The Swan and Spain – Again

About a year ago I wrote this piece  looking at where Spain would be positioned on the Swan diagram. To recap, the Swan diagram is way of analysing an economy in terms of both its internal and external balance.

On the y axis, we have the real exchange rate, while on the x axis we have domestic demand. We also see two curves that represent the internal and external balance of the economy. The upward sloping curve refers to internal balance and it shows how the real exchange rate adjusts to maintain full employment. If internal balance was to be achieved as domestic demand increased, the upwards pressure on employment and inflation would need to be offset by a higher real exchange rate that discouraged exports. To the left of this curve, the real exchange is too high for internal balance, so we see unemployment. To the right of the curve, the real exchange rate is too low, so we see inflation.

The downward sloping curve represents external balance, which can be thought of as a balanced current account. It is downward sloping because the increase in domestic demand pulls in more imports, which needs to be offset by a lower real exchange rate that benefits exports to maintain the external balance. To the left of this curve, the real exchange is lower than necessary, so the economy is producing more exports and we see an external surplus. To the right of the curve, the real exchange rate is too high, meaning that not enough exports are being produced to offset the increase in imports, so we see a deficit in the external balance.

Spain, then and now

This time last year, Spain was suffering from both high unemployment and an external deficit. The real exchange rate facing Spain was too high and needed to come down to encourage a balanced economy. The issue for Spain is that in a monetary union, they cannot have a nominal depreciation of their currency. This means that a real exchange rate depreciation must come from the price side of this equation, otherwise known as ‘internal devaluation.’ This placed Spain in the top quadrant, revealing both an imbalance externally and internally.

What has changed? Over the last year, Spain has seen a moderate improvement in it’s competitiveness as it has seen downward pressure on its prices. This has helped the real exchange rate come down relative to last year and exports have been improving relative to imports, leading to a smaller trade gap. The current account is now much more balanced than 12 months ago as well.

These changes on the external account have improved Spain’s position on the Swan diagram, but the picture for the internal balance has not seen the same improvement. In terms of unemployment, it has actually become worse than last year. Unemployment is now in the mid-20s, which is quite an extraordinary figure, while the rate of youth unemployment is much, much higher. Consequently, Spain is still very much on the unemployment side of the Swan diagram, as can be seen in the diagram below.

swan & spain 2

This depiction of the Spanish economy shows that while they have taken one step forward, they have also taken a big step back. The Euro crisis is in a less acute phase at present, but with social unrest increasing across the world, the question has to be asked as to how long this internal imbalance can be maintained? If this level of unemployment persists in the coming years, it will take a monumental effort from Spanish leaders to maintain political stability in this weakened economic context.

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