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The Trouble In Spain

August 28, 2012

Of all the Eurozone countries, Spain laments its miserable macroeconomic performance.  As this Wall Street Journal article demonstrates, Spain is in its “moment of deepest decline” in terms of GDP.  Students of macroeconomics will note that while exports are helping the economy grow, the other spending sectors are declining more severely.

” (H)ousehold spending fell by 2.2% on annual basis compared with a 1.5% contraction in the first quarter. Also, government spending dropped by 3% in the second quarter, compared with 3.6% in the first quarter.”

Adding to their tale of woe is an unemployment rate that has reached a dangerously high 24% in recent months.  This is nearly three times the normal rate, and is considered “depression”-level joblessness by any modern EU standard.  That’s “depression” as in the Great Depression, when the global economy tanked completely in the 1930s, and when Europe sought out radical (fasicst and communist) solutions to its economic problems.

If shown on an AD/AS diagram, the scenario would most likely resemble this below.  Led by decreases in consumption and government spending, AD in Spain is moving backward.  As the amount of output/income is reduced from Yfe to Y1 and then Y2, the number of workers needed to produce that output is reduced as well.  This is causing major cyclical unemployment (unemployment as a result of fluctuations in the business cycle).

Image

So clearly, things are going badly in Spain.  What should be the solution?  As my IB and AP economics students are growing to understand, there are a variety of responses at the command of a government facing recession.  After the Great Depression, the traditional response for most governments is to increase their spending and to lower tax rates.  This will result in a budget deficit, the government paying out more than it takes in, which is normally viewed to be irresponsible.   Why is this the standard response?

Keynes called it “spending against the wind.”  In this case, the wind is the overwhelmingly pessimistic economic conditions.  What business would attempt to expand or develop when their customers are unemployed (or worried about being unemployed and saving their money)?  Few would rationally invest at this time.  As for consumers, with 1 of every 4 Spaniards out of work, everyone knows someone who’s jobless, so there’s a real worry that “I’m next.”  So, therefore consumption is drying up.  (For example, a friend in the European car industry told me that private auto sales are dead right now.  Only fleet purchases, by businesses for company cars, are holding steady.)

This is what makes Spain’s reduction of government spending (-3%!) so baffling.  Why cut spending, and seemingly make the recession worse?  If the government is the only actor capable of pushing Spain out of depression, why cut spending?

Welcome to Europe in 2012.  Spain’s part of the club of countries that has already borrowed so heavily that it can’t afford to borrow (and spend ) their way out of this recession.  Spain owes so much in public and private debt (to banks and governments) that the ECB and Europe’s creditor countries, led by Germany, have insisted on an “austerity” plan for Spain to pay back its old debt.

Now.

During the New Depression.

Critics of this policy cite the old idea that to borrow is to be beholden to someone, but to lend significantly to another is to become obliging to the borrower.  As the article notes, if Spain does not grow, it will have even less tax money to pay off its debt.

What can Spain, and the other debtor countries of Europe, hope to do in this case?  We’ll consider the other options in future posts.  For now, suffice it to say that Spain is set to endure significant economic pain over the next couple of years.  This is causing unrest, even violence as Spaniards protest the austerity measures that have been adopted.

Check your understanding:

  1. Identify the four sectors of spending in the AD model, and explain the current status of each sector in Spain.
  2. Explain, using a diagram, how the AD has moved in response to these events.
  3. Show, using a diagram, how a traditional Keynesian stimulus program would help solve the recession.
  4. Identify the reason why Spain is not able to enact a Keynesian stimulus program at this time.
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