Euro Football

A Beneficial Straitjacket – Analysis – Eurasia Review


By William Chislett*

Twenty years ago this month Spain
was one of the 11 EU countries that started to use the euro when the
common currency was first introduced. Joining the euro and being in the
vanguard of a European movement, 13 years after Spain entered the
European Economic Community (EEC) and ended a long period of isolation
from mainstream Europe, was very much a matter of national pride.

Yet has it been worth it? Euro zone membership deprived
Spain of its former capacity to set interest rates and devalue its
currency. Interest rates are set by the European Central Bank, not by
member state central banks, and euro zone countries cannot devalue. The loss of independence in
these areas meant that when the Spanish economy entered a long period
of recession as of 2008, as part of the meltdown of the North Atlantic
financial system and the subsequent Eurozone debt crisis, it could not
use some of the most important macroeconomic tools –monetary policy and
exchange rates– to restore competitiveness and perhaps emerge from
austerity more quickly and less painfully but not necessarily on a
sustained basis. The country had to rely on ‘internal devaluation’,
cutting production costs, mainly wages, in order to lower unit labour
costs and make the economy more international and competitive.

Preparing the country for the euro, which involved a tough
wrench, mainly fell to the conservative Popular Party under José María
Aznar. When he took office in 1996, Spain met none of the criteria for
joining the Economic and Monetary Union (EMU) as of 1999. Inflation,
interest rates, the budget deficit and public debt all breached the
convergence requirements enshrined in the Maastricht Treaty of 1992 for
setting up the euro zone. Many policymakers and pundits thought Spain
would never be fit for the purpose.

The Spanish political establishment was determined to prove
them wrong. Civil servants agreed to a wage freeze, public spending was
reduced, privatisations began on a larger scale than under the
Socialists, and various structural measures were taken. By the spring of
1998, Spain had met the conditions: its budget deficit was less than
the maximum allowance of 3% of GDP (6.5% in 1995), public debt as a
proportion of GDP was on a downward path and inflation was down to 2%
from 4.5% in 1995. With it, interest rates fell. The path was also eased
by Spain being the largest net recipient of EEC funds.

The macroeconomic stability required for sustained economic
growth as a result of meeting the euro criteria ushered in a virtuous
circle of high growth, low inflation and job creation. The country’s per
capita income increased from 80% of the average of the 15 EU countries
in 1996 to 87% in 2004, and thanks to the creation of 1.8 million new
jobs the unemployment rate dropped from 23% to 11.5% during this period.
The economy was going so well that José Luis Rodríguez Zapatero, the
Socialist Prime Minister between 2004 and 2011, adopted a football
metaphor and proclaimed in September 2007 that Spain ‘has joined the
Champions League’.

The truth is that Spain’s decade-long boom was a false bonanza, as it was mainly propelled by the debt-fuelled property sector (construction’s
share of GDP grew from 7.5% of GDP in 2000 to 10.8% in 2006), creating a
massive bubble that burst as of 2008. But was that the euro’s fault?
While building and consumption in general was spurred by the sharp drop
in interest rates after Spain joined the euro –average short- and
long-term rates fell from 13.3% and 11.7%, respectively, in 1992, to
3.0% and 2.2% in 1999 and to 2.2% and 3.4% in 2005, encouraging
borrowers to go on a spending binge–, the euro itself cannot be blamed
for banks’ reckless and irresponsible lending practices, particularly
those of the politically-influenced cajas de ahorros (savings
banks). The Bank of Spain did not do enough to discourage the orgy of
borrowing, but it deserves credit for introducing macroprudential
provisions. When several banks, including Bankia, the fourth-largest
lender, were on the verge of collapse in 2012, euro membership enabled
Spain to avail itself of the zone’s bailout fund, the European Stability
Mechanism (ESM), without which the whole financial system might have
gone awry.

Nor was the building of ‘ghost’ airports and other white-elephant projects scattered
around the country the euro’s fault. Spain wasted more than €81 billion
on ‘unnecessary, abandoned, under used or poorly planned
infrastructure’ between 1995 and 2016, according to a damning report
published by the Association of Spanish Geographers last year. Likewise,
the euro is not to blame for Spain’s consistently high unemployment (it
reached 24% in 1994, five years before the introduction of the euro,
and it has never got below 8% since the euro was adopted). Today, the
jobless rate stands at 15%, down from a peak of 27% in 2013.

The sharp drop in interest rates and in
Spain’s risk premium (the yield spread with the German bond fell from
500bps in 1993 to below 50bps) enabled companies to borrow funds much
more cheaply in order to expand abroad. The creation of a bevy of
multinationals has been one of the most significant economic
developments in Spain over the last 20 years (the stock of outward
direct investment rose from US$129 billion in 2000 to US$597 billion in
2017). A stable currency (the peseta was devalued many
times) has also been good for attracting inward foreign direct
investment (it increased from US$156 billion in 2000 to US$644 billion
in 2017) and keep relatively high living standards.

The strong euro did not hinder making Spain’s exports of
goods and services more competitive (they rose from 26.4% of GDP in 1999
to around 34% in 2018).

Spain suffered far more than Italy during the euro crisis,
but it has also reformed more and, as a result, enjoyed a much stronger
recovery. The euro ‘straitjacket’ made Spain reform, to its benefit,
while Italy resisted. Unlike Italy, Spain’s economic output has been
above its pre-crisis peak since the middle of 2017. Italy’s GDP is still
some 5% below its prior peak. There was no shortage of misguided
predictions after the Spanish economy crashed that Spain might exit the
euro. Whereas the populists in Italy’s government have toyed with
leaving the common currency, all of Spain’s main parties support staying

Close to two-thirds (62%) of Spaniards believe the euro has been good for Spain,
slightly down on a year ago, according to the latest Eurobarometer (see
Figure 1). More than 20% of the population was not born when the euro
came into force and has not known another currency. Figure 1. Having the euro is a good or a bad thing for your country? (%) (1)

A good thing A bad thing Can’t decide Don’t know
Euro area 64 (=) 33 (=) 7 (=) 4
Finland 75 (73) 15 (14) 7 (9) 3
France 59 (64) 29 (25) 6 (5) 6
Germany 70 (76) 21 (16) 7 (5) 2
Netherlands 69 (68) 21 (23) 6 (=) 4
Portugal 64 (60) 24 (26) 7 (10) 5
Italy 57 (45) 30 (40) 11 (12) 2
Spain 62 (65) 27 (23) 6 (=) 5

(1) 2017 figures in brackets. Source: Eurobarometer, December 2018.

Three-quarters of people in the 19 euro zone countries are
in favour of the euro, the highest since 2004. But that does not mean
that all is well with the single currency, as even its most fervent
advocates acknowledge. Its design flaws include the lack of a banking union (recognised
but not fully implemented) and a system for making fiscal policy
counter-cyclical. When economies are expanding, they need fiscal
discipline and when in recession some freedom to borrow. Another
omission is the absence of any means to ensure euro countries adopt
structural reforms, which only tends to happen in times of crisis and as
a last resort. Governance that is better designed for crisis management
is also required.

We will never know with certainty whether Spain would have
been better off not joining the euro. What we know is that in real GDP
growth terms Spain has performed better than Germany, France and Italy
since 1999. Were Spain to leave the single currency today and return to
the peseta, the move would have huge repercussions, including
skyrocketing interest rates and a currency devaluation.

*About the author: William Chislett, Associate Analyst, Elcano Royal Institute | @WilliamChislet3

Source: This article was published by Elcano Royal Institute

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