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Supply and demand both matter

Summary:
There's an unfortunate tendency for economists to align themselves into "supply-side" and "demand-side" camps. Many conservatives in Europe denied that the ECB's tight money policy caused a double-dip recession, leading to a dramatic rise in unemployment between 2008 and 2013. Indeed conservative Eurozone policymakers caused that recession. On the other hand, many demand-siders go too far, ignoring the fact that the relative performance of individual countries within the Eurozone reflects supply-side factors. Greece and Spain would have been better off never having joined the Eurozone. But given that they did so, they should have tried to make the best of it by adopting labor market reforms to make their economies more flexible, and austere fiscal policies with budget surpluses. Greece and Spain both had very poor labor market policies, and Greece had almost unbelievably reckless fiscal policies. The Financial Times reports that Spain has recently been growing rapidly, after adopting some unpopular economic reforms: For some, not least the Spanish government and Europe's political establishment, this is a moment of relief and vindication. In their view, the recovery of the eurozone's fourth-largest economy shows that the unpopular policies pushed through at the height of the crisis worked.

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There's an unfortunate tendency for economists to align themselves into "supply-side" and "demand-side" camps. Many conservatives in Europe denied that the ECB's tight money policy caused a double-dip recession, leading to a dramatic rise in unemployment between 2008 and 2013. Indeed conservative Eurozone policymakers caused that recession.

On the other hand, many demand-siders go too far, ignoring the fact that the relative performance of individual countries within the Eurozone reflects supply-side factors. Greece and Spain would have been better off never having joined the Eurozone. But given that they did so, they should have tried to make the best of it by adopting labor market reforms to make their economies more flexible, and austere fiscal policies with budget surpluses. Greece and Spain both had very poor labor market policies, and Greece had almost unbelievably reckless fiscal policies.

The Financial Times reports that Spain has recently been growing rapidly, after adopting some unpopular economic reforms:

For some, not least the Spanish government and Europe's political establishment, this is a moment of relief and vindication. In their view, the recovery of the eurozone's fourth-largest economy shows that the unpopular policies pushed through at the height of the crisis worked. Despite causing initial pain, Spain's decision to reform the labour market, overhaul the banking system and cut the deficit paved the way for a return to growth. It is a message Madrid would like to resonate beyond Spain's borders: countries can reform their way out of an economic crisis, even while being locked into the single currency.

There is, however, another view. Critics, mainly from the left but also from parts of academia, argue that the country's recovery is not just incomplete but that the price of austerity and reform was too high. The unemployment rate may have fallen sharply, but at 18.6 per cent it remains far above the pre-crisis level and almost double the eurozone average. Ms Oltra is one of many who bemoans the creation of a new class of "working poor" in Spain. Inequality has increased dramatically and public finances continue to bear the scars of the crisis: Spanish government debt is 100 per cent of GDP, up from 40 per cent before the crisis.


Here it is important to avoid "mood affiliation". My views are much closer to the first paragraph than the second, even though the people making that argument are to a large extent the same people who caused the Eurozone crisis, which imposed so much misery on the Greek and Spanish public. But on this particular issue they are correct, supply-side reforms are the key, once you've ruled out leaving the Eurozone.

Let's start with a comparison of growth rates. Here are the quarterly growth rates in recent years in Spain. (If you are an American, it helps to multiply by 4 to annualize the rates.)

Supply and demand both matter
Compare that the Greece, which is just treading water:

Supply and demand both matter
But what about Spain's 18.6% unemployment rate? There's no denying the fact that unemployment remains a huge problem in Spain. But it's also important to note two other facts. First, just a few years ago it was over 26%. Second, Spain has a very high natural rate of unemployment. Since 1980, their unemployment rate has fluctuated between about 10% during booms and 20% to 25% during recessions---even garden-variety recessions that are much milder than the Great Recession.

Supply and demand both matter
Thus an 18.6% unemployment rate in Spain is not nearly as horrific as the same rate would be in the US or Japan.

Finally, the creation of a "new class of working poor" should be viewed as a policy success. To see why, just look at the huge class of poor in Greece, who are not working at all.

PS. In my view the ECB should adopt more expansionary monetary policy as well. This post is looking at options from the perspective of individual Eurozone members.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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