Rafael Pampillón. Professor. IE Business School
9 January 2009
Spain has the same symptoms as those that preceded the Great Depression. And just like then, the only way forward is to facilitate loans and increase public spending.
My colleague and friend Pedro Schwartz published an article ("Is Pampillón wrong?”) here on 31 October in which he expressed his disagreement with the economic policy measures I propose for putting this economic crisis behind us. How does he differ?
1. Professor Schwartz disagrees with the diagnosis, and this is most important since a realistic diagnosis is fundamental if the right policies are to be applied. He considers that, although we are experiencing an ebb of the cycle, we are not on our way to a depression like that of the 1930s.
My diagnosis is different, since I consider that the Spanish economy is in crisis owing to an insufficient aggregate demand of unknown proportions and that, if we do not apply the right measures, we will very soon enter a long, deep recession.
We must remember that the Great Depression of the 1930s came from a fall in demand, which led to high levels of unemployment, negative economic growth and deflation. To overcome that crisis, expansive aggregate demand policies were applied, together with increases in public spending.
What is happening now in Spain? The weakening of housing prices, the fall in consumption and credit restrictions have lead to negative economic growth rates since the month of June and it would appear probable that there will be an even greater drop in activity in the future. As a result, unemployment is increasing quickly, having reached 12.2% of the working population in October (according to official unemployment figures) and may reach 16% by the end of next year.
Is this, as Schwartz says in his article, a temporary crisis caused by the natural completion of a cyclical phase? I don´t think so, since the completion of the cycle will be joined in the near future by three phenomena: (a) a sharp fall in consumer demand due to the increase in unemployment and the poverty effect (exacerbated by a drop in the worth of peoples’ homes); (b) a sudden fall in family demand for residential investment; and (c) possible reductions in investment by business corporations, which seem to be putting off investment decisions while waiting for possible credit and a clearer economic outlook. These symptoms (less consumption and less investment) unveil a recession that will become more serious in the future as a result of a fall in the aggregate demand.
2. What can be done to increase the aggregate demand? In my opinion, one of the first measures to be taken is for the ECB to continue lowering interest rates. Doctor Schwartz says that the ECB’s lowering of interest rates may not encourage credit and, indeed, this has been the case in recent months.
I agree with him, but it is also true that (a) the ECB started to lower interest rates one month ago and the euribor rates also began to fall, consequently reducing financial costs for businesses and families alike, and (b) what we need is for enterprise to recover the credit given to it by the banks before the liquidity crisis as soon as possible. Consequently, the more and cheaper the finance obtained by the banks, the easier it will be for them to lend it to enterprise. We cannot force businesses to invest, but if we want them to invest, the credit must be available.
3. Professor Schwartz is worried because he fears that an expansive monetary policy might increase inflation. However, I am more worried by the possibility of deflation. Consequently, I propose a reduction in direct taxes (expansive tax policy) in conjunction with the lowering of interest rates to help economic growth even further.
Less taxation on corporate profit would increase enterprise´s capacity for self-finance. Less taxation on family income would increase the money available and consequently increase consumption and private saving.
Increased saving would reduce family debts and increase the supply of funds that can be loaned, reducing the cost of credits offered by the financial system, which could lead to an increase in investment. Pedro, I don´t know if you agree with me when I say that taxes need to be lowered.
4. Another possibility is to increase public spending to also increase the aggregate demand. Pedro Schwartz points out the fact that this policy has never worked very well. However, I think that public spending can and should be increased temporarily and selectively when there is an abundance of productive capacity and a lack of inflationary pressure.
What type of spending? Perhaps that which improves productivity: infrastructures (roads, toll motorways, hydraulic and railroad infrastructures), information and knowledge technologies, education and R&D. I would not support permanent public spending such as an unnecessary increase in civil servants or current expenses.
This set of Keynesian measures would have to be fine-tuned, depending on the seriousness of the situation. But my theory is that, with an abundance of productive resources, the private sector does not spend on consumer and investment goods and we must make it possible for it to do so, reducing taxes and interest rates and if that is not enough, the state should assume its responsibility and spend to prevent the economy from falling into depression. We also need other measures aimed at improving the aggregate supply, but I shall look at them on another occasion.