
adjustment phase. Moreover, this good starting point has, for example, avoided the need to
react to the current losses of revenue by raising taxes, which would have certainly magnified
the intensity of the adjustment. That said, the slowdown in spending is having a significant
impact on tax revenue, reducing the budget balance very rapidly, so that utmost prudence
must be exercised in fiscal and budgetary decisions.
The need to provide the appropriate incentives means that it is advisable not to adopt
widespread and permanent discretionary budgetary measures that attempt to counter the
effects on households and firms of the inevitable reduction in national spending required by
the adjustment process. Measures to increase spending would, at best, enable activity to be
sustained only temporarily and would not help to improve the prospects for expansion in the
medium term. And I say at best because, without an improvement in external
competitiveness, a large part of the increase in public spending would leak abroad and have
only a minimal impact on domestic activity.
Likewise, strengthening control over current general government spending is an essential
measure in response to a low-growth phase, since it limits the deterioration in the budget
balance, signals stability and rigour to the private sector, and provides greater leeway to
undertake public investment projects that enable the Spanish economy's productive base
and competitiveness to be enhanced.
It should also be remembered that, since the bulk of public spending, including investment, is
carried out by regional and local government, the behaviour of these authorities is going to
be decisive in determining the general government contribution to weathering the
adjustment.
In the case of the Spanish adjustment, moreover, a shift in productive activity is required. It
seems obvious that the relative size of the construction sector, following its strong expansion
over the last decade, is going to be reduced, while other activities need to fill the gap. To
facilitate the reallocation of resources of all kinds (human, financial, technological) entailed
by this shift in output, it is essential that goods and factor markets should have a flexible and
competitive structure. Thus, in a period like the present one, it is fundamental to review the
situation of these institutions and to explore the scope for undertaking structural reforms to
make the economy more flexible, liberalise sectors and markets and increase competition, so
that resources can be used optimally.
Despite the efforts made in recent decades, there are still a number of areas of the Spanish
economy in which these reforms continue to be very necessary. The high inflation rates
recorded for some components of the consumption basket and the large mark-ups observed
in certain activities underline the need to enhance the competitive environment in certain
segments, such as goods distribution and services provision. The transposition of the
Services Directive is an opportunity to boost competition in this sector that must not be
missed. Lower inflation rates would not only favour the competitiveness of our economy,
which is so vital at a time when national spending is slowing, but would also improve
household purchasing power against a background of declining household income on
account of the oil price shock and the slowdown in employment. There are many other fields
(such as the postal service, railway transport, ports, airports, energy, etc.) in which structural
reforms giving a greater role to the private sector and competition need to be adopted as
soon as possible.
As I have already mentioned, the residential sector clearly needs to slim down and it has
been doing so quite rapidly in recent months. The rise in uncertainty regarding both the
economic outlook and house prices is inhibiting residential demand, even though household
creation, due to the increase in the population and the observed tendency for average
household size to decline, is still growing at significant rates. Improving the regulation of
rented housing, to make it more flexible, profitable and attractive, would enable the demand
for residential services from those who do not wish (or are unable) to buy to be met and
would reactivate that part of the demand to purchase housing that basically stems from the
investment motive, thus reducing the current excess supply in the market.
In particular, providing legal certainty to home owners and deregulating the rental periods
that may be agreed by tenants and landlords would boost the rental market. Since in recent
years a part of household wealth has taken the form of property investments, if the number of
houses used to generate funds through rental could be increased, it would also help many
owners to meet their debts.
A third area in which reform is fundamental is the labour market. The performance of this
market will probably be the key to determining whether the current adjustment will be rapid
and slight or whether it will be prolonged and far-reaching. It is often said that the Spanish
labour market is very flexible, and the evidence cited for this is the high proportion of
temporary workers. Indeed, the existence of a relatively high proportion of temporary
contracts may mean that some firms have a greater capacity to respond to changes in
economic conditions, but these contracts are not evenly spread across sectors, nor would
they seem to be conducive to the proper training of workers. Moreover, the idea that the
labour market is flexible because it allows the burden of adjustment to fall on temporary
workers is hardly equitable, since it means that a very specific group (generally the last
entrants to the labour market) bears the main burden of that cost.
However, as I noted at the beginning, it is of interest to explore decision-making areas other
than that of the authorities. Firms are the basic economic agent, since they take most of the
economy's production decisions and their management, strategy, adaptation to demand and
use of resources ultimately determine the economy's growth rate, productivity and
competitiveness abroad. Given the weak national demand with which they are faced, firms
will evidently give their utmost attention to managing their productive processes efficiently. In
particular, the surge in oil prices will force them to review the energy consumed in
production. Although oil prices have moderated in the last few weeks, the uncertainty
surrounding this market makes it advisable to maximise efficiency in oil use. In this respect,
progress has to be made in introducing competition in the energy market and, at the same
time, taxation must be revised to stimulate energy saving, since this input represents a
significant burden on Spain's trade balance.
Spanish firms are tackling this phase through three lines of action, which the authorities
should support.
First, firms are reviewing their growth strategy in Spain. They are analysing the markets in
which they compete, but also others in which they still do not and to which demand may shift
in the future. Firms will try to see beyond the next few years of low growth to identify
opportunities and imagine what the forthcoming needs and demands of consumers will be, in
order to position themselves advantageously in those business areas. There are still highly
profitable sectors and businesses with plenty of scope for expansion, so firms have to be
able to refocus their activity flexibly and to set up new companies without hindrances in a
framework of competition. Moreover, the cyclical weakness will require firms to follow a
moderate pricing policy and reduce mark-ups, which would be easier to achieve if
competitive pressure were to increase in the sectors where it is weakest.
Second, faced with the inevitable fall in domestic demand, firms have no alternative but to
turn to foreign markets. It is important to realise that, compared with the foreseeably low
growth of national demand in the next few quarters, Spain's export markets may grow at
relatively high rates in the coming years. In 2008 Q2, for example, national demand grew by
1.4% in year-on-year terms, while goods and services exports rose by nearly three times that
figure. For this reason, efforts to boost the internationalisation of Spanish firms must be
maintained. Compared with the 46 million people comprising the Spanish market, the
inhabitants of the euro area countries number 320 million and the European single market
consists of nearly 500 million. Note that Spain's share of goods exports in world trade is still
below its share of world production. Also, Spain sends a smaller fraction of its exports to the
emerging economies (whose imports are more dynamic) than the other EU countries. To
increase our exports, domestic costs have to remain on a moderate path and the strategies
for opening up the economy and fostering trade have to be developed. There are
government initiatives to promote economic and trade relations with new areas (such as the
Integral Market Development Plans), which are delivering good results and in which firms
should not hesitate to take part.
Finally, firms should continue to pursue innovation and quality as a means of enhancing
competitiveness, a strategy which calls for specialised, well-trained workers. In this respect,
education should pay greater heed to the practical needs of the productive sector by
involving the business world more closely in the design and definition of vocational-training
and university course contents. Here it is fitting to point out that some areas of education in
Spain continue to produce disheartening results: in particular, the percentage of young
people completing secondary school studies continues to be among the lowest in Europe.
Hence government policies aimed at remedying this underperformance (in which the regions
play a central role) should be prioritised.
Firms, along with trade unions, also face the challenge of containing the effect of the
adjustment on employment. Given the repercussions that unemployment has for spending
and, above all, for household confidence and the general climate of uncertainty, this variable
is crucial, since a smaller impact on employment would reduce the fall in demand and lower
the probability of being caught in a vicious circle.
In this connection, it should be kept in mind that all macroeconomic adjustments are
different. That seen in Spain in 1992 and 1993 stemmed from an accumulation of substantial
losses in competitiveness, which could be recovered fairly rapidly through the devaluation of
the peseta. But the devaluation also led to a steep rise in the import bill which reduced
Spain's real income and made it necessary to impose tighter financial conditions in the form
of high interest rates, making the adjustment of national demand particularly pronounced. In
the current circumstances, membership of the euro area prevents a sharp currency
depreciation from reducing household purchasing power and, at the same time, limits the
possible financial shocks that domestic borrowers might suffer. However, belonging to the
euro area also makes it impossible to rapidly restore nominal competitiveness to a more
advantageous level for national production. For this reason, it is much more important than in
the past for Spain to set in train immediately all the mechanisms that allow it to curtail cost
rises and to increase productivity gains, so as to make production competitive and to reduce
the negative effects on employment. Hence the external sector could provide a substantial
offsetting influence in the adjustment phase and a larger boost to the subsequent recovery.
This moderate cost behaviour demands a responsible response from firms and trade unions
to the current labour market situation. Clearly the wage bill cannot be expanded by major pay
rises, since this eventually leads to a higher relative cost of labour and, consequently, less
job creation, higher unemployment, loss of household confidence and fresh falls in demand,
which would mean still lower growth and more unemployment. Therefore, it is crucial to
adapt wages to the specific situation of firms, to their activity, productivity gains, profits, etc.
The current wage bargaining system does not take into account the large differences in
individual firms' specific situations, so it is not the most suitable one to prevent the bout of
weak demand from generating a sharp fall in employment.
Further, the predominance of indexation clauses in collective labour agreements is a problem
that becomes particularly harmful when, as in the current circumstances, inflation has risen
due to an external shock, like oil prices, at a time of cyclical weakness. It is naive to believe
that automatic wage adjustment to reflect past consumer price increases provides any
protection to household disposable income. On the contrary, these clauses (which have now
been done away with in most European countries) lessen the ability of firms to compete and
keep creating jobs, generate inflation (which affects those not protected by similar provisions)
and, in short, hinder adaptation to the external shock.
In general, these characteristics of the Spanish labour market have meant that employment
has so far been the economy's main adjustment variable in periods of crisis, since it is the
quantities (i.e. the number of workers) that change given the impossibility of adjusting prices,
i.e. wages. Thus it is not surprising that in the past year the unemployment rate in Spain has
risen by 2.4 percentage points to 10.4% in 2008 Q2, while in the same period the euro area
unemployment rate has remained relatively steady at a little above 7%. The fact that Spain
has the highest unemployment rate of the OECD countries should lead us to reform our
labour market institutions and improve this lamentable ranking.
Many of my talks in recent months have referred to the activity of Spanish financial
institutions. These played an essential role in the fourteen years of expansion and, thanks to
their capable management, were in a sound position at the beginning of the international
financial crisis. But it cannot be denied that Spanish institutions face difficult challenges: first,
as noted above, although they were not agents of the crisis, they are being affected by the
standstill on the international financial markets; second, balance-sheet building by firms and
households, which I mentioned earlier, will lead to a substantial moderation of borrowing by
these sectors and hence to a reduction in the business of credit institutions; finally, the phase
of real-estate adjustment and, in general, of economic slowdown, is already being reflected
in increased doubtful assets, although this was to be expected and is still far from reaching
alarming levels. For all these reasons, it is clear that there is no room for complacency and
that institutions must act to achieve tighter cost control and to rationalise their procedures.
Against a background of rising doubtful assets it seems essential to build up both the amount
and quality of capital and to establish sound risk control mechanisms. Lastly, institutions
should continuously carry out stress testing and develop contingency plans to anticipate what
line of action to take in the face of different market situations. Regarding the supervisor, I
believe there has been widespread recognition of the reliability and quality of Spanish
banking supervision. Therefore this work should continue to cultivate a close relationship and
permanent contact with institutions, but without relaxing the demands made of them.
The last agent to which I wish to devote attention is households. In the current circumstances
it is inevitable that households should regard the future with greater uncertainty and restrict
their spending, stepping up their saving and reducing their level of indebtedness.
The behaviour of households will be influenced by whether or not they are indebted and, if
so, the weight of this debt burden on their current income.
In the case of the more heavily indebted households (in proportion to income), the picture is
more complicated since, to the prevailing uncertainty about the economic outlook may be
added the tightening of financing conditions, which is largely a result of the financial turmoil.
It is difficult to predict whether this tightening will continue, although money market rates (the
main benchmark in Spanish mortgage loans) now contain a substantial risk premium over
the ECB's official rates, currently at 4.25%. In addition, the adjustment phase will lead to a
decrease in the high debt of households, which is a necessary step for them to be able to
drive a fresh phase of high growth.
As in the case of firms, households will also have to be asked to adapt to the changes.
Above all, this calls for a greater effort in training, acquiring professional skills and versatility.
It would also be useful if energy saving could be included in households' day-to-day
activities, although, as in other areas, the provision of proper incentives by the authorities
(particularly through energy price and taxation policies) is crucial.
I would like to end with a message of confidence on the Spanish economy's capacity for
growth: the country's productive foundations are much more solid than in the past and there
has been a process of convergence with average European income levels which is unlikely
to be reversed. Spain is a stronger economy than at the start of the 1990s and its productive
and market structures are more flexible and modern. Moreover, macroeconomic stability is
assured: the inflation rate will probably be closer to the European average in 2009 and 2010
and the markets expect interest rates to continue at relatively moderate levels, far from the
double-digit levels of the 1980s and 1990s. Also, there is a broad consensus about
maintaining a high degree of budgetary stability, probably the most significant development
in the Spanish economy in the past decade.
That said, the unemployment rate is rising rapidly and the growth rate of activity has begun to
decline notably. Today I have tried to put forward the idea that all economic agents
(authorities, social partners and households) can contribute to making this adjustment phase
brief and to helping the Spanish economy to harness this opportunity to strengthen its
foundations for growth. In particular, a bolder attitude on the part of the authorities in their
reforms and on the part of the social partners in their shaping of wage-setting and other
labour-market mechanisms would lead to an earlier and stronger emergence from this
complicated phase.