Spain: the tough choices ahead Dani Rodrik May 28, 2010

Widening external imbalances

And rapid structural change away from tradable sectors

An international comparison

…on industry share of GDP

What countries in Spain’s position need to do 1. Reduce aggregate expenditures Private sector has already retrenched significantlyPrivate sector has already retrenched significantly 2. Boost competitiveness of tradable goods and services (exports and import substitutes) Key: increase labor demand in tradablesKey: increase labor demand in tradables The second is needed to moderate the adverse effects of belt-tightening while accomplishing the needed structural change. Without it, the recession runs deeper, unemployment is larger, and the fiscal hole becomes more difficult to fill.

Spain starts from a low point in terms of competitiveness Source: IMF

What about structural reforms? What may be desirable in the medium- or long- term may not be particularly effective in the short-run What may be desirable in the medium- or long- term may not be particularly effective in the short-run Structural reform may not be a good substitute for policies that directly increase competitiveness Structural reform may not be a good substitute for policies that directly increase competitiveness –Labor-market reforms  Reducing cost of firing workers will not increase demand for labor much when no-one wants to hire new labor to begin with  Decentralizing wage bargain may have little effect on the level of wages And it can eat up lots of political capital And it can eat up lots of political capital

How to boost competitiveness (1) Increase productivity in tradables Increase productivity in tradables –This reduces unit labor costs –But: this is a medium- to long-term strategy  It cannot happen quickly enough –Recent productivity growth achieved through labor shedding  Which of course defeats the purpose

Spain’s productivity performance Source: EIU

How to boost competitiveness (2) Currency depreciation Currency depreciation –Gives quick boost to competitiveness, unless wages and prices catch up –It is the traditional remedy used by countries to extricate themselves from crises of this type –But Spain doesn’t have its own currency  even a large depreciation of the Euro would be insufficient since 70% of Spain’s exports go to other EU members  Leaves exit from the eurozone as the only (unappetizing) option

How to boost competitiveness (3) A “fiscal” devaluation A “fiscal” devaluation –Raise import tariffs and apply export subsidies –In principle, it mimics a currency devaluation –But few successful cases  South Korea and Taiwan during the 1960s and 1970s; China in 1990s –And would violate EU and WTO rules in any case

How to boost competitiveness (4) A cut in nominal wages A cut in nominal wages –Reduces domestic costs and boosts external competitiveness –But needs to cover private sector  Can’t be limited to public sector wages –And it needs to be accompanied by similar cuts in the prices of other services and non-tradables (e.g. utilities, transport and logistics, housing, …)  Otherwise the effect on competitiveness remains limited  And workers bear unnecessarily large real wage cuts

How to boost competitiveness (5) Industrial policy Industrial policy –Targeted promotion of new industries  Through subsidies, public loans, public-private collaboration to remove identified bottlenecks –All successful countries engage in industrial policies, even if they do not call it that –But takes time to implement and get results –And it requires a lot of government capacity –Unlikely to be effective on its own in a depressed economic environment –There is no successful example of IP in a high-cost environment

The bottom line Two unappetizing options Two unappetizing options –Quit the eurozone and let the currency depreciate –Engineer an economy-wide reduction in wages and prices of services  Requires political leadership and a social compact