Recovery and domestic demand

The revival in the Spanish economy over the last few months has surprised a number of analysts by its continuity and strength within a euro area whose expansion is still going through some good and bad patches. This recovery was expected to be driven by exports, which has happened, but no-one anticipated domestic demand reacting with the speed and energy we have seen recently. This unexpected surge in the domestic market, particularly private consumption and machinery investment, must surely be due to the drastic change in confidence among business people and households once the apocalyptic scenarios that were being considered just one or two years ago have been abandoned. International private financing return to Spain has also been crucial, relieving internal financial tensions and helping to stop the fall in the country's asset prices.

At present a large number of economic policy proposals believe domestic demand should be strengthened to push growth even further and thereby more quickly absorb the huge unemployment figures still haunting the Spanish economy. According to this view, it is not wise to expect the recovery to come solely from exports. On the one hand, due to their relatively lower weight in the economy and, on the other, because a greater effort to reduce unit labour costs could be harmful since this would affect, so the argument goes, the population's purchasing power and ultimately consumption and the rate of activity.

However, it is important to stress the serious risks the Spanish economy would incur if its growth were based too much on domestic demand over the coming years. If this happened, it would undoubtedly be possible to achieve, and quite quickly, GDP growth rates close to 3% but at the cost of undoing part of what has been achieved recently in terms of correcting the imbalances.

Accelerated growth in domestic demand would reverse the gains made in competitiveness and the balance of the country's external accounts, achieved last year. It would probably result in a faster correction in public accounts but this adjustment would be based not on structural changes in public budgets but on cyclical trends in the economy. And, lastly, it would also put a halt to the deleveraging process which has yet to be completed, given the extent of the country's private debt. In short, it is possible for a strong push by domestic demand to lead to a boom period but this would be followed by a period of adjustment in which international financial markets or the European authorities would demand policies to once again correct macroeconomic imbalances.

The Spanish economy's recovery must continue to be based predominantly on its external competitiveness, widening its surplus compared with the rest of the world to gradually re-establish an external debt position that makes it less vulnerable to fluctuations in the sentiment of international investors. If this strategy succeeds, it will result in domestic demand expanding, gradually building up steam as citizens' disposable income improves. Moreover, it is essential to continue making an effort to improve competitiveness, both because of its beneficial effects on the external balance and also to create jobs. This is not an approach that harms domestic consumption or demand as these essentially depend on the trend in employment and, in particular, on citizens' expectations of the likelihood of finding a job.

Jordi Gual

Chief Economist

30 June 2014