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Edward Hugh is only able to update this blog from time to time, but he does run a lively Twitter account with plenty of Spain related comment. He also maintains a collection of constantly updated Spain charts with short updates on a Storify dedicated page Spain's Economic Recovery - Glass Half Full or Glass Half Empty?

Monday, October 06, 2008

As Europe's Banks Falter, Is There A Risk To The Eurozone?

by Edward Hugh: Barcelona

“We do not have a federal budget, so the idea that we could do the same as what is done on the other side of the Atlantic doesn’t fit with the political structure of Europe,”
Jean-Claude Trichet, commenting last week on the Eupean "summit" in Paris last Saturday

``If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska......It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people'' in the euro area."
Jean Claude Trichet in an interview with Ireland's RTE radio last July, following the controversial decision to raise ECB interest rates to 4.25%

"Europe gives up on a joint rescue plan against the crisis," since the EU "lacks the necessary institutions to respond as the United States has done".
Spain's El Pais yesterday (Sunday 5 October)

For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe’s monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008

The euro experienced its biggest one-day drop against the yen in seven years this morning as the deepening credit crisis prompted European governments to pledge bailouts for troubled banks while stopping short of giving any concrete programme of coordinated action. The 15-nation currency declined to a 14-month low against the dollar - hitting $1.3598 at 8:52 a.m. in London - and to its weakest in two years versus the yen after European leaders meeting this weekend avoided announcing any plan that would be equivalent to the U.S.'s $700 billion bailout. And the reason for the euro's fall is clear, the ability of the eurozone countries to apply a concerted startegy to address the problems in the banking and financial system has been called into question, and nowhere is the huge gap between the currency's ambition and its political architecture so evident as it is in the above two quotes from Jean Claude Trichet. When push comes to shove, the US Treasury, as we have seen last week, does not concentrate on the needs of Florida or Massachusetts, but on those of the entire United States, and who, may we ask is in a position to concentrate at this point on the financing needs of the whole 15 member eurozone-area, since trying to manage economies which are one organic whole by splitting them analytically into monetary and fiscal entitites simply isn't going to work, and it never was. Let me expain.

The current pressure on the euro is more the result of liquidity and solvency problems in the banking sector (and perceived institutional deficiencies when it comes to being able to address these) than it is a response to the growing weaknesses in the real economies eurozone real economies, which, as I have already recently argued here, probably mean that the zone as a whole has now entered the first recession in its short history.

When it comes to the liquidity and solvency issues, I do think we can already identify some clear trends, since we can see that in those European countries which had substantial housing booms - the UK, Ireland, Greece, Spain and Denmark - the bank exposure is to the drop in the value of the underlying assets (the houses, or the land, or the malls, or the office blocks) and to the defaults in payments (either by builders or by companies, or by homeowners) which have their origin in the impact of the mortgage seize-up on the real economy (rising unemployment, declining bonus payments, falling retail sales and industrial output, etc), whereas in non-housing boom countries (lead by Germany, Italy, Sweden and Austria) the exposure is to lending which was made to banks in the boom countries - first and foremost in the United States, but also in the UK and Ireland (see Germany's Hypo and it's Irish subsidiary Depfa) and, of course (and the largest slice of this is yet to come) in Eastern Europe (lead by banks in Sweden, Austria and Italy).

The other key thread is whether or not the institution in question lent against deposits, or depended on the wholesale money markets for funding. The banks - lead in this case by the Spanish armada - who were most dependent on external borrowing are now evidently those who have (or are about to have) the biggest problems as the worlds wholesale money markets remain firmly closed, with little possibility of them being permanently reopened until this crisis is over.

In theory, the 27-nation EU structure should offer a ready means of coordinating policy. But while the EU has unified laws on areas like trade and labour standards (and in the near future on immigration) more broad-reaching policy harmonisation (such as fiscal coordination) has long been resisted, and the recent sorry attempts to introduce a basic constitution provide clear evidence of the difficulties which lie ahead for any substantial moves in this direction. The EU has no institutional equivalent of the US Treasury, which is why all the initiatives which we have seen to date - for all the European "feel" about them - have been either ad hoc bi- or tri- lateral arrangements.

US National Bureau of Economic Research head Marty Feldstein has long been on record as pointing out that the greatest weakness in the eurosystem architecture from the start has been the absence of a common fiscal system, and the inability to correct the problems caused by deficits in one country by drawing on surpluses in another. When he first raised these issues Feldstein was undoubtedly thinking about the possibility of asymetric recessionary processes, and the need to coordinate fiscal stimulus - and I doubt was thinking about a problem of the severity of the one we now face - but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another. As Jean Claude Trichet is now finding out, in macroeconomic management terms you simply cannot have your cake and eat it.

My basic point is a simple one: the European institutional structure with a centralized monetary policy but decentralized fiscal policies creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP. An effective political agreement among the Eurozone countries is needed to prevent those deficits.

Without either discretionary monetary policy or an automatic cyclical adjustment of interest rates or of the exchange rate, a country can stimulate aggregate demand only by fiscal policy. While a fiscal policy can in principle take the form of a revenue neutral change in fiscal incentives – e.g., an investment tax credit offset by a temporary rise in the corporate income tax rate – the usual fiscal response to an economic downturn is a tax cut that increases the budget deficit. Moreover, deficitexpanding fiscal policy has greater potency with the interest rate and exchange rate essentially fixed than it would if the country had its own currency.

There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a “local” area – i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.

The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside. In short, the combination of a centralized monetary policy and a decentralized fiscal structure in Europe increases the need for and the effectiveness of countercyclical fiscal policy.
Marty Feldstein, The Euro And The Stability Pact

The issue really is that any economy is a single organic whole, and that monetary and fiscal policy really form part of one integral continuum. Basically both are concerned with demand management, monetary policy via the indirect route of trying to influence peoples saving and borrowing behaviour, and fiscal policy via the direct route of either injecting or withdrawing demand from an economy. Trying to manage one without having control over the other simply ends up in incoherence at the end of the day, and it is just this policy incoherence that we are in danger of seeing now as the financial crisis (and the political credibility one which is liable to follow in its wake if people aren't careful) takes hold. Basically economies like Spain and Ireland, where the real economies are now almost in free fall (Spain's industrial output fell at the fastest rate of any among the 26 key global economies tracked on the JPMorgan global purchasing managers index in September) need a substantial injection of funds via the fiscal conduit to enable their governments to inject liquidity and demand into their systems without those governments seeing their accumulated debt to GDP ratio's rising at rates which will set of alarm signals over at the credit ratings agencies. And they need this funding now, since - and without wanting to sound too dramatic - the situation is deteriorating rapidly, and by the day.

Unicredit Sinks Like A Stone

The shares of Italy's second largest bank, UniCredit SpA, fell as much as 16 percent at one point in Milan trading this morning, hitting 2.59 euros and taking the shares back into the region of the 11-year low of 2.55 euros registered on Sept. 30. The drop follows a capital boost of 6.6 billion euros decided on at an emergency board meeting held yesterday afternoon, where among the exceptional measures decided on to raise the cash was the idea of paying this years dividends to shareholders by giving them more company shares.

The "shares for dividends decision" forms part of a battery of measures which includes significant cost cuts and asset sales in order to try to guarantee that the core Tier I capital ratio, a measure of the banks' financial strength, rises to 6.7 percent by the end of the year, from 5.7 percent now. A core Tier I of 6 percent or higher is generally considered an adequate minimum for banks, while anything below it starts to raise eyebrows.

During a chaotic day trading in Unicredit shares was suspended several times following the initial dramatic fall, and they were finally down on the day by 5.5 percent, closing at 2.914 euros. Indeed the problems being experienced at Unicredit lead the whole Italian banking sector down, and with it Italy's S&P/MIB Index, which declined the most in more than seven years this morning, losing 1,435, or 5.5 percent, to 24,476.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008

UniCredit SpA, is, as I say, Italy's second biggest bank and it is also owner of Germany's HVB Group. The current crisis started last week when shares fell more than 24 percent in three days as it became increasingly clear that the bank was going to need to raise money to strengthen its finances. One of the issues arising was whether or not UniCredit would be asked to help in the bailout of Germany's Hypo Real Estate Holding, a development which could have negative consequences for Unicredit's capital position. Hypo Real Estate was in fact spun off from the Unicredit owned HVB Group in 2003.

But Unicredit is also exposed due to the extent of its lending in Eastern Europe - which is estimated to amount to one quarter of the banks total lending operations. Unicredit is deeply involved right across Eastern Europe via its ownership ofthe HVB group, as well as via it's ownership of Bank Austria Creditanstalt. Among other issues Unicredit is evidently exposed in the Baltics, given the fact that as of September 1, 2007 ASUniCredit Bank Estonian took over the business of HVB Bank Tallinn. But the extent of Unicredit East European lending is much more extensive than this, and with property markets in one EU10 country after another now likely to "correct" the problem is about to become considerably larger than simply the German Hypo Real Estate one. Unicredit made direct acquisitions in 2007 in Kazakhstan and Ukraine, while extending its position in the Russian banking sector. The first of these counries had a financial "sudden stop" in September 2007, while the latter two are in the process of a major domestic credit "unravelling.

Fitch Ratings last Thursday downgraded the Outlook on UniCredit to Negative from Positive. At the same time Fitch changed the Outlook on Unicredit's main subsidiaries - Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG - to Negative from Positive. Fitch stressed as reasons for the downgrade the poor macroeconomic outlook in Italy and Germany and in particular the less benign outlook for some central and eastern European markets. Fitch also regards UC's current capitalisation (end-H108 Basel 1 core Tier 1 ratio of 5.55%) as tight in relation to its risks especially given thatconditions in the wholesale funding market remain "extremely challenging".

So the question is going to be, is Unicredit too big to fail, or too big to save?

Government Guarantees For Deposits

One popular way of handling the present wave of pressure hitting the banks has been to give guarantees to depositors. The Irish were the first to do this, and they have been subsequently followed by The Greeks, the Danes, the Swedes and now the Germans. Up to this point the Italian and Spanish authorities have been notably silent on the matter, and the reason why is not hard to imagine.

Basically Ireland may have quite large problems, but it can, being a small country, "piggy back" from the United Kingdom, by attracting deposits from their larger neighbour. An analysis carried out at Credit Suisse has shown how movements of cash by relatively few depositors may have a bigger effect in countries which a significant proportion of deposits is concentrated among relatively small percentage of the customer base, as is the case in the U.K. (for example) where 4 percent of the banks' customers hold 45 percent of the deposit base.

But where can the Spanish banks look for this kind of support? It is their very size and the size of the problem they have that makes for the difficulty. The vaguely-insinuated plan which was "nearly - but never actually - proposed" at last Saturday's Paris meeting was for a fund of 300 billion euros. But Germany's Die Welt reported over the weekend that Hypo Real Estate alone will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, to be followed by as much as 100 billion euros by the end of 2009. And this is just one relatively minor "quasi bank".

Spain's needs are likely to be much larger - I personally have estimated a sum of between 300 and 500 billion euros for Spain alone, between the need to roll-over toxic financial instruments and non-performing loans from builders and other corporates. And what about Unicredit? We have no real idea at this point how much funding Unicredit may need.

And so we need to go back to Marty Feldstein, and to think about the budget deficits issue. In general European governments have little room for large scale fiscal support either on the annual deficit side, or on the debt to GDP ratio one. Given the ageing-related commitments (pensions, health costs) which are looming (in particular after 2012) for some key European governments (especially Germany and Italy) it is reasonably clear that - following the deficits which were all too often being run during the "good years" - there is now not much headroom to play around with, and remember all this government support for banks that is bbeing freely undertaken has to be funded somehow - either out of revenue, or by raising debt. In particular, if certain of the EU national governments move back on the commitment to balance the budgets by 2011 then we will only start to shift from banking instition downgrades to sovereign rating ones. This is why I titled this post the way I did. If either Italian government finances, or the Spanish banking system, are simply allowed to unwind for lack of visible support, then the integrity of the Eurozone itself which most definitely be put at risk. And events could happen very rapidly indeed if either important systemic banks or a large sovereign government suddenly go into financial meltdown. So the visible lack of any coherent startegy or plan could not be reasonably considered one of those cases where some people somewhere busy fiddling with their thumbs while Rome and Madrid were burning, now could it?


Charles Butler said...


Pardon me for taking the under, but the 'end of the euro' story from the Brit press is getting a little tiresome.

In no particular order:

Setting off the rapidity with which the U.S. reacted against the rigidity of the EU begs asking a question concerning the appropriateness of the solution that resulted. The possibility that they did the wrong thing, on the advice a very interested party, but quickly, is currently being attested to by the credit markets.

On the same lines, no town crier announcing the end of the euro has been able to show a governmental structure capable of dealing with the rapid disappearance of what was once thought to be money. If the EU is a failure, find me a word to describe Britain, U.S., or Iceland.

All the euro bashers are, in my opinion, underestimating the will of member states to make it work, despite the constant bickering over chickenshit. The description of the problem as being defined by one state, structural inadequacy, and one outcome, disolution, is, quite frankly, absurd. Do you think that the lack of a public pronouncement following recent meetings actually means that common contingency plans are not already being made? Munchau certainly does not. But he knows who's paying his mortgage.

As to whether U.S. policy favours one region over another, a pretty convincing argument can be made that TARP was structured to save Wall Street. Again, the credit markets, now also frozen for industrial corporations, have spoken on its benefits to the U.S. as a whole.

The Stability Pact is, for the time being, dead. This is an emergency. National governments now have fiscal latitude that is not revealed in a study of the official structure.

And, just to throw up a balloon - why not consider the possibility that a varied collection of central banks might end up, in fact, displaying more flexibility than a central command. The structure will not saved at the expense of the community.

Best regards,


Edward Hugh said...

Hello Charles,

"but the 'end of the euro' story from the Brit press is getting a little tiresome."

Well look, fortunately I don't read the British press beyond the FT to any great extent, so I am not sure what they are getting up to, except of course Ambrose Evans Pritchard, who is a very special case, and whose prejudices in this regard are pretty much up front.

I am looking at all this from a macro economic perspactive, and I am trying to explain, from the viewpoint of a technician, what can and cannot work.

So let me be categorical: you cannot run an economy without some measure of control over both the fiscal and the monetary dimensions. And the authority I cite in support of this view is not British, but the head of the US NBER, with whom I have long agreed on this count.

I am not saying that the euro has to fail. What I am saying though, and I want to be quite categorical on this, is that if we don't know move on - and quickly - to put in place the necessary political architecture to make the existence of a eurozone economy as one single entity coherent, then it will, more or less inevitably, fall apart, one way or another.

Diagnosing a problem is NOT the same as hoping it happens, rather it is a first step to adoting remedies and cures.

This is my opinion, and this is now an empirical question, so we are now about to see who is right here. Perhaps I would rather be wrong, but that doesn't matter. Like Luther before me, "here I am, I can do no other".

Of course, until we get the confirmation we need - one way or the other - we are all entitled to our opinions, and in this sense I fully respect your right to hold the ones you hold. As Bernanke says, the Euro is a very interesting experiment for theoretical economists, but I doubt the people who are using the currency as legal tender realised that they were enetering a laboratory when they decided to adopt it.

Edward Hugh said...

A couple more points:

"All the euro bashers are .... Munchau certainly does not. But he knows who's paying his mortgage."

Munchau is not a euro basher. He has been one of the strongest supporters of the common currency. Obviously though he is sufficiently open to reality to be able to recognise a problem when he sees one.

Also he is not a Brit, he is German, and he is in the FTs Frankfurt office.

Just a small detail:

"All the euro bashers are .... Munchau certainly does not. But he knows who's paying his mortgage."

Munchau is not a euro basher. He has been one of the strongest supporters of the common currency. Obviously though he is sufficiently open to reality to be able to recognise a problem when he sees one.

Also he is not a Brit, he is German, and he is in the FTs Frankfurt office.

"Do you think that the lack of a public pronouncement following recent meetings actually means that common contingency plans are not already being made?"

No. But I would really love to know why Spain was not invited to Paris last Saturday. The absence of an explanation on this is deeply preoccupying.

"The Stability Pact is, for the time being, dead. This is an emergency. National governments now have fiscal latitude that is not revealed in a study of the official structure."

Well not really. This is an emergency I agree, but the stability pact is not dead, and can't be, since if the key ageing societies don't adhere to the scehdule then they risk starting to get credit downgrades, and will begin to have problems funding sovereign debt.

Spain, at this point is not one of these, but obviously moving a lot of private debt over to public debt can change this quickly. This is how Japan got up to the (unsustainable IMHO) current (OECD analysis) 182% of GDP in debt, from around 60% in 1995. Spain cannot go down this road, or the euro WILL crash. We are already running a 3% deficit rate as it is, and Zapatero just announced 50 billion euros of state asset purchases that amount to another 5% of GDP. How he is going to fund this isn't clear at this point, but we should remember that this is only a first (small) begining. There is a lot more to come, and Spain can quickly go up from the current (benign) level of 50% of GDP indebtedness to 70 - 80%, which is when the thing goes critical IMHO, given the ageing liabilities and the fact that the pension system has not been reformed. Everything is going to hit Spain at once. Which is why Spain is simply unable to stand "Solo ante el peligro" at this point.

"All the euro bashers are, in my opinion, underestimating the will of member states to make it work,"

Well I'm no euro basher Charles, and I would like to see it work, but statements like the following one from Peer Steinbrueck certainly do nothing to reassure me that you are right.

"The chancellor and I reject a European shield because we as Germans do not want to pay into a big pot where we do not have control and do not know where German money might be used," he said in a separate interview with WDR 2 radio."

Charles Butler said...


I'm fully aware of Munchau's residency. One would expect his argument to differ at least a bit from Evans-Pritchard's literal take on the functioning of the EMU with an on-off switch as the end game.

For the argument to have any validity, it has to propose that some option that does work, or is going to work. So far, that has yet to be demonstrated. If the euro fails under circumstances of a generalized collapse, nothing can be claimed to have been proven. Think two indigents living under a bridge arguing about whose method of getting there was superior.

To keep the proof playing field level here, I'll suggest a couple of competing outcomes:

1). Does the euro come undone before Britain joins the EMU;
2). Or before the U.S. defaults on its sovereign debt.


Do you think, by the way, that centralization would have permitted Santander, for example, to sink itself up to its arse in off balance sheet garbage? I do.


Charles Butler said...

Sorry missed your other response.

Consider the possibility that Spain wasn't invited because we would have sent ZP. And who needs an idiot at the table under the circumstances?

Let me tone that down.

If Steinbrueck continues to make a fool of himself calling the kettle black, his days may be numbered. I don't put alot of faith in political grandstanding for the home audience, in any regard. He gets himself off the hook by saying it's not going into a pot, but a jar. As for whether Germany will have control - they do own the ECB.


François said...

This blog is getting more enlightening by the day, litteraly.

Kudos for both the text and additional comments.

I still finbod the current EC banking situation highly paradoxical. And just wonder whether our political are not just all buying time.

Concerning Zapatero and his beloved finance minister, this not an issue but a solid fact. Solbes has started buying time but Spain as you mentioned certainly does not enjoy the signature of the US.

The question is now very practical "How much time can he buy? What is the cash-burning rate?"

Who has a copy of Solbes cash-burning Excel spreadsheet?

I'd be interested in the one for Deutche Banke and UBS as well by the way.

These times are extremely messy and I now really wonder about all western currencies as a pack....

Charles Butler said...


Time is the real issue that credit markets are testing. Who breaks first, so to speak. Although it can be argued that they are really saying that the system is already broke, and this is what that looks at. Regardless, we don't come out of this as if in middle of 2006.

The announcements from Moncloa were interesting in that Spain has, according to the same, the strongest banking system in the world. The immediate problem, though, in this country is that of bank runs and it looks like that is what they are addressing.

Also interesting, in light of German insistence that they don't want to lose control over who gets bailed, or not, is that Portuguese, French, Spanish and even Irish 10 year bonds have outperformed the Bund since January (Italy and Greece being the laggards). That market says Germany will be needing others before vice versa.

Credit showed signs of easing yesterday, BTW and for what it's worth. A few more weeks of that and governments can start dealing with banks on a case-by-case basis rather than systemic.

Anonymous said...

Well, we have at least one good news: Trichet has finally realized the mess we are in and has changed his views on figthing an inexistent problem "inflation" and will address deflation. But as Roubini says it may be too little too late. This action comes so late, that I am afraid the ECB has lost control over LIBOR. Spain has created a fund to buy morgages from banks (similar plan as paulson's that got such bad reviews from major economics and that is about to be changed to infusing capital in the banks.) In Spain, we probably also need bank recapitalization, will see how this will work out. Concerning bank runs, several friends in major bank entities have comented to me that they are literally flooded with deposits coming from smaller "cajas". Spanish government should have issued a blanket cover for 100% of the deposits. Not doing so, will only accelerate the run on the smaller and less provisioned entities. Obviously some of them will be merged with the big ones, but will not this create less liquidity for the solvent ones? Tomorrow migth be the D day with the unwinding of lehmans CDS. Let's see how that goes....

Edward Hugh said...

Hello MDM,

"Well, we have at least one good news: Trichet has finally realized the mess we are in and has changed his views on figthing an inexistent problem "inflation" and will address deflation."

First off, let me apologise for not replying to your earlier comment on the ECB. I was on holiday at the time, and wrote a reply in a cyber cafe, which I duly lost as I tried to save. Such is life. The bankers aren't the only ones having problems at the moment.

Broadly I agree with you, the problem facing Spain at the moment is not inflation but deflation, as demand collapses. Oil went year on year negative yesterday just for starters. So from now on y-o-y changes in oil prices will drag the CPI DOWN.

But the most important impetus towards price deflation in Spain is going to be the huge drop in demand (see my real economy post about "Spain on the precipice"). Obviously September was a very bad month, but October will be worse, and then, in all probability, November and December. The official discourse here (either in Madrid or in Brussels) doesn't get anywhere near the reality of the problem. Spain needs help, and it needs it today, and if Brussels can't move then it should be the IMF. But first ZPT needs to come clean and admit that what is happening is happening.

We don't need panic, but we do need the "all hands on deck" call, and everyone to the pumps: ie a change in national mentality, moving from sitting back and watching someone else's problem (passive mode) to a "this is my problem, I'm going to play my part" one - however humble that part may be (active response mode).

National mentalities are very important in having the WILL to do things in these situations: what Keynes loosely called animal spirits. In Iceland they held a rock concert to protest the bank collapse. In Spain I expect "caceroladas", and seeing highways and ring roads blocked. But these kinds of demonstrations of helplessness are not the way, we need positive responses.

I don't blame any politician here. The people have to accept their own responsibility. Everyone was speculating with flats. Spain became a nation of speculators, so some degree of generalised self-criticism would be a good first move.

People ask me "what went wrong": what went wrong was simply that a whole generation of new financial products (cedulas, covered bonds, CD's, whatever) which supposedly reduced the risk of property related investment, simply didn't work. Now all the cars are being called back to the manufacturers. So the ocean, having bucketed out, suddenly rolls back.

What was needed was not cheap mortgages, but cheap houses (more efficient production techniques, better productivity etc). The cheap mortgages only lead to increased house prices, rampant speculation, and massive excess building of houses which weren't needed (on the coast, in the rural areas for second homes) rather than high quality cheap homes for young people wanting to start up and have a family.

How many time did you hear people say "the great advantage of being in the eurozone is the cheap interest rates we get". This was a huge misunderstanding (sorry Charles) as we are now seeing. Spain needed appropriate interest rates, not simply "cheap" ones. It needed affordable housing, and a monetary policy which generated this result. As we have now seen, this is what we didn't get.

And we still haven't started to count the cost of all this on the health of the Spanish population (stress, which we now understand is more and more important in general well-being) and the hit fertility will take as all those indebted young people in the critical ages put off yet one more time having that much needed baby. Of course since we aren't even recognising we have a problem, we are light years away from thinking about things like this at this point.

"Spain has created a fund to buy morgages from banks (similar plan as paulson's that got such bad reviews from major economics and that is about to be changed to infusing capital in the banks.)"

Do you have any details on this? I am about to write something up for the blog. Zpt said he was only going to buy "first class assets" so my feeling is that they are really only talking here about the state buying cedulas and other RMBSs that are coming up for rollover this autumn. Since the term on these is probably 5 years, then this means they were likely issued in 2003, which is when all this really got started here. So at this point - given that TINSA are hardly recognising any drop in prices still - these would seem to be fairly "safe" at this stage.

The point is, if I can put it like this, we simply don't know how far back in time Spanish prices will go as the depression gets its grip, to 2003, to 1999, or to 1997. It is idle chatter to speculate on this at this point, but the drop is going to be substantial, and as we move backwards in time more and more of the paper will become "toxic".

But the point is, if the 50 billion euros is only to buy securities of the banks, this is a net zero for liquidity, since the money goes to pay the people who are holding these now, and who want out of Spain.

So we get to Francois's point:

"ho has a copy of Solbes cash-burning Excel spreadsheet?"

We simply don't know how long Spain can keep this up unaided. Look at Iceland if you want to see a bad example of where we could go, if the EU "shield" proves to be insufficient or ineffective.

Again, I will try and spell all this out in more detail in a post later this morning, but you need to think about "Spain incorporated" and its total idendebtedness. Between, government, companies and households this is currently at 250% of GDP, and now the new financial products are being withdrawn from the market this will need to come down: how much down I don't know, but down,, as will the CA deficit need to be headed towards zero, since these amount to one and the same thing at the end of the day. Now the only way you can start to balance the CA deficit and reduce total indebtedness is by increasing exports and decreasing imports. Both of these imply very large deflation (assuming Spain keeps the Euro and we don't go back to the pesseta). Increasing exports means deflation, since unless the floor falls out of the euro (ie we go back to 90 to USD or something like that, but the US couldn't handle this, since they themselves are hardly in "tip-top health" at this point) you can't get the competiveness back by simple productivity improvements, the gap is too large and there isn't enough time. Reducing imports, of course, means deflation since it is associated with the collapse in internal demand, bankruptcies, rising undemployment etc, etc.

And think about this rather frightening fact. Bank lending continues. The government, corporates and households are all increasing their debt to GDP ration. The latter two are still loading on new date at the rate of 10% per annum, which means (given that between them they have debts of 200%+ of GDP) that the debt to GDP ratio is going up still at 20% per annum, which GDP itself is now actually contracting. This is a VERY BAD "bang for the buck" ratio and clearly unsustainable.

The only coherent proposal I have seen on the table at the moment comes from Zoellick at the World Bank, which is to draw-in a set of major emerging economies to the G7 - I would bring in China, India, Turkey, Brazil, Indonesia, Philipines and Egypt if we want to go for more or less population numerous ones - and then thrash out a new version of Bretton Woods, with these currencies playing a much more important role in return for a Marshall Plan type guarantee of local currency lending in these countries: ie the G7 should be underwriting investment grade for these countries NOW, and not playing around trying to defend it on Spanish cedulas or Hungarian covered bonds.

Basically, the only way we are going to get "collectively" out of all this is by underwriting the development of the emerging economies, and doing so immediately. Ethically I think the proposal is also fine, since it will start to roll back that horrendous and long standing gap in global living standards.

And before I wind up here, I want to stress that I consider keeping the immigrants a key part of the policy package you need to stop the situation becoming simply hopeless. Charles says:

"Or before the U.S. defaults on its sovereign debt."

Now obviously, with governments everywhere lining up to give "guarantee of last resort" to the banks, no one's sovereign is safe if things go badly wrong, since the whole thing could just fall apart, and lead us to have to start again from zero, but at this point we don't need to accept this as likely or inevitable.

The key to the US rebound is - as everyone knows - the housing market - and the key to the housing market is domestic demand for houses, otherwise known as the rate of new household formation. Now the US is lucky in this respect, since fertility was never allowed to fall to 1.3 tfr, and there are now very large generations of Latinos, who will want houses. The way out for the US will come from this quarter, and I am very susrprised to see that the presidential candidates don't seem to be suggesting that legalising the 11 million illegals, turning them into regular citizens, and offering them mortgage guarantees now that the prices are relatively cheap and affordable might not be a "one off" jump start approach.

Basically, Spain has a huge property overhang already, and if the population now starts falling as immigrants and the Brits leave (handing their keys over at the bank first), then we will hit a critical point at some stage, but again, there is simply no discussion of this at the national level, and Corbacho insists on paying people to go.

Charles Butler said...

edwar and others,

One way or another, the creditor nations have to bite the bullet here and give back some of their dollar reserves to solve the crisis. The fast and ugly way is a U.S. default. The slow and ugly way is the U.S. inflating its way out. Same thing, different time frame.

The civilized way would be to make a deal, both sides agreeing that they got fat on a Ponzi scheme and taking their lumps. My guess is that, unfortunately, the U.S. will be the most difficult to get on board on terms acceptable to the guys with deep pockets. It will be hard to accept that, short of firing off a nuke, they have no more bargaining power than Iceland.

Anonymous said...

Hello Edward,

I do not have more details on the plan, except what has been written in the press ( and a little from The fund seems to me very much inspired from paulson's plan of buying assets (probably more toxic than not), and as this is currently being changed ( I think they will change it in spain too, and make it more similar to the brits plan.
I know you have been very busy lately, but please keep on blogging as you are rigth now one of the only competent blog we have for spain's economy.

Edward Hugh said...

Hello Charles,

"One way or another, the creditor nations have to bite the bullet here and give back some of their dollar reserves to solve the crisis."

Well, we are agreed then it seems, since Germany was one of the leading parties here, in terms of being a creditor nation. It has been running huge BoP and CA surpluses for the last 5 years. So now is the time to dig deep, and fork out, whatever Steinbrueck's prejudices may be. If not the whole thing risks falling over.

Spain cannot "correct" its CA deficit without help. This is my opinion. Left alone it is full ahead south towards Argentina. CDS's on Ukraine debt surged a record 473 base points yesterday to hit 1700 (or 17 per cent). This could easily happen in the eurozone to Spain, Italy and Greece if the spreads start to widen, and the ECB and Brussels lose credibility as effective backstops for the European universe.

"The fast and ugly way is a U.S. default. The slow and ugly way is the U.S. inflating its way out. Same thing, different time frame."

I stopped commenting on the US some time ago. I think there are loads of people out there with better skills than I have in this context, and I simply don't have the time to dig down to the depth that I feel I need to to have something useful to say.

Basically, I think no one knows what is going to happen next week, and while that may sound like a pretty frightening thing to say, but I feel that at this point it is true.

Obviously eventually the equity markets will bottom out (but how far are we away from "eventually" at this point, and what else might happen on the way), and then we will be looking at the marco economic carnage that all this will have caused, and I am much more at home with all of that.

"on terms acceptable to the guys with deep pockets."

Well, I think there are two types of guys with deep pockets, those who have some sense and those who don't.

The former are dug in up to their ears in Russia and China at the moment (so, the earth might well simply swallow them up), while the latter will be moving-in heavily into Brazil and India six months or so from now. That is, the BRICs are about to break in two, and IMHO that will be the big macro news of 2009.

We will be able to whistle the "all clear" on the current turmoil when the MSCI indexes for India and Brazil rebound, since if they can't grow in this environment, then who the hell can. That, at least, is my opinion.

First world consumer "construction-and-financial-services-driven booms" just "maxed out" - which is why, if you see the other post, I think deflation, rather than inflation is going to be the tonic moving forward.

The first-world consumer is simply "over leveraged", and deleveraging will be deflationary.

Of course, some key commodities may still get more expensive, especially if they are in great demand during emerging market industrialisation. There are billions of people out there only too willing to step up to the plate and get as rich as we are. So there are lots of candidates.

OTOH, did you notice the little detail that the Austrian bourse was closed on Friday? Hard times are a coming from the East - and this will especially affect Germany, and Italy (vie Unicredit).

The Czech bourse also closed due to the importance of Erste bank, and the Ukraine and Russian bourses are closed more than they are open at the moment.

I think Ukraine is about to unwind, and that this will bring the EU 10 tumbling down via contagion. We then need to watch and wait to see how the EU institutions respond to this. Romania or Bulgaria are the most likely canditates to become "Argentina-like" member states.

Of course Austria will be directly cuaght up in the backstream.

Sorry if I am more focused on Europe than the US at this point, but Europe is my home, and while I appreciate the US is in real difficulties I do feel that they have a very large group of very talented economists working away at the problem night and day, so I don't feel I have that much to add. I just wish I could say the same about Europe.

"It will be hard to accept that, short of firing off a nuke, they have no more bargaining power than Iceland."

Which is why Charles, I expect deflation rather than inflation. I just don't think that they have the ability to fire up the domestic inflation to monetise the debt at this point. Bernanke is willing to buy all the way up the maturity curve and expand the instruments almost indefinitely, but global demand is just shrinking too quickly at this point. It is interesting to note that after years of trying to tell the Japanese what to do, the US authorities are gradually taking measures from the Japanese play book, including now - via the Japanese influence on UK thinking - taking ownership in the strategic banks and guaranteeing deposits.

ZIRP-style massive monetary easing is now on the agenda at the ECB and my guess is people like Paulson and Bernanke are now whiling away their few precious free hours reading Irving Fisher.

Edward Hugh said...

Hi Charles,

This is now Sunday morning, and I am busy reading the newspapers. I see George Bush met with the major finance ministers yesterday, in the midst of strong infighting between Obama and McCain. I am almost waiting for him to announce a third "emergency" candidacy for the coming US elections, where he informs us that he, Bernanke and Paulson will be standing on a joint ticket for the newly formed united socialist party - you know, the one that will be commited to not starting any more wars, nationalising the banks and financial institutions, guaranteeing the value of Chinese holdings in US agencies so their sovereign wealth fund can move in and support the equity market (Putin style) in the process socialising the US corporate sector, gauranteeing health and pension resources for all America's elderly, and above all ensureing that there will be abundant cheap and affordable mortgages for all those members of the irregular Latino population who want to become respectable US citizens, and do their duty by buying up all those unsold homes.

Having said this, I would emphasise that I am not a political commentator, and that despite the fact that I am a human being, and capable of making ironic comments, I am not moved by ideology, only by what little I understand about how our economies work.

I see the eurozone leaders are meeting today in Paris, and I do welcome this as a necessary first step to taking some sort of coordinated action (which of course they should have initiated some time ago). I am also animated by the strength of this weekend's declarations by Dominique Strauss-Kahn to the effect that bold action must be taken to avoid meltdown.

I also welcome Christine Lagarde, statement that today's gathering will go beyond talking about remedies to "put meat, muscles on the bones of that skeleton and to develop, follow up and execute upon it."

I don't expect that we will see everything we would like (or even nneed) to see from today's meeting. European electors simply are not ready for the full agenda yet. My feeling is that after they receive a little more punishment they will be though.

Tomorow it seems likely that the UK will partially nationalise Barclays, HBOS, TSB and RBS. Spain cannot be far behind, otherwise the Spanish banks will simply become the most exposed to attack.

As we know Spain doesn't have an idle 500 billion euros knocking around, so the EU will have to stump up. They will not say this today, but if they make a committment to guarantee systemic banks, then they will have to make good their promise at some point.

Basically the thing you are missing I feel in your comments about "the British press" in the context of people like myself and Munchau is that while the British eurosceptics are against the euro in principle, and wish to see it fail, others (like me and Munchau I think) are saying that in order for the whole thing to work we need fiscal co-ordination - and we are in fact arguing FOR this.

When I was young, there was a habitual practice that reluctant grooms were lead to the altar at the point of the father-in-law's shotgun. I think we may now be about to see something similar, vis a vis the evolution of the EU institutional structure. Certainly if we don't it will be impossible to prevent systemic bank collapses and avoid sovereign defaults. Ironically, and in the context of my earlier joke, it may well be that GWB was playing the role of "irate" father in law in Washington yesterday. "Well" he could in all validity have whispered into Steinbrueck's ear as they took the photo "it was you who got the poor girl pregnant in the first place" (in reference to Spain's current little "embarassment").

All of this will doubtless make the "little englander" eurosceptics among us hopping mad, but effectively they have no say, since the UK is not a member of the eurozone, and their Treasury is busily bound up with the UK's home grown problems. So they can opine what they will, since that is their democratic right, but they can basically do nothing.

Of course after this is all over, we will need a long hard look at what common monetary and fiscal policy will mean in the future, and we will need to talk about how we are to address Europe's ageing population problem, but for the time being sufficient unto the day, and all that.

The patient is in intensive care, and right now the important thing is to keep the heart, lungs and brain working.

Edward Hugh said...

Hi again,

And now we are at Monday, and a plan is on the table. I will post something on this dureing the day, but obviously I think it is a good FIRST move. More will now come, since the important point would seem to be that they will not allow any systemic bank to go bust, and it is hard for them to go back on this without losing all credibility. The smaller ones (the regional cajas etc) can be taken care of by the individual national governments.

Now far be it from me to be a defender of Wolfgang Munchau - with whome I have many differences of opinion normally (in particular on occassion he veers towards the "austrian" camp in economics, which I most definitely do not) - but he is saying more or less the right things at the moment, from where I am sitting. I reccomend his piece in the FT this morning, where he says, among other things, this:

"I had a better feeling about Sunday’s eurozone summit. It produced a detailed and co-ordinated national response to recapitalise the banking system, and to provide insurance to revive the inter-banking market. But as far as I could ascertain, this was still agreement on ground rules for national plans, and it is not clear how well this agreement would cover the numerous cross-border issues that have arisen. There is no doubt that, in the eurozone at least, we have come a long way since Friday. It is an okay policy response, but I wonder whether this is going far enough at a time when global investors are pondering whether to pull the big plug."

I am emphasising Munchau's contribution, since I do feel that there haven't been that many people around on the EU scene (apart possibly from Straus Kahn) who have been saying that what needed to be done needed to be done. Obviously, if you have been reading this blog, you will know that I have. And there is plenty more to come, this, as I say, is just the start, although it will in all probablility move us on from the financial crisis to the real economy one.

Charles Butler said...

My points, Edward, are the following:

The worst case scenario for the eurozone has been beaten into a coma, both by well- and badly-intentioned commentators, to the complete exclusion of any of a wide variety of outcomes over a range of time frames - this because it sells copy in Britain.

The concentration on the structural impediments to concerted action to prove the assertion of imminent failure is indistinguishable from taking the authorized biography of some celebrity as representing the truth. The official version is seldom true.

Many, many commentators believe that a good lot of the actions the U.S. government is taking right now are illegal on the constitutional level. Does this not imply immediately that America is structurally incapable of dealing with the crisis? Well, yeah. And so what?

Administrative structures are not (or should not be) suicide pacts.


Stock market action says, BTW, that Sabadell is to be the first 'beneficiary' of the plan.



Edward Hugh said...

"Administrative structures are not (or should not be) suicide pacts."

Yeah, well quite. But I would point out that it was the Dutch and French (and most recently the Irish) electorates who voted down the most recent attempts to plug the constitutional holes, and their leaders are now going to have to swallow this latest bout of "virtual federalism" whole.

The have offered guarantees, and they will need to honour them, but their electorates may not be happy with them, bailing out the South of Europe isn't a popular topic in more places than the UK, and if the intervention ultimately doesn't work - and it might not, this is all now very delicate on the macroeconomic front - then there will be political debts to be paid as well as financial ones, and voters don't take normallyhaircuts for an answer.

Also, it isn't clear whether Eastern Europe isn't already getting sacrificed, if you look at the fact that Hungarian bank accounts are not included in the guarantee, and they are having to turn to the IMF. Looking at the lack of response to the Russian incursion into Georgia, and the lack of an ability to stretch a helping hand in times of trouble, things could get complicated in the East.

Indeed, all of this could turn into quite a nasty mess. Obviously I hope it doesn't, but at the present time I am not taking my eyes off Unicredit, or Erste Bank, and I am not willing to simply leave my "wits" in the antechamer, tie a knot in my handerchief and hope for the best.