The Spanish conundrum

Spanish wages rose by 50 percent between 1998, the last year before the introduction
of the euro, and 2008. In the same period, in Germany, the increase was only 25
percent. This would not be remarkable if the wage differential was matched by
changes in productivity; there is no obligation for members of a monetary union to
proceed at the same pace. But this was not the case. In Spain, where construction and
traditional services have driven growth, productivity growth has been less than in
Germany, where industry has been completely restructured (seven percent compared
to 15 percent). The result has been, in one decade, the opening up of a 30-point
competitiveness gap. Even taking into account that Germany entered the euro with an
overvalued currency, this gap needs as much as possible to be closed over the next
few years. How can it be done?

The first method Spain could use is ‘competitive deflation’, as practiced by France
during the 1980s, and Germany since 2000. This means imposing wage restraint and
thus gradually closing the competitiveness gap. However, it works desperately slowly,
particularly if inflation is low and productivity growth is weak.

The second method is deflation. This does not work through gradually adjusting
salaries or prices, but through lowering them as suddenly and as simultaneously as
possible. On paper, it looks attractive. If a government can obtain a simultaneous 10
percent cut in wages and prices, the loss of purchasing power will only be felt with
imported products, which will become more expensive. The purchasing power loss
would be limited to 2.5 percent in Spain’s case, because imports account for a quarter
of GDP. However, this method is only really feasible for small, open economies, such
as Ireland or Estonia, where cohesion is strong and there are obvious competitiveness
concerns. In a large, complex economy marred by disputes over income distribution,
deflation is hardly likely to be practical. In France, Laval’s deflation policy in the
1930s ended in economic failure and political disarray.

Some say there is a third way, through which the results of a straightforward deflation
could be achieved by less-direct means. US economist Martin Feldstein, in a proposal
aimed primarily at Greece, has suggested exit from the euro, followed by re-entry at a
devalued exchange rate. But this would soon turn the single currency into an empty
shell. The introduction of parallel currencies has been suggested. If it were possible to
temporarily denominate contracts in a quasi-currency, say in ‘pesos’, while
depreciating the ‘peso’ against the euro, everything would fall into place. But
Argentina tried this, and the results were inconclusive. Lastly, VAT can be increased,
and social security contributions reduced: in combination such measures tantamount
to a devaluation. But there is only a limited margin for a VAT hike (Spanish VAT is
16 percent, soon rising to 18 percent).

The last possibility would be to leave the euro area. However, this would be a step
into the unknown, and contracts, in particular public debt obligations, are
denominated in euros. Even the announcement by a government of an intention to
leave would immediately provoke a financial crisis of great magnitude because of
generalised concern about the consequences of such a decision for the solvency of
counterparties.
So we are back to the first method: slow and painful steps towards the recovery of
competitiveness. Getting there will test the endurance of Spanish society. The
European Union’s responsibility is to smooth the path, especially as Spain is not an
isolated case. This implies that the European Central Bank should visibly and
steadfastly concentrate on increasing inflation to two percent. Currently the risk of
too-low inflation is greater than the risk posed by too-high inflation. The implication
is also that the German social partners must understand that wage freezes, such as that
just negotiated for metalworkers, risk making the Spanish conundrum insoluble.
Neither economically nor politically would this be in Germany’s interest.