Economics is a dismal science. Oftentimes, a situation that looks at first glance to be an economic blessing ends up being a curse. The so-called Dutch disease is one example of this. In the early 1960s, the discovery of oil in the North Sea was hailed as a stroke of good luck for the Netherlands. The euphoria ebbed, however, when oil exports began pushing up the exchange rate of the guilder as well as overall Dutch labor costs, thereby bankrupting many of the country's exporters and manufacturers. Another example of this sad phenomenon is when a country suddenly gets access to easy money. Such was the case of Spain during its Golden Age (roughly between 1550 and 1700).
When conquistadores Hernán Cortés and Francisco Pizzaro set out to conquer the Aztecs and the Incas, they were driven by their belief they would find tremendous riches in the New World. El Dorado and the Cities of Gold might have remained a legend, but unheard of wealth was nevertheless unearthed in the silver mines of Zacatecas in central Mexico and Potosi in Bolivia. It is estimated that out of the latter alone 45,000 tons of silver were sent to Spain between 1550 and the late eighteenth century. At today's prices, this would equal roughly USD 30 billion, while Spain's average gross domestic product (GDP) during this period is estimated to have been less than USD 7 billion.
This substantial influx of precious metals should have tremendously enriched the Spanish Crown and its subjects. But while it allowed Spain to become the major European power in the sixteenth and the early seventeenth centuries, other nations managed to profit much more from it. According to the estimates of late economist Angus Maddison, Spain's per-capita GDP increased by roughly 30% between 1500 and 1700. Spain's main rivals during those two centuries, Britain and the Netherlands, grew their per-capita GDP by 75% and an astonishing 180%, respectively.
In fact, coaxed on by the easy money pouring in from its American colonies, Spain began living far beyond its means. Constantly at war with the English, the French and the Ottomans, facing independence struggles from the Dutch and the Portuguese, trying to defend the Catholic faith against the Reformation, and building landmarks like the Escorial in Madrid, Spain's Golden Age became an era of imperial overreach.
Despite all its New World wealth, the Kings of Spain defaulted six times in less than a century: 1557, 1575, 1596, 1607, 1627 and 1647. Moreover, many contemporary observers complained about how much Spain was importing from other countries. This fact makes it very likely that Spain was actually facing a twin deficit during its Golden Age. Not only the government but also the whole country was living above its means. Finally, the influx of precious metals from the Americas led to a surge in prices in Spain and ultimately Europe as a whole, by a factor of six over 150 years. When this influx finally ran out, the Golden Age of Spain was over. Britain, France and the Netherlands became the ascending European powers.
While not as dramatic as past history, events in Spain since it joined the euro show a modern day reflection of the infirmities of its Golden Age. It is true that this time the Spanish government remained quite frugal until the financial crisis let its deficit explode. But the whole country has been on a spending spree boosted not by an influx of precious metal but by fiduciary money printed by the European Central Bank. In the decade before joining the European Monetary Union, Spanish real interest rates averaged 5.5%. In the ten years with the euro, those same real interest rates dropped to an average of 1.5%.
While inflation was contained, this easy money and the low costs of taking on debt led to a housing price bubble and then a bust of even larger proportions than the ones hitting the US and the UK. Unit labor costs were increasing much faster in Spain than in many competitors in the North and especially in Germany. In synch, the Spanish current account deficit, which averaged roughly 1.5% of GDP in the 1990s, ballooned to an average of 6% in the 2000s.
This Spanish curse shows that a sound fiscal policy is only one prerequisite for a currency union to work. The other, much more difficult, prerequisite is that due to the sudden boost in money supply and the sinking costs of credit, a member country does not start to live massively above its means. This makes optimal currency unions so difficult to achieve and currently does not bode well for the future of the euro.
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