Sunday, August 03, 2008

Spanish Stagflation

I have long argued that the real threat to the European economy lies not in the U.S. downturn, but rather in home made booms that are turning to bust. This problem is apparent in many countries, including Ireland, the U.K., Sweden and the Baltic states. And, most significantly for the euro area, Spain.

That it is Spain and Ireland who faces particular problems is evident in the latest unemployment report from eurostat. While the unemployment rate for the euro area as a whole is still slightly down from a year ago as Germany, France, Belgium and Finland experiencing significant declines in unemployment, Spain and Ireland have experienced significant increases in unemployment. The Irish unemployment rate rose from 4.5% to 5.7% and the Spanish unemployment rate rose from 8.1% to 10.7%. As a result of the latter, Spain has surpassed both Slovakia and Poland in unemployment, and has the highest unemployment rate within not just the euro area but the entire 27 nation EU as well.

If you go the Spanish statistical office own report on unemployment, you can see that things aren't quite as bad as the dramatic increase in unemployment suggest. Employment is actually still up slightly compared to last year, as the number of immigrants continues to grow fast and as the female participation rate continues to grow. Still, this is hardly ground for complacency as a country with a growing population and increased willingness of women to work outside the home clearly should experience rapid employment growth given the rapid growth in labor supply this implies.

You can also see the effect of the housing bust in the fact that employment in the construction sector has begun to contract, and contracts quite dramatically (8% in the latest year). Almost the entire decline in the employment rate can be attributed to this bust.

The main difference between Spain and Ireland is that the relative inflation rate compared to the rest of the euro area hasn't declined in Spain. In the euro area as a whole, the inflation rate rose from 1.9% in June 2007 to 4.0% in June 2008, or 2.1%:points. In Ireland, the increase in inflation was just half that (1.1%:points) and at 3.9%, Ireland now has slightly lower inflation than the euro area average. By contrast, Spain has seen its inflation gap differentiate as inflation rose from 2.5% to 5.1%, or 2.6%:points. And according to preliminary estimates Spanish inflation may have risen to 5.3% in July, which given the preliminary euro area average of 4.1% would widen the gap further. While the economic situation has become more stagflationary in the rest of the euro area as well, nowhere are the stagflationary conditions as bad as in Spain.

The higher inflation rate Spain could perhaps limit the nominal decline in house prices compared to Ireland, but on the other hand it also means that Spanish competitiveness will continue to be eroded, making it more difficult to compensate for the housing bust through rising net exports. Also, even if the nominal decline is smaller, the real decline will be as great, and the lower real interest rates will also make it more difficult to achieve the necessary increase in household savings.
For these reasons, Spain's monetary situation is arguably worse than Ireland's. On the other hand, Ireland is far more dependent than Spain and the rest of the euro area on trade with the U.S. and the U.K. and will therefore be hit harder by the slumps in those two countries.


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