Alatriste
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- 24 Dic 2006
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Do current account deficits matter inside a monetary union? The answers are “no” and “yes”: no, because there cannot be a currency crisis; and yes, because there cannot be a currency crisis. Where unsustainable divergences in competitiveness emerge, adjustment occurs largely through changes in relative nominal costs, particularly of labour. The bigger the required adjustment, the greater the pain.
The challenge posed by divergent competitiveness inside the eurozone has been widely discussed for the case of Italy. But Spain is even more interesting. Spain, unlike Italy, has been an enormous economic success; Spain, unlike Italy, has a huge current account deficit; Spain, unlike Italy, has enjoyed a vast construction boom. But Spain, this time like Italy, has low productivity growth and deteriorating external competitiveness.
The question, then, is not whether adjustment will happen, since it is sure to do so. It is how it will happen.
Between 2001 and 2005, the eurozone was the sick giant of the world economy. Over those five years, eurozone growth averaged a mere 1.4 per cent a year. In response, the European Central Bank adopted an expansionary monetary policy. But the impact of low interest rates was greatest not where demand was weakest, but where conditions for a property boom were best: notably, in Ireland and Spain (see chart).
Spain’s overall economic performance has been of a kind certain to generate euphoria. As the latest economic survey from the Organisation for Economic Co-operation and Development notes: “the country has experienced a 13th consecutive year of strong growth. The economic vitality has had the effect of narrowing the gap in per capita gross domestic product with the euro area average from 20 per cent to under 12 per cent over the past decade”.
This impressive expansion has been driven, on the supply side, by huge increases in employment, including of immigrants. Between 1998 and 2006, employment contributed 3 percentage points of the 3.5 per cent annual rise in Spain’s potential GDP and productivity just 0.5 percentage points. The contribution of “factor productivity” – or the increase in the efficiency with which factors of production are used – was negative, at -0.2 percentage points a year.
Meanwhile, on the demand side, domestic consumption and investment, particularly construction, have driven the economy. Between 2002 and 2006, construction grew at an average rate of close to 6 per cent a year, in real terms. By 2004, investment in new housing alone accounted for 8 per cent of GDP, a figure surpassed among OECD members only by Ireland.
Meanwhile, the foreign balance deteriorated year by year (see chart). Last year’s current account deficit of $107bn was the second largest in the world after the US. At just under 9 per cent of GDP, it was also the second largest in the eurozone on this measure, after that of Greece. Indeed, without Spain’s deficits, the eurozone would have had a sizeable current account surplus, largely reflecting Germany’s move into surplus, and so would have exacerbated the global “imbalances” (see chart).
“So what?” one may reasonably ask. Why should the emergence of so-called imbalances inside the eurozone be of any greater significance than the balance of payments between Scotland and England? Indeed, are the huge capital flows that are the counterpart of the current account surpluses and deficits not what the creation of a currency union is designed to achieve?
In the absence of currency and expropriation risk, investors seek the best returns where they are to be found. If that ends up generating large net borrowing by people living in a given country (or region), that is surely of no significance.
Up to a point, this argument is correct. But if investors are unaware of the interdependence of the risks they are running, they may find that their debtors are significantly less creditworthy than they had thought. More precisely, lenders into a construction boom are likely to find that a downturn in the local property market affects the solvency of many debtors. They may then decide to withdraw credit or stop providing new credit quite suddenly. If so, that will lead to a regional recession, as construction activity contracts.
Thus, inside a monetary union, currency risk turns into credit risk. Again, even widespread bankruptcy may not matter much if wages and prices are reasonably flexible in nominal and real terms, or it is easy to expand production of competitive tradeable goods and services. Adjustment then is relatively straightforward, as experience in east Asian and Nordic economies has shown in the not too distant past.
In such cases it is at least relatively easy to replace the lost domestic demand with foreign demand. But it is hard to be confident that this would be true of Spain when the property and construction booms end, for six reasons, all of which emerge from the OECD report: first, Spain has suffered a sizeable loss in competitiveness (see chart); second, the technological capacity of Spain’s tradeable goods industries is weak, on many dimensions; third, much of Spain’s recent investment effort has gone into the production of non-tradeables, particularly buildings; fourth, Spain’s industries are relatively vulnerable to competition from cheaper wage producers in central and eastern Europe and Asia; fifth, underlying productivity growth has been low, which will make it harder to restore competitiveness; and, finally, wage bargaining is quite rigid and, above all, unresponsive to conditions in the eurozone.
Spain has enjoyed a wonderful boom at a time of weak eurozone demand and expansionary monetary policy. As the eurozone recovers, monetary policy is being tightened. While Spain will benefit from the greater demand among its principal partners, its borrowers will face a substantially greater debt-service burden. That must bring closer the point at which the remarkable property-related borrowing and construction booms will end. Then adjustment will have to begin and Spain’s politicians will have to manage all the consequences.
For Spain, better times for the eurozone presage a much bigger challenge to itself. Adjustment to a different and more sustainable path will be required. A decade or so from today we should have a far better idea than today of how far one of Europe’s hitherto most successful economies is able to thrive within the straitjacket of the currency union.
http://www.ft.com/cms/s/16e554ac-dc80-11db-a21d-000b5df10621.html
The challenge posed by divergent competitiveness inside the eurozone has been widely discussed for the case of Italy. But Spain is even more interesting. Spain, unlike Italy, has been an enormous economic success; Spain, unlike Italy, has a huge current account deficit; Spain, unlike Italy, has enjoyed a vast construction boom. But Spain, this time like Italy, has low productivity growth and deteriorating external competitiveness.
The question, then, is not whether adjustment will happen, since it is sure to do so. It is how it will happen.
Between 2001 and 2005, the eurozone was the sick giant of the world economy. Over those five years, eurozone growth averaged a mere 1.4 per cent a year. In response, the European Central Bank adopted an expansionary monetary policy. But the impact of low interest rates was greatest not where demand was weakest, but where conditions for a property boom were best: notably, in Ireland and Spain (see chart).
Spain’s overall economic performance has been of a kind certain to generate euphoria. As the latest economic survey from the Organisation for Economic Co-operation and Development notes: “the country has experienced a 13th consecutive year of strong growth. The economic vitality has had the effect of narrowing the gap in per capita gross domestic product with the euro area average from 20 per cent to under 12 per cent over the past decade”.
This impressive expansion has been driven, on the supply side, by huge increases in employment, including of immigrants. Between 1998 and 2006, employment contributed 3 percentage points of the 3.5 per cent annual rise in Spain’s potential GDP and productivity just 0.5 percentage points. The contribution of “factor productivity” – or the increase in the efficiency with which factors of production are used – was negative, at -0.2 percentage points a year.
Meanwhile, on the demand side, domestic consumption and investment, particularly construction, have driven the economy. Between 2002 and 2006, construction grew at an average rate of close to 6 per cent a year, in real terms. By 2004, investment in new housing alone accounted for 8 per cent of GDP, a figure surpassed among OECD members only by Ireland.
Meanwhile, the foreign balance deteriorated year by year (see chart). Last year’s current account deficit of $107bn was the second largest in the world after the US. At just under 9 per cent of GDP, it was also the second largest in the eurozone on this measure, after that of Greece. Indeed, without Spain’s deficits, the eurozone would have had a sizeable current account surplus, largely reflecting Germany’s move into surplus, and so would have exacerbated the global “imbalances” (see chart).
“So what?” one may reasonably ask. Why should the emergence of so-called imbalances inside the eurozone be of any greater significance than the balance of payments between Scotland and England? Indeed, are the huge capital flows that are the counterpart of the current account surpluses and deficits not what the creation of a currency union is designed to achieve?
In the absence of currency and expropriation risk, investors seek the best returns where they are to be found. If that ends up generating large net borrowing by people living in a given country (or region), that is surely of no significance.
Up to a point, this argument is correct. But if investors are unaware of the interdependence of the risks they are running, they may find that their debtors are significantly less creditworthy than they had thought. More precisely, lenders into a construction boom are likely to find that a downturn in the local property market affects the solvency of many debtors. They may then decide to withdraw credit or stop providing new credit quite suddenly. If so, that will lead to a regional recession, as construction activity contracts.
Thus, inside a monetary union, currency risk turns into credit risk. Again, even widespread bankruptcy may not matter much if wages and prices are reasonably flexible in nominal and real terms, or it is easy to expand production of competitive tradeable goods and services. Adjustment then is relatively straightforward, as experience in east Asian and Nordic economies has shown in the not too distant past.
In such cases it is at least relatively easy to replace the lost domestic demand with foreign demand. But it is hard to be confident that this would be true of Spain when the property and construction booms end, for six reasons, all of which emerge from the OECD report: first, Spain has suffered a sizeable loss in competitiveness (see chart); second, the technological capacity of Spain’s tradeable goods industries is weak, on many dimensions; third, much of Spain’s recent investment effort has gone into the production of non-tradeables, particularly buildings; fourth, Spain’s industries are relatively vulnerable to competition from cheaper wage producers in central and eastern Europe and Asia; fifth, underlying productivity growth has been low, which will make it harder to restore competitiveness; and, finally, wage bargaining is quite rigid and, above all, unresponsive to conditions in the eurozone.
Spain has enjoyed a wonderful boom at a time of weak eurozone demand and expansionary monetary policy. As the eurozone recovers, monetary policy is being tightened. While Spain will benefit from the greater demand among its principal partners, its borrowers will face a substantially greater debt-service burden. That must bring closer the point at which the remarkable property-related borrowing and construction booms will end. Then adjustment will have to begin and Spain’s politicians will have to manage all the consequences.
For Spain, better times for the eurozone presage a much bigger challenge to itself. Adjustment to a different and more sustainable path will be required. A decade or so from today we should have a far better idea than today of how far one of Europe’s hitherto most successful economies is able to thrive within the straitjacket of the currency union.
http://www.ft.com/cms/s/16e554ac-dc80-11db-a21d-000b5df10621.html
