Spain and the Euro: Two Decades of Economic Transformation and Challenges

Twenty years ago marked a significant milestone for Spain as it joined eleven other EU nations in adopting the euro, a shared currency that symbolized European unity and economic integration. For Spain, becoming a founding member of the Eurozone was more than just an economic decision; it was a powerful statement of national pride, occurring just thirteen years after the country’s entry into the European Economic Community (EEC) and signifying the end of a long period of isolation from mainstream Europe. But after two decades, it’s crucial to assess: has embracing the Spain Euro been a worthwhile endeavor for the Spanish economy?

Eurozone membership fundamentally altered Spain’s economic policy toolkit. The nation relinquished its ability to independently manage interest rates and devalue its currency – key macroeconomic levers. Interest rate decisions shifted to the European Central Bank, and currency devaluation became impossible within the Eurozone framework. This loss of independence became particularly salient when the Spanish economy plunged into a deep recession starting in 2008, triggered by the global North Atlantic financial crisis and the subsequent Eurozone debt crisis. Unable to utilize monetary policy and exchange rates to regain competitiveness and mitigate the crisis’s impact, Spain was forced to rely on ‘internal devaluation’. This painful process involved cutting production costs, primarily through wage reductions, to decrease unit labor costs and enhance the economy’s international competitiveness. This strategy aimed for a recovery, but its sustainability was uncertain and the process was undoubtedly arduous for the Spanish populace.

The groundwork for Spain’s euro adoption was laid by the conservative Popular Party under José María Aznar, a period that demanded significant economic adjustments. Upon assuming office in 1996, Spain failed to meet any of the convergence criteria stipulated in the 1992 Maastricht Treaty for joining the Economic and Monetary Union (EMU) in 1999. Inflation, interest rates, the budget deficit, and public debt all exceeded the required thresholds. Skepticism was rife, with many policymakers and commentators doubting Spain’s ability to qualify for euro membership.

“The truth is that Spain’s decade-long boom was a false bonanza, as it was mainly propelled by the debt-fuelled property sector”

However, the Spanish political establishment was determined to prove the doubters wrong. Austerity measures were implemented with resolve. Civil servants accepted wage freezes, public spending was curtailed, and privatization efforts were accelerated beyond the scope of previous Socialist administrations. Alongside these fiscal adjustments, various structural reforms were enacted. By the spring of 1998, Spain had demonstrably met the Maastricht criteria. The budget deficit was reduced to below the 3% of GDP limit (a significant improvement from 6.5% in 1995), public debt was on a downward trajectory relative to GDP, and inflation was brought down to 2% from 4.5% in 1995. These achievements led to a decrease in interest rates. Furthermore, Spain’s position as a major net recipient of EEC funds facilitated this economic transformation.

Meeting the euro convergence criteria and establishing macroeconomic stability paved the way for a virtuous cycle of robust economic growth, low inflation, and job creation. Spain’s per capita income rose from 80% of the average of the 15 EU countries in 1996 to 87% in 2004. Impressively, 1.8 million new jobs were created during this period, driving unemployment down from 23% to 11.5%. The Spanish economy’s strong performance led José Luis Rodríguez Zapatero, the Socialist Prime Minister from 2004 to 2011, to famously declare in September 2007 that Spain had “joined the Champions League” of economies.

However, this apparent economic triumph masked underlying vulnerabilities. “The truth is that Spain’s decade-long boom was a false bonanza, as it was mainly propelled by the debt-fuelled property sector” Construction’s contribution to GDP surged from 7.5% in 2000 to 10.8% in 2006, inflating a massive property bubble that inevitably burst in 2008. But was the euro to blame for this crisis? While the sharp decline in interest rates after Spain adopted the euro – average short- and long-term rates plummeted from 13.3% and 11.7% in 1992 to 3.0% and 2.2% in 1999, and further to 2.2% and 3.4% in 2005 – fueled borrowing and spending, the euro itself cannot be held responsible for the imprudent lending practices of Spanish banks, particularly the politically influenced cajas de ahorros (savings banks). While the Bank of Spain could have been more proactive in curbing excessive borrowing, it did introduce macroprudential measures to mitigate risks. Crucially, when several banks, including Bankia, the fourth-largest lender, teetered on the brink of collapse in 2012, Spain’s euro membership proved to be a lifeline. It allowed Spain to access the Eurozone’s bailout fund, the European Stability Mechanism (ESM), without which the entire Spanish financial system could have imploded.

Similarly, the proliferation of underutilized infrastructure projects, often dubbed “white-elephant projects,” across Spain cannot be attributed to the euro. A report by the Association of Spanish Geographers revealed that Spain squandered over €81 billion on “unnecessary, abandoned, under used or poorly planned infrastructure” between 1995 and 2016. Likewise, Spain’s persistently high unemployment rates, which predate the euro (reaching 24% in 1994, five years before euro adoption), are not a consequence of the single currency. Although unemployment remains a significant challenge, currently standing at 15% (down from a peak of 27% in 2013), it’s a structural issue largely independent of euro membership.

“Spain suffered far more than Italy during the euro crisis, but it has also reformed more and, as a result, enjoyed a much stronger recovery”

The significant reduction in interest rates and Spain’s risk premium – the yield spread with German bonds narrowed dramatically from 500bps in 1993 to below 50bps – resulting from euro adoption, provided Spanish companies with access to cheaper capital for international expansion. The emergence of numerous Spanish multinational corporations is one of the most notable economic achievements of the last two decades. Outward foreign direct investment surged from US$129 billion in 2000 to US$597 billion in 2017. Furthermore, a stable currency, in contrast to the historically volatile peseta with its frequent devaluations, has fostered inward foreign direct investment, increasing from US$156 billion in 2000 to US$644 billion in 2017, and supported relatively high living standards in Spain.

The strength of the euro did not impede the competitiveness of Spanish exports of goods and services, which grew from 26.4% of GDP in 1999 to approximately 34% in 2018, demonstrating Spain’s adaptability within the Eurozone’s economic framework.

While “Spain suffered far more than Italy during the euro crisis, but it has also reformed more and, as a result, enjoyed a much stronger recovery.” The constraints imposed by the euro, the so-called ‘straitjacket’, compelled Spain to undertake crucial reforms, ultimately benefiting its long-term economic health, while Italy resisted similar adjustments. Consequently, Spain’s economic output has surpassed its pre-crisis peak since mid-2017, whereas Italy’s GDP remains approximately 5% below its pre-crisis level. Despite dire predictions of a potential Spanish exit from the euro following the economic crash, unlike the populist movements in Italy that have flirted with euro exit, all major Spanish political parties remain committed to the single currency.

Public opinion in Spain largely reflects this consensus. Close to two-thirds (62%) of Spaniards believe the euro has been beneficial for Spain, according to the latest Eurobarometer, although this is slightly down from the previous year. Significantly, over 20% of the Spanish population has grown up entirely with the euro, having never known the peseta.

Figure 1. Having the euro is a good or a bad thing for your country? (%) (1)

(1) 2017 figures in brackets.

Source: Eurobarometer, December 2018.

While support for the euro across the Eurozone is strong, reaching a high of three-quarters of the population, even proponents acknowledge the single currency’s inherent design flaws. These include the incomplete banking union (partially addressed but not fully implemented) and the absence of a robust mechanism for counter-cyclical fiscal policy. Ideally, Eurozone economies need fiscal discipline during expansions and flexibility to borrow during recessions. Another shortcoming is the lack of effective mechanisms to ensure member states implement necessary structural reforms, which often only occur under duress during crises. Improved governance structures are also needed to better manage future crises within the Eurozone.

Ultimately, definitively stating whether Spain would have been economically better off outside the euro is impossible. However, data reveals that Spain’s real GDP growth has outperformed Germany, France, and Italy since 1999. Were Spain to contemplate leaving the single currency and reverting to the peseta today, the economic consequences would be severe, including soaring interest rates and a drastic currency devaluation. For Spain, the spain euro journey, while not without its challenges, has largely been a positive force for economic transformation and integration within Europe.