EU Economic And Monetary Policy Case Of Spain

This research paper aims to discuss how the EU has influenced economic and monetary policies of Spain and vice versa. This dual relationship is of utmost importance as we look at the costs and benefits the EMU has brought to Spain and the possibility of the long-standing inflation problem in Spain affecting EU’s monetary policies. EU membership has undoubtedly largely influenced the economic policies and conditions of Spain. For example, Spain’s accession in 1986 forced the government and economic elites to adopt the necessary policies to embark on economic modernization. In addition, the European Monetary Union (EMU) Maastricht Treaty criteria resulted in Spain having to implement micro and macroeconomic policies like fiscal consolidation, central bank independence and wage moderation (Royo, 2006). Also, the current Greek debt crisis has also thrown the spotlight on Spain which is also undergoing a crisis of itself: “competitiveness crisis”. With this crisis in mind, it is highly unlikely but still possible that EU might either choose to expel Spain from the euro area or undergo a series of policy reforms to deal with this crisis. This research paper will begin with an introduction of Spain’s accession into the EU, followed by the costs and benefits Spain experienced from complying with the EMU Maastricht Treaty. This will be followed by an investigation on the competitiveness crisis in Spain and its influence on the EU. Lastly, this paper will have a discussion on the possible economic and structural reforms that both Spain and EU should undertake to smoothen EU integration for both parties.

Spain’s accession into the EU

Before accession into the EU, Spain’s economy was of a protectionist nature. It remained largely outside the international economic trading area. However in the 1980s, Spain decided to integrate with Western Europe, and was enthusiastic in accommodating to the EC trade customs and rules in order to secure accession. Spain joined the EMU because it was economically beneficial then as the majority of Spain’s trading partners are in the EU.

On January 1986, Spain joined the European community as a full member. Spain was a firm supporter of the European and Monetary Union from the very beginning and rushed to be a part of the European Monetary System (EMS) in 1989 (Sebastian Royo, 2003). The European Monetary Union was established with the purpose of creating and improves trade among European countries.

Based on the accession agreement, the taxation policy of Spain was transformed dramatically. Firstly, Spain had to gradually remove custom duties as well as industrial tariffs on EC goods (US Library of Congress). Spain’s tax rebate on exports had to be removed too. In addition, Spain had to impose a value-added tax (VAT) which had affected Spain negatively in the 1980s. For instance, the introduction of VAT makes Spain a more expensive destination for inbound visitors/tourists and this will affect the Spanish tourism industry.

2.1 Implications of European financial integration on Spain

More importantly, membership in the Economic Monetary Union has many implications on Spain’s domestic economic policies. This is because Spain now loses control of monetary and exchange rate polices to fix problems in its economy and have to rely on the EMU’s monetary policy instead. The EMU is tasked with the objective to conduct policies to ensure and achieve stability and growth in the Euro zone (Trichet, 2005).

European financial integration kick-started a series of reforms aimed at liberalizing and modernizing the Spanish economy. Accession to ERM and then EMU membership resulted in the reform of the tax system. This reform of the Spanish tax system includes the introduction of VAT as well as a reduction of import duties. This was accompanied by a fiscal consolidation process (reducing government budget and debt deficits).

Membership in the EU which resulted in European financial integration has both positive effects and negative effects on the economy. The general consensus is that the economic outcome for Spain’s membership is still largely positive. For example, gross domestic product per capital (GDP) increased significantly from 1985 and 2005 (Elcano Royal Institute & European Parliament – Office in Spain, 2006). The Spanish economy has also enjoyed growth since accession. Furthermore Spain has received a large amount of funds since accession and has made use of these funds to finance regional cohesion projects and develop infrastructures to modernise the economy. In addition, with greater exchange rate stability, imports of goods and services in Spain rose significantly and thus there was a greater degree of openness in the Spanish economy. However there remain major differences in economic development between Spain and the leading economies in the EU.

Financial integration due to EMU was not totally smooth-sailing for Spain. The financial integration, which resulted in industrial restricting, has adverse effects on the economy in the early 1980: it resulted in high unemployment. In addition, the 1992 EMS crisis was traumatic for Spain. The 1992 crisis originated from an increase in government spending in Germany. This coupled with contractionary monetary policy led to increase in interest rates which affected the rest of the members of the EMU. The result was a sharp decline in the growth rate of real GDP and Spain having to devalue thrice. Many jobs in Spain were lost in the crisis. Fortunately these effects were cushioned somewhat by an economic boom in Spain, the continuing fall in oil prices and large inflow of foreign direct investment into Spain as many foreign companies seek to grab a slice of Spain’s expanding consumer market (US Library of Congress).

Therefore for Spain to seize the benefits of EU membership and enjoy economic growth as well as low inflation, it has to push forward its structural reforms as well undertake sound fiscal policies. Spain till now has succeeded in conducting sound fiscal policies. However its inherent problem of high inflation continues to threaten its competitiveness and hence its trade balance. This has not been resolved quickly partially because of complacency due to its early economic success in the EU (Royo, 2006).

European financial integration of the EU which entails efficient free movement of capital, commitment to exchange rate stability as well as harmonization of capital taxes have many positive implications on the Spanish macroeconomic policies. One benefit is that free movement of capital results in a decrease in financial costs for companies and thus allowing companies to raise more resources. However European financial integration has its drawbacks too for Spain. For instance, such commitments come into conflict with the aim of the Spanish government to reduce inflation as such commitments tend to result in lower interest rates thus raising inflation rates. Nevertheless, EU membership has contributed to some extent in lowering inflation in Spain. The introduction of the Euro and the European Central Bank (ECB), have considerable success in limiting price increases. The ECB’s main aim of its monetary policy is to keep inflation of those in the euro zone under control and achieves this by raising interest rates. The ECB therefore sets long-term interest rates for all the EMU countries. Since entering the EMU and participating in the single currency, Euro, the Spanish economy has transformed in a starkly different manner as compared to its counterparts in the EU. Spain’s economic growth in terms of GDP and inflation rate has been significantly higher than the other member states in the EU (Andres, Hurtado, Ortega, & Thomas, 2009). These differentials particularly the inflation differential is most probably caused by the convergence and the integration of foreign markets. In fact, the surrendering of a nation’s right to pursue autonomous monetary policy as a result of complying with EMU and ECB is one reason why Spain has problems reducing her traditionally high inflation rate. Therefore this is perhaps the reason why Spain is powerless to use initiatives like setting interest rates to control inflation.

As mentioned previously, one of the most significant implications of EMU membership for Spain was the convergence of interest rates which resulted in extremely low interest rates in Spain. (Royo, 2006). The drastic decline of interest rates in Spain was necessary in order to secure entry into the EMU. In fact, this convergence of interest rates as a result of EMU membership has an indirect effect on Spain’s current account trade deficit. Low interest rates led to an explosion of credit and mortgages. This raises houses prices. Low interest rates cause savings to decrease and thus the saving rate is insufficient to finance investment projects, resulting in the private sector having a large trade deficit. Low interest rates also result in excess demand and leading to high goods and wage inflation.

Therefore, although membership in the EU served as a primary trigger for the Spain to embark on liberalizing the economy and has largely improved trade, it also contributes to problems regarding Spain’s trade balance. This is because most of Spain’s trade partners (countries which Spain exports her products to) are in the EU. (Royo, 2006)This coupled with rising GDP, which increased at a faster rate than exports, resulted in a growing current account deficit.

It is important to note that the high inflation problems and the rising current account deficit took place in a setting of fiscal stability (Ubide, 2007). Once again, membership in the EU has resulted in Spain having a lack of monetary and cyclical tools to achieve fiscal surplus and control rising inflation. Having the national currency in a fixed exchange rate due to the EMS thus caused Spain being unable to resolve these economic problems. In other words, if Spain is not a member of the EU and do not participate in the single currency, Euro, she could have devalue her currency with respect to other currencies and improve its competiveness of its exports, and thus improve her trade balance.

3.1 The Competiveness Crisis in Spain

The Greek debt crisis has put the spotlight on the peripheral member states of the EU especially Spain. However Spain is undergoing another crisis which of a different nature as compared to Greece. Spain’s crisis is not due to a lack of budgetary discipline, but caused by the boom in domestic credit (due to convergence in interest rates in the EU). The membership in the EMU can be attributed to the boom in domestic credit leading to the construction boom in Spain. EMU reduced the cost of borrowing for households as real interest rates for households fall substantially. This is due to the reduction in the risk premium as a result of EMU membership. Therefore, reduced cost of borrowing for households led to an increased in number of houses built and thus a boom in the construction industry. The construction boom in the private sector was accompanied by poor economic performance in the other sectors; this resulted in instability as well as trade imbalance.

From the late 1990s to 2007, Spain has displayed poor international cost competitiveness (as compared to the rest of the EU members) as a result a significant increase in cost of production especially in the tradable goods sector (Marzinotto, 2010).This significant increase in cost of production is caused by Spain’s real estate investment boom. “Other factors that contributed to poor international cost competitiveness include wage indexation to past high inflation and extension of wages which are agreed at industry level” (Marzinotto, 2010).

In the 19809s, Spanish firms were facing intense competition from Latin America and the Far East on products like clothing, textile which are Spain’s main exports. These countries from the Far East and Latin America have leverage on Spain because they are able to produce these goods far cheaper than Spain due to their low wages (Royo, 2006). As a result, Spain is often overlooked by foreign investors who chose to set their operations in these countries instead. This situation worsened when the enlargement of the European Union to the central and eastern European countries materialized. This is because Spain has to deal with new competition from new members on industries which are labor-intensive which form the bulk of Spanish trade. This further affect the trade balance of Spain because these new members also are able to exploit their low wages thus are able to produce cheaper exports as compared to EU.

It is a tough obstacle for Spain to resolve the resulting current account deficit because such trade imbalance exists independent of any utilization of sound fiscal policies. This is not only an important issue for Spain but also has an important influence on the EU. This is because the poor international competitiveness of Spain will affect the stability of the Euro too.

3.2 Spain’s crisis and its implications on the EMU

Based on the current competiveness crisis of Spain, one of the unlikely options for Spain is to exit from the euro area. However such an option begs another central question: is a euro exit possible and how will the credibility of the euro being affected? Firstly, the credibility of the euro is unlikely to be threatened if countries like Spain and Greece exit from the euro zone. However in an event of a Spanish exit from the euro zone, it will lead to other troubled nations pondering over similar departures and such spill over effects will create an uncertain environment which is not conducive for further European financial integration. Nevertheless, such concerns may be redundant because the chances of Spain exiting the euro zone or any other member state doing likewise is extremely unlikely because of the difficulty in doing so.

One important barrier to exit is the financial integration between the members of the EU has reached a significant degree thus cross-border assets are very high. “Therefore an exit will result in massive upheaval” (Willams, 2009). Of course there will be benefits for Spain to leave the euro as it implies regaining autonomy in pursuing independent monetary policy as well as exchange rate flexibility. However, the costs of withdrawal are high too. For instance, there will be a cut in access to finance as well as a sharp increase in funding costs due to a removal of funding by the EMU as a result of withdrawal. This thus suggest a likely situation where Spain will remain in the euro zone and attempt to deflate its housing boom without the use of independent monetary policy or currency devaluation.

This crisis has wide implications on the EU. The EU cannot and will not hang these struggling economies out to dry. Therefore to fix the competiveness crisis in Spain, there is a need for the EU to make some changes or introduce some frameworks. One possible way in which the EU can manage this crisis is to introduce a system to monitor wage and price developments (Marzinotto, 2010). This is not exactly a novel avenue which the EU has not implemented before. One of the requirements of the Exchange Rate Mechanisms ERM (before the introduction of the euro) was that no member country could change its nominal exchange rate without the consent of the others due to its effects on competitiveness. This is not the case now. “Member states can now change its real exchange rates via VAT increases and cuts in social security contributions” (Marzinotto, 2010).

Therefore in this avenue, the EU should regularly monitor the real exchange rates in the euro zone and should introduce initiatives whenever economic developments pose a threat to the stability and the operation of the EMU. In addition this European competiveness monitoring framework (Marzinotto, 2010) should have a euro-wide perspective and focus as Spain’s current account deficit means a surplus for another country. Therefore in the event of necessary adjustments, the EMU must take into consideration both the interests of the “deficit” and “surplus” member states.

In addition to a monitoring framework, there should also be an alert procedure (Marzinotto, 2010)that will have an assessment whenever fluctuations in a country’s current account deficit exceed the predefined limits. In the alert procedure, the country that has flouted the predetermined limits will be assessed based on its efforts to correct this problem. If the assessment is negative, the commission will then propose initiatives to solve the problem based on a euro-wide focus.

Nevertheless, despite these recommendations to help Spain and other similar countries to solve such competiveness crisis, the onus is for these countries to make a concerted effort to resolve it via national efforts. The Spanish government should implement a national competiveness monitoring framework (Marzinotto, 2010). This framework includes utilizing a range of policies for remedial action. However this will not be any easy task due to obligations to the EU. Policies that Spain is hindered from using due to euro membership include encouraging inward investment by offering tax incentives and cheap loans to investors as well as devaluation. Therefore there seems to be only supply-side policies which Spain can use to remedy the crisis. Supply-side policies are favourable because an improvement in supply-side performance tends to lead to sustained economic growth without a rise in inflation rate, ceteris paribus. However, a good supply-side performance alone is not sufficient and must be accompanied by a sufficiently high level of aggregate demand so the productive capacity of the economy can be utilized. The Spanish government can encourage an entrepreneurial culture by providing regional policy assistance for entrepreneurs and also helping these firms with regards to access to knowledge and advice.

In addition, although Spain has managed to maintain a sound fiscal policy, it has not fully utilized the fiscal policy to deflate the housing boom. Spain can modify the tax treatments of interest payments on house loans to cool the domestic housing market. With higher cost of capital, the disposable income of a household will be affected thus leading to a reduction in excess housing demand. In fact Ireland has demonstrated that raising the cost of capital of households can be achieved by removing interest relief on mortgage interest payments, (Gerald, 2004) is possible within the EMU. This goes to show that the loss of independent monetary policy (as a result of EMU membership) to correct the crisis cannot be an excuse for failure. This is because a well targeted fiscal policy can be used effectively to reduce excess demand in the housing market. However such measures undertaken by the Spanish government may not be popular with the Spanish public.

3.3 Efforts by the Spanish government

Spanish government launched the National Reform Program (OECD, 2007) in 2005 to identify challenges to the economy (as a result of indirect implications of EMU membership) and propose initiatives to solve these problems. Despite the intentions of the program, it has not been very successful in meeting the challenges. In addition, the tightening by the European Central Bank has not managed to cool the domestic demand in Spain by a small degree. Furthermore, although the housing market in Spain has showed some signs in slowing down, residential investment continue to form a significant part of Spain’s GDP and house prices are still steadily increasing (OECD, 2007). Industry productivity has not improved significantly thus inflation differential still persist between Spain and the rest of the euro zone members.

As compared to other members of the euro zone, Spain has embarked on a fiscal consolidation policy with a more concerted effort. This is because of a need to counterbalance the effects of the current loose monetary policy conditions. Although ECB raised the interest rates in 2007, it had limited success in cooling the domestic demand in Spain. This is partially due to tax reductions on households which increase the households’ disposable income. Therefore Spain should continue or even enhance its restrictive fiscal stance to reduce pressure on the domestic demand.

The Spanish government has also attempted to develop the rental housing market. However it has met with limited success. “Therefore, it will be better to gradually phase away any forms of assistance which home owners can receive in order to balance the incentives between renting and purchasing and moderate demand pressures.” (OECD, 2007). Another measure is to “improve the legal security of relations between owners and tenants so as to improve the use of the housing stock” (OECD, 2007).

With the gradual decrease in EU transfers to Spain as a result of enlargement, there is an increasing need to have and manage the government budget effectively. The Spanish government has recognized this need and have adopted reforms to improve the management of the government expenditure and resources. “The Spanish government limited the growth of government expenditure to below the projected rise in nominal GDP and also used tax revenue to reduce indebtedness” (OECD, 2007). The government has also increased the accountability and responsibility of regions regarding their expenditure. This is achieved via increasing the control the regions have over the taxes imposed on their specific regions. This will have the effect of reducing the reliance by these regions on the central government for transfers. Therefore this delegation of responsibility will also enhance the regions’ revenue raising powers. However there are problems associated with such decentralization, there may be loss of information thus affecting efficiency. Therefore there have to be an independent agency to monitor and evaluate the polices of the various government agencies of the respective regions (OECD, 2007). In addition such assessments have to be transparent to the Spanish public.

The Spainish government has also reformed the 2003 Fiscal Stability Law (OECD, 2007)in order to maintain fiscal stability and prudence in a decentralised system. According to the 2003 Fiscal Stability Law, each level of the government has to ensure that its accounts are permanenty in balance. In addition, the law assessed the cyclical position of the Spanish economy by monitoring its expected growth rate against it potential. Although this law seems has a great influence on maintaining fiscal stability, the government must execute this law with caution to prevent a situation of a pro-cyclical budgetary outcome where a loose fiscal stance is adopted when times are good and a restrictive fiscal stance when times are bad.

Conclusion

Since accession into the EU in 1986, Spain has enjoyed a positive economic growth. In addition, EU transfers had also allowed Spain to modernise and develop its economy as well as infrastructure. Although the financial integration process was difficult for Spain with the introduction of VAT and other measures, Spain accommodated its national policies to secure entry into the EMU. Despite Spain maintaining an environment of fiscal stability, the high inflation differerntial between Spain and the rest of the euro zone members threatens to harm Spain’s international competitiveness. This competition crisis can be partially attributed to the low interest rates set by the EMU thus leading to domestic credit boom and hence excess demand in the housing market. This is a central issue for both the EU and Spain as it has wide implications for both parties. Therefore it is likely that EU’s economic policies and framework will be modified to include initiatives like a monitoring framework to manage the Spain’s crisis or other similar crisis by other member states in the future. In addition, although Spain is tied by its obligations to the EMU (which include not being able to devalue its exchange rate or pursuing an independent monetary policy to deflate its booming housing market), there are some supply-side policies and national reforms that Spain can pursue to reduce inflation. Lastly, remedial action by both the EU and Spain will invariably have implications on each other as well on the rest of Europe.