Spain Must Take the Lead in Europe

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Includes: FXE, IEV
by: Michael Pettis

As Europe stumbles toward debt crisis, Spain is trying hard to distance itself from countries like Greece, Portugal, and Ireland in the hopes that investors make a permanent distinction between itself and the countries that will be forced into default. Spain wants to be considered among the virtuous countries that work hard and save, and not among the vicious ones that consume too much and are unable to repay their debts.

But this strategy is wrong for three reasons. First, Spanish leaders can pretend all they want that Spain is different, but the truth is that the problems afflicting Spain are the same as those afflicting Greece, Portugal, Ireland, and all the other despised countries. And like them, Spain will almost certainly be forced to leave the euro and default on its debt, or else suffer many years of crippling unemployment, rising debt, and economic stagnation.

Second, the problems afflicting Spain and the rest of peripheral Europe have nothing to do with virtue or vice. They are the consequences of many years of bad policy, driven in large part by German policies. These problems cannot be resolved without a German adjustment at least as serious as the adjustment in peripheral Europe. In fact, the less the Germans adjust their policy distortions, the greater the cost to Europe overall and the greater the share of that cost must be borne by countries like Spain.

Third, the only solution that can minimize the pain for Spain—and even minimize the cost of adjustment for the rest of the world—requires that the countries that have suffered most from the unbalanced growth of the past decade band together and insist on adjustment policies across Europe. The natural leader of this group is Spain, but if Spanish politicians pretend to be different, rather than to acknowledge their similarities, they will forfeit any chance of leadership and any chance to arrive at a real solution to the problems of Europe.

In order to understand why Spain must lead, it is important to understand what caused the crisis. In the debate about the root causes of global imbalances, moralizers love to praise high-savings countries (let us call them all “Germany”) for their hard work and thrift, and deride high-consuming countries (which we will call “Spain”) as lazy and altogether too eager to spend more than they earn. The world cannot possibly rebalance, they argue, until the latter become more like the former.

There is almost nothing of value in this argument. Culture and individual preferences may cause some of us to save more of our income and others to save less, but when entire countries have persistent abnormally high or low savings rates, individual preferences are never the reason. Abnormal savings rates over long periods of time are largely consequences of trade and industrial policies at home and abroad.

In fact, domestic policies by the German government can explain both high German savings and low Spanish savings. For example, assume that Germany has an undervalued currency, low wages for its level of productivity, high consumption and income taxes, and expensive infrastructure funded by these taxes. In that case it is very likely that German GDP growth will exceed the growth in household income, since households are effectively (and usually without their knowledge) forced to subsidize growth. In periods of high unemployment—like that which occurred in Germany after reunification—these policies might make sense for Europe overall, but they cannot remain in place for long without creating economic distortions.

Savings must balance

Why? Because in a system with limited consumer finance, consumption growth is largely determined by the growth in household income. With German GDP growth exceeding consumption growth for many years, by definition the German savings rate must rise. National savings, after all, are simply national production less national consumption.

The high German savings rate, in other words, will have nothing to do with whether Germans are ethnically or culturally programed to save. It is the automatic consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing—usually at the expense of manufacturers elsewhere. Since the trade surplus is the excess of domestic savings over domestic investment, Germany must run a large trade surplus, and this large trade surplus requires that it absorb foreign demand to generate domestic growth and higher employment.

What does this have to do with Spain? Obviously if Spain has the opposite conditions, it is likely to have a very low savings rate and a trade deficit. In that case German anti-consumption policies will be matched by Spanish anti-manufacturing policies.

But it turns out that Spain’s low savings rate might itself simply be a consequence of Germany’s high savings rate, and not the consequence of Spanish policies. The most obvious reason for this is the currency. If Germany’s currency is undervalued, by definition Spain’s must be overvalued, which means the implicit tax on imports into Germany that is effectively used to subsidize German manufacturers, is matched by a tax on Spanish manufacturers that is used to subsidize Spanish imports. Not surprisingly, Germans will tend to under-consume relative to production and Spaniards to over-consume.

But there is more. Since German policies force it to produce more than it consumes or invests domestically, Spain must consume and invest more than it produces. Globally, savings must balance investment, and if one country forces up its savings rate, it can force down the savings rates of its trade partners.

If German anti-consumption policies force up the German savings rates, in other words, there are only four ways Spain can respond. First, it can force up the Spanish investment rate. Since German policies are likely to erode the profitability of Spanish manufacturing, private investment is unlikely to rise, but public investment can, funded by German capital exports. This means, of course, that Spanish government debt must rise.

Second, Spain can allow domestic consumption to rise faster than GDP, which by definition means a declining savings rate and a rising trade deficit. This is usually caused by rising consumer financing funded, again, by German capital exports and is often accompanied by rising asset prices. This is especially likely if Spanish interest rates are kept artificially low by the European Central Bank.

Third, Spain can allow domestic unemployment to rise, usually by raising interest rates sharply (although as a member of the eurozone this option is very difficult to implement except when a debt crisis forces up Spanish rates). Rising unemployment will actually reduce Spanish savings, but if it causes investment to decline more quickly, Spain will not have to absorb Germany’s excess savings. It will, however, have to keep unemployment high until wages have declined sufficiently to allow Spain to compete.

And fourth, Spain can devalue its currency against Germany’s currency or it can impose trade barriers. In either of these two latter cases Germany must adjust, either with a rise in domestic unemployment or with an increase in state investment.

Both sides must adjust

Notice that all of these things are automatic consequences of policies that affect the different growth rates between German GDP and German consumption. It turns out that the relative savings rates of the two countries have nothing to do with siestas or good food or life on the beach.

For this reason the solutions to the global imbalances don’t need exhortations that Spaniards become as virtuous as Germans. Virtue has nothing to do with it. The solution requires a combination of policies that force faster GDP growth (relative to household income growth) in Spain and faster household income growth in Germany.

If only Spain is forced to adjust, the consequence must be a rise in global unemployment because a decline in Spanish GDP growth must be matched by an even more rapid decline in household income in order for Spain top rebalance. Rather than accept the surge in domestic unemployment, Spain will then have to consider intervening directly or indirectly in trade, and so force most of the rising unemployment onto Germany. It would be astonishing if Spain did not at least consider intervening.

The peripheral countries of Europe are in trouble, for faults of their own, of course, but also because of anti-consumption policies in Germany aimed at generating rapid employment growth at the expense of its European partners. For this reason the deficit countries must band together and force a sharing of the adjustment cost across Europe.

If only the peripheral countries are forced to adjust, they can do so through economic stagnation and many years of high unemployment. But the threat that they will take steps together to force unemployment back onto Germany is the one way that German policymakers can be convinced to stop criticizing lazy southerners and take concrete steps to rebalance its own distorted economy.

The world needs less moralizing and more focus on why savings rates vary among countries. Moralizing may feel good, but it confuses the issues and must almost inevitably result in rising trade tensions. More than seventy years ago John Maynard Keynes explained that trade imbalances are caused by misguided policies in both the surplus and the deficit countries, and that forcing only the deficit countries to adjust is bad for global growth and terrible for the deficit countries.

Spain has the chance to take leadership on this issue and force Europe into more rational policies. Europe should not force Spain and the other deficit countries to rebalance through collapsing investment and high unemployment. If Germany and the other surplus countries do away with the policies that forced up their savings rates to artificially high levels, Spanish savings rates, and the savings rates of the other European deficit countries, will automatically rise without the need for permanently high unemployment. The surplus countries are as responsible for the terrible European policies as are the deficit countries. Let them share the burden of adjustment by reforming their own economic distortions.