Gain or more pain in Spain?

In a new CER policy brief, 'Gain or more pain in Spain?' Simon Tilford demonstrates why Spain is no poster child for fiscal austerity and structural reforms. Tilford shows that Spain’s growth performance is less impressive than it appears at first sight. The level of economic activity remains highly depressed compared to pre-crisis levels (see Chart 1). He highlights that: The return to growth in fact owes much to a loosening of fiscal policy (Spain has the biggest budget deficit in the EU) and a (temporary) boost to spending from lower inflation. Spanish employment is rising, but from an extremely low base (see Chart 2). Spain’s strong export performance reflects cost suppression and rising exports of fuels, raw materials and food, not a move up the value-chain as a result of structural reforms.

Chart 1 Chart 2 Tilford argues that not only is Spain's recovery less than it seems, but that the country faces a host of daunting problems:   The flipside of cost suppression is stagnant nominal GDP and limited deleveraging. Low inflation means there will be little erosion of the burden of public and private debt. High real borrowing costs and the damage done to labour supply by mass unemployment risks depressing investment and with it productivity growth. A shrinking working age population as a result of a low birth rate and net emigration. A recovery in domestic demand will lead imports to rise rapidly, causing a renewed current account deficit and worsening of Spain’s very weak net external asset position. The Spanish authorities have few policy tools at their disposal to combat a renewed weakening of domestic demand, meaning the next downturn could be very painful. Commenting, Simon Tilford said; "It is hard to see Spanish living standards converging with the wealthier member-states of the eurozone, at least in the absence of substantive eurozone reforms. Without much more growth-orientated macroeconomic policies, and fiscal transfers to compensate poorer eurozone members for the impact of capital and skilled labour concentrating in the wealthier core, Spain faces plenty more pain.” Spain is the eurozone's latest poster child for austerity and structural reforms. The country's economy is growing robustly on the back of strong employment growth, recovering real wages and a pick-up in business investment. Indeed, Spain is on course to be the fastest expanding big economy in the EU this year. Spain’s return to growth is good news, but there is little evidence that it is the result of austerity and reforms. Moreover, the economy’s outlook is cloudier than the dominant narrative would suggest and the challenges facing the country remain formidable. Inflation will be too low to erode the real value of the country’s daunting debt burden. Unemployment will remain high for many years and continue to bear down on prices. And the ECB will shy away from the aggressive monetary easing needed to raise Spanish inflation. Real borrowing costs are highest in weak eurozone countries such as Spain (where inflation is lowest), and lowest in the strongest (where inflation is highest), leading capital and skilled labour to flow to the eurozone’s stronger economies. The Spanish government cannot boost government spending to counter this effect and the eurozone lacks fiscal mechanisms to compensate weaker member-states for it. Spain needs stronger productivity growth if living standards are to converge with those in wealthier EU countries. But there is little sign that investment is switching from lower to higher value-added activities. Most of the jobs created over the last couple of years have comprised poorly-paid service sector employment, especially in tourism. Spain’s relatively strong export performance since the depth of the crisis has been powered by sectors such as fuel and food rather than a move into higher value-added sectors. Recovering domestic demand will lead imports to rise more rapidly than exports, causing a renewed current account deficit and worsening of Spain’s already very weak net external asset position. Construction activity has bottomed out, but is set to stagnate at low levels of activity given Spain’s poor demographics and the country’s overhang of empty homes, some of which are being demolished but many of which will continue to weigh on the market. One of the lowest birth rates in the world and net emigration means that Spain’s working age population is set to shrink rapidly. This might not sound like a problem for a country with mass unemployment, but countries with shrinking workforces tend to suffer weak economic growth, which makes public and private debt harder to pay back. Spain is likely to enter the next downturn having barely recovered from the previous recession, with high levels of public and private sector indebtedness, and unemployment well above pre-crisis levels. Crucially, it will have few policy tools available to combat a renewed weakening of domestic demand, which increases the likelihood that the next recession will be a deep one.  Download PDF - See more at: http://www.cer.org.uk/publications/archive/policy-brief/2015/gain-or-more-pain-spain?utm_source=All+website+signups+as+of+21+March+2014&utm_campaign=fe1fd0b776-&utm_medium=email&utm_term=0_c3be79867d-fe1fd0b776-301763949#sthash.ggf6bB3K.dpuf Written by Simon Tilford   Notes for editors: Simon Tilford is deputy director of the Centre for European Reform.