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Tuesday, September 16, 2014

What Is The Risk The Euro Crisis Will Reignite?

The euro zone crisis is not back -- at least not yet.

Recent movements in global markets following concerns about Portugal’s Banco Espirito Santo really had as much to do with market nerves after a long spell of repressed volatility as it did with the state of the bank’s balance sheet. Despite the current calm, everyone knows that volatility will return one day, and no one wants to be caught on the back foot when it does arrive. So the initial response is to hit the “sell” button and then ask questions.

Beyond this context, there is a lack of certainty in the market about which way bond yields for the so-called “peripheral” euro zone countries are heading in the near term -- and what exactly the risks associated with holding them really are. Riding the yield compression, in the case of the Portuguese 10-year bond from over 7 percent to under 3.5 percent was a one-way-bet no-brainer once the impact of Draghi’s July 2012 speech became crystal clear.

But now yields have started to tick up again, so the advantages of holding in anticipation of further declines become less obvious, while the risks continue to mount. In many ways, the situation is analogous to yen depreciation and the Bank of Japan. The first leg was easy, as the yen fell into the 100 to 105 to USD range. But now it is stuck there, and the debate has become a “will she, won’t she” on further BoJ easing.

It is clear the recent European Central Bank decision to launch Targeted Long-Term Refinancing Operations has disappointed. TLTRO's may do something to help ease access to credit in the south in the mid-term, but they will hardly be effective in combating deflation. In particular, we may need to wait more than six months to see any net liquidity impact, since the September and December allocations coincide with earlier LTRO repayments, leaving what Pantheon Macroeconimcs’ Claus Vistesen calls “a potentially worrying ‘air-pocket’ over the next six months where the central bank’s balance sheet continues to contract, making the verbal commitment to easing increasingly difficult to rely on as a sole back-stop."

Will we really have to wait till 2015 to see any significant step to try to stop the deflation rot?

Digging deeper, and beyond fears about what the coming ECB bank stress tests may turn up, the simple passage of time in itself could complicate things. The recent round of  numbers has had everyone busily revising down their 2014 growth forecasts, and it is obvious that even if outright deflation is avoided inflation will be very, very low. In fact whether or not the Euro Area slumps back into outright recession or not seems to depend more on Vladimir Putin than on the ECB at the moment,

But the key point to take away from all this is that nominal GDP over the next couple of years may barely increase, with the knock on consequence that sovereign debt levels in the most indebted countries will surely be jolted onwards and upwards. This is important since all official sector projections have these levels peaking either this year or next, but now these estimates will surely need to be revisited.

Second quarter GDP data was horribly bad. France's economy stagnated, but more worryingly for policymakers Germany relapsed (minus 0.2 q-o-q), leaving Spain as the only one of the "big four" to put in a positive growth performance (0.6 q-o-q). While the immediate drag on short-term growth may well be the impact on sentiment of a crisis on the frontier between Ukraine and Russia,  the Euro Area  is now clearly stuck in some form of longer term secular stagnation. The daylight just around the next recovery corner argument rings hollower and hollower with each successive loss of momentum.

"Europe is becoming Japanese" is an expression you hear more and more. People saying this normally point to the fact that German 10 year bund yields have now gone under 1% (and hence have started to look like 10 year JGBs).

But behind this argument lies some sort of version of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue. The ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE.  So to talk about the Japanification of Euroa Area yields is a little misleading. Bond purchasers and their models are PROVOKING this downward lurch, not weak growth or deflation. To push Mario Draghi into QE markets would need to move back into risk-off mode on periphery assets. As long as the bond markets remain well behaved Draghi will do as little as possible, as I will discuss below.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics.

"If you’re worried that secular stagnation might be depressing the natural real rate of interest — the rate consistent with full employment — and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."
The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation (see my secular stagnation summary here). This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" (authors Derek Anderson, Dennis Botman and Ben Hunt). The first part of the abstract runs as follows:
"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."
Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it will be.

So Which Way For The ECB?

Evidently members of the EU Commission, ECB governing council members, and senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. The secular stagnation hypothesis is at this point more akin to a theoretical research strategy than a workable template for policy-making, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. As the editors of a recent book on the topic put it in their introduction: "Secular stagnation proved illusory after the Great Depression. It may well prove to be so after the Great Recession – it is still too early to tell. Uncertainty, however, is no excuse for inactivity. Most actions are no-regret policies anyway". As they suggest the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (see here) and if it doesn't what happens to all the accumulated debt?

On the other hand time always has a cost. Letting things drift further means letting debt levels rise, and risking testing market patience and this becomes especially important in the cases of Italy and Portugal. The longer time passes the more difficult it is going to be for anyone to convince themselves that the debt of these countries is sustainable.

So there may come a point after which the Germans simply will not allow Draghi to buy Italian bonds without a prior haircut (see my "Italian Runaway Train" here). OK, they've said they won't do more PSI, but they've said a lot of things, and the cost of irritating investors is limited when you have a regional current account surplus and a central bank buying bonds.

Maybe the costs of the Euro "widowmaker" trade will be borne by all those eager bond purchasers who thought nothing could possibly go wrong. I am sure German politicians would decide a loss of credibility on PSI would be less costly to them than getting German taxpayers on the hook for current Italian debt levels. Especially in a country where they are now proudly announcing they have reduced government debt for the first time in more than 50 years. So in this case, maybe the turkeys just did vote for Xmas.

The thing is, despite the meeting between Draghi and Renzi (who may also be a turkey by Xmas) nothing substantial is going to happen in Italy. The government is under no pressure to ask for help (and doesn't even feel it needs it), and Draghi won't act before things change. Gridlock - with rising debt.

Naturally in the short term the “Mario Draghi ultimately has my back” feeling will still prevail, but with markets continuing to finance debt levels that any official study will soon have to recognize as unsustainable lack of proactive policies from the ECB will only fuel concerns that the size of the pill may become just too big for the bank to persuade Germany comfortably swallow, leaving the specter of private sector involvement to once more rear its ugly head. How do you tell people who have just sacrificed hard to get their debt under control that they are now about to help "pardon" 50% of someone else's. It simply doesn't make sense.


These arguments are developed at greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Thursday, September 11, 2014

The Catalan Vote: Why It's Time To Start Getting Worried About Complacency In Madrid

When Barack Obama told a CNBC interviewer last autumn that Wall Street ought to be "genuinely worried about what is going on in Washington" in reference to the US government shutdown he raised more than a few eyebrows. Normally political leaders try to calm and reassure markets, so this attempt to stir them up on the part of the US President was, in its way, something of a first.

Last May the Financial Times issued a similar warning in an editorial with a clear message: right now you should be more worried than you are about what is happening in Madrid. According to the newspaper, “secessionist demands have created a rolling crisis involving Catalonia and the national government in Madrid,” a crisis which it warns could end in a “head on collision” if the issues being raised are not addressed.

The issues have not been addressed, and  there is now  a  provisional date for that woeful collision to occur: the 9 November this year, the date chosen by the Catalan parliament for the holding a popular (non binding, not a referendum) consultation under a new law which will receive parliamentary approval on 19 September. The original intention of the Catalan parliament was to hold a referendum on the region’s future authorized by Madrid. With that intent parliamentary representatives took a proposal last spring to the Spanish parliament. The reply was a polite but near unanimous “no” since Spain’s parliamentarians took the view any such vote could be considered “unconstitutional”.

As Mariano Rajoy pointed out, given the way the Spanish Constitution is currently worded neither he, nor even the Spanish parliament, have the power to authorize such a vote. The Spanish prime minister’s view was also endorsed recently by the country’s constitutional court, who ruled that the proposed referendum would be unconstitutional under the terms of the constitution as it stands. The court however added an important rider to the judgment, a rider to do with the political problem of legitimacy. If in a discrete part of the national territory, the court suggested, a significant majority of the population are not satisfied with the current arrangements, and these arrangements are not changed,  then a constitutional crisis ensues.

Thus the issue moves from being a purely juridical one to a political one, and any eventual solution - even if this means accepting Catalan independence - needs in essence to be political. Effectively the court threw the ball back into the politicians’ court: if the constitution doesn’t permit a vote it can be changed, if there is the political will to do so. Amending the constitution didn’t seem to be such an insurmountable obstacle at the height of the sovereign debt crisis, when agreement was reach between the various parties in a matter of days to place constitutional limits on the level of government debt, a fact which does not escape the attention of those Catalans who feel themselves in urgent need of the right to a vote.

This is also what the FT had in mind when the editorial argued “it is disingenuous” for Mariano Rajoy “to hide behind the Spanish constitution”. Sooner or later democracy will out. This is why the newspaper argues the Spanish government needs to urgently formulate some sort of counter proposal, along the lines of the so called “third way”: an approach going beyond the current arrangements but falling short of full independence. The core of such a proposal, the paper argues, would be an improved fiscal arrangement, and more autonomy.

In the opinion of the present author these proposals look fine on paper, but arriving at any sort of agreement on them seems highly unlikely. In the first place, Spain’s ongoing economic issues make the financing of any new fiscal agreement extremely problematic. The economy may be showing signs of recovery, but it is a weak and fragile one, and the aftermath of the country’s property bust will cast a shadow of at least a decade over the country’s economic future. In addition there is no easy “win-win” solution available, since letting the Catalans keep more of their own money will undoubtedly mean someone else will receive less. Who will that someone else be? A glance at the political arithmetic shows that the major Spanish party closest to considering the third way is the socialist PSOE. But PSOE relies on votes from the country’s most populous region – Andalusia – and this would surely be one of the areas most negatively affected any substantial fiscal change.

More autonomy sounds nice, but what exactly would it look like? Would it allow the region, for example, to opt out of laws which are highly unpopular in Catalonia like the recent abortion one or the proposal to make bullfighting form part of the national heritage? And what about the identitarian issues which are really what lie at the heart of the current tension? From the Spanish point of view, the most contentious of the Catalan demands is their claim to have their identity as a nation included in any rewritten constitution. Any addressing of this long standing grievance would seem to open the door to solving another, that of having national sports teams to compete in international competitions. Are Spaniards – not simply Madrid politicians – ready for this?

Then there is the language. Far from the impression being given that Spaniards are getting more and more comfortable with linguistic coexistence the situation seems to be quite the opposite, with moves to restrict the use of the language in schools having taken place in the regions of Valencia, the Balearic Islands, and Aragon, in each of which there are significant Catalan speaking communities. Even in Catalonia proper the central government is currently trying to implement an education reform which restricts the autonomy of the Catalan education minister to decide matters of language policy. It is hard to see in any of this a reflection of a will to improve relations.

It seems to me that such feelings of national identity affect both Spaniards and Catalans. They are strong and deep seated, on both sides, and far more important than the economic ones. The difficulty is they cannot be changed either in committee or overnight. I repeat, is there any real sign of a desire among the Spanish population to make the sort of attitude changes which a successful implementation of a third way would imply? President Mas visited Prime Minister Rajoy in the Moncloa in July to discuss the situation. He presented a list of 23 issues about which they could talk. To date the Spanish Prime Minister has not replied. He seems content simply to chant the mantra "there will be no vote". But as the Constitutional Court pointed out you cannot generate political legitimacy by only explaining what won't happen.

Naturally this "no" to the possibility of voting has come to the forefront in recent days with the publication of an opinion poll showing that the "yes" vote might win in Scotland.

As for the Catalans, we have yet to discover what it is they really want. This is what the demand for a vote is all about, so that the wishes of Catalans can be registered in a fashion which goes beyond the innumerable opinion polls. Determining what people actually want is a basic prerequisite so that the democratic process can then go to work. In the meantime they will simply look on in envy on the 18 September as Scots exercise their basic right.

What then happens next? The Catalan parliament will on 19 September pass into law a formula which will allow opinion seeking, non-binding consultations to be held under Catalan rather than Spanish law.  It is not clear at this point whether the Madrid government will challenge this law. Possibly they won't, since it is probably not unconstitutional. Then the Catalan parliament will pass as second decree law convening a consultation with an already announced question for the 9 November.  Madrid have already made clear that they will not permit this question to be asked and will take the matter to the Constitutional Court.

Which brings us to 9 November itself: if it is not possible to have a vote then Catalonia’s President Mas has suggested he might call plebiscitary elections. The purpose of these elections would not be – as some suggest – to authorize the parliament to declare UDI, but to establish the size of the majority in favor of a vote. The newly constituted parliament will then have the responsibility for deciding what to do next.It would be a mistake to think that these elections - if held - would be the end of the matter. They will take the collision onto a new level and generate a very high degree of uncertainty about where things are going from that point on.

So although the world will not change on November 10, and even if there are elections instead of a vote on independence the outcome could well produce a definitive sea change about how Catalans view their relations with Spain. They may well mark a “point of no return”. So to go back to where we started. Right now global markets and most of the international press are being pretty sanguine about the situation, when – as President Obama suggested in the case of the US government crisis – perhaps they shouldn’t be. Perhaps they should be worried about the complacency in Madrid, and remember that one of the principal ways of letting something unexpected happen is to assume it won’t.

Tuesday, July 15, 2014

Spain and the IMF: Round the Bend or Out of the Woods?

"Spain has turned the corner". With this stark statement the IMF opened it's annual Article IV consultation report for 2014. Naturally the statement rankled, with this author among others, because at first sight it seems to be saying something which on closer reading of the report you find it isn't. At best it's misleading, possibly from a PR point of view intentionally so, but then Article IV reports are supposed to be more sober, measured assessments. One Spanish journalist summed up the surprise many felt in the following tweet.
Dear IMF, You can't say "Spain has turned the corner" and "the unemployment remains unacceptably high" in the same paper It's silly Yours, C
 What I suppose the authors of the report were trying to convey was the feeling that an important turning point had been passed along the long winding road out of the mess that was generated in Spain in the first seven years of the Euro's existence. Personally I can't help feeling the expression would have been none the less prosaic and much more complete had they added the line from a well know Jimmy Cliff song - yet there are still "many rivers left to cross". Equally, "not through the rapids yet" comes to mind.

The danger of putting things in the way the IMF Spain team just did is that you open yourself up to the accusation of being complacent, even self-congratulatory, and almost lacking in the necessary even handedness since it could be seen as lending a helping hand to a struggling government which is about to ramp up its 2015 election campaign. Indeed more than one journalist took it this way.

There's a danger here, one of institutional credibility, should the economy once more succumb and fall back into a triple dip. Indeed the downside risks detailed in the report  offer plenty of arguments as to why just that might well happen. In any event this wouldn't be - as Landon Thomas pointed out in this article - the first time the Fund has gotten things badly wrong on Spain.

 Fair And Balanced?

The thing is, once you get past that troublesome first phrase, much of the report - leaving aside one or two topics I will draw attention to - seems remarkably unobjectionable. The opening paragraph continues, "Growth has resumed, labor market trends are improving, the current account is in surplus, banks are healthier, and sovereign yields are at record lows", most of which is unquestionably true.

And then those positive evaluations are suitably and appropriately counterbalanced by a string negatives, "But unemployment is unacceptably high, incomes have fallen, trend productivity growth is low, and the deleveraging of high debt burdens—public and private—is weighing on growth".

So actually the fund isn't at all saying that all is well in Spain, and that the level 5 alert is now all but over - far from it. Perhaps an opening phrase more in tenor with the general drift would have been "Spain's recovery continues to gain traction".

Export Lead Recovery?

As I say, most of the positive assessment offered is valid. Most, but not all. There is one exception: the state of the current account. It is no longer positive.

Surely it is true to say, as the authors do, that "Spain has managed a remarkable improvement in its current account". During the last 5 years the balance improved by 11 percent of GDP, moving from a deficit of 10 percent in 2007 to a 1 percent surplus in 2013. But that was then, and this is now, and as the recovery has progressed part of the improvement has been lost. During the 8 months between May and December 2013 the account was in positive territory. 8 months in something like the last 150. For each of the five months of 2014 however - just as the economy has been accelerating - it has been consistently negative. Indeed the fact this might happen was expressed as a constant concern in earlier editions of the report (namely, that as things improved the CA balance would once more turn negative). Now it has, which is perhaps one of the reasons why they were ill-advised to use that "corner turning" phrase.

As the Fund points out, only one other advanced large non-commodity exporting country has managed to achieve a current account improvement of a similar order, and that was South Korea in 1997–98 (so comparisons and precedents here are few and far between), and the key factor in the Korean case was the ability to devalue the Won. As the Fund says:
"Spain’s current account improvement is particularly notable given that it was achieved without nominal depreciation. South Korea’s adjustment was facilitated by a large nominal exchange rate depreciation, an option that was not available to Spain. While Spain’s real effective exchange rate (REER) did depreciate significantly based on unit labor costs, it largely reflected labor shedding. The CPI-based REER has not depreciated much."
What the authors are getting at here is that Spain's nominal internal devaluation was very small, and indeed the overwhelming majority of Spanish experts have consistently argued that more wasn't needed since the economy hadn't lost as much competitiveness as "outsiders" claimed. On the other hand there was a large improvement in Unit Labour Costs produced by the comparatively small fall in GDP output (roughly 7%) and the very large drop in the number of those working (about 20%), but this way of doing things always left the concern that as the economy started creating jobs again the average Unit Labour Cost would start to rise again, as we have seen happen in Ireland (see chart below).

 In fact there is even some indication that this may already be happening. In the 12 months to March the economy grew by 0.6% while the number of those paying national insurance contributions (a reasonable proxy for employment) rose by 115,000 (or 0.7%). As a result the rate of productivity improvement has declined sharply.

The danger thus is that many of the hard won gains of the crisis years are unwound during recovery. The current account deficit  fell sharply on the back of the drop sharp drop in employment which accompanied the crisis as consumption collapsed (retail sales are still down 30% from 2007 peak) and imports followed suit. Little by little this process is now reversing, imports are once more rising as domestic consumption starts to recover and the goods trade surplus is once more deteriorating.

So the correction is far from complete at this point and the risk the corner has been not been completely turned is not negligible. Which bring me to another minor quibble with this section of the report. "Exports are performing well," the authors tell us. Well perhaps the best thing that can be said about this statement is that it is a little bit out of date. In the three months to May Spain's goods exports were up by 2.75% over the same period a year earlier. In comparison in 2013 they were up by 6.5%. Spain's export machine has been losing momentum, and - as I argue in this post -exports are now roughly stuck at the level  they were at in June last year. Naturally there are reasons for this, emerging markets who were strong Spanish customers last year have had their own crisis, and now tensions in Eastern Europe surrounding Ukraine may be leading the Euro Area itself to loose momentum. But this is just it, a fragile and tenuous recovery is easily knocked off balance.

The current position can perhaps be best summed up by the situation described in the chart below. Between 2010 and 2013 the economy was re-balancing nicely with external demand doing the heavy lifting while the current account moved towards balance, but over the last twelve months things have changed and external demand is now, once more, a negative drag on the economy as imports rise. This is obviously a worrying development, and naturally a cause for concern.

Indeed the authors of the IMF report more or less implicitly accept that the external correction is far from complete when they say:
"Model-based and historical REER analysis suggests the real effective exchange rate is some 5– 15 percent above the level consistent with medium-term fundamentals and desirable policies. However, achieving significantly lower unemployment rates closer to international peers in the medium term may require an even larger adjustment in the exchange rate".
What Does Unacceptably Mean?

 I think we are all in agreement on one thing: Spain's unemployment remains unacceptably high. But what does "unacceptable" mean? Well normally it means you don't continue to accept it and do something about it. And this is just the part I find missing from this year's IMF report.

If we go back twelve months, and take a look at last years report, then it's easy to notice a clear difference: the IMF offered a proposal for doing something. Essentially the proposal, which naturally was not at all popular in Spain, was to move towards a wage cut in return for job sharing (indeed I myself agreed with this proposal - see my "Doing Nothing Is Not An Option", and even wrote a chapter arguing for it in my Spanish book on Spain).

Another possibility, which I have personally advanced inside Spain, would be to temporarily change the retirement regulations to allow people to retire from 60 onwards on the condition that their employer replaces them with someone previously unemployed and under 30 (not obviously job for job) on a long term contract.

Now, you will say, doesn't this roll back the 2010 pension reform which tied retirement ages to life expectancy and saw a progressive increase in retirement age from 65 to 67? This reform was much applauded at the time, and was indeed a core part of the Zapatero government's attempt to regain market credibility. My response to this objection is, indeed it would, but lets think about the situation for a moment, and in particular about the meaning of Keynes's oft over-cited phrase, "in the long run we are all dead". What Keynes is getting at here is that we need to be "nimble of thought" enough to be able to distinguish between the different time horizons involved in economic policy. (And not simply shrug our shoulders because "in the long run it will all sort itself out). Simply because something is advantageous in the long run, doesn't mean that a policy to promote it is what is needed in the shorter term. There can be a trade-off of interests, and doing something which might be harmful in the longer run (running up government debt), could be not only a palliative in the short run but could lead to a superior long run outcome if it is done wisely. The dilemma we face in Spain was summed up in more theoretical terms by the founder of modern growth theory - Robert Solow - when he admitted in his Nobel acceptance speech, that "the problem of combining long-run and short-run macroeconomics has still not been solved".

In the long run, despite the fact that we will all die, we are all living longer, and having longer working lives makes sense. But in the short run, in a country with 5.9 million people unemployed (half of them for over a year) and over 50% of those between 16 and 24 who are looking for work unable to find it, asking people to work longer doesn't seem to make that much sense.

Letting people retire to be replaced by people with a younger mindset makes obvious economic and productivity sense, but what about the implications of such a decision for the pensions system? Wouldn't this be moving backwards? Well this is where the second (2013) pension reform comes in. That reform introduced the principle of "sustainability" into the Spanish pension system. Sustainability means - across the economic cycle - as much money needs to come in as goes out. I think this is a good reform, indeed a vital one, since it turns Spanish pensions from being a defined benefits system (which would be unable to live up to its promise) into an easy to understand defined contributions one. The pension system becomes an implicit contract between those working and those receiving benefits and takes the government (and most importantly its finances) out of the middle. There is a formula to decide how much can be paid in any given time period, so if more people suddenly start claiming pensions naturally pensions will go down proportionately, but there is no system to collapse, and there will be no knock on effect on government finances.

What both these proposals have in common is that they involve solidarity and they involve sacrifice, and neither of these seem to be very much in fashion at the moment. But people need to be aware of the longer run consequences of doing nothing. And this is just where expressions like "Spain has turned the corner" don't really help, since they don't put people in the right frame of mind. If unemployment is unacceptably high then it is an urgent matter to do something more about it, and not just sit there with our arms folded to see if the IMF forecast of unemployment moving under 20% in 2019 is fulfilled or whether it happens in 2018, or 2020. These kind of outcomes simply won't do, and as we will see below they will have long run consequences for Spain.

Long Run Growth Potential

I think virtually everybody agrees that the Spanish economy will grow this year at a rate lying somewhere between 1% and 2%. Naturally a lot of debate and energy has been invested in arguing about just which end of the range will be nearer the final mark. The end result, whatever it is, will be better than expected six months or so ago but at the same time it will hardly constitute an economic revolution. No game changer to see here, please move along.

The issue is really what we can expect from Spain in the years ahead, well beyond 2014 and 2015, and in approaching that tricky question there is no piece of current economic data that can help us decide. We need a different approach: growth analysis.

To put things into some sort of perspective on this account it is worth perhaps noting Spanish retail sales were up a mere 0.3% in the three months through May over the same period a year earlier, while industrial output was up around 2.5% over the same time horizon. The notable difference between these two numbers reflects the fact that at the end of the day the future of Spain's economy is now more linked to the sale of industrial products abroad than it is to the level of shop sales at home. But the second thought to take away is the sobering one that  both of these indicators are still down around 30% since 2007, and that at current rates the economy will need over a decade to get them back to earlier levels, if it ever does.

I say *if* it ever does, since a clear possibility exists we may not ever see Spanish retail sales activity in getting back to their earlier pre-crisis highs. The reasoning behind this idea is simple: after rising rapidly in the first decade of the century Spain's population is now falling and aging at quite a rapid rate, and if that rate isn't at least slowed then a decade from now (whatever the reform progress the country makes) it is hard to see the Spanish economy eking out a hell of a lot in the way of growth. Which means if we don't hit those pre-crisis levels soon, which we surely won't, we may never do so -  a more thorough explanation of the justification for this (for many perhaps surprising) assertion can be found in my Secular Stagnation Part 1 - Paul Krugman's Bicycling Problem).

What we need to think about then are not the country's short-term economic dynamics, but its growth potential in the longer term. On this issue the recent report does indeed have something to say (and what it says is backed-up by a deeper analysis in the 2014 edition of Spain Selected Issues). The authors of the Article IV report tell us the following:
"Longer-term potential growth prospects also appear weaker than in the boom years. Growth during 1995–2007 was sustained by large accumulation of capital (the credit-fuelled housing boom) and labor (immigration and rising participation rates) hiding a substantial decline in productivity growth. Demographic trends have now turned negative (emigration and the ageing population) and capital accumulation will likely be lower (given the large rise during the boom and falling population). Spain will also need to tackle the negative effects of very high structural unemployment. In this context, potential growth may only be around 1 percent over the medium term."

They back up the idea that Spain's longer term growth outlook (as opposed to short term recovery-from-the-slump growth) is moving steadily lower with the help of the nice chart I reproduce below.

Over time Spain's growth rate is falling, as it has been in most developed economies. In the Spanish case while the economy grew by an average of 3.5% a year between 1995 and 2007 there was an important structural shift taking place. The rate of per capita GDP growth slump dramatically after 2000 as the employed population surged and much of the growth became labour intensive, a point which is illustrated nicely by another IMF chart:

Before the mid 1990s a significant part of Spain's growth had come from productivity improvements. Even in the second half of the nineties this remained to some extent the case. But between 2000 and 2007 the red markers almost completely disappear from the chart and as can be readily seen from the chart growth was almost entirely explained by increases in the capital stock (the result of construction activity) and higher labour force growth. This is not the direction a country which wishes to raise its living standards by engaging in higher value added work wants to go.

Now, in the wake of the crisis, the country faces an enormous challenge since it has to start raising average productivity at the same time as it tries to put 3 million low skilled workers back to work. We have noted above that Spain has been creating employment on much lower than expected GDP growth, this is only partly good news, since the other side of the coin is that productivity improvements (see the red markers in 2012/13) are now slowing. This is what many feared might happen (current again deficit turn negative, productivity gains weaken) and is a warning signal that the current recovery may not be on such solid ground as some imagine.

But moving beyond the present, the reason we can expect this ongoing fall in trend growth rate to continue  has to do with the composition  of growth and how trend growth is estimated. Basically long term growth potential is a function of working age population dynamics and total factor productivity (TFP) growth, as shown in the diagram below which illustrates the version of the approach used by the EU commission.

Leaving immigration and emigration aside for a moment, Spain's population is now virtually stagnant, fertility is around 1.3 (tfr) and the annual balance will soon turn negative. The annual number of births had been rising before the crisis, but has now started falling again (see chart from statistics office below).

The annual balance between births and deaths also rose to a peak in the boom years only to subsequently fall back (see chart below). In fact the difference between births and deaths was a record low of 36,181 in 2013, and within a few years the balance will surely be negative. But again we need to remember, in economic growth terms it isn't the size of the population that matters, it is the age structure, and Spain's working age population will certainly shrink faster than the overall population will. So even on the best of scenarios Spain's workforce is now facing slow and steady decline and this will undoubtedly bring down the trend growth performance.

But Spain isn't facing the best of scenarios. Where once people were arriving, the dire state of the country's labour market means they are now leaving. And once we factor in immigration, things start to get a bit more dramatic. As the IMF notes (in the 2014 selected issues document):
"Demographics have turned negative. After expanding at a fast pace until 2007, population growth slowed significantly and turned negative in 2012. This is likely to be a new trend, as INE projects working-age population to continue to decline over the next years........Labor dynamics will make a much weaker contribution to potential output. Demographics will be a drag on growth due to declining working-age population (emigration and ageing). The Spanish statistical agency (INE) expects working-age population to fall by 1 percent a year over the medium term."
During the boom years over nearly 6 million immigrants came to live or work in Spain. The population - which as we have seen is nearly stationary in terms of births minus deaths - shot up from 40 to 46 million.

But now, as the IMF say, this dynamic has turned negative. Quite how many people of working age are leaving Spain every year is hard to say. This, in part, is because while the number of former immigrants leaving is known with a reasonable degree of accuracy, the number of young Spanish nationals who do so is much harder to pin down, in part because you need to go to receiving countries like the UK and Germany to obtain the data since most Spaniards who are working abroad have not registered with the national authorities.

According to the latest estimates (30 June 2014) the net number of emigrants leaving Spain in 2013 was 256,849.  Of these the net number of Spanish nationals leaving was 45,913. But this latter number is confusing since during 2013 some 190,000 former immigrants obtained Spanish nationality and some of these subsequently left for other EU countries. More to the point perhaps, is that these are net numbers. The gross numbers are even more shocking: over half a million people left Spain in 2013 (547,890 to be exact), while some 291,041 new immigrants arrived.

Now I don't want to get into the issue of the enormous tragedy that is taking place daily on Europe's southern borders (and in any event many of the newcomers currently arriving in Spain are doing so as part of family regroupment processes) but the absolute number of people leaving is very large, and those leaving possess a skill set which is vastly superior to that of those arriving, so in the longer run the human capital drain on Spain is massive, again reducing the potential longer term growth rate. As the IMF point out, projections here are pretty risky, but still the Spanish statistics office (INE) have made an attempt, and the result can be seen in the table below.

The impact of this hemorrhage (if it is confirmed over time) on Spain's population pyramid will look something like this.

Basically Spain's population will suddenly have become much smaller and much older. The population will fall by 2.6 million, and the number of people in the  20 to 49 age group will fall by 4.7 million (or 22.7%). This is why it is so important to try to do something more and boost employment rapidly. Otherwise the impact on long term growth will be sizable, and the pressure to reduce pensions constant. This INE population and emigration forecast is, if you like, based on a no policy change assumption, on what will probably happen unless substantially more is done. It is the sense of urgency about this need to do something more that I - and others - do not find encapsulated in the phrase "Spain has turned the corner". If these population projections are realized then quite simply it won't have done so. Pensions, for one thing, will be set on a continuously downward path, which is why I think pensioners could be convinced of the need for them to make sacrifices now, if the situation were better explained to them. For another the debt which is currently accumulating will have fewer and fewer people left to pay it. And lets not even start talking about the impact of this sharp reduction on the value of Spanish property.

The real problem in Spain - and this issue isn't treated in the report - is the complete collapse of civic confidence in many of Spain's institutions, from the Bank of Spain, to market regulator CNMV (the Bankia IPO, Preference Shares), to politicians and political parties (the Barcenas affair, among many others), to the monarchy. It is this crisis of confidence which makes it so difficult to get the consensus to make more sacrifices.

Many say that there can't possibly be 25% unemployment in Spain since if there were there would be a revolution (referring to the existence of the underground economy but conveniently forgetting that the worst years of the 1930s depression were not years of revolution, those came later).

What people are missing about Spain is the way the credibility of the institutional structure is weakening. Voices talking about a constitutional crisis are growing. The economic crisis basically coincided with the moment when the set up established - including the return of the monarchy - during the transition from Franco's dictatorship to democracy was increasingly seen as having "run its course". Many observers recognise that major constitutional reform is needed and some kind of "rebirth" and renovation in the political system. Last months EU elections were the latest warning signal. The two main political parties (the so called institutional parties) for the first time since the transition failed to get over 50% of the popular vote between them, while the Syriza-like Podemos - who hadn't even been listed in the opinion surveys - surged from nowhere to take 5 seats and 9% of the vote. And in Catalonia a large majority of voters voted for parties who are actively campaigning for independence from Spain. A general election is coming next year, but it is hard to see either of the "old" parties getting a majority without a complex set of coalition partners.

So rather than asking whether Spain has now gone round the bend perhaps the Fund would have been better off sticking with "Getting better, but not out of the woods yet, not by a long way".