The role of internal devaluation on the correction of the Spanish external deficit

Abstract

The Spanish economy has been one of the EU’s most affected by the Great Recession of 2008, recording a rate of unemployment of 26.2% in 2013. However, since 2014 Spain is growing faster than most Euro Area countries, reaching an annual growth rate over 3% during the period 2015- 2017. Moreover, it has turned its historical current account deficit, which peaked in 2007, into a surplus of 2 % of GDP in 2017. International and Spanish institutions, as well as some scholars, have rooted this readjustment of the current account in the “internal devaluation strategy”. Consisting in the reduction of wages, this strategy is supposed to have boosted exports and therefore Spanish economic activity, through the reversion of the accumulated loss of price-competitiveness since the creation of the European Monetary Union. Nevertheless, empirical evidence shows that changes in demand (and some exceptional factors as the recent evolution of oil prices) are much more important to explain the evolution of Spanish net exports than changes in price competitiveness. Based on an extended version of the Bhaduri-Marglin model, which enables the disentangling of the price effect from the demand effect, this paper sheds light on the true influence of internal devaluation on the deficit correction occurred in the Spanish external sector. It reveals that wage restraint has meant only limited gains in price-competitiveness, having affected external balance mainly through a “demand effect” on imports, although to a limited extent. The estimations carried out show that the internal devaluation strategy readjusted the Spanish external sector by 1.74 p.p. during the period of 2010-2017. Of all this correction, 98% is induced by a change in the demand of the economy, and only 2% is due to the effect on prices. It makes also clear that although exports performance has been remarkable during last years in Spain, it does not differ much from the previous decade, and it cannot be explained by internal devaluation.