Euro Crisis

What Should Spain Have Done Differently?

06.27.12 9:15 PM ET

No idea about the Euro crisis is more prevalent in America—or more dangerous—than the idea that the crisis originates in Europe's excessively generous welfare states.

Some of those welfare states are excessively generous, yes. But Germany manages to run a very generous welfare state without anyone doubting its ability to stay on the Euro. (Germany also runs a debt-GDP ratio about as high as the United States.)

The problem is the loss of currency control, and Martin Wolf today offers a powerful new way of thinking about such loss:

In January 2004, I attended a property conference in Switzerland, to give a talk on the European economy. I talked about the end of European catch-up on US productivity levels. But the most interesting part of the conference was a workshop in which I argued that a number of European countries, the UK being one, had dangerous property booms.

The most dangerous of all, I suggested, was Spain’s, because it is a large European country which was experiencing a huge rise in property prices and, as a result, a huge boom in property development and a correspondingly overheated construction sector. The results could be extremely painful. This remark led to a heated altercation with a Spanish property developer. I understood why he was so angry. But he was wrong, of course.

The Spanish property sector created a huge boom and a huge crash. The big question is what the Spanish authorities should (or could) have done about it.

And the short answer is: not much, because the best tool for dealing with a property boom—a rise in interest rates—had been taken away form them by the Euro.

The only other answer would be a massive increase in taxes or massive cut in spending, sufficient to crush economic activity in Spain.

This would have been an utterly perverse response, since Spain in the 2000s was already running budget surpluses. Tax increase or spending cuts with no other purpose than to slow the economy would have seemed bizarre under the circumstances—especially when you consider how large they would have had to have been.

In retrospect, the only way the Spanish authorities could have prepared themselves for the shock would have been to run fiscal surpluses of 10 per cent of GDP over the five or six years before the crisis, so generating a positive net asset position of at least 20 per cent of GDP. That might have been enough (though even that is uncertain). There is no chance whatsoever that a democracy would run such surpluses

The great British financial journalist Walter Bagehot is supposed to have said, "John Bull can stand many things, but he can't stand two percent"—meaning an interest rate set too low. That rule is true for all countries. The creators of the Euro blithely disregarded it, and now southern Europe is paying the price even as the people who did the damage scold them for it.