Sunday, January 10, 2010

What Spanish pigs can teach us about economics

The contribution of the humble porker to economic theory has been pretty negligible up until now but, after reading about the crisis in the Iberian ham industry, I was struck by how perfectly the story illustrated a crucial but little-appreciated piece of economic theory that goes a long way to explaining the crisis.

First the problem piggies. Iberian pigs are renowned for the quality of their meat and dry-cured hams from acorn-fed free range herds are a prized delicacy in Spain and among gourmets around the world. But as the FT reported recently ("Austerity takes a slice out of Spanish ham sales") demand has plummeted in the recession and taken prices of some grades of ham 50% lower. Priced at up to 60€ a kilo, jamon serrano is a luxury that some people, particularly companies who used to buy whole legs for corporate hampers, have dropped in these straitened times.

At this point you might be thinking, "but what insight does that give us into economics?" The recession has crashed demand for all sorts of products (my last post was about the travails of the Spanish car industry and Spain's scrappage scheme); surely falling demand can be blamed on the recession but doesn't explain the crisis itself. Time to introduce the theory and then see if we can tie it back to the pigs.

Some economists point to the "intertemporal misallocation" explanation of the business cycle as a good way to understand and view the crash. Many have argued that interest rates around the world were held too low, for too long in the years before the crash, causing a boom and then the inevitable bust complete with debt hangover. But the intertemporal explanation takes this view a step further and explains the real danger in holding down interest rates.

Generally we see interest rate cuts as a "good thing" as they "stimulate" the economy. Low interest rates encourage more consumption and make it cheaper to borrow to invest to meet the increased demand, thus setting a up a virtuous cycle of economic activity. But there is a flaw in this logic and it relates to the job interest rates do allocating an economy's resources over time: they make sure that current consumption does not crowd out investment for the future and that, when the future increase in production arrives, there are consumers willing and able to buy it because they have savings. If rates are too low then the signals get distorted: people save too little while companies borrow and invest too much. The economy hots up for a while but the contradiction soon reveals itself. Companies have new production/supply coming on stream just at the point where their customers are borrowing and consuming less to enable debts to be repaid. Back to the pigs.

The collapse in demand for hams was only part of the story. The industry association was quoted as saying: "With overheating fuelled by easy credit, and permissive regulations protecting all types of pork meat, a lot of businessmen, including many property developers, went into the ham business and started mass production." The supply of top quality ham rose 33% in the ten years to 2009 and the lower grade production increased by over 400%. But does Spain really need so much ham? Did the country save enough to be able to afford the increased production? Obviously the answer is no on both scores: Spain was the victim of low interest rates which sent out the wrong signals to producers and consumers alike. The same story was repeated across all sectors most tellingly in the case of property. So next time you see a boarded up shop, empty car showroom or unfinished apartment block think back to a herd of pigs munching acorns and what they can teach us - low interest rates can hurt just as much as high interest rates.

Please contact me if you need a Spanish accountant or tax adviser for your New Year "to do list". My personal email is jb@advoco.es or see the website www.advoco.es Happy New Year


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