Tuesday, 20 January 2009

Quite right Ambrose

Real interest rates of minus 2pc set by Frankfurt for German needs led to a Spanish property bubble of fearsome scale. Construction rose to 16pc of GDP, trumping the British and US bubble by large margins. Spanish companies tapped the euro capital markets as if there was tomorrow. Reliance on foreign borrowing reached 10pc of GDP, among the world's highest. Wages went up and up. The result is a current account deficit that is also 10pc of GDP.

Interest rates were too low for Spain (and Ireland etc) in the boom times. Now they're too high in the bad times. But much more than that we know of two ways which a country can use to get out of these bad times. The first is to lower interest rates and thus devalue the currency. But if you're in a single currency like the euro of course you cannot do that. The second way is to have wage deflation in that country.

That means falling wages....not just falling wages in real terms (ie, accounting for inflation) but falling wages in nominal terms (that is, the actual amount of cash people gets must fall). Now this is indeed possible: but I'm not sure that I can think of any democratic society that has managed to reduce nominal wages. At least, not without a great deal of rioting in the streets.

Spain has to claw back 20pc to 30pc against a stern German that will not inflate. Therefore, Spain must deflate. It must embark on a 1930s policy of draconian wage cuts.

It remains to be seen whether this will be tolerated by a democracy. Brussels expects Spanish unemployment to reach 19pc – or 4.5m people – by late next year. This is a depression.

This is an effect of the euro. No, it's not a side effect nor was it unseen. It's a direct effect of, if you're going to have one currency then you also have to have one interest rate, and it was predicted. Indeed, it's the sort of thing that even I, not an economist, was predicting back in the 1990s.

Thank goodness we didn't in fact join and let this be a lesson to those arguing that we should. If it's not an optimal currency area then a single currency just doesn't work.

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