Countries with a long history of low growth and high inflation that enter into a monetary union expect to see economic growth speed up at the same time that their inflation converges to the rate targeted by the union’s monetary authority. The decision-makers in such countries are normally conscious of having to implement institutional reforms and commit to some basic disciplines imposed by the union.
The crisis that affects several euro area members has given support to the view that those decision-makers were not totally aware of the price their countries would end up paying by relinquishing independent monetary policy as a tool to cope with the financial crisis and to renew growth after recession.
Nowadays, outside Europe, many economists maintain that Greece, Ireland, Portugal and Spain would have been better off not entering into the euro. The UK is mentioned as the best example of a country that, by preserving its national currency, has better tools to fight the effects of the deep recession and financial crisis, which followed from the burst of the various real estate bubbles that plagued several nations in the first years of the 21st century.
A comparison of the economic performances of Spain and the UK should be useful to shed some light on this subject. Their economies share many common characteristics, but differ precisely in the availability of monetary policy as a sovereign tool. Spain has given this up by joining the euro, while by preserving sterling as the national currency, the UK’s Bank of England is able to conduct an independent monetary policy.
It is immediately clear that real estate bubbles cannot be blamed on belonging to a monetary union. The real estate bubble in the UK was not very different from that of Spain and, looking more broadly, the biggest recent bubble developed in the US, the country with the most powerful monetary policy in the world. But, it is argued, once a bubble bursts and a recession and financial crisis develops, the country that can conduct an independent monetary policy can mitigate the negative effects of the crisis, and find a sustainable solution to the crisis and renew growth.
The purpose of this article is to examine this argument in the light of the crisis that began in the US in 2007 and spread around the world during 2008. In particular, the focus is on the crisis in Europe, inside and outside the euro area, taking Spain and the UK as two country cases to compare. The main conclusion is that any advantage the UK has in combating a recession by the availability of a sovereign monetary policy is not compelling enough to induce a country such as Spain, which gets valuable long-term benefits from being in the euro area, to abandon the euro and to reassert monetary sovereignty. In Spain’s case, the lack of exchange rate flexibility can be compensated for with labour market and tax reforms that will produce the same effect on comparative unit labour costs as currency depreciation, without losing the advantages of being a part of a monetary union.
In 1980, Spain’s gross domestic product (GDP)1 represented 54% of the UK’s, and by 2010 this ratio had increased to 68%, see Table 1. The biggest jump took place after the launch of the euro. In 1998, Spain still represented only 55% of the UK’s GDP. So, in 12 years Spain’s GDP jumped 13 percentage points in relation to the UK’s GDP, but during the previous 18 years had only managed one percentage point. An alternative way to view the same phenomena is to compare growth rates of GDP. While between 1980 and 2010 Spain grew 6.1% a year, the UK grew 5.3%. The biggest difference in performance happened between 1998 and 2010, when Spain grew 6% and the UK 4.1%. Before Spain joined the euro area, both countries grew at quite similar annual rates: 6.2% for Spain and 6.1% for the UK. From the point of view of GDP growth, since the creation of the euro, Spain has outperformed the UK.
Growth since the start of the crisis
Since the first quarter of 2008 until the first quarter of 2011, GDP2 suffered a similar fall in both countries: 4.1% in Spain and 4% in the UK, see Table 2. Looking at the data quarter by quarter, it becomes clear that the impact was initially larger in the UK and the recovery has been slower in Spain, but generally, the magnitude of the crisis looks very similar. However, there are some surprising differences in the expenditure composition of the decline and recovery of GDP. In spite of the fact that Spain could not devalue its currency to promote exports and discourage imports, the increase in exports and the decline in imports were both larger in Spain than in the UK. Between the first quarter of 2008 and the first quarter of 2011, exports increased 1.5% in Spain and very close to zero in the UK. Imports declined 16% in Spain and only 6% in the UK. The quarterly movements, see Table 3, show some differences in timing, but the overall picture is the one described by the behaviour of exports and imports along the three years of the current crisis. In the first quarter of the crisis, the fall in exports was greater in Spain than in the UK, but imports fell even more in Spain than in the UK, so the adjustment in the current account was, from the very beginning, stronger in the country that could not depreciate its currency.
Turning to consumption, shown in Table 4, the contraction and subsequent recovery in final private consumption was also quite similar in Spain and the UK. Spain could expand fiscal policy to soften the first impact of the global crisis more than the UK, but since the fourth quarter of 2009, public consumption turned slightly contractive, while in the UK it was slightly expansive. Overall, the UK did not use more fiscal expansion than Spain. Differences in the behaviour of investment between Spain and the UK showed up only in the last four quarters. Investment in Spain has continued contracting at a rapid pace, while on average, investment has expanded in the UK since the second quarter of 2010, see Table 5 overleaf.
From 1980 until recently, inflation was higher in Spain than in the UK, as Table 6 shows. During 1980–2010, annual inflation measured on the CPI index was 5.3% in Spain and 3.6% in the UK. The difference was much higher in the period 1980–1998 than since the creation of the euro area. From 1980 to 1998, annual inflation was 7% in Spain and 4.7% in the UK. From 1998 to 2010, annual inflation was 2.8% in Spain and 1.9% in the UK. So entering the euro helped Spain to reduce the inflation gap with the UK.
At the beginning of the crisis, inflation went down much more in Spain than in the UK. Spain actually suffered deflation, a phenomena that the UK could avoid by letting the pound depreciate. From the fourth quarter of 2009, inflation has risen again much more rapidly in the UK than in Spain. In Spain’s case, the variability in the rate of inflation came mainly from the behaviour of foreign prices. This is not the case for the UK as shown by the smaller differences between the rate of inflation measured by the CPIs including food and energy, and that excluding them.
In Spain non-food, non-energy consumer prices reached almost zero inflation but never deflation, and in the last quarter increased up to 1.3% (annualised) compared with 3.2% in the UK. This means the deflation in Spain’s case during the second and third quarters of 2009 originated in the fall of commodity prices in dollars whose impact could not be dampened by currency depreciation, as was the case in the UK.
The comparison of the course of inflation (see Table 6) during the crisis suggests that without monetary policy as an instrument to dampen the effects of the recession, a country cannot prevent imported deflation but, as a compensation, it does not risk a post-crisis jump in inflation. No doubt entering the monetary union helped Spain to speed up long-term growth and converge on the inflation target set by the monetary union. Since the creation of the euro, growth has been higher in Spain than in the UK, and inflation, even though it continued to be higher in Spain than in the UK, tended to converge around the 2% ‘target’ set by the European Central Bank, very similar to the Bank of England’s target. So far, the comparison between Spain and the UK, before and during the recent crisis, does not support the conventional view that conserving a sovereign monetary policy by not entering into a monetary union is a big help to avoid recessions and financial crisis.
But those who argue that the UK is better equipped than Spain to cope with the crisis show the larger number of unemployed people in Spain compared with the UK as irrefutable proof of their statement. In April 2011, there were 4.3 million unemployed in Spain and 1.5 million unemployed in the UK. The argument runs as follows: by letting the pound depreciate, unit labour costs (ULC) in the UK can go more rapidly down than in Spain and, therefore, unemployment can be reduced more rapidly in the UK. The figures on exchange rate-adjusted ULC (see Table 7), do confirm this difference in the pace of decline.
Exchange rate-adjusted ULC were lower in Spain than in the UK until 2007. Since that time, while ULC fell in the UK, in Spain it first increased up to 0.83 in 2008 and then fell slowly. In 2009, exchange rate-adjusted ULC were 17% higher in Spain than in the UK. For more recent years there are no data yet, but it is likely Spain’s ULC continued to decline slowly.
The figures on the number of unemployed are clear on the differences between Spain and the UK, as Table 8 shows. But the much higher number of unemployed in Spain is not associated necessarily with the recent crisis. Actually, from the first quarter of 2008 to the first quarter of 2011, the number of unemployed increased 87% in Spain and 81% in the UK, only slightly less in the UK than in Spain. The higher number of unemployed in Spain is a structural problem in its economy, related to the lack of flexibility in the formal labour market, to the pace of increase of the labour force and the high social security contributions on wages and salaries that create a large gap between labour costs and take-home income of workers.
The much higher flexibility of labour markets in the UK than in Spain is well documented. The more rapid long-term growth of the labour force in Spain is clearly seen in the figures on the labour force over time (see Table 9 below).
Spain’s labour force increased 73% during the period 1980–2010, while the UK’s grew only 18%. In terms of number of people the difference is also striking. While in Spain during the 30 years, 9.7 million people entered into the labour force, in the UK the increase was only 2.1 million. Note also that of course the UK’s economy is much larger than that of Spain. Both, during the 1990s and the first decade of the 21st century, the increase in the labour force in Spain exceeded that of the UK by 18 and 19 percentage points respectively. During the 1990s, while in Spain the labour force increased by 17%, it fell by 1% in the UK.
The other important characteristic that explains the lower structural unemployment in the UK relates to the tax structure of its economy (see Table 10 overleaf). While total revenue of the government is a higher proportion of GDP in the UK than in Spain, the social security contributions that create a gap between labour costs for the employer and take-home income for the employee are much higher in Spain than in the UK. In Spain, 35.4% of total government revenues are collected as social security contributions, while in the UK only 19.8% of total revenues are collected that way.
Social security contributions are calculated as a proportion of the payroll of the employers that comply with labour and tax laws, and they create a gap between the labour costs for the employers and pocket income for the employee. When social security contributions are too high, many employers and employees decide to operate in the informal economy where labour and tax laws are just ignored. At times of crisis the shifts from the formal to the informal economy increase, as seems to be happening now in Spain. Typically, people who after losing formal employment continue working in the informal economy, register as unemployed in order to get unemployment benefits. So it may well be that in Spain today the large number of registered unemployed hides, to some extent, an enlargement of the informal economy rather than true unemployment.
Joaquin Cottani and I suggested some time ago that Spain could get the same effect on unit labour costs in relation to the price of tradable goods perceived by producers (equivalent to the exchange-adjusted unit labour costs concept for fixed exchange rate economies) by reducing the rate of social security contributions and increasing the rate of the VAT. If Spain introduces this tax reform, it will be shifting the incidence of taxes from the payroll to consumption and, therefore, would be producing the same effect of currency devaluation, without abandoning the euro.
The substitution of VAT for social security contributions could be of varied dimension. In a soft movement it could try to jump to the rates of the UK, which are similar to those that prevail in the US. Alternatively, it could go to the extreme of completely eliminating the social security contributions, as is the case in Australia. Most of the countries outside the euro area have social security contributions no higher than 21.2% of total government revenues.
The prevailing high rates of social security contributions in most euro area countries suggest that not only Spain, but other economies suffering from too high unit labour costs could resort to the same solution rather than abandoning the euro and devaluing a new currency. Such a tax reform should be only part of the more complete fiscal and regulatory reform oriented to fiscal consolidation and higher labour market flexibility. The advantages of belonging to a monetary union reside precisely on the obligations it imposes to look for structural and long-term solutions to fiscal and regulatory problems, rather than only postponing them by letting a currency depreciate and weakening monetary discipline, something that, most frequently than not, would end up reintroducing persistent inflation into the economies.
This article draws on material prepared for the conference: What is Next? Monetary Policy and Financial Markets after the Crisis, June 17–18, 2011, at the University of Navarra, Pamplona, Spain.
1. All GDP figures are measured in purchasing power parity (PPP) terms.
2. Quarterly figures of GDP are measured at constant prices, not at PPP.