Ever since the beginning of 2008, the noisy collapse of the Spanish stock exchange has seemed to anticipate the way the economy is now evolving. Inflation and the current account deficit are out of control; economic growth is slowing down and job creation is coming to an end. “Inflation in Spain is higher than the average rate in the countries that we compete against,” says Rafael Pampillon, professor at the Instituto de Empresa business school. In addition, “the household savings rate is declining, financing needs of companies are growing and the current account deficit is at 10% of the GDP,” Pampillon notes. “Recently, the word ‘stagflation’ has been rearing its head, and we can’t forget that it is usually a powerful cocktail that is risky for the economy.” According to Francesc Javier Mena, a professor at the ESADE business school, Spain is undergoing a period of low economic growth coupled with high inflation. “We are in the midst of an economic slowdown that seems to be relatively severe. Inflation is not under control; it is running at above the average rate for Europe,” he says.


What do we mean by stagflation? “It is a very dangerous combination of slow economic growth and simultaneously sustained inflation,” explains Pampillon. He says Spain is not yet suffering stagflation. “For now, it is only suffering the phenomenon of ‘slowflation.’ That means that economic growth is slowing down and unemployment is growing along with inflationary pressures.” Pampillon says that Spain is moving away from the strong pace of growth in recent years. “For the moment, stagflation is merely a possibility but it appears that the tide is moving in that direction.”


A Term Coined in the 1970s

The term “stagflation” first became stylish during the 1970s when OPEC quadrupled the price of petroleum. “It was an era in which inflation, interest rates and the unemployment rate were all in double digits. Inflation rates were a lot higher than the inflation rate we currently see in the United States and Spain,” recalls Pampillon. The governments of many countries, including Spain, then opted to apply Keynesian policies. More specifically, they took “an expansionary fiscal policy by increasing spending at the cost of higher inflation. This led workers to impose greater pressure [on management] to raise salaries, which fed the inflationary spiral even more. And then governments raised interest rates to fight those price increases.”


The results couldn’t have been worse. “The undesirable effects aggravated a situation that was already bad. The expansionary fiscal policy also brought with it a worsening of public sector finances, which led to increased tax burdens and ultimately discouraged investment even more,” notes Pampillon. That’s when some economies faced the worst of both worlds: “stagflation (stagnation + inflation).”


Not everything went wrong. According to Pampillon, the devaluation of 1997 was a success. “In effect, the strong price rises that occurred as a result of the first oil crisis led to a loss of competitiveness that was manifested in Spain by large current account deficits from 1974 through 1976. Devaluation enabled the country to recover its lost competitiveness and achieve a surplus in its current account in subsequent years.” After the Spanish currency was devalued, the Moncloa pacts were signed in 1977. These agreements were “consistent with a contractionary monetary policy. The budgetary policy limited the size of the public sector deficit, led to lower growth in public spending and defined a new framework for labor relations through the Workers’ Statute, which made the labor market more flexible,” adds Pampillon.


The current situation in Spain is quite comparable, “although on a lower scale,” with the situation during the 1970s. Three factors distinguished that period: “A persistent, acute inflation rate — double the average of the member states of the Organization of Economic Cooperation and Development [OECD]; a decline in the consumer savings rate and in investment that led to a slower GDP growth; higher unemployment rates; and a strong deficit in the balance of payments,” says Pampillon.


What’s behind Spain’s current plight? So far this year, the Ibex 35 index has fallen by 10%. It seems as if the stock market is sending a warning. “The Spanish economy is headed toward a more dramatic cooling off than the analysts had predicted. The markets are already discounting the fact that there will be a more sizable adjustment than predicted earlier in the level of activity and, very possibly, also higher unemployment. Beyond that, we’re afraid of a higher rate of inflation that will become uncomfortable,” says Pampillon.


If that happens, the phenomenon known as ‘stagflation’ could result. “This year’s stock market declines demonstrate that this possibility is growing day by day, according to analysts and investors,” he adds. According to Mena,Spain has undergone 14 years of very considerable growth propelled by two engines: construction and consumer spending. “The incorporation of women into the labor market along with the jobs taken by immigrations; the decline in the unemployment rate, and the higher level of indebtedness among Spanish families have all been factors that made the Spanish economy grow as fast as it has until now. Now, it will dip into a state of deceleration,” comments Mena. This is a condition that had to arrive sooner or later, he adds.


External factors affect every economy. However, according to Pampillon, Spain is the victim of other factors that are intrinsic to that country. “Spain is much more vulnerable in the energy sector because of its strong dependence on foreign [energy sources]. It is also affected by the rigidity of its labor market. The fiscal policy that the government has applied has not done enough to slow down the economy. And since we don’t have our own monetary policy, much greater control of public spending would have been necessary, along with a surplus that was higher than what was achieved. The Spanish model of growth, based on construction, is quite a local phenomenon, and it has made things a lot worse for the economy when the real estate bubble finally burst.”


According to Pampillon, Spain already realizes that applying expansionary demand policies can generate imbalances that are hard to resolve. “Any expansion in public spending would distort incentives and the efficient allocation of resources. In addition, it would endanger the budget surplus.” In his view, devaluing the currency is also impossible because we don’t have that authority.” Given the fact that Spain does not have any foreign exchange policy, the only way Spain can improve its current account balance, while creating jobs and stabilizing prices, is by improving its competitiveness. That means Spain needs to “design and implement supply policies that intensify its efforts to increase corporate productivity through, for example, expanding the use of information technologies as well as increasing investment in R&D and human capital,” says Pampillon. He also recommends taking measures that give priority to other energy sources such as nuclear power. “Some technology experts say that [Spain’s] nuclear power output should reach at least 20,000 megawatts in 2030, compared with only 7,700 today, so that we can guarantee the stability of the national electricity system and satisfy demand.”


For his part, Mena thinks that in the short term it is impossible to figure out which measures would bring this situation to an end. “We can’t devalue; we can’t touch interest rates if the European Central Bank doesn’t do that; and we can’t create large-scale public spending programs because that would put us in deficit… And so, we have to look for medium-term structural policies. That would involve training more workers; awakening the innovative spirit; globalizing the economy… In other words, we have to make the economy more competitive.”


Pampillon recommends that Spain copy countries such as Finland and Ireland which have built a sound production structure based on a highly qualified, educated workforce. “The ideal thing would be to achieve a social consensus among business managers, labor unions and the government with the eye toward achieving the sort of long-term price stability that enables us to maintain our global competitiveness. And it is fundamental that we increase our spending in R&D,” he notes. In Finland, for example, the private sector spends 70% of the country’s total R&D budget. Every country has its pluses and minuses, and each one should focus on exploiting all of its resources. “We could learn a lot from the way Germany has figured out how to export its products. The Italians are very good when it comes to creativity. Finland and Ireland are very dynamic and flexible; they have invested in the knowledge economy and in innovation. London has a spectacular finance center that makes it the envy of everyone, including the United States…”


Medium-term Solutions


The Spanish economy has registered cumulative imbalances in recent years that make it very vulnerable in this more uncertain global environment. “They need to finance a remarkable deficit in their balance of payments; deal with growing differential inflation and enormous corporate and consumer debt. They also have to deal with the inflated evaluations of their real estate assets. I’m afraid that we are not entering good times,” suggests Pampillon. Mena advises Spain to take control of the rudder and change the direction of the ship so it can avoid crashing. “It is a country that has very sizable imbalances, and the foreign deficit is too large… We have to begin to create an economy based on competitiveness, and not only on construction and consumption.”


Two months before Spain’s next general elections, Pampillon recommends that the debate focus on how Spain will be affected by the international crisis and how to solve that problem. “We are living on foreign credit, and the future is going to be difficult. Rising prices for energy and food are sending inflation higher in Spain than in nearby countries. Spain should debate if its fiscal policy should be contractionary or expansionary and whether or not public-sector spending should continue to grow.” Pampillon also questions if Spaniards are wondering about what is going to happen during the economic slowdown of 2008. How will the real estate sector adjust? It accounts for about 10% of GDP. What fiscal policies should be taken? The street debates have begun. For Mena, the economic issues will be a hard pill for the public to swallow in the general elections of March 9. “Spaniards need to think about which policies will work out better during this slowdown period. It is not just a question of achieving efficiency; you have to think about who will enjoy the benefits and who will bear the burdens.”