Facebook Blogging

Edward Hugh is only able to update this blog about once a month at the moment, but he does have a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Sunday, March 29, 2009

And So It Begins, The Bank Of Spain "Intervenes" In A Spanish Savings Bank




Well , we didn't have to wait too long. Only last Friday I wrote the following:

Two Spanish regional savings banks have already reached a preliminary merger deal - Unicaja, based in Spain’s southern Andalucia region, and the smaller Caja Castilla La Mancha (CCM), located in the central-southern province of the same name - following talks which were carefully brokered by the Bank of Spain. Clearly this merger willl need to be followed by a capital injection from Spain’s Deposit Guarantee Fund to help them clean up the “troubled assets” which will naturally be found in the combined accounts of the new bank which emerges.

Today we learn that the merger is off. It is off for the simple reason that Caja Castilla La Mancha is about to cease to be an independent, autonomous entity. It has been "intervened" by the Bank of Spain. This is the first, it will not, of course, be the last.
According to Noticias Cuatro:
The governing council of the Bank of Spain has taken the decision to intervene in the operation of the Caja after carrying out an analysis of its financial position, thus taking as read that the negotiations which might have lead to its merger with the Andalucian 'Unicaja' have not been able to reach a successful conclusion.

The "intevention in Caja Castilla La Mancha will mean in the first place that the Bank of Spain will now manage the Caja directly via the management commission it is about to establish. Sources at the central bank have given an assurance that all the banks clients' savings are guaranteed. The Bank of Spain will now negotiate with the government urgent measures to guarantee the liquidity of the Caja, and its normal functioning.

In the second place, the Bank of Spain will be responsible for making an immediate detailed evaluation of all the Caja's assets and liabilities. In addition the central bank intervention implies the immediate replacement of the entire previous bank Administrative Council.

The last time the Bank of Spain intervened in a Spanish bank was in 1993, when the central bank too over control of Banesto. The necessary decisions will be taken in the next few hours since all other potential solutions have been discarded, including the assimilation of the Caja with Caja Madrid.

The Spanish newspaper El Pais reports that the Spanish cabinet (the Consejo de Ministros) are holding an extraordinary meeting at 18:00 this afternoon to discuss a proposed Decree Law to inject capital into the bank.

According to Finanzas.com, the "hole" in Caja Castilla La Mancha could be something in the order of 3 billion euros. This money could be paid from the bank funded Deposit Guarantee Fund (FGD), however, and as I said on Friday:

the (FGD) insurance fund holds only 7.2 billion euros in bank contributions, and since this is orders of magnitude less than the size of the problem it is obvious the government will end up having to putting money into the recapitalisation process, and especially into the Savings Bank sector, since the Spanish press has been reporting that 20 of Spain's 45 savings banks are now considering mergers. And it is obviously only a matter of time before one of the mid-sized Spanish banks like Popular, Sabadell or Banesto joins the consolidation process.


The Spanish government said following this afternoon's meeting that it will provide up to 9 billion euros to Caja Castilla-La Mancha to shore-up the bank's finances and protect depositors. Pedro Solbes in the press conference was at pains to stress that the 9 billion was an "upper estimate" that would not be needed, and stated that the final quantity anticipated would be between 2 billion and 3 billion, which sort of confirms the estimate offered by Finanzas.com "sources" earlier in the day. The funding is provided via the Bank of Spain and guaranteed by the Spanish Treasury. Solbes also explained that "if at the end of the day the bank is declared insolvent (quebranto)" that is, if there is not sufficient money in the bank to cover all liabilities (deposits and debts) the Royal Decree will stipulate how the outstanding obligations will be divided between the Treasury and the FGD.

Friday, March 27, 2009

Two Graphs That Tell It All On Spain

First, the one year Euribor reference rate, which has been falling since the ECB started lowering interest rates in the autumn of last year.



And secondly the chart showing the average rate of interest charged by Spanish banks on new mortgages, which as we can see, has been rising steadily since December 2007.



The average interest rate charged by Spanish banks for new mortgages in January 2009 was 5.64%, meaning that the average cost of a new mortgage had gone up by 10.2% over January 2008 (when the rate was 5.1%), and by 1.1% when compared with December 2008. Meanwhile the Euribor reference rate looks set to close this month at all time record lows of 1.91%. In January - the last month for which we have data on mortgage lending - the Euribor rate was 2.27%.

The reasons lying behind this upward movement in Spanish mortgages are twofold. On the one hand the Spanish banks are having increasing difficulty raising finance due to their perceived risk level, and on the other they themselves have have been forced to raise the risk premium they charge to clients due to the rising levels of non performing mortgages they have on their books.

Basically what this means is that the ECB policy isn't working in Spain, and that despite the massive quantities of liquidity provided, the monetary conditions continue to tighten, and doubly so give that the real value of the rates charged (ie the inflation adjusted value) keeps rising automatically as inflation falls.


Mortgage lending in Spain more than halved in January while the number of homes started in the fourth quarter dropped an annualy 62 percent. The 51.7 percent year on year fall in mortgage lending for urban dwellings was the steepest in 12 straight months of decline.



House sales fell in January by 38.6 percent, figures published earlier this month showed, and Housing Ministry data showed the foundations of only 40,737 homes were laid in the fourth quarter - 62 percent fewer than in the fourth quarter of 2007, and 27 percent down on the preceding quarter. During 2008 as a whole, Spanish builders started 360,044 homes - a 41.5 percent fall on 2008. On the other hand 633,228 homes were completed last year, reflecting the optimist which prevailed in 2006/07 when the buildings were started at the height of the boom in 2006-07.




Spain has a supply overhang estimated at almost any number you like over 1 million unsold homes (the minimum estimate, and no one really knows), or more than three times the number of new households created each year in Spain.

The number of mortgages offered has crashed as banks restrict credit given forecasts non-performing loans will reach around 9 percent next year, while unemployment is now likely to rise above 4.5 million by years end, up from the current 3.5 million.

As I indicated in this post yesterday, we are moving from a situation where people the banks were afraid to lend, to one where people become increasingly afraid to borrow (since they don’t know when they will lose their jobs, or even their homes), with Spain's citizens becoming more and more reluctant to take on additional debt due to fears they could be caught in the next round of job losses.

As a result January mortgage lending falling to 6.47 billion euros, while the rate of new bank lending to households dropped to 3.9% year on year.





Spanish debt defaults leapt 197 percent in 2008, with construction and property firms accounting for 4 of every 10 failures. The number of firms and individuals that filed for administration rose to 2,902, the highest level on record, according to Spain's National Statistics Institute. Also bad loans at Spanish banks rose by 15.3 percent in January, the sharpest monthly increase since property developer Martinsa Fadesa filed for administration in July. Bad loans rose more than 9 billion euros to 68.18 billion in January compared with an average monthly rise in the last six months of around 5 billion euros.

The non-performing loans (NPL) ratio for all institutions was at 3.8 percent in January, up from 3.3 percent in December, with rates among savings banks the highest at 4.45 percent compared with 3.79 percent a month earlier. Commercial banks had an NPL ratio of 3.17 percent, up from 2.81 percent. In fact Spain's financial institutions have seen NPLs more than quadruple in the last 12 months from 16.23 billion euros in January 2008.

Spain's savings banks, responsible for about half the country's loans and the most exposed to the property market downturn, could see NPLs rise to 9 percent by 2010, according to the saving banks association.

What To Do With The Bad Banks?

As a result of all this an embarassing and very public row (unusual in Spain) has broken out over what to do with the broken banks.

The Spanish Economy Minister Pedro Solbes has said the government is prepared to recapitalise healthy banks but suggested that those with serious solvency problems should seek a merger rather than look for state aid.

"In cases where banks have acted correctly in relation to solvency and the health of their accounts...logically they could receive support," Solbes said in a speech to an economic conference in Madrid. "Banks that are unable to remain solvent and clean up their accounts should cease to be players in the financial system so they don't generate distortions in the public sector."

What Solbes has in mind is that the troubled banks should turn to Spain's privately-funded Deposit Guarantee Fund (FGD) should they need capital injections to make tie-ups viable. However, the insurance fund holds only 7.2 billion euros in bank contributions, and since this is orders of magnitude less than the size of the problem it is obvious the government will end up having to putting money into the recapitalisation process, and especially into the Savings Bank sector, since the Spanish press has been reporting that 20 of Spain's 45 savings banks are now considering mergers. And it is obviously only a matter of time before one of the mid-sized Spanish banks like Popular, Sabadell or Banesto joins the consolidation process.

Clearly many of those most directly involved in the banking industry are laothe to accept the Solbes formula, since wuite simply they cannot afford it. And this was made pretty clear by Francisco Gonzalez, chairman of Spain's second largest bank BBVA, when he pointed out last week that nationalisation of the bad banks was the only realistic way forward.


"When a bank shows signs of extreme weakness the authorities should take control of it, which implies removing the directors and reducing or eliminating share capital in the institution," Gonzalez said at a conference in Madrid.Governments should then appoint a new team to separate toxic assets from healthy ones and quarantine them in publicly controlled funds, the chairman said, advocating a level of state intervention not yet seen in Spain. "Then the bank would be privatised again through a transparent sale to private companies," he said, without making specific reference to Spanish banks.


Two Spanish regional savings banks have already reached a preliminary merger deal - Unicaja, based in Spain's southern Andalucia region, and the smaller Caja Castilla La Mancha (CCM), located in the central-southern province of the same name - following talks which were carefully brokered by the Bank of Spain. Clearly this merger willl need to be followed by a capital injection from Spain's Deposit Guarantee Fund to help them clean up the "troubled assets" which will naturally be found in the combined accounts of the new bank which emerges. Many other such regional caja "weddings" are obviously soon to follow. But the big question is, where will all the financing come from? It is pretty clear that the problem which is building up is bigger than Spain can handle alone, and finance (not loans) from the European Union will be needed, with centrally backed EU Bonds being the most likely mechanism with which to fund the injection.

Update Sunday: No Caja Castilla-La Mancha/Unicaja Merger

Finanzas.com had this piece which I am publishing direct in Spanish while I sort out what is happening a bit more. This is obviously the first, but it certainly won't be the last.

There is going to be no merger between these two banks, since the Bank of Spain has decided to "intervene" in the running of Caja Castilla-La Mancha, due to its "delicate financial situation". Below is a link from

No habrá fusión con Unicaja. El Banco de España va a intervenir Caja Castilla-La Mancha (CCM) debido a su delicada situación fiancniera y su desfase patrimonial, estimado en unos 3.000 millones de euros.

La decisión está tomada en fin de semana previsiblemente para evitar la posible fuga de depósitos. La caja manchega se encuentra actualmente en plenas negociaciones con la malagueña Unicaja para una eventual fusión, una operación avalada por el Gobierno y tutelada por el Banco de España y que el PP ha denunciado por "oscurantista".

Los 'populares' incluso han solicitado en las Cortes de Castilla-La Mancha una comisión de investigación que determine las responsabilidades de los "gestores políticos de la caja" en unos posibles créditos dudosos que han supuesto que CCM tenga ahora un abultado agujero, que algunas fuentes cifran en 3.000 millones de euros.

La entidad que preside Juan Pedro Hernández Moltó obtuvo en 2008 unos beneficios individuales de 92 millones de euros y 30,2 millones de euros de beneficios consolidados.

Fuentes próximas al Consejo de Administración de CCM han indicado hoy a Efe que la caja manchega prevé adelantar al 31 de diciembre de 2008 las dotaciones previstas para el 2009 e incurrir incluso en resultados negativos, con la finalidad de fortalecer su estructura patrimonial, en la próxima reunión del Consejo, que tendrá lugar este martes.

Tuesday, March 24, 2009

Retail Sales and Bank Lending In January

Well just two topics here, one almost an incidental detail at this point, and the other something which goes right to the heart of the problem.

First off, Spanish retail sales fell a calendar-adjusted 5.4 percent in January compared to a year earlier, clocking up in the process the the 14th straight month of of decline. The pace of the contraction did slack slightly from the previous month, but I don't think we can draw much in the way of conclusions from that, since we are at the height of what is left of the "stimulus programme".




Looked at from the long view, January's fall came on top of a 2.4 percent year on year decline in retail sales in January 2008, so January 2009 level of sales was about 8 percent lower than in the same month of 2007, which must surely give us some sort of indication of the force of the present contraction - especially since things have hardly even gotten started yet.



The Decline In Household Lending Continues In January

Now for the data point that goes to the heart of the problem. Look, if you want to understand what happens next in Spain now, you need to follow two variables, the contraction in the annual rate of bank lending (to both households and corporates), and the closing of the massive (10% 2008) current account deficit. These two processes go hand in hand, and make the Sanish economy more like a ball of negative energy at this moment, with the contraction feeding of itself as the one interacts with the other.



The other two key vaiables would be employment and prices. As people progressively lose there jobs this only drives consumption and investment further downward, and as prices start to fall (as they surely will with this blast driving into them, deflation) then nominal (as opposed to real) GDP will start to fall, with current price GDP dropping more than price corrected GDP, which will send us off into an Alice in Wonderland world where the only "for sure" thing is that the weight of debt hangs heavier and heavier on people's shoulders.

In fact household lending fell again in January, by 853 million euros, while year on year the rate of increase dropped to 3.9% year on year. The January drop follows a 4,3 billion fall in December. If it goes on like this we will hit negative lending grwoth year on year at some point.



Lending to corporates was up by 3.6 billion euros in January, but again the rate of increase is down, falling to 6.4% year on year.





Update: Construction and Industrial Output

In the construction sector, seasonally adjusted production1 rose by 1.3% in the euro area and by 1.8% in the EU27 in January 2009, when compared with December. In December 2008, production fell by 2.8% and 1.8% respectively. Compared with January 2008, output in January 2009 dropped by 9.1% in the euro area and by 7.3% in the EU27.

Before reading what follows I think it is worth bearing in mind that construction covers both housing and civil engineering, so we may well see month on month increases in some countries (like Spain) based on the substantial government stimulus programmes, but we should not draw any major conclusions about this. Weather is also, evidently, a factor in winter, since even while seasonal adjustments are made, the weather does fluctuate significantly in winter, with evident effects on construction activity. Some evidence for this can be seen in the case of Slovenia, where activity was up 22.4% on January over December, but down 20.7% year on year in January.

Monthly comparison

Among the Member States for which data are available for January 2009, construction output rose in five countries and fell in six. The most significant increases were registered in Slovenia (+22.4%), Spain (+7.8%) and Sweden (+2.2%). The largest decreases were recorded in Hungary (-13.9%), Germany (-7.8%) and Romania (-6.4%).


Building construction grew by 0.1% in the euro area and by 1.8% in the EU27, after drops of 2.6% and 2.8% respectively in December. Civil engineering rose by 5.1% in the euro area and by 2.3% in the EU27, after drop of 2.7% and 1.4% respectively in the previous month.


Annual comparison

Among the Member States for which data are available for January 2009, construction output rose in three countries and fell in eight. Increases were recorded in Poland (+9.1%), Romania (+7.0%) and Sweden (+1.2%). The largest decreases were registered in Germany (-25.6%), Slovenia (-20.7%) and Hungary (-16.0%).


Building construction fell by 12.0% in the euro area and by 9.0% in the EU27, after -14.7% and -12.0% respectively in December. Civil engineering declined by 1.6% in the euro area and by 2.1% in the EU27, after -9.9% and -5.4% respectively in the previous month.

So Spain's contraction continues even when the stimulus programme is added in, even if at a reduced rate in January.

But if we look at the output index, then the decline since early 2007 is obvious and constant, that is there is no evidence of any slowing down, nor should we expect to see that much, since even when the Spanish economy starts to "steady up" this industry will need significant downsizing.



And if we look at this chart below - which comes from a recent Deutsche Bank presentation, we can see just why the downsizing will be so large, since housing output in Spain and Ireland was just way way above all the rest.

As Deutsche Bank note:

In Spain the supply of new housing units exceeded the number of new households by more than 300.000 units p.a. in the last few years. This has led to a vacancy of more than 1 m units.

In only a few years nearly 90.000 new residences were built in Ireland, a country with only 4 m inhabitants (three times more than in Berlin in the boom years).

Their conclusion that the United Kingdom, France and especially Germany should be affected less on the supply side seems eminently reasonable to me.

Industrial Output


In January 2009, seasonally adjusted industrial production1 fell by 3.5% in the Eurozone2 (EA16) and by 2.9% in the EU272. In December3 production decreased by 2.7% in both zones. In the year to January 2009 compared with January 2008, industrial production declined by 17.3% in the Eurozone and by 16.3% in the EU27.

In January 2009 compared to December 2008, production of non-durable consumer goods fell by 1.1% in the Eurozone and by 0.3% in the EU27. Energy decreased by 1.6% and 0.4% respectively. Durable consumer goods dropped by 2.6% in the Eurozone and by 1.8% in the EU27. Intermediate goods declined by 3.6% and 3.4% respectively. Capital goods fell by 6.0% in the Eurozone and 5.7% in the EU27.

Among the Member States for which data are available, industrial production fell in fourteen and rose only in Ireland (+6.7%) and Hungary (+2.5%). The most significant falls were registered in Latvia (-11.2%), Portugal (-9.8%) and Germany (-7.5%).




Annual comparison

In January 2009 compared with January 2008, production of energy fell by 2.9% in the Eurozone and by 4.4% in the EU27. Non-durable consumer goods decreased by 4.9% and 4.0% respectively. Durable consumer goods declined by 18.0% in the Eurozone and by 18.3% in the EU27. Capital goods fell by 21.4% and 21.1% respectively. Intermediate goods fell by 24.4% in the Eurozone and by 23.7% in the EU27.

Industrial production fell in all Member States for which data are available. The largest decreases were registered in Estonia (-26.8%), Latvia (-23.9%), Sweden (-21.1%) and Hungary (-21.0%), and the smallest in Ireland (-0.8%), Lithuania (-4.7%) and Denmark (-9.6%).

Spain's output was down 20.2% year on year according to Eurostat data.

Sunday, March 22, 2009

Ireland Faces A Tough Budget And Some Hard Decisions

Well, today I am taking an unusual decision. I am publishing whole an article from Ireland, by the Irish Independent's Alan Ruddock. I am doing this since I think the whole situation in Ireland should be of interest to Spanish readers, since Ireland is in many ways the country in the Eurozone which is most like Spain. With the important difference that Ireland has already started to get to grips with its correction, while Spain has hardly started.

Before going ahead, I would draw attention to a Paul Krugman post yesterday, since I agree with this almost more than I can say. The basic point is that the Obama-Geithner plan looks like it may well not work, because people are buying up assets which no one really knows the value of. The thing is why has the banking system dropped so much in value.

If you think it’s just a panic, then the government can pull a magic trick: by stepping in to buy the assets banks are selling, it can make banks look solvent again, and end the run. Yippee! And sometimes that really does work.

But if you think that the banks really, really have made lousy investments, this won’t work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that’s the Swedish solution, it’s what we eventually did with our own S&Ls.

Now, early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that’s an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.
There is an analogy in the European situation as I try to argue in my Krugman Says Nationalise The (Bad) Banks, And I Say Nationalise The (Bad) Countries post.

And in a subsequent post he makes the following point:

Brad treats the prospect that assets purchased by public-private partnership will fall enough in value to wipe out the equity as unlikely. But it isn’t: the whole point about toxic waste is that nobody knows what it’s worth, so it’s highly likely that it will turn out to be worth 15 percent less than the purchase price. You might say that we know that the stuff is undervalued; actually, I don’t think we know that.


That we simply have no idea what most of this toxic stuff is worth is what I have been tirelessly arguing on this blog (and to many protests from the "analysts" since summer 2007 about the Spanish cédulas hipotecarias. Since we have no idea at all what the Sapin's houses (and the associated mortgages)are worth, how could we? Basically we have no real idea to within any reasonable order of magnitude what Spanish GDP over the next decade is going to be worth. Which is why I have been arguing all along that the ECB should buy up all 300 billion euros (or so) worth of them (30% Spanish GDP) and park them in the vault in a locked box marked "not to be opened till 2030" (like the ECB minutes).

And also why I argue we need another 300 billion euros from those EU Bonds I hope we will be seeing one day, simply to clean out all the bad building and developer loans there are in the Spanish banking system. Do we need a Swedish solution for the Spanish banks, I don't know yet, I think we need to wait and see how the situation develops before making judgements like that. The cyst is swollen and festering, but it hasn't burst yet.

Meanwhile it is the Spanish real economy that is breaking apart at the seams.

Back then to Alan Ruddock. I would single out a couple of paragraphs as worthy of note (as well as all the background on the furor about the ECB bailout fund.

He is definitely for the Swedish solution in Ireland:
If the leaks so far are to be believed, the Government is being guided towards yet another half-way house solution that will shovel all the costs onto the taxpayers, all the rewards onto the banks and will store up more trouble for a later day without freeing up the banks to lend into the economy.

The neatest solution -- temporary nationalisation of the banks, the creation of a 'bad company' to hold the bad debts and the re-privatisation of the cleaned up banks -- is avoided like the plague. Instead, we will either carry the insurance risk for the banks' poor lending decisions, or we will buy those bad debts for ridiculously inflated prices.


So now, here is the complete article.

Kill or cure: Budget is crucial to our survival

The Government must drag the country out of this crisis before the EU comes looking for its pound of flesh, writes Alan Ruddock

There was no ambiguity in Otto Bernhardt's comments last week to Reuters, the international news agency. Bernhardt, who chairs a finance policy group in the German parliament and is a relatively senior member of Chancellor Angela Merkel's CDU party, was outlining the European Union's plans to bail out struggling member countries.

"The finance ministers have agreed the procedures. The core point is: 'We won't let anyone go bust','' he told Reuters. Ireland, he said, was in the "worst situation of all", followed by Greece, and he was clear, too, about the pound of flesh that Germany would extract as the price of its support.

"We would look very closely at past sins. We will not tolerate there being low-tax countries like Ireland for example. We will insist on a minimum corporate taxation rate."

In the event of a default, or imminent default, Bernhardt said: "We are in a position to act within 24 hours. The ECB would take immediate action. The ECB can make an unlimited amount of money available . . . What is the alternative? We would otherwise lose our currency."

His comments caused consternation in Dublin and Brussels and were dismissed out of hand by Brian Cowen, the Taoiseach, and Micheal Martin, the Minister for Foreign Affairs. Peer Steinbruck, Germany's finance minister, was a bit more circumspect. "I can't confirm such a meeting (of finance ministers to agree the plan) or such conclusions," he said.

Bernhardt later claimed he had been misinterpreted, but it is hard to see how. He was speaking the unspeakable, but it makes sound sense: if Ireland or Greece or any other struggling member of the eurozone should tip perilously close to default, Germany and the rest of the EU will have little choice but to lend immediate support, because if they allow default they will invite the destruction of the euro.

Joaquin Almunia, the EU's economics commissioner, said as much recently when he confirmed that the EU did have a plan to help struggling eurozone states but said, "It is not clever to talk in public about this solution". Indeed.

Such common sense should be reassuring, but it is not. The knowledge that help is on hand is balanced by the realisation that the rest of Europe thinks we will need that help and is already manning the lifeboats.

For Cowen and Brian Lenihan, the Minister for Finance, Bernhardt's comments are nerve-jangling. Next month's emergency Budget will determine the country's future: within weeks, possibly days, of its delivery, Ireland will be declared a basketcase, or it will limp into remission.
And if that were not enough pressure, the slow-burning crisis in the Irish banking sector is still far from resolution. If the leaks so far are to be believed, the Government is being guided towards yet another half-way house solution that will shovel all the costs onto the taxpayers, all the rewards onto the banks and will store up more trouble for a later day without freeing up the banks to lend into the economy.

The neatest solution -- temporary nationalisation of the banks, the creation of a 'bad company' to hold the bad debts and the re-privatisation of the cleaned up banks -- is avoided like the plague. Instead, we will either carry the insurance risk for the banks' poor lending decisions, or we will buy those bad debts for ridiculously inflated prices.

First up is the Budget, though the point of crisis moves so swiftly that the banks could easily force their way to the top of Lenihan's agenda over the next two weeks.

Until the publication of last week's retail sales figures, the Government had been leaning ever closer to the opportunistic populism of the Labour Party and the rest of the redistributive Left, softening us for a series of punitive tax increases on the 'wealthy' (code for the middle classes) and lesser tax increases on everyone else.

Those tax increases would be presented as a sign of Government toughness, but in truth they would be just another device to avoid tackling the real problem: the Government's spending.
Huge tax increases and headline cuts in some capital programmes might raise money on paper, but they will do nothing to deal with the structural problems that have caused the Government's borrowing requirement to spiral out of control, and they risk causing deeper harm to the economy.

The awfulness of those retail sales figures -- down 20 per cent in volume terms, the worst fall on record -- must have stopped Cowen and Lenihan in their tracks. The figures gave the clearest evidence yet that this country is gripped by fear -- fear of job losses, fear of tax increases, fear of shadows.

There is no chance of confidence returning to Irish consumers until they are certain that all the bad medicine has been administered, so the Budget has to be tough enough to make people realise that the Government has woken up to its responsibilities. If people fear that yet another emergency Budget is just a few months down the line, or that the December Budget will impose yet more pain, then spending will shrivel and last month's record will soon be broken.

The figures should also have made Cowen realise that taking yet more money out of consumers' pockets carries enormous risk. He must see that his priority is to cut government spending, and only turn his attention to tax increases once he has exhausted all other possibilities -- including privatisation and tax reform.

It is an incredibly difficult balance to strike and his task is made far, far more difficult by the failings of the Bertie Ahern years. His and Ahern's abject failure to reform the public sector or embrace privatisation -- a direct result of the sclerotic effect of social partnership on Government thinking -- has left him with a huge problem.

The public sector trade unions are already flexing their muscles, calling strikes and filling the airwaves with disingenuous cries for 'fairness', when what they mean is 'let the private sector take the pain'. It is class warfare by a subtler route, but it is still class warfare.

Cowen has been conditioned by social partnership and is frightened by its breakdown, so he tries to rebuild it when he needs to confront it. His task is made more difficult by the opportunism of the opposition parties, who court populism to inflict political damage, but by so doing put the country at even greater risk.

Richard Bruton, Fine Gael's finance spokesman, made a powerful case for politics as normal in Friday's Irish Times. "Adversarial scrutiny and accountability will not be abandoned in favour of a phoney consensus," he said, dismissing out of hand the notion that Opposition and Government should form a united front to deal with the economic crisis. It is a valid point if the opposition parties can find the courage to scrutinise honestly. For the moment, they can not. They are blinded by the prize of destroying Fianna Fail and cannot see that they risk destroying much more than just a political party.

Honesty is required urgently: from Cowen, Enda Kenny and Eamon Gilmore. They might all dismiss the idea of a national government, but they must agree on a unity of purpose. Whatever their political differences (which are slight), they must put aside personal animosity and personal ambition to deal honestly with this crisis. If they do not, the Government will not find the courage to tackle its spending and the markets will pass a very hostile verdict on the April Budget. And then we can prepare for Otto Bernhardt and his pound of flesh.

The Almunia Syllogism



European Monetary Affairs Commissioner Joaquín Almunia recently, and possibly totally inadvertently, stumbled on a very interesting argument. Here it is:
"Who is crazy enough to leave the euro area? Nobody," Almunia said. "The number of candidates to join the euro area increases. The number of candidates to leave the euro area is zero."


Reductio Ad Absurdum

Now you don't need a PhD in economics to understand what follows, although a little bit of basic logic would help. What we have here could be construed as a kind of syllogism (and from now on let's christen this one "The Almunia Syllogism"). The Almunia Syllogism has the following form:

a) Anyone leaving (or aiding and abetting the departure of someone from) the Eurozone is crazy
b) The EU Commission, The ECB and The National Leaders are not crazy
c) Therefore no one will leave, or be allowed to leave, the eurozone (at least under current conditions)

Q.E.D. We Will Have A United States Of Europe.

Well, ok, I do need to add a lettle lemma here to the effect that the only way to enforce (c) is to build the necessary architecture, and there is room for debate about this, since this lemma is neither proven, nor is it self evident. You also need to accept that there is an excluded middle here, and we do not have a "now either the EU leaders are crazy ot they aren't" fork which we can get diverted down.

As I say, the lemma is not self evident, although my own opinion is that in the weeks and months to come its validity will become extraordinarily clear even to the most reticent among us, but this still needs to be established. The thing about the lemma is that it focuses the debate. Those who do not agree with it need to be able to show how we can have (c) within the present architecture (since here there is a middle to exclude, either we can or we can't). The results coming out from the "we can" camp are not entirely encouraging. For example, ECB Executive Board member Lorenzo Bini Smaghi's recent attempt to argue that Krugman has it wrong, and that (we can manage with what we have) fails stupendously to convince, in my opinion, and especially the extract I reproduce below (which exemplifies precisely the point those who want new achitecture are making).

For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The whole issue is that we need a mechanism to average out the stimulus, is that so hard to understand? Is this obscurantism, or simply stupidity?

A Literary Trope Not A Syllogism

On the other hand, the formal validity of the following "utterance" from Almunia is rather more questionable.

"Don't fear for this moment," he said. "We are equipped intellectually, politically and economically to face this crisis scenario. But by definition these kinds of things should not be explained in public."

The first phrase is an exhortation, one which I would agree with (but not for the same reasons), the second is an assertion whose truth content is, at least, questionable, while the third is an admission, one which would perhaps better not have been made, or a piece of advice, which the unfortunate Otto Bernhardt seems never to have received.
A senior German lawmaker said euro zone states stood ready to come to the aid of financially fragile members of the currency bloc, sparking furious denials from European leaders that a specific rescue plan existed. Otto Bernhardt, a leading lawmaker in Angela Merkel's Christian Democrats (CDU), told Reuters in an interview late on Thursday: "There is a plan."

and then Bloomberg let us know a bit more about the details of the plan.
The German Finance Ministry has no knowledge of a rescue fund organized by the European Central Bank for troubled euro-region members such as Ireland and Greece, spokeswoman Jeanette Schwamberger said.

Otto Bernhardt, finance spokesman for Chancellor Angela Merkel’s Christian Democratic Union, said in an interview with Reuters today that the ECB has a fund at its disposal to help troubled countries and can make money available at 24 hours’ notice.

Thursday, March 19, 2009

The Serial Borrowing of Catalonia's "Robin Hood"

From Wikipedia:

Enric Duran, also known as "Robin Bank" or "Robin Hood of the Banks" is a Catalan anticapitalist activist and member of the "Temps de Re-volts collective". On September 17, 2008, he publicly announced that he had 'robbed' dozens of Spanish banks of nearly a half-million euros as part of a campaign of political action to denounce what he termed the "predatory capitalist system" and finance various anti-capitalist movements. From 2006 to 2008, Duran took out 68 commercial and personal loans from 39 banks with no guarantees or properties as collateral. Duran published an article entitled "I have 'robbed' 492,000 euros from those who most rob us in order to denounce them and build some alternatives for society" explaining via the internet that he had taken out a series of loans from numerous Spanish banks as well as publishing his "confession" in the Catalan magazine Crisis. Duran called his action an act of 'financial civil disobedience.'


Of course, while Timothy Geithner recieves a supportive understanding pardon for his "sin of omission" (he forget to present adequate tax returns), and AIG directors continue to haggle about their bonus payments, Duran is whiling away his time in prison awaiting trial on charges of fraud. There is a fairly credible rumour going the rounds that he will be receiving no support from the official government "bail"-out fund.

Meantime we are constantly reassured that Spain's banks are completely sound, that every loan was judiciously and meticulously checked, and that there really is nothing at all to worry about.

My point here is not to defend Duran's actions, but to highlight the double standards embodied in the way we go about things. I think his case can also give us some inkling of an insight into why it is that some of our young people are now becoming so disaffected. Apart from being left with the lions share of the debt to pay off over the years to come, they will also be called upon to sustain our ever more fragile pension systems.

We are told that recovery is just round the corner, maybe as soon as the end of this year. Personally I fail to see how this can be the case, not only because none of the macro economic data I am looking at are consistent with such a view, but also because it isn't at all evident how things can ever "correct" themselves while we still have such a massive "values overhang". Part of the problem we just got into was about greed (it always is), not just the greed of those who wanted an ever bigger cash bonus, but the petty greed of all those millions who got themselves ever deeper into debt on the basis of the flawed idea that the price of their home (or second home) would simply go up and up forever. We still have a lot of "cleaning out" to do in this department, all of us, before what is steadily getting worse can start getting better.

The much maligned Keynes went to work as a volunteer at the Bank of England during World War II, the man who was arguably the twentieth century's greatest philosopher (Ludwig Wittgenstein) spent the war as a porter in Charing Cross hospital (he was already old, and a pacifist), while one of Russia's greatest painters, Pavel Filonov, starved to death in 1943 since stayed behind in a beseiged Leningrad simply to take care of a sickly old woman. When we start to see people of this calibre up there and running things, then we will know we are starting to emerge from the crisis. Meantime, its "war" as usual, although hopefully not the type of "class war" that Duran and his associates would have us get ourselves into.

Of course, these scenes shot outside Barcelona's central university yesterday afternoon are one good example of how NOT to handle the crisis.

Monday, March 16, 2009

Getting Ready

Paul Krugman has a reasonably to the point Op-ed in the New York Times today. And he came, it seems, all the way to Madrid to write it. It starts off like this:

I’m concerned about Europe. Actually, I’m concerned about the whole world — there are no safe havens from the global economic storm. But the situation in Europe worries me even more than the situation in America.
and ends up like this:

For much of the past decade Spain was Europe’s Florida, its economy buoyed by a huge speculative housing boom. As in Florida, boom has now turned to bust. Now Spain needs to find new sources of income and employment to replace the lost jobs in construction. In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.

Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.

But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?

Amen to that!

Meanwhile, Pedro Solbes has been talking about EU Bonds:

The euro zone is not yet ready for a joint bond but states in the 16-member currency area could coordinate their debt issuance more closely, a German newspaper on Wednesday reported Spain's economy minister as saying. 'I think the currency union is not yet ready for something like that,' Economy Minister Pedro Solbes, referring to the idea of a joint bond, told Germany's Handelsblatt in extracts of an interview to run in the business daily's Thursday edition.

So the argument isn't that they are not a good idea, it is that - with Spain's unemployment now at 3.5 million, and money starting to run out on the public works "stimulus programme" - we aren't yet ready for them. When will we be ready, when unemployment here hits 5 million, or six, or seven, or when we have 5 million people who have run out of INEM payments, or when things start to fall apart at eurozone level perhaps? Come on. Enough of all this passivity. Let's have some action up there. The issue is we set up a currency union without the necessary political architecture to make it work, so now we need to go to work on the architecture. Do our leaders have the mettle to finish the job, or, as Krugman fears, are they simply intent on proving all the skeptics right!

You can find some explanation of what EU Bonds are, and how they might work, in this post here.

Incidentally, he also gives this bit of background to his Spanish visit on his blog:

I’m in Yurp for a week, spending some time on other peoples’ problems (although in a way it’s all part of the same problem.) And one has to say that Europe has gotten itself into one heck of a mess, worse even than ours — because they have intractable adjustment problems on top of the general crisis.


As he says, we in Europe have some pretty intractable adjustment problems on our hands, or at least they are tractable, but we need to be bold enough. If we can't have the luxury of devaluation here in Spain, then we at least need to make sure a policy of sticking to the 2% inflation ECB price stability objective is implemented. Krugman's post also has some pretty useful argument and explanation about the current account deficit and unit labour costs, which are pretty much compatible with what I ahve been saying here, for those who have been following this blog.

Tuesday, March 03, 2009

Eurozone Inflation Expectations Fall As The Output Gap Rises

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday


What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.



In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.




The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).


And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).


Monday, March 02, 2009

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.
Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).



Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.



Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.



Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.



Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.



and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.



So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).



REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.



Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.





Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.


As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?