Spanish macroeconomic policy appears to have been highly responsive to developments in the external account during 1974-7 and 1980-2. Following these periods, the Democratic Centre government devalued the peseta by 15% and tightened monetary policy in July 1977, and the Socialist government embarked on a 10% devaluation accompanied by a further tightening of monetary policy and a set of structural supply-side reforms to improve production potential in 1982. Since this policy shift and entry into the European Community in 1986, Spain has experienced strong output growth and gradual disinflation, accompanied by a serious deterioration of the current account. Spain has now become a net creditor and the peseta is appreciating in both nominal and real terms. Much debate currently surrounds the possible need for corrective policy measures to sustain Spain's current external position.

In Discussion Paper No. 505, Research Fellows Juan Dolado and José Viñals focus on the `long-run' external constraint: that the present values of spending on domestic and foreign goods plus net external debt equal domestic income. They distinguish movements of net external liabilities associated with total investment, which need not be repaid in the event of a financial crisis, and net debt assets or liabilities, which must always be repaid. They argue that the authorities should target the economy's `fundamental' account balance to stabilize debt as a proportion of GDP, and they test for solvency on this basis. They find the Spanish economy is now perfectly solvent and even shows signs of dynamic inefficiency, which they attribute to the authorities' application of policy rules designed previously to avoid debt explosions. Since the Spanish economy is presently overheated, the continued application of these rules might lead to a severe loss of competitiveness over time and to falling rates of return on foreign direct and portfolio investment.

Dolado and Viñals use a simple model of fundamental exchange rates to show that the peseta was severely and persistently overvalued in real terms during 1974-7 and 1980-2 and that most of its recent real appreciation is an equilibrium phenomenon, which is driven by large inflows of foreign direct investment in industry. Nevertheless, there are signs of real over-appreciation during the last two years, which calls for policy measures to adjust the economic fundamentals to eliminate `real output gaps' permanently. The authors propose that this be achieved through policies to promote saving rather than to restrain investment, which may be supplemented by selective supply-side policies.

Macroeconomic Policy, External Targets and Constraints: The Case of Spain
Juan Dolado and José Viñals

Discussion Paper No. 505, January 1991 (IM)