Spain Economy Watch

A Month In Spain That Didn't Shake The World

2012-01-22T22:38:00.002+01:00

Journalists are undoubtedly having hard time following official economic policy in Spain at the moment. The core of the problem they face is that we have a hydra headed government which speaks with many tongues. In some ways the lack of coordination can be put down to simple newness and inexperience, although it should be noted that all the principal actors were in action the last time the PP was in office, as part of the Aznar government.

On the one hand there is Luis de Guindos, the former Lehman Brothers Spain CEO, who is now economy and competitiveness minister. Then, on the other, there is his dopellganger, Cristobal Montoro, long time professional politician with the country's Popular Party, who is the country's new finance minister. Then, of course, there is Prime Minister Mariano Rajoy who has decided he himself will assume overall responsibility for economic policy coordination and effectively be the country's economy "supremo", even though it is important to understand that he will normally communicate his decisions to us through the lips of his deputy prime minister, Maria Soraya Sáenz de Santamaría.

The key point to grasp here is what Soraya says goes.

Now having got that straight, and putting this important question to one side, we might like to consider other matters like economic policy, and how to handle that most serious crisis which Spain's economy finds itself in. Here Luis de Guindos has recently been most helpful, since he choose to use the pages of the Wall Street Journal to outline the general policy approach of the new government. As he tells us, "Fiscal consolidation is not a choice". In other words, Spain was going to stand by its commitment to try for a 4.4% fiscal deficit in 2011. (This reminds me of one of those old "billion dollar question" quiz shows, you know will you go for the big question, even though if you get it wrong you might loose everything - Spain is, he tells us, going for it).

This public revelation was, to say the least, curious, since at more or less exactly the same time the "other" economy minister - Cristobal Montoro - was telling the Financial Times Deutscheland (that's why I mentioned several tongues) that the government was having a rethink, and maybe in the light of such a strong recession in Europe, a slightly smaller deficit reduction would be more appropriate (for those who will loose the subtelty of the argument in the German version here is a brief English account).

Naturally - you already guessed - Soraya was quick to come out and make the position clear.

Hours later, the Spanish government scrambled to nuance the comments, which appeared to deviate from what has been a strict policy of deficit-cutting. Deputy Prime Minister Soraya Saenz de Santamaria said the government was determined to meet the 4.4 percent goal and if "more reforms and greater rigor" were needed to achieve it, they would be enacted.

Don't miss that bit, more reforms and greater rigour. Spain is evidently being entered for the "iron man" contest, although it wouldn't surprise me to soon see references to our dear Soraya as the new "Iron Lady".

Not that this was the first time she had had to step in and separate her tow squabbling economy ministers, signs of tension between the two departments had already appeared during the first days of the government, with Cristobal Montoro claiming the 2011 deficit was 8%, a complete 8%, and nothing other than 8%, while Luis de Guindos was saying that the final number was likely to be several tenths of a percentage point above 8%. On this occassion it was not Soraya, but the interior minister Jorge Fernández Díaz, of all people, who came out and gave the official government version, 8.2%.

Complete & Perfect Knowledge

Going back to the Luis de Guindos WSJ article, I would highlight a number of points. In the first place he makes a pretty strange claim. "We perfectly understand," he tells us, "the reasons our country has been brought to the outrageous situation of having the highest unemployment rate among developed economies." Now I don't know if I am alone in this, but I do find it a rather incredible, way of putting things. The phrase is even more incredible given that it repeats almost word for word a statement Prime Minister Mariano Rajoy declared earlier in the week. "My government," he told his audience, “knows perfectly well what it needs to do to improve Spain's reputation, stimulate growth and create jobs".

At face value it seems an almost arrogant way of putting things, given that perfect knowledge is something we humans are not normally thought to have, and doubly so since even among "experts" there is still a huge debate going on about why Spain's economy didn't recover along with many other developed economies, but then it occurs to me that such a bold posture may be more to do with uncertainty and insecurity about what to do, and the aparrent disarray among the various economy representatives does seem to give this idea some credance..

The claim that the Spain's new government have been drinking the elixir of total knowledge looks even more questionable when we look at the next claim de Guindos makes:

"In Spain, we have inherited a very centralized wage bargaining system that establishes salary increases at the sector level. This system has proved to be one of the main reasons for the loss in competitiveness we have suffered during the last decade".

I think Mr de Guindos is confusing two things here: why Spain lost competitiveness, and why Spain now has the highest unemployment rate in the developed world.

It's The Housing Bubble, Stupid!

Simply put I think Spain's centralised wage bargaining system can explain why Spain hasn't had an internal devaluation and wage and price reduction of the kind Latvia, or even, Ireland had. Spain's labour market and market structure is inflexible, and this is why the economy is having so much difficulty adjusting, and making the transition from a construction and consumer demand driven economy to an export driven one.

But this lack of labour market flexibility isn't NOT the main reason competitiveness was lost before the start of the crisis. The reason competitiveness was lost was the availability of excessively cheap borrowing made available by Europe's large and deep capital markets and cheap interest rates at the ECB. It was this massive and cheap liquidity which generated one of the largest property bubbles seen this century. The bubble created huge distortions (many of which have still to be unwound), and basically meant that it was too easy for everyone (workers and employers alike) to make money, so there was no pressure even on the employers themselves to address the fact they were paying increasing wages without getting increasing productivity. It was simply a "cool" time for everyone.

Other countries lost competitiveness during those years, but not all of them had the same labour laws or bargaining systems. The problem here is that if you don't "perfectly understand" why the country had the crisis in the first place, then you may not be able to put the consequences straight. Spain's problems have a clear European dimension, a dimension which goes well beyond the simple difficulty of selling bonds which forms part of the Sovereign Debt Crisis. Strangely Mr de Guindos's article has little to say on this point, so here he and his government would do well to study a little more closely the playbook Mario Monti is working from.

Now obviously Spain's labour laws and bargaining system needs reforming, and Spain's economy minister suggests that his government is working towards the kind of single contract being proposed by the authors of this article. Certainly they make a convincing case for the changes they propose, but my feeling is that a reform of this type won't be sufficient to dynamise growth in the way everyone is expecting, since the measure relies essentially on job churn to have an impact and this in an economy where employment is contracting, and likely to continue contracting over the next two years at least.

Evidently there is currently a high volume job churn in Spain, but this process is only taking place among those workers the authors term "ousiders" - the ones with secure long term contracts (the "insiders") tend not to move (for obvious reasons, and naturally this is why the labour market is rigid and inflexible). Basically the present system favours older workers to the disadvantage of younger ones, who have to face very high levels of unemployment (not far short of 50% in some age groups) and those who leave their studies with often excellent qualifications find few opportunities for rapid promotion and all the evidence suggest are voting with their feet and steadily leave the country, following in the footsteps of an Italian experience which was already very clear even during the first deacade of the century. If you are going to rely on labour market reform to carry out your competitiveness devaluation, then something much more radical needs to be contemplated: like resetting the whole current system of contracts and staring over again.

A Country Fit For Young People To Stay In

Naturally Spain's political leaders are reluctant to contemplate this, since the response from older workers already benefitting from seniority would be monumental. The electoral weight of voters over 50 in a rapidly ageing country like Spain is very important, and as far as politicians are concerned their neeeds are much more "strategic" than those of the far smaller generations of younger voters. It is not without significance that one of the fisrt measures the new government announced, despite the existence of what they call a most grave financial situation, was to raise pensions by 1%.

Part of the problem with restarting a broken and structurally distorted economy like the Spanish one how to enable companies to restructure and downsize. In particular, if the country is to adopt a "new economic model" this process needs to be made much cheaper for the individual concern, and wages need to be tied to productivity, not seniority, with compensation funds for redundancy being held by central government, and not at the individual firm level.

Spanish workers, like their Japanese counterparts, need to accustom themselves to the idea of adopting a second, less well paid, career in the 55 to 70 age group. We also need to get away from the idea that doing so-called "menial jobs" has some sort of social stigma attached. It sounds marvellous to talk about high-tech, high-value growth models, but the reality is that most of Spain's 55+ workers lack the necessary skills to participate in this, while there are lots of socially useful jobs (looking after old people, which is now almost entirely done by recent immigrants who continue arriving) that people could take on. Subsidising people at 58 to go for early retirement is no substitute for a sustainable employment policy.

Naturally Spain is not alone in suffering from this growing brain and talent drain. There is a steady flow of young talent away from Europe's periphery, and it continues to cause controversy. Only this weekend Ireland's finance minister Michael Noonan got himself into some hot water by saying that an important factor influencing young people in leaving the country was a lifestyle decision. Naturally there is a lifestyle choice involved, in particular since many of the young people leaving don't want to spend the rest of their lives in societies driven by "depresssion economics", accepting the kind of lifestyle their older compatriots seem quite content to vote for. They don't want to first have to accept the main burden of the crisis (as the "oustiders" in all those inflexible labour markets), and then the cost of maintaining in perpetuity the various oversubscribed health and pension systems which Europe's ageing societied are going to produce. Michael Noonan is quite right, leaving is a choice, and in many cases it is an appropriate and intelligent one. What is not appropriate and intelligent is the response of national politicians either denying the phenomenon doesn't exist, or suggesting the consequences won't be important.

No Money, No Credit, No Credit, No Jobs

Which brings us to the third strand of the new governments "gamechanging" policies, the reform of the financial system.
"The new financial reform we will launch shortly will oblige banks to increase their provisions sufficiently to cover any writedowns that may emerge on their real-estate-related assets and loans. Taxpayers' money will not be used to finance the additional regulatory requirements arising from the reform. All the funds implied will have to come from the system's own internal resources".

What this basically means is that while the ECB's 3 year LTROs will help banks with their liquidity problems, the banking system is going to be left to itself on the solvency related issues. Capital ratios have to go up, as will provisioning, and doing this without taxpayers mone lending will need to be cut back, there are no "ifs" or "buts". But if lending is cut back, how do you get growth or job creation?

Why is it so obvious, you may ask, that doing Spain's financial restructuring with only a minimum of government money will lead to a reduction in lending. Well actually, this idea is not so surprising, Spain's financial system is struggling, and if you look at the charts below you will see that lending in Spain (to both households and corporates) is falling and has been doing so for some time.

As Charles Penty reported in Bloomberg last week:

Loans and deposits at Spanish lenders fell at their fastest pace on record in November and defaults jumped as Prime Minister Mariano Rajoy prepared measures forcing banks to recognize more real-estate losses. Lending fell by 2.94 percent from a year ago and deposits slid 2.99 percent, the biggest drop since the regulator’s records started half a century ago, the Bank of Spain said on its website today.

Basically the issue here is that most of the economies on the Euro Area periphery are currently over leveraged. That is to say the proportion of their TOTAL debt (public and private) to GDP is too high relative to their future capacity to pay, and this problem is really behind why we had the global financial crisis in the first place (in most developeed economies including in the US). If 4 years into the crisis people haven’t gotten thru to this simple point, then they can't have been reading the right kind of material.It is important to understand that from this point of view it doesn’t matter whether the debt is public or private.

Now, and here comes the issue where there is debate, if you have too high a debt ratio (that is, if you are overleveraged) you can reduce it either by growing GDP (nominal GDP) or by reducing the debt. That is why Paul Krugman tries to ridicule those who say you can't reduce debt by contracting more debt. It isn't that simple. If you run a company, and you have a good product, then getting some working capital from the bank to let you produce, and even a subsidey from the government to get you started, then maybe by going to work you will be able to pay back more of what you owe. And as with the single company, so with the whole economy on aggregate.

But, here comes the rub: the countries on the periphery can’t get the growth they need until after they have deleveraged, since getting more credit will only make them even more leveraged and since they have a competitiveness issue they can't expand their export sectors as fast as they need to to get traction. So they are stuck, and this - and not the credibility of some ratings agency or other - is what the whole Euro Area debt crisis is about.

Once these economies have deleveraged, which means the banks will have less credit on their balance sheets, then, of course, the banks can leverage again and offer new credit. This kind of deleveraging is long painful and arduous, since it also produces deflation (economies contract along with credit) but with time (let's say a decade) competitiveness is restored. In the meantime it is not clear how many of the countries young people will have already thrown the towel in and left.

The other alternative is to write off bad loans, but this means accepting losses, and with these government intervention in the financial sector. So banks and governments are reluctant to do this, since it balloons the deficit (see Ireland), and prefer the slow process.

What I am saying is not that no new loans are possible, but that new loans can only be issued after old ones are paid or written off, and after the balance sheet has been reduced to deleverage a bit. Which means the quantity of new loans is not sufficient to produce growth or (in Spain’s case) stop unemployment rising.

This issue is deep structural (if complex) and there is no simple rule from a central bank which can produce new credit (although see my Masssendowngrade Effect post for more detailed explanation about bank "liability management", and how this interferes with the process of "creative destruction").

A Tripod That Doesn't Work
So Spain's government is basing its strategy on an attack on three fronts - the deficit, the labour market, and the financial system. They have made their analysis, and now they are going to work.

On the fiscal deficit, their argument is not, of course, incorrect. Fiscal consolidation at this point is not a choice but an obligation for Spain. However I can't help asking myself, given that Spain's debt to GDP at 70% is still significantly below the EU average, and given that the government isn't going to use public money to help clean bank balance sheets (at least it is going to try not to, it remains to be seen if it can avoid this outcome) whether it wouldn't have made sense to do what Cristobal Montoro was suggesting, and negotiate a bit more "wiggle room" with the EU on the 4.4% objective for this year, since really the cumulative effect of having a negative external environment, banks deleveraging and such drastic cutbacks will surely be - as I've been arguing - to send Spain into a serious economic depression (even the IMF now see Spain having a 1.7% contraction this year and a 0.3% one next, and the actual outcome could be significantly worse).

Spain's economic problems are very grave. The country is facing a decade long depression, and if enough young qualified people leave during this period then the country could enter a negative dynamic from which it will never properly recover. At the outset (2007) I and others argued for a 20% internal devaluation to shift resources over to the export sector. This did not happen, and virtually no one is interested in the idea. The main priorities are still reducing the deficit, and restructuring the financial sector without injecting any significant quantity of public money. Both these policies are contractionary in their impact. In addition the proposed labour market reform is timid, and won't act quickly enough to stop the rot on the growth front.

One of the key reasons given by Standard and Poor's recently for downgrading the Spanish Sovereign by two notches was preoccupations about the growth outlook in the context of the cut-backs and recapitalisation. Investor confidence and credit ratings will come back up when economic growth is put realistically back on the agenda for Spain. I have a feeling S&P's understand this reality a little more "perfectly" than Mr Guindos and his advisors do. In any event, at the end of the day we all live in an imperfect world where perfect knowledge is available only to gods not mortals.

The Rain In Spain Falls Mainly On The Journalists, It Seems

2012-01-01T16:17:00.001+01:00

Things in Spain are never exactly what they seem to be. This is a painful lesson that even Angela Merkel must have learnt in recent days, especially since she put her credibility so much on the line in backing the country's deficit reduction efforts. "Spain has really done its homework and I think it is on the right track," is the message she has been trying to sell to the world.

Naturally then she will not have been amused to learn last Friday that rather than the 6% promised under the Spanish stability programme, the country's deficit in 2011 is going to be something like 8%. Some sort of overshoot was long being anticipated, but such an overshoot? Naturally it isn't (quite) Greek proportions, but it is still hardly evidence for a credible and praiseworthy effort. This is the thing about Spain, it obviously isn't Greece, but still all isn't quite what it should be. Add to this deficit result the fact that the Bank of Spain is reported to be frantically pressuring banks into revising the valuation of their property asssets following the publication by ratings agency Fitch of a report which claims they are currently on average 43% overvalued. Naturally any major downward revaluation of the repossesed assets will give an entirely new reading for the balance sheets of many of the institutions involved (the Caja de Ahorros del Mediterraneo went from having a 50 million euro profit at the end of 2010 to 1.7 billion euros in losses in June 2011 following the application of just such a mark-to-market procedure - and the savings bank was finally sold to Banc Sabadell for the princely sum of one euro). Put two and two together here, and it is clear that the country's bond spread may once more be in for a bumpy ride when investors finally recover from their yuletide hangovers.

Excuses are, of course, already being prepared for this lamentable state of affairs, and in particular the argument is being run that in fact the responsibility here does not lie with Spain's central government (which was entirely composed of choirboys and girls), but with a lamentable set of constitutional arrangements which give far too much spending power and control to the country's regional governments. To some extent this is true, but as I say, it is important not to take everything here at face value, since as ever, all is not what it is made out to be.

This advice could, as it happens, have proved useful to New York Times reporter Suzanne Daly who vertently or inadvertently seems to have been taken for a complete ride with the article she wrote for the newspaper last Friday. The focus of the article was purportedly on regional extravagance in Spain, but in the event she seems to have allowed herself to be used to float a political agenda which primarily seeks to take the attention away from the country's central government, and the responsibility it has for the current lamentable state of affairs. Naturally examples of regional extravagance certainly abound (hell, the entire country was living beyond its means), but I started to smell a rat when I saw the example she chose to highlight in her article - the prison at Puig de Les Bases, Figueres (which just happens to be located only a few kilometres from where I live).

What worried me is that the prison you can see in the photo above is NOT an example of something that isn't needed, like a phantom airport, or a golf course where no one will ever play golf. The problem with Puig de Les Bases is not that there aren't prisoners waiting to be moved there from the two outdated prisons which are scheduled to close (there are, 300 of them, to which can be added an additional 450 once the new one is open). No, the problem here is that there isn't enough money to run the place after it opens. This situation is not untypical, since many town halls and regional governments, not to mention the central government itself with its new high speed train network that the country can ill afford, find that they invested money on projects using the extraordinary income they were receiving during the years of "excess" but that now they don't have the current revenue to keep the facilities created operating.

In fact Suzanne Daly does notice this, but she seems to get so carried away with the force of her own rhetoric that she doesn't catch the significance of the point.

"Evidence of the regional profligacy dots the countryside. On the top of a hill here in the birthplace of Salvador Dalí, in northeastern Spain sits a giant, empty penitentiary. But even without a single prisoner in residence, the prison is costing Spain’s heavily indebted regional government of Catalonia $1.3 million a month, largely in interest payments. If prisoners were actually moved in, it would cost an additional $2.6 million a month. So it sits empty, an object of ridicule around here, often referred to as the “spa.” "

So the question is, is this an example of regional profligacy, or an example of cuts which are biting, and a country which is coming to terms with its new reality?

The issue, however, goes deeper. The offending prison is in Catalonia, and Catalonia is a region which has long been seriously underfunded by the central government - indeed as was suggested by the regional minister of economics, Andreu Mas Colell, it looks suspiciously like the central government were not paying funds owing to some key regional governments to make the regional deficit look worse, and the central deficit look better.

Mas Colell, who is a former Harvard professor and distinguished micro-economist in his own right, recently told the central government that it should be ashamed of itself for withholding money which legally belonged to someone else (in this case 759 million euros for investments which have already been completed) and basically acting in complete bad faith.

"Els hauria de caure la cara de vergonya", "és una mala jugada poc honorable i que no oblidarem", "estan fugint i fent servir excuses de mal pagador", "són molt poc exemplars", "no poden desentendre's amb arguments pobres", "els avergonyirem". Són algunes de els expressions que ha utilitzat el conseller d'Economia per referir-se a l'impagament dels 759 milions per part de l'Estat...... Amb tot, el conseller veu una clara intencionalitat en el no pagament d'aquests diners. "L'Estat vol que se'ns carreguin a nosaltres els quatre punts de dèficit que suposen aquests 759 milions i no a ells. I no paga perquè no vol pagar i no vol augmentar el seu dèficit".

"They should be ashamed of themselves... its an injustice without honour, and we won't forget... they are running away from their responsibilities using the typical excuses of someone who doesn't pay their debts... this is hardly setting a good example... they can't ignore the situation isung pathetic arguments... we will make them feel ashamed". These are some of the arguments used by the Catalan economy minsiter with reference to the non payment by the Spanish government of the 759 million euros ... The minister did not mince his words when it came to the reason behind the non payment. "The central government want to put on our account the 0.4% percent of deficit which these 759 million euros will involve for us, and they don't want to add them to their deficit. They aren't paying simply becuase they don't want to pay, and they don't want to increase their deficit."

Naturally, the Catalan government is taking the central government to court over the issue, but given the efficacy with which justice is executed in Spain, I don't think I'd be waiting for the result before finding solutions to the problem all this represents.

The central point here is picked up on by a group called Collectiu Emma, (an association of activists which spends it time correcting factual inaccuracies which appear about Catalonia in the international press, inaccuracies which in no small part have their origin in a constant public relations campaign conducted from Madrid). As they say:

"One key point that is overlooked in your otherwise informative article on Spain's economic difficulties (As Spain Acts to Cut Deficit, Regional Debts Add to Woe, December 30, 2011) is that Spain is not a federal State. Under the country's fiscal arrangement taxes are collected by the central government, which will keep part of the proceeds for itself and distribute the rest among the regions to pay for the services that have been devolved. There is no correspondence between what the regions get to spend and the wealth they have generated."

"For the last year Catalonia, one of the most productive and most heavily taxed communities, has been undergoing painful cuts in services. And yet, the share of tax money that it contributes to the State and never comes back is estimated today at a staggering 8-9 per cent of its annual GDP. If Catalonia could use even part of those funds to finance essential services for its own population, it would have no deficit and no debt, and could even afford one or two extravagant schemes like those that other regions -and the central government itself- can enjoy as long as they are paid for with somebody else's money. Catalans would not mind a serious revision of the regional setup, but only if it envisages fiscal responsibility on the recipients' part, better control over their own money by those who have earned it and more transparent procedures by the central government".

Now one of the points Collectiu Emma didn't make, but could have, is that Catalonia is one of the few regional governments (and maybe the only one) which has responsibility for administering the prison service. Catalonia also received so little money from central government in 2011 that it effectively ran out of cash in December (not because it is "extravagant" but because it is seriously underfunded) to such an extent that it was not able to pay all public servant salaries for December before the end of the year. So in fact one of the reasons the prison is lying idle is that the central government is not forwarding money it has a legal responsibility to transfer, and the reason it is doing this is to massage its own deficit, and encourage people like Susanne Daly to write the article she wrote.

It gets worse, since some of the "misinformation" about the situation in Catalonia has, in my opinion, a deliberate political intent - to recentralise Spain. This is certainly the objective of tax minister Cristobal Montoro, since many in the Partido Popular are already very fed up with the fact we insist on using our own language, and doing things our own way (like banning bull fighting).

"And while Spain’s overall fiscal status is nowhere near as dire as Italy’s, it has another problem all its own, as the new budget minister, Cristóbal Montoro, made clear Friday: serious budget shortfalls in its 17 autonomous regions, which have spent recklessly in the past decade".

It is also striking how the article also draws attention to spending issues in the community of Andalusia (which is the only community the socialist PSOE really controls now, and which the PP hope to win in elections in the spring) while there is no real mention of communities like Valencia, or Galicia, which are controlled by the PP and where there are plenty of examples which could be mentioned, like the phantom airport in Castellon, built under the eager eyes of former Valencian President Francisco Camps, who had to resign and is now facing corruption charges in a trial which is currently attracting a lot of media attention.

Now I am sure, as the Collectiu Emma people point out, there are many examples here in Catalonia of projects which were not needed (the Alguaire airport in Lleida would be one), but the key difference here is that Catalans overspent using their own money, while many regional governments (some of them ruled by the PP) did so using Catalan money. So it is curious, to say the least, that the author decided to kick the article off with a big picture (see above) of a prison in Catalonia to serve as the stylised example to epitomise the problem.

But there is another issue being raised here, since it is not clear whether all the attention which is being focused on the Figueres prison is not - in some warped way - a by-product of protests by prison staff unions against the all the recent spending cutbacks. Searching around for background information, I discovered a most interesting article in El Pais (sympthetic to the Spanish socialist party PSOE) entitled "locos por ir a la carcel" (desparately seeking to go to prison). The gist of this article concerns the plight of a number of unemployed people who have passed the exams needed to have places in the prison service, but who can't be offered work since the prison is not open.

What the El Pais article offers us is the view of a heartless Catalan government making swingeing cutbacks on important social projects. Far from putting the blame on the outgoing socialist lead catalan government who built the prison in the first place, the article blames the new justice department head, Pilar Fernández Bozal, who hasn't opened because she hasn't been able to obtain the funding needed. The impression I get is that in this game it is hard to win.

At the end of the day the lesson I would advise Suzanne Daly (or Angela Merkel if it comes to it) to learn from this whole affair is that nothing in Spain is exactly as it appears to be, and that few of the arguments politicians and so called "experts" advance are entirely innocent. Mostl "information" circulating in Spain is highly politicised. Really "independent" analysts are virtually unknown.

Government and opposition in Spain operate like a revolving door. Crickey, I even saw outgoing Minister in the Zapatero government Alfredo Rubalcaba on TV yesterday, openly criticising Mariano Rajoy's government for all the cutbacks that have just been announced and for having no policy up to the task of dragging Spain out of its crisis, without even blushing or mentioning that the cuts in question were so big because his government overspent - or tolerated overspending - or that the policies the new government are following were basically identical with those which guided his own government.

Far from suggesting that the prison project was an extravagant excess, El Pais implies it is badly needed (since space in the Catalan prison system is extremely scarce), and my feeling is that with crime on the rise after 4 years of continuous crisis, El Pais is probably more right about this than the New York Times author is. Lesson to be learnt: simplistic answers to complex situations are rarely satisfactory. And if you want to come to Figueres and look for a spending white elephant, well, you need go no further than the high speed railway line linking the town with Barcelona. The track has been up and ready for around a couple of years now (see the bridge to nowhere in the photo above), but there is no sign of any train, since there is not sufficient money available to finish the job. But then this particular piece of short term redundancy was planned and executed by the central government on a live-now-pay-later basis, but that wouldn't fit the story we are being sold, now would it?

How Would You React To The News Your Local Central Bank Just Went Bust?

2011-11-21T09:56:00.001+01:00

Well, it's been more time than I care to remember since I posted anything on this site. In the interim many things have happened, especially on the European sovereign debt front. I think I now have plenty of stuff lined up to waffle about, but maybe one simple way to ease myself back in to the world of blogging would be to republish the lengthy interview I just gave to the website Barcelona International Network. The topics covered range from the debt crisis itself, to prospects for Spain under the new Partido Popular government of Mariano Rajoy, and to the kinds of tensions with might arise in the months and years to come between Catalonia and the rest of Spain, and, of course, how this relationship might itself in turn have an impact on the debt crisis itself.

Barcelona International Network: There seems to be some chaos and confusion surrounding the future of the euro and the sustainability of a cohesive eurozone at the moment. Can you briefly summarise the background to the present crisis?

Edward Hugh: You are right. The situation is far from clear. To understand what is happening now it is important to understand the evolution of this crisis from the beginning. Europe's monetary union was founded on the idea that with time the various economies which make up the Euro Area would ultimately converge towards one common prototype. This unfortunately has not happened, indeed what we saw during the first decade of this century was quite the contrary: the divergence of the constituent economies. Thus, while it is common to talk of "core" and "periphery" it is important to understand that the so called core economies are not identical, while those on the periphery do not all suffer from the same ailment. In Greece the problem has been excessive (and indeed almost fraudulent) deficit spending. In Italy the problem is accumulated government debt - debt which has been amassed during two decades now. In Spain and Ireland the problem is the bursting of a housing bubble, a bubble which was made possible by the application of an excessively loose monetary policy by the ECB. In Portugal the problem has been one of very low economic growth. etc, etc. So if there is not one common illness it is hard to apply one common cure.

In many ways it is unfortunate that the Greek crisis was the first one to break out, since this has reinforced earlier stereotypes that the problem with the Euro is the lack of sufficiently strong fiscal controls from the centre. This is surely the case, but it is only part of the problem, and far too much of Europe's leaders time and energy has been devoted to this issue, to the neglect of many others which in many ways have equal or even greater importance. What is true is that lying at the heart of the present crisis (across developed countries, that is including Japan, the UK, the US etc) is the issue of debt, whether this be public sector debt or private debt. That is why what we have is called a sovereign debt crisis.

In addition, another of the characteristic features that make this crisis historically unique is that it is occurring in the midst of an unprecedented process of population ageing in economically developed societies, with rapidly rising elderly dependency ratios - hence the importance given to the sustainability of health and pension spending into the future. It is not only accumulated debt that worries investors, but implicit liabilities, and how these are going to be met.

Thus the crisis of the Euro Area is only the most extreme form of a debt crisis which engulfs almost all developed societies. And the situation is only further exacerbated by the fact that the deleveraging of debt which is now required (and hence the likely low growth levels) have as a backdrop a surge in growth in many emerging economies which makes these an attractive candidate for investment from those who worry about the sustainability of debt in the mature economies. So the relative risk evaluation between developed and emerging economies is changing, and this process is unlikely to go into reverse gear. Developed society debt is unlikely to ever be so cheap to finance and so easy to sell as it was during the first decade of this century.

Barcelona International Network: What do you see as the three most likely future scenarios for the euro from this point, in order of increasing probablility?

Edward Hugh: As I have suggested, the Euro Area crisis is similar to that in other developed countries, but worse due to the institutional deficits with which the monetary union was created. In particular attention has focused on two areas, the role of the central bank (the ECB) and the lack of a common fiscal treasury. To some extent these deficiencies are now being remedied, but the pace of adaptation is slow, and the financial markets are starting to lose patience. Alarm signals have been going off over the last week, not only due to the surge in the yields on Spanish and Italian debt but also due to evidence that the infection (contagion) is now spreading to what was previously considered to be the core (France, Austria) with the evident danger that more countries will lose their triple A rating. Should this materialise it will make some earlier strategies for financing Euro Area debt essentially non-viable.

Thus the crisis is in grave danger of turning critical, with market attention increasingly focusing on the viability and the sustainability of the common currency itself. As President Barack Obama said recently the key question that now needs answering is who (or what) stands behind the Euro? "Until we put in place a concrete plan and structure that sends a clear signal to the markets that Europe is standing behind the euro and will do what it takes, we are going to continue to see the kinds of market turmoil we saw," he told a news conference in Canberra last week. The key point to grasp is that we are talking about money here. What is the financial backstop which lies behind and guarantees the currency?

This has put the spotlight on the ECB as an institution, but the bank is reluctant to adopt the role of ultimate guarantor. This is not principally due to the so called "inflation fear" - demand driven inflation is extremely unlikely in the Euro Area in the near term - but rather due to a fear of accumulating sizeable losses in the event that large quantities of bonds are purchased and then countries like Italy and Spain have to restructure their debt. The fear in Germany is that the German treasury could then be asked to shoulder the central bank recapitalisation. Hence there is a great reluctance to let this happen. Naturally some argue that a central bank can simply accept losses, since the bank doesn't necessarily need recapitalisation and could be allowed to carry on regardless of the red ink on the bottom line. I am not very convinced by this argument, in part because banking and currencies are all about confidence, and it is not clear to me how the world would react to a headline like "European Central Bank Goes Bust". I think my fears are shared by the Bundesbank, and my intuition is that they are not at all keen to run the experiment just to see what actually happened. As Mario Draghi recently put it, “losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs”.

Hence we have a logjam, with the investor world asking for clarification about who stands behind the Euro, and no one stepping out from behind the curtain to say "I do". In addition there is a kind of "dialogue of the deaf" taking place between the investor community and Europe's political leaders, with the latter asserting that what we have is simply a liquidity crisis, while the former are not convinced, and often consider that what we are facing to be a solvency crisis. The lastest proposal to emerge - that the ECB lend to the IMF who then lends to countries like Spain and Italy - simply highlights the sum total of all these difficulties.

According to the argument as it is going the rounds, the ECB is not allowed, according to its charter, to purchase sovereign bonds in the required quantity, or to lend to the stability fund (the EFSF) for the same express purpose. But the EU normally has little difficulty finding its way round initial regulations and treaty clauses when needs must (wasn't there an opinion once that bailouts would be illegal?), and in this case I am sure that if there were a will there would be a way. The problem is, as I am suggesting, there is no will for this solution from the German political leadership, due to the kind of losses which could be incurred. So the ECB asks the IMF to accept a loan and then lend on its behalf, but is this solution really credible? If a bank doesn't want to lend to a client due to concerns about the ability of the client to repay the loan, why should a neigbouring bank accept a loan from the first bank in order to lend to a client the latter does not want? What is involved here is a risk transfer, and it is not clear that non-European members of the IMF have any more stomach for accepting the losses which have been generated by 10 years of the Euro experiment than the core members of the Euro Area have. The UK posture in this regard is indicative - "you made the mess, now you clean it up".

Of course, matters are not that simple. In the first place the global economy is experiencing a slowdown, a slowdown which is in part being fuelled by the decline in global risk sentiment associated with the European debt crisis. So everyone has an interest here in finding solutions. The rise in bond spreads in both France and Austria is associated with a similar process.

In the French case investors are worried about the sustainability of French debt should Italy be forced out of the Euro, or be forced to restructure. French banks have something like 400 billion euros in exposure to Italian debt (both public and private), and were anything bad to happen to Italy then something bad would also inevitably happen to France. Which illustrates another feature of the crisis, the interconnectedness - via debt chains - of all the Euro Area economies. In principle the French economy is sound. It doesn't have an irresponsible government spending problem, and it didn't have a housing boom. Certainly the French economy is in need of structural reforms, especially in the labour market area, but it is not a deeply sick economy in the way that most on the periphery are. So the fact that French sovereign debt stability is now in question is a huge warning signal that things here could rapidly get out of hand.

The Austrian case is similarly worrying. "Contagion" means what it says, that parts of the body economic which get infected risk passing the infection to previously healthy parts if the underlying issues are not treated rapidly. This is what is now happening, and the clearest example is in the East, where many economies are now slowing rapidly as a result of the crisis in the Euro Area. This is putting pressure on debt instruments in the region - and in particular in Hungary - and this increase in risk aversion is then feeding back into Austrian bond yields due to the Austrian bank exposure to the East of Europe.

So basically we are all in this together, whether inside the Euro Area or out of it, here in Europe or in China or the United States. It is vital that some clear solution is found to the problem, and in particular that Europe make some rapid institutional changes which put real money on the table, and in sufficient quantity to calm the markets. Basically this means a common fiscal treasury in tandem with a much more interventionist ECB. Will this happen? At this stage in the game it seems unlikely, but then the alternative is the abysss, and peering directly into the abyss does have the strange property of concentrating people's minds, so you never know. Another possibility, which I have actively advocated, would be to divide the Eurozone in two, between a Northern core and the Southern periphery. This would be doable technically, and while being far from perfect would certainly go a long way towards easing the present stresses, but again, it would need clear, co-ordinated and determined action from the European leadership, and given everything we have seen so far there is little to suggest they will be able to rise to the challenge.

So we have the last "alternative" which is simply that markets push the issue to the limit, the centre does not hold (Germany, for example could be threatened with being stripped of its triple A), and the whole thing flies apart in the most disorderly and disaggreeable of fashions. If you were to ask me at this point which of the three above alternatives I considered most probable, I would have to say the latter, although naturally in no way do I wish this to happen, it is simply the risk that Europe's leaders are now taking. The worst part is that if involuntary Euro fragmentation did occur it could all happen very quickly indeed, as was the case with the initial attempt at EMU in 1992, although unfortunately this time round the consequences would be much more serious.

Barcelona International Network: What can the incoming PP government do in the face of this situation?

Edward Hugh: Despite popular beliefs in Spain - where a great deal of importance and attention is focused on the political dimension of economic crises - the sad truth is very little. This reality is even evident in the last statements of Jose Luis Rodriguez Zapatero (who called for the ECB to act vigorously) and Economy Minister Elena Salgado (who stated bluntly that the problem was a European and not a Spain specific one) just before leaving office. The new government will be caught on the horns of a dilemma, since the 2011 fiscal deficit is widely expected to come in at over 7% of GDP as opposed to objective set in the Stability Programme of 6%. Mariano Rajoy can either try to dodge the bullet or accept the challenge that this situation presents.

If he tries to dodge it - and according to one theory currently going the rounds the PP would like to pospone any deep cuts till after the Andalusian elections in the spring - then he will be dead on the starting block, despite being elected with the largest majority ever obtained by his party in the Spanish parliament. People who talk of trying to hold out till the spring are simply totally out of touch with the reality and the urgency of the present crisis. On the other hand, if he accepts the challenge, he could wind up a victim of market sentiment just the same.

Basically Spain's economy barely recovered from the previous recession and is now entering a second one. House prices have not ceased falling, and unemployment has been rising uninteruptedly since the end of 2007. This situation is putting enormous strain on the financial system, with all parties effectively agreed that the Spanish financial sector needs a second restructuring. The problem is there is no funding available for this at the Spanish level, hence eyes had been looking towards the European Stability Fund (EFSF) for support in this sense. But in the current environment the EFSF is also struggling to finance itself, and herein lies the problem. The present situation is unsustainable, not only due to the high cost of funding Spanish debt, but due to the liquidity pressures that the falling value of Spanish government bonds is placing on the banking sector. The latter problem is much more important than the former in the short term, and indeed it was this pressure on bank liquidity (and not the sustainability of sovereign debt as such) that pushed first Ireland and then Portugal into a bailout. If we add to this problem that Spain's initial financial restructuring process is already leading to an acute credit squeeze which is basically strangling the real economy on the vine, then basically you have all the seeds of a truly full blown crisis.

According to the latest EU Commission forecast, the Spanish deficit next year is expected to be 5.9% of GDP rather than the 4.2% objective set down in the EU stability programme. If Mariano Rajoy applies the kind of spending cuts which would be required to bring the deficit into line with targets in the context of an economic recession, then the probability is that Spain would have a rather severe economic contraction in 2012, similar to that which is currently occurring in Portugal. On this scenario the impact on unemployment would be severe (JP Morgan is already forecasting Spanish unemployment could rise to 27% in 2012), and the knock-on effect of this on non-performing loans in the banking sector correspondingly negative, and so on and so forth. So whichever way you look at it, Mr Rajoy is certainly facing a "heads I lose tails you win situation", with no easy solution.

Which is why I say at the outset that the response has to come at the European level. The era of single country rescues has really come to and end with the arrival of Spain and Italy in the casualty unit. Both countries are of course, too big to save in the conventional sense, while at the same time if they both fail then the Euro in its present form is surely finished. In addition, the political dimension is much larger. Italy is not Greece, and Spain is not Ireland. It would be impossible to treat either country in the way which their smaller peers have been treated, and Europe's leaders are well aware of this.

So we are back to the backstop for the Euro, making large quantities of funding available to both sovereign debt issues and to the financial sector restructuring one, a restructuring which would almost certainly involve the costly creation of a bad property bank in order to take the large accumulated volume of toxic assets of balance sheets and free the system up for the provision of more normal credit. But as I said earlier, all we have from Europe's leaderes at this point are vague promises coupled with silence on the key issues. A silence which becomes more and more deafening with each passing day. As ECB President Mario Draghi put it at the end of last week - highlighting the failure of governments to make operational the European Union’s bail-out fund, the European Financial Stability Facility, launched 18 months ago - “Where is the implementation of these longstanding decisions?”

Barcelona International Network: What specific effects are future developments likely to have on Catalonia's relations with the rest of Spain? Given the substantial PP majority in the Spanish Parliament, do you see increasing political tension between a centralist nationalist government and a Catalan administration under increasing citizen pressure to exercise the right of self determination, or do you believe sufficient common ground will be found to make agreement and cooperation achievable to address the current economic issues?

Edward Hugh: Well, as you probably know the situation here in Catalonia is very difficult. The cutbacks in public spending here have been very severe, more or less 10% across the board including in key areas like health and education. Yet despite this the underfunding of the region is so severe that the government is not going to be able to comply with the 1.3% of GDP deficit target laid down for 2011 by the central government. This year's deficit is likely to be around 2.6% of Catalan GDP but the government in Barcelona has made no secret of this, since it always considered the proposed reduction too drastic to carry out in one year. It is important to understand here that Catalonia has a large fiscal SURPLUS with the rest of Spain, maybe 8% of Catalan GDP.

Catalonia is one of Spain's richest regions, and effectively subsidises spending in other parts of Spain. Most Catalans accept this, and accept that their region should make some contribution to balancing disequilibriums across the Spanish territory. What Catalan citizens cannot understand is the extent of their contribution, and why it is that their regions should be receiving swingeing health cuts while other areas seem to be able to avoid them whether by hook or by crook. So this is a very unstable situation.

Catalans are also pretty fed up with the lamentable efforts of the previous Zapatero adminstration to find solutions to the economic crisis and to find ways of improving their financing problems - it is important to remember that Catalonia is one of the richest and most productive regions in Southern Europe, yet Catalan debt is treated scarcely better than Greek debt by the financial markets. We do not deserve this.

My feeling is that the new Rajoy adminstration will go to some considerable lengths to try to avoid confrontation with the Catalan administration, and many Catalans will be ready and willing to respond to such overtures. I well remember close Mariano Rajoy adviser Baudilio Tomé saying to me "Edward, you are one of those Catalans who recognises when Spain goes well, Catlonia goes well, and for Spain to go well, Catalonia has to go well". And yes I, like many others, take this view. The thing is, Spain isn't going well, and in the near future it is unlikely so to do.

In addition the new government's room for manoeuvre may be very constrained. The Catalan Parliament is preparing a new financing proposal, but in the short term anything which improves Catalonia's situation is inevitably going to make the position in some other parts of Spain worse, so this is going to be an aspiration which it will be hard for a Spanish nationalist party to fulfil. So while in the short term there will be conciliation, in the longer run confrontation would seem to be far more likely, given the diametrically opposed aspirations of the various parties.

Naturally, any kind of disorderly Euro disintegration would add to these strains enormously. I recently attended an experts meeting on the legal background to state creation. It was really fascinating stuff, but what I was most surprised to learn was that in the event of a Catalan declaration of independence, and absent an amical agreement between Spain and the new state, the liability for servicing existing debt issued by the Spanish state would fall on Spain and Spain alone. This would mean that the country without the Catalan financial contribution would be virtually immediately bankrupt. This is a daunting thought, and should serve to concentrate everyone's minds in the months and years to come. Catalonia could easily finance itself and live up to its responsibilities outside Spain. The same cannot be said of the parent country absent Catalan financing. I think it's high time for a change of mindset in Spain about this reality, and time that Catalonia's problems were treated with the respect and importance which they deserve.

Going Dutch - One Possible Solution To the Euro Debt Crisis?

2011-08-17T21:34:00.000+02:00

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing -- after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago -- ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe's leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor's to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet's third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe's financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe's banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained "no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong".

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:

“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.

The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No..., No..., No..., No..., No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states -- and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.

The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone -- as it is now -- might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.

So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.

The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.

In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke.

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.

This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title "The Euro and the Scalpel"

Appendix - The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I'm German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.

These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.

Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.

It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Spain's High Risk Election Process

2011-08-03T08:28:00.003+02:00

As Mr Zapatero put it on Saturday, when he announced the date of Spain's general election, the decision "is in the country's interest" since from now on there will be certainty, and "certainty is stability". While it is quite possible that almost all of Spain's politicians shared this sentiment, and welcomed the bringing forward of the election date, they may very well be the only ones to do so. Certainty is undoubtedly a strong positive, but when the only thing about your country which people can be certain of is the election date, then maybe on balance you won't have gained much.

In fact, as we are now seeing, you may well have lost a lot, and thus many of those who assented to the announcement with a knowing nod of the head may already be rueing the careless moment when they did so, as the country's debt crisis escalates, and the sovereign spread with Germany hits ever higher levels. Could they not comprehend that, seen from the outside, the very fact that the coming of these elections could be seen as good news inside Spain simply constituted one further illustration of just how parochial the country's politicians are, and how detached from economic realitities of their country they have become? They have simply turned themselves into the victims of their own propaganda, since if they hadn't been watching too much Spanish television they would have realised the the country's economy was on the verge of a double dip contraction, and not the imminent recovery which was used as justification for the election call.

Had they read their own official and Eurostat reports they would have known that unemployment was rising not falling - it hit 21% in June according to Eurostat data, and went up by a seasonally adjusted 29,603 between June and July, according to the monthly report from the Spanish labour office.

And had they been following events on the ground rather than election timetables they would have been aware that the housing market,far from having bottomed out had just entered another downward slump. The interannual rate of price decline according to the TINSA valuers index has risen steadily from 3.71% in March, to 4.38% in April, to 5.88% in May, to 6.6% in June. Back in October last year Mr Zapatero famously informed a stupified Maria Bartiromo from CNBC that Spanish house prices had bottomed:

MS. BARTIROMO: Are you expecting real-estate prices to continue coming down? Have they hit the bottom or not yet?

PRIME MIN. ZAPATERO: I think that the price of housing has hit the bottom. It won’t go down any more. For the past two or three months, what we see is that not only has it not dropped. But in certain parts of Spain, the price of housing has gone up. This is especially the case in those areas of — not where people are buying their second house, if you like, with the prices there have still gone down a bit, but rather where they’re buying their first, there the prices have gone down in the housing sector. So in general the prices have been stable recently, and they’ve even been increasing. So demand seems to be ticking up again.

Even more importantly, the recent rise in the 10 year bond yield (and spread) had been giving clear signals that the whole "decoupling" thesis behind whose figleaf the Spanish administration had been guarding their chastity had now become bereft of all credibility.

So the only (and I do mean only) positive Spain had to cling onto before the markets was the credibility it could have earned by coming in with a 6% deficit result on target this December.

If Spain needed a change of government (and I fully accept it did), then what it needed was some kind of "save the nation" (and the euro) coalition, to thrash out what would effectively be a new set of Pactos de la Moncloa, such is the gravity of the situation facing the country, and indirectly the European Union. (The Pactos de la Moncloa were the agreements reached between the various parties to facilitate a bloodless transition from dictatorship to democracy in the initial post-Franco years). But times have changed, and far from being able to achieve major aggreements of state, Spain's political parties are typically too heavily committed to endulging themselves in squabbling over the post boom-years leftovers to busy themselves with more pressing concerns like finding collective solutions to their country's (and Europe's) problems.

Outside Spain things are seen in a rather different eye. Victor Mallet, writing in the Financial Times, put it like this: "neither the certainty of an election date nor the probable victory of the rightwing opposition Popular party will necessarily soothe investors’ fears about where Spain is headed", he said, just before citing Nicholas Spiro of Spiro Sovereign Strategy to the effect that “Spain’s debt market needs this election like it needs a hole in the head". Well, some of the country's leaders might be forgiven for feeling, in the light of what has now transpired, that it is they and not the markets who have been left with a hole in the head, or at least a large gaping hole in the side of their already leaky ship.

Mr Zapatero's actual choice of words was at one and the same time interesting, and revealing. “On January 1, the new government must work on economic recovery and on reducing the deficit.” Excellent, the thread will be picked up again at the start of 2012. And in the meantime? The real issue facing investors and financial market participants at this moment is what is going to happen to the deficit between now and the 31st December. By no stretch of the imagination can Spanish pre-election periods be considered to be propitious for spending cuts.

Concerns about regional spending were already widespread before the election announcement. Commerzbanks Ralph Solveen in a report expressing widely shared views and revealing the sense of frustration already felt by many analysts and observers, desribed the possibilty of Spain achieving the 6% target by the end of this year as increasingly remote. And his reasoning was impeccable:

The Spanish central government is still only managing to reduce its budget deficit at a very slow pace. According to figures published today, its deficit for the first half of the year was just €5.6 billion lower than in the same period last year. In addition, most of the Spanish regions reported higher deficits than last year, so this year's target for reducing the overall government deficit ratio from 9.2 per cent to 6 per cent, is now receding into the distance.......This figure is only slightly higher than the reduction of €4.5 billion that was reported at the end of May, such that the reduction per month fell.

Consequently, the target set for reducing the overall government deficit by more than three percentage points this year is becoming even more remote, all the more so because the first quarter deficits reported for the regions were, on average, even higher than last year. The figures for the second quarter are not yet available, but reports for individual regions such as Castile-La Mancha bring little hope of a significant change for the better.

Part of the reason for the slow rate of deficit reduction has been the fact that economic growth is slower than forecast, a problem which is hitting revenues. Naturally a further batch of measures really are needed, but what sort of "swingeing cuts" can we realistically expect to see from a government which is in the midst of a battle for its political life? Telling government employees that they will lose half of their 2 extra monthly payments (one policy option strongly rumoured to have been under consideration before the election announcement) would hardly be likely to win them votes.

As I say, the tragedy in all this is that achieving the deficit target was about the one (and only) thing the government had going for it. The only real proof of its seriousness. Despite all the scepticism about (and slippage in) regional finance, I would have been prepared to sign on to the idea that Spain's deficit would still come in around the 6% mark. But now,.......

The deficit progress was what Spain had to put on the table, since when you come to all the rest, economic growth, employment and unemployment, financial sector reform, the housing market the only thing the sky was really full of were black clouds.

Naturally, the election declaration was only what the Greek historian Thucydides would have called the efficient cause (or trigger) for the next stage in the crisis, the final cause is the inability of either Madrid, or Brussels, or Washington (the IMF) to come up with an adequate policy mix to drag the Spanish economy out of the hole into which it has fallen, and into which (short of viable remedies) it will soon drag the Spanish and then the European financial systems along behind it.

Going naked (not a fig leaf is left) into the conference chamber sounds like a very apt and appropriate desciption of where Mr Zapatero and his team are right now. The situation can hardly be comfortable for them, but then, at the end of the day sympathy would be misplaced, since the only people responsible (or should that be "irresponsible") for the decision and hence the situation are they themselves and those who lead the governing PSOE party. Unfortunately though they will not be the only ones who pay the consequences.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Recession Warning On Europe's Periphery

2011-07-25T18:31:00.001+02:00

As Europe’s leaders struggle to convince markets that their Greek debt problem-resolution-proposals are actually viable, and will really do the trick, last week's flash PMI readings seem to have attracted rather less attention than they might. Nonetheless, the fact of the matter is that it is steadily becoming clearer that the current slowdown in Eurozone economic growth is turning into something more than just another one of those pesky “soft patches”. The pace of economic expansion in core Europe has slowed dramatically, falling back in July for the third consecutive month, according to the latest flash PMI. Commenting on the flash results Chris Williamson, Chief Economist at Markit said: “The Eurozone recovery lost almost all of its momentum in July, recording the weakest growth since August 2009 when the recovery first began. Excluding the financial crisis, the July survey was the most downbeat since the Iraq war in 2003, and consistent with a flat trend in quarterly gross domestic product.

In fact the rate of expansion – the composite indicator registered just 50.8, only slightly above the dividing line between growth and contraction - was the lowest since August 2009, when the recovery was just starting out. More importantly (for the longer term) new business coming in showed only a very marginal increase in July, registering what was the smallest rise since demand for manufactured goods and services first started to return to growth back in September 2009. Levels of incoming new business fell in manufacturing for the second month in a row, declining at the fastest rate since June 2009 – with new export orders actually falling for first time since July 2009.

What this means, of course, is that the slowdown has now extended, spreading deep into the heart of the core, with both services and manufacturing in both Germany and France affected.

The German composite index fell to 52.2, from 56.3 in June, and while the latest reading still remained comfortably above the 50.0 no-growth value, the month-on-month index fall of 4.1 points was the largest since the November 2008 post Lehman drop. Tim Moore, Senior Economist at Markit said in his report “Almost in the blink of an eye, German private sector output has gone from rapid growth to a slow crawl.

But even as growth in the core economies approaches stall speed, out on the periphery a new recession seems increasingly on the cards, and most importantly in countries like Spain and Italy which have so far managed to keep their heads just above the waterline. Growth in the second quarter of the year looks likely to have been minimal in both cases, and the outlook for the third quarter suggests we are entering a bout of economic shrinkage.

The PMI readings also coincide with the impression offered by monetary indicators.

As Henderson Global Investors’ Simon Ward points out, in late 2010, while real (ie inflation adjusted) current bank deposits were contracting in Spain and Italy, they were still growing robustly in both Germany and France, implying a solid economic growth economic outlook in the core for the first half of 2011 (this monetary indicator is often thought to give an indication of activity with a 6 month lag).

But currently, as can be seen in the above chart (which shows rates of six monthly growth) real deposits have even started to contract in the core, while in Italy the rate of shrinkage has accelerated considerably, suggesting that the earlier “two-speed” Eurozone recovery may now be about to give way to a period of much more generalised weakness, reinforcing the impression given by the PMI order indexes. What is most striking is the way Italian M1 deposits have been contracting much more strongly than Spain’s have of late, although this development should not take us completely by surprise, since, as I have been consistently pointing out (see here, here and here) it has been clear from both real and survey data for some months now that Italy was heading towards recession again.

And looking at the second monetary chart that Simon provides, it is evident that the weakness in Spain and Italy forms part of a much more general contractionary phenomenon on the periphery, but then I imagine that the idea that Greece and Portugal might be in recession comes as a surprise to no one.

Part of a Bigger Global Picture

Of course, the vulnerability we are seeing on Europe’s periphery is being played out in the context of a global economy which is itself clearly losing momentum. This generally weakening in global growth has been clear from the evolution in the global manufacturing PMI for some time now.

And the latest China manufacturing flash PMI (which showed contraction for the first time since the middle of 2010) suggests the ongoing pattern will be once more confirmed in July, with global manufacturing moving closer to the critical 50 dividing line which marks the frontier between growth and contraction.

Even more importantly the Chinese export order component (which could be considered as a long leading indicator giving us information about possible activity levels three to six months from now) reinforced the idea that the slowdown is likely to be extended in time.

This impression (of an extended period of lower growth globally) is also confirmed by the business expectations component of the German IFO. I would about anticipating an early termination of the slowdown till we see some real sign of sustained improvement in Chinese new export orders and a solid uptick in IFO expectations.

So Why Don’t We All Be Just That Little Bit More Vigilant?

Where does all this that leave Europe in policy terms? Well, in principle recent developments in the real economy should present the ECB with significant monetary policy dilemmas, given the risks to the integrity of the monetary union that could result from a combination of reform/recession weariness out on the fringe and bailout fatigue in the core. Evidently the slowdown will make it harder to meet deficit targets in Spain and Italy, and will most likely mean there is a need for new measures which will become harder and harder to sell to voters, while any deterioration in the jobs market in Germany (we should be watch the unemployment numbers in Germany in the coming months) could well make bailout contributions harder to drum up. As John Hussman put it in a note to investors this morning:

"As I've noted several times in recent months, bond market spread imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It's Different, "Overt domestic default tends to occur only in times of severe macroeconomic distress." The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbours at a cost to their own citizens".

So in theory what these leading indicator readings should be telling us is that we should expect little more in the way of rate rises during what remains of 2011. Continuing to raise rates into an economic slowdown where there are clear risks of financial instability would not seem to be sound monetary policy.

In addition, given the way the pace of manufacturing input price inflation now seems to be cooling rapidly (see chart below), it would not be surprising to see a change the wording of the risk assessment for price stability from ‘on the upside’ to ‘balanced’ at the next meeting. This would avoid a lot of potential communication difficulties in the months to come, and would open the door up to a much more flexible interest rate policy.

One critical point to grasp is that the ECB decisions themselves have now become one of the main factors which will influence the outcome of the slowdown, not simply via the standard monetary policy path on Europe’s core economies but via the impact its decisions will have on policy sustainability on the periphery, and though this channel on the level of global risk sentiment.

In this sense ensuring economic growth is not the only distraction which could divert the ECB’s attention from its principal mandate in defence of price stability, since there is also debt stability to think about too. Recent days have show that large peripheral economies like those of Spain and Italy, far from having totally decoupled from the smaller and weaker countries, are now once more being drawn back into the maelstrom.

In particular Italy’s government debt to GDP level of 120% has been attracting growing attention. Simple calculations show that just to stabilise debt at this level with the previous prevailing interest rates the country needed a 3% annual growth in nominal GDP. Now, of course, they are likely to need slightly more. But real GDP growth this year will be significantly under 1%, while all those earnest efforts by the ECB to push the country’s inflation rate down below 2% will simply serve to help nudge the debt level upwards, in the process raising the premium investors will ask to buy Italian debt, with the implication that next year the country will need an even higher rate of nominal GDP growth, and so on, and so forth.
And the situation is Spain is hardly better, with 85% of mortgages being attached to variable rates, pushing Euribor upwards simply starts to weaken the hitherto comparatively robust performance of the bank mortgage books, while the slower economic growth will make government deficit targets even harder to maintain.

So really, the issue is not whether the ECB was right to go ahead with this months rate rise given its main mandate, the issue is whether members of the Governing Council could by any chance prove themselves sufficiently flexible in the future to change their discourse in the face not just of Greek default woes, but also of heightening recessionary and debt management risks? In his report just before the last rate meeting, Deutsche Bank’s Gilles Moec argued that the situation was “not bad enough” for the Bank not to raise. I wonder if the deterioration we have seen since that time makes it “now bad enough”? Just how bad do things have to get for us to reach that point, and just what is prudent and what is risky behaviour in current circumstances? Certainly Council members need to be vigilant, but in particular they need to be vigilant that their attempts to avoid one problem do not inadvertently generate another, even more difficult to handle, one.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Nine Reasons Why Spain's Economy Is More Different Than You Think!

2011-06-25T11:15:00.001+02:00

Spain, as those 1990s tourist brochures used to tell us, is different. And it certainly shouldn't be confused with Greece. Even a cursory look at the most basic of maps should satisfy any doubts we might be harbouring in that regard. But being different is not the same thing as being economically sound. Which is what Societe Generale's Klaus Baader has just tried to argue in a recent research note: "The Spanish bond market was hit hard in the wake of the quantum leap in the Greece crisis. But fundamentally the case for Spain remains strong".

In singling out the nine points that Klaus advances in support of his thesis for detailed examination, I do not do so because I find the arguments particulary bad (or even especially "noteworthy" in the negative sense). He has a point of view, and he is doingh is job, and in neither case can I fault him for this.

The reason I have decided to single Klaus out for special treatment here is because he conveniently brings together, in a clear and succinct fashion, a number of arguments which are widely accepted and used by both analysts and policy makers. Unfortunately the fact that arguments are widely held does not make them valid, or in anything other than the most trivial conventialist sense "true". Indeed it is precisely because I feel that these arguments are not well founded that I have decided to reply to them in this rather detailed way. Basically I don't buy the idea that Spain is simply suffering from a crisis of confidence, one which, in its turn, puts pressure on the government bond spread. I think Spain has a problem in the fundamentals department, and unless this problem is first accepted and then addressed the wrong (inadequate) remedies will continue to be applied, putting the Eurozone and its citizens at risk of financial catastrophe in the medium term.

Argument Number One: - Public sector debt is low and will stay low.

"Spain’s public sector debt ratio of 60.1% in 2010 is nearly one third below the euro area average. Excluding potential bank bailout costs, but also privatisation receipts, debt is expected to peak at less than 70%".

Not so! Or rather not necessarily so, since the beauty, here as always, is in the details. Certainly Spain's public debt to GDP ratio is low by European Union standards, and significantly below the EU average. But it is not the case that it is universally expected to peak below 70%. In fact the IMF (to name but one) expect Spanish government debt to GDP to hit 72.1% of GDP in 2014, rise to 74.13% in 2015, and stand at 75.94% in 2016 (according to their April 2011 World Economic Outlook forecast).

In fact, we don't yet know where Spain's debt to GDP will peak, or when, since there are too many unknowns in the equation to reach a definitive conclusion, all we do know for sure is that it continues to rise, indeed according to Bank of Spain data released last Friday, by the end of the first quarter of 2011 Spain's gross debt was up again, and stood at 63.6% of GDP.

There are many factors that could condition the size of the debt to GDP ratio, the unpaid bills on regional government books (93.6 billion euros at the end of Q4 2010), the 83 billion euros given by the government in guarantees (or 7.8% of GDP, a quantity which will only be turned into debt should the guarantees need to be honoured), the debt which is languishing on the books of public sector companies (55.7 billion euros at the end of Q4 2010), the possibility that the Spanish economy have a bout of deflation at some point, etc.

But all of these are, when all is said and done, comparatively small beer, and would simply imply, for example, under a worst case scenario that Spain's debt to GDP might peak around 95% of GDP as opposed to the IMF's 75%+ calculation, high, but not unmanageable, provided the economy returned to growth. But, as the Societe Generale commentary suggests, by far the largest downside risk in the whole picture is the size of any potential bank bailout costs. Here we are almost totally in the dark, since we know the minimum (the cost of the current FROB restructuring) but we have no real idea of the maximum, a point which was brought home recently by Barclay's Bob Diamond when he visited Spain's Prime Minister Jose Luis Rodrigo Zapatero in the Moncloa to discuss the possibility Barclay's might buy the troubled Caja de Ahorros del Mediterráneo. Most observers have little doubt that Barclay's interest was real, but the stumbling block was not the price: Bob Diamond wanted Prime Minister Zapatero to give guarantees over the potential downside for the bank assets, and of course he couldn't. I am sure Mr Zapatero has no better idea what these are than I do.

What we do know is that without being able to arrive at a conclusion on this topic, all the current debt to GDP numbers floating about don't have a lot of importance, since we can all remember only too well how Ireland's debt to GDP shot up from 25% of GDP in 2007 to an anticipated 114% in 2011. So if this risk wasn't real and a concern to market participants, then it would be hard to understand why the Spanish 10 year bond spread is currently hovering around 270 basis points over the yield on the equivalent German bund. German gross government debt is currently in the region of 80% of GDP, or some 15 percentage points above the Spanish level. So without the presence of this perceived risk market pricing would be inexplicable (which, in fairness, to Spain's economy minister Elena Salgado, she probably thinks it is).

Argument Number Two - Public sector deficit reduction is on track.

"Unlike Greece, Ireland and Portugal, the fiscal consolidation targets have been reached in 2010 and are on track in 2011, even allowing for some deficit overshoots in some of the Autonomous Regions. That means that the 3% benchmark level stands every chance of being met by 2014".

This argument, notwithstanding that this is the issue which most seems to have been worrying investors of late, may well be more or less valid. Spain's government has made great efforts to comply with what they perceive to have been investor concerns since the "about turn" in May 2010, and it is reasonable to assume that these efforts will continue, and that despite some first quarter slippage, the fiscal deficit may well come in this year at or around 6% of GDP.

Issues: the fact that public spending (and debt) increased significantly faster than they should have done in the first three months of the year (even making a positive contribution to the first quarter growth number), means that the cut backs in the second half of the year will need to be greater than anticipated (especially if growth is nearer to the Bank of Spain and IMF 0.8% estimate than to the Spanish administration's 1.3%) and these additional cuts will, of course, also further negatively impact GDP growth.

In addition there has been the recent rise of the "indignados" protest movement. With this movement gaining strength (as we have also recently seen in Greece) and becoming increasingly openly opposed to the Brussels inspired stability programme, the government's margin for manoeuvre may become increasingly restricted, and especially if unemployment continues to rise and Spain drifts back towards recession. This movement is a new factor on the Spanish scene, and its presence needs to be taken very seriously.

Argument Three - The banking sector problems are manageable.

"There is no doubt that the Spanish banking sector, particularly the savings banks (cajas), has problems. But even the most apocalyptic predictions of potential losses amount to some €200bn, which is 20% of GDP. Our analysis suggests that this would lead to a new capital requirement of some €60-70bn, equivalent to 6% of GDP".

This argument is obviously one of the most tendentious of value judgements. What is manageable here, and what isn't? Where do we begin in this minefield? To know the true level of losses to which the banking system is exposed we would need to know a number of things we evidently don't know and are possibly in principle incapable of knowing with any exactitude until the Spanish economic drama unfolds further. This is effectively the reason why Spain's Prime Minister José Luis Rodriguez Zapatero couldn't give Barclay's CEO Bob Diamond the guarantees he was looking for on his visit to the Moncloa to talk about buying the Caja de Ahorros Mediteraneo. Mr Zapatero couldn't help him, since he didn't know either.

To be able to adequately answer the question we would need to know how far, and during how long Spanish property prices were likely to fall. Really this is a question to which no one has a real answer. Certainly we know that the index maintained by property valuers TINSA fell at an interannual rate of 5.88% in May, the fastest drop since December 2009, and that the market is showing all the signs of having a double dip, especially taking into account that total house sales hit a post crisis low of 24,100 in April, while new home sales fell to 11,500. In fact house prices on the TINSA reckoning have now fallen 21.5% since their December 2007 peak, and we have no real clear idea of how much further they have to fall.

We would also need to know the level at which Spain's unemployment were going to peak, and how long it will need to get back down to single digit levels. This is becuase one of the key factors which will also have a sure and certain impact on the level of bank loses is the level of unemployment, since it will influence mortgage default rates, and also serves as a proxy for many other economic indicators which also affect bank profitability. Monthly labour office signings fell back in April and May, due to the impact of seasonal industries like tourism and agriculture, but the seasonally adjusted figure continues to rise, and stood at 20.7% in April according to Eurostat data.

One think we do know is that Spain's banks still don't have normal access to the interbank market. Thus confidence among other bankers (as opposed to among politicians and policy makers, or what bankers themselves say in public) is not as high as it could be that these problems are easily manageble. In addition, every time risk aversion rises in the Eurozone pressure on Spanish banks mounts, and it is not insignificant that they have been going back to the ECB in increasing numbers since April this year.

Argument Number Four - The current account is under control.

“Spain had a current account problem in 2004-2009, with a shortfall that peaked at 10% of GDP in 2007. But by 2010, the shortfall had fallen to 4.5%, and a further decline is likely as domestic demand remains weak at least until the end of 2012, and export competitiveness improves, both in manufacturing and in services/tourism”.

Unfortunately, the Spanish current account is NOT under control. The twelve month trailing deficit has reduced by around 60% from the 2008 high point, but has been stationary at around 4% of GDP for over a year now.

Two factors have accounted for this sharp drop, a fall in imports and a reduction in interest servicing costs on the external debt. Exports have returned more or less to their pre crisis high (see below), while imports dropped sharply and have not recovered their earlier level, so one part of the CA deficit improvement is due to lower consumption and lower living standards, a change which due to the way GDP is calculated (only net trade counts) is actually GDP positive, but try telling that to the “indignados” protesters. The only politically sustainable way to carry out this sort of transformation over time is via a sharp increase in the historic trend level of exports.

But it is the second component in the current account improvement which most analysts miss, and that is the change in the income account (see chart below).

The 12 month trailing income account balance has improved by roughly 40% since early 2009. The reason for this is not an improvement in Spain’s external indebtedness position (see below), since logically with an ongoing current account deficit the external position continues to deteriorate, but a decline in corporate profitability associated with the crisis, and a drop in interest servicing costs on the debt as interest rates have fallen to historic lows. The important point to grasp here is that both of these components are CYCLICAL and not STRUCTURAL. That is to say, if interest rates were to rise again to previous levels (normalise) ECB, and corporate profitability recover then the income account would automatically once more deteriorate. The good news is that this is unlikely to happen, but the bad news is that this is unlikely to happen since the Spanish economy is unlikely to recover, and the ongoing weakness in the peripheral economies (including Italy) means that the ECB is unlikely to be able to go very much further with its rate normalising policy.

The real problem is the country risk element. As the spread on Spanish sovereign debt and bank debt rises the income account will evidently deteriorate, and this is obviously one of the major risks for the Spanish economy at this point. The more country risk rises, and the more the weight of interest payments pressurises the current account the more living standards internally need to be compressed (via austerity measures) simply to keep the country afloat. Clearly at some point or another this hits political viability limits. Also, it should be noted that while net external debt is around 90% of GDP (very problematic in and of itself), gross debt is roughly double that, and if Spain country risk (and hence the cost of financing) rises, while country risk (and hence interest rates) in key emerging markets (from a Spanish point of view) continues to fall, then the structural income balance can even deteriorate, as well as the cyclical balance.

Argument Number Five - Competitiveness is not as bad as many think and improving.

"One, Germany is not the benchmark – it was clearly not competitive in 2000, owing to unification in particular. The gap to the euro area aggregate for example is less than 10%. Two, Spanish ULC were in part driven higher by ULCs in the construction sector, which has little bearing on export competitiveness. In any case, if Spain has really lost so much competitiveness it would be unlikely to export as successfully as it does: from 2005 to 2010 (annual data, nominal), Spanish exports rose every bit as much as German exports (21.0% versus 20.9%). And Spanish labor is cheap: according to Eurostat data, wage levels in Spain are 25% below the euro area average".

This issue is basically the nub of the question. If Spain's economy is not fundamentally uncompetitive then it should gradually return to sustainable growth, given enough time and a few labour and product market reforms. But if it is as uncompetitive as I, and other macroeconomists, argue (needing a price adjustment with Germany of around 20%), then not only will the growth not return, sovereign debt default 5 or 6 years down the road could become a growing possibility as the banking system creaks and strains under the weight of accumulated debt and non performing loans.

If Germany is not the benchmark for Spain, then it is hard to know who is. Evidently it should not be Italy, or any of the other low growth peripheral economies, since being as uncompetitive as they are is hardly going to help see Spain through. Perhaps France is the benchmark? But then France has a deteriorating current account position, so even France may not be a good role model for Spain, especially since the French private sector is not heaviliy indebted in the way the Spanish one is, and hence the economy is still laregly driven by domestic consumer demand, something which is now impossible in Spain - at least while the deleveraging process is taking place.

So here is the nub of the matter, and the key problem that those who tend to dismiss the macroeconomic arguments need to try to follow, since this isn't a game to see who is right and who is wrong, it is about saving the Spanish economy, and with it (if possible) the euro: THE SPANISH ECONOMY IS NOW TOTALLY EXPORT DEPENDENT FOR GROWTH.

This is why macroeconomists tend to use the German economy as a benchmark, since the German economy has successfully become an export driven one, and Spain needs to follow in Germany's footsteps. Evidently, as Klaus Baader tells us, the German economy was far from competitive in 2000, which why the German economy had to go through a hard and painful restructuring process to gain the competitiveness it needed to generate the level of exports it needed to improve the growth performance. Now Spain needs to follow in Germany's footsteps, and I don't see the point in trying to deny this.

Spain is now an export dependent economy due to both debt overhang issues and due to the economic impacts of population ageing. Spain is not returning to the pre crisis world it knew, because Spain is already too much in debt to be able to drive growth by generating even more debt, and because Spain's median age is rising in a way which is going to change the pattern of national saving and borrowing. And there is a third and "last nail in the coffin for the old way of life" kind of argument that is important here, and that is the Spanish are about to realise what either Franco Modigliano or Milton Friedman could have explained to them decades ago, and that is that a house is a place to live in, that is to say a consumption good, and is not part of some fancy new asset class of investment good which you can use to get rich easily, and speculate with. 77% of the total stock of Spanish savings is invested in property, and around 85% of the Spanish population own one or more homes, which means, as the Spanish themselves are now discovering, that as property prices go down you suddenly start to get poor in just the way you formerly got rich.

Indeed herein lies one of the key floors in the way Spanish policymakers tend to think about economic issues. We are now no longer living in the pre 1930s world were spending out of current income was the key indicator to understand economic growth, either credit or export surpluses drive modern growth, and where there is little credit, and insufficient exports, then there is little (or no) growth. In fact, with property prices falling in a way which constantly reduces the value of their stock of savings, Spanish families may well be caught in a modern paradox of thrift whereby no matter how fast they try to save out of current income they still are in a negative net wealth dynamic as property prices fall and fall.

Anyone who wishes to understand why Spain's banks have not driven prices down sharply through firesales should consider carefully how this would impact on household wealth, and saving and spending patterns.

But back to the issue in hand, export dependence and Spanish competitiveness. Evidently, the first piece of evidence macroeconomists present is the comparative Reel Effective Exchange Rate data. Of course, critics of macroeconomists argue that this is almost irrelevant, but I don't see why we should shy away from presenting this data simply because some people don't like it, since in my humble opinion it certainly isn't irrelevant. Looking at the chart below it should be obvious that Spain lost price competitiveness vis-a-vis Germany systematically from 2000 to 2008.

Of course, there is another way of looking at the whole problem, and that is to look at productivity movements. Again we can see that from the start of the century till the outbreak of the crisis, German productivity improved significantly over Spanish productivity. This situation reversed somewhat during the crisis (I will come back to this below).

On the other hand, when it comes to living standards, what we find is the exact OPPOSITE, that is to say Spanish living standards improved significantly more than German ones. So in one country living standards rose, while in the other productivity rose - surely something is upside down here, isn't it. Naturally, and on aggregate, the Spanish paid themselves more than they were economically worth, and used borrowing guaranteed by their houses to do this. There is no great mystery here. But what it does mean is that Spain LOST COMPETITIVENESS. They weren't the worst along the periphery in this sense, but that is beside the point. And it doesn't matter at all here whether Spanish wages are low or high, what matters is how much you produce in each hour you work. Something Angela Merkel learnt to her cost recently when she suggested that Spanish workers should work longer hours and take less holidays (you know, that siesta feeling), only to find that the Spanish work longer hours than the Germans. Also, I have used nominal GDP per capita (and not living standards) here, because it doesn't matter how much your earnings can buy in real terms for this calculation, becuase the fact of the matter is that the Spanish worker is paid in those very same Euros as German workers are, so the direct comparison is valid. If Spain still had pessetas all that extra inflation wouldn't have mattered so much, since the country could have devalued and made the adjustment. But it can't, it is stuck with the legacy of the past, which is why I and other macroeconomists have been advocating a simulated (internal) devaluation to bring the price and wage level down by 20%, but virtually no one has been listening, since like Klaus Baader, they don't think it is necessary. They think - along with members of the current Spanish administration that talk of Spain's loss of competitiveness is exaggerated.

Another way of looking at things is via a comparison of unit labour costs. As we can see, Spain's unit labour costs rocketed when compared with Germany's during the first 8 years of this century. This is only the same thing as saying that productivity didn't rise very fast while wages did. What is interesting is that this process moderated with the onset of the crisis, and indeed Spain's unit costs fell, even as Germany's rose somewhat. Many have cheered this as an indication of a successful adjustment. But they are missing something here, and this is what is known as the compositional effect. Basically Spain's economy shed nearly three million low-paid, low-productivity workers as the construction boom unwound. The result of this was that aggregate productivity ROSE, and aggregate unit costs fell - while unemployment rose from around 8% to over 20%.

German employers, on the other hand, made great efforts to retain workers via the system known as Kurzarbeit, and as a result unit labour costs rose, and indeed productivity fell (remember the productivity chart). German industry sacrificed some of its competitiveness in the interest of social cohesiveness, and not inflating the government deficit, and unemployment continued to fall almost all the way through the crisis (see chart below). Naturally now the German economy is more or less back to its earlier capacity levels productivity is once more improving.

Now, let's go back to the international competitiveness argument. Obviously this is not the same thing as saying that each and every Spanish company (or sector) is uncompetitive, but that the economy as a whole is not sufficiently competitive, that is to say not sufficiently competitive to generate the export activity needed to return the economy to sustainable growth. There is an externally tradeable sector which is comparatively competitive, and a munch larger non tradeable sector that is completely uncompetitive. In this sense, don't look at the exports, look at the imports: Spain needs to produce domestically a lot more of what she imports, this alone would turn the trade deficit into a trade surplus, and provide employment to boot. The problem is that the sectors which produce these products have either been closed down or are not able to compete on price. Talk about the energy deficit is irrelevant here, since oil prices are what they are, and since Spain is externally dependent on energy this needs to be imported. Of course, the energy deficit can be reduced by conservation changes and alternative energy sources, but none of this alters the fact that Spain needs to produce sufficient exports to cover ALL imports, and then some more to generate a surplus to drive GDP growth.

So, and summing up, the key point about Spain's export sector is not that it is not competitive, but that it is FAR TOO SMALL for the job it now has to do. Spain's exports have returned to their pre.crisis high.

As have Germany's, but just look at the relative size of the two sectors (and this chart is goods & services, so tourism is included).

Of course, Germany's economy is a lot bigger (but not THAT much bigger), so let's look at the relative shares of Spanish GDP and exports as compared with their German equivalents. As can be seen in the chart below, Spanish GDP increase steadily as a % of German GDP in the years before the crisis (as we have seen, there was no relation between what people were being paid and productivity in Spain over these years, quite the opposite), while exports as a share of German exports actually went DOWN. Make of that what you will, but it is another interesting data point for anyone who really wants to get to the heart of Spain's current problems.

On the other hand, with exports now back near their previous peak, capacity levels must be getting strained, so Spain's export sector should be in need of increasing investment in capital goods, shouldn't it?As can be seen in the following chart, investment in machinery and equipment in Spain was rising steadily as exports rose in the pre-crisis period. Then the rate of investment fell by nearly 40%, and since that time the level HAS HARDLY MOVED.

In Germany, on the other hand, we see the same pre-crisis pattern, and then the slump, but in contrast to the Spanish case, investment took off again as exports started to pick up. Germany is increasing capacity, while Spain isn't, doesn't that tell us something about competitiveness. It is one thing to get export prices more or less right using an old capital stock, and relatively cheaper workers (under the new contracts), and quite another matter to buy new capital and start to increase export market shares.

And as always, the proof of the matter is in the eating. If things were going well, and Spanish exports really were doing as well as German ones, how come one economy is booming and the other flirting constantly with recession? Enough of misleading casuistical arguments and more facing up to reality, please!

Argument Number Six - Competitive disinflation is underway.

“Wage growth in Spain has slowed sharply, and is now running below euro-area average rates (and those of Germany)”.

Obviously it depends what you mean by competitive disinflation. As Kluas Baader says, wage growth has slowed, and wages are now rising more slowly than Germany's are (but not by that much!).

On the other hand, the general price level is once more consistently rising faster than Germany's is, and this in an economy which is hardly growing and in comparison with one which is booming. So the gains which are being made on wages are being lost in general inflation differentials.

And Spanish industrial producer prices are also consistently rising faster than German ones, which gives us the strongest argument for much deeper structural reform that I can think of.

Bottom line, as of the time of writing competitive disinflation is NOT underway.

Argument Number Seven - Much of the economic weakness reflects rebalancing.

“Weak domestic demand growth is not so much a sign that the economy is hopelessly uncompetitive, but rather reflects a necessary, and in the end healthy, rebalancing. This pertains especially to the construction sector, which must shrink from an unsustainably level. But the share of total construction investment in GDP down from a peak of 18% to 12% in just three years. Hence, most of the adjustment has already taken place”.

Weak domestic demand growth is a reflection of significant over-indebtedness, a shortage of credit (even for solvent activities) , and the weight of a massive debt overhang. Uncompetitiveness comes in, as we have seen above, when you need to get export driven growth following the collapse in domestic demand produced by the over indebtedness.

But what rebalancing is taking place here? One section of the economy, the construction one, has shrunk massively, with the result that unemployment has risen to 20.7%.

But, as seen above, investment in new sectors is NOT taking place, so, there is no re-balancing at this point (unless, again, one insists on being causuistical) , and if anything the economy is even more lop-sided, since rather than balance there is simply a huge hole letting in water, rather like a battleship which has just seen an exocet tear through it just above the waterline.

Just how unbalanced is the Spanish economy? Well look at the size of outstanding developer loans shown in the chart below, something like 320 billion euros of them. These represent houses that are either unsold, unfinished, or even as yet unstarted.

The Spanish economist Ricardo Vergés, who is a housing market expert, has calculated that Spain may have a potential excess of 2.3 million housing units. Vergés, who used to advise the now defunct Ministry of Housing on housing market statistics, arrived at this staggering number by calculating the difference between housing starts and final house sales over to reach a figure for the unsold (or as yet unbuilt) new homes (including homes still under construction or abandoned unfinished).

Subtracting registered sales since Q1 2004 of 2.45 million from housing starts since Q3 2004 of 4.77m, Vergés comes up with his figure of 2.3 million housing starts that have yet to end in sales. It is estimated that roughly 1 million of these houses have been completed, thus there may something like 1.3 million more waiting to be finished, and hence the large mass of developer loans outstanding. Naturally, to complete these houses the banks will need to provide yet more credit to developers, making it even more difficult to fund new profitable businesses even as credit in general is reined-in in a bid to meet the new (higher) core capital requirements.

To get an idea just how difficult it would be to shift all these developer loans and turn them into sales, a contrast with the existing stock of mortgages (after all the boom years) is instructive. At the present time the Spanish banking system is financing just short of 700 billion euros in mortgages. To accomodate all the latent needs of the housing sector this number would need to go up by something like another 50%, and in a period of "rebalanced" economic activity. The argument staggeringly fails to convince.

Argument Number Eight Private sector debt is high but correcting.

“Spanish household debt is high at 120% of disposable income (same as UK, lower than Netherlands, Ireland or Sweden, but above the 82% euro area average). But the deleveraging of the household sector has begun: the household savings rate soared from 10.3% of disposable income in 2007 to 17.7% in 2009 (it has since eased back to 13.0%). Credit growth has come to a complete halt”.

Firstly we need to be clear, household debt is not the sum total of all private sector debt in Spain, there is also corporate debt to think about. The combined total is something like 220% of GDP (90% for household debt and 130% for corporate debt). Some deleveraging is going on, but it should be remembered that government debt is now increasing, so the total indebtedness of the economy isn't changing much.

On the other hand, as Klaus Baader says, credit growth has come to a "complete halt". Indeed it is even contracting. In April the total stock of corporate loans was down 0.1% over a year earlier.

While the stock of household loans was down 0.1%.

Is this a good thing? Well it is and it isn't. It is positive in the sense that the private sector is timidly deleveraging, but it is also systematic of the fact that there is a strong credit crunch taking place, and that new initiatives (that could help rebalance) are finding it extremely hard to get credit. Basically the banking system isn't on the point of implosion, and it isn't going to disappear tomorrow, but it is sufficiently badly affected that it is strangling the real economy, and that is one of the main reasons a recovery isn't coming.

Argument Number Nine - Spain is not being crushed by market interest rates.

“Unlike Greece, Ireland and Portugal, Spain is not being crushed by unsustainable refinancing costs for its public sector debt”.

Well...... This is not the best moment to be asserting this Klaus! Certainly Spain's interest rates have not reached the horrific heights attained by their Eurozone neighbours, but they are also hardly rubbing shoulders with historic lows. Last week the spread of the Spanish ten year bond over the German bund equivalent hit a new Euro era high of 288 base points.

More to the point, the 10 yr yield closed on Friday at 5.68%, for the first time going above November's previous high of 5.67%. Obviously psychological thresholds now loom at 300 bps on the spread and 6% on the yield, and if the market breaks resistance on these there is a danger that they could move higher quite sharply, especially if the Greek situation deteriorates in any way, or if the ECB surprises markets by not moving rates in early July. Not exactly the best of environments for a critical Bankia IPO.

As I said above, since April the Spanish banks have been returning to the ECB funding fold in increasing numbers, for the first time since Spain managed to "decouple" after the Eurozone crisis of May/June 2010. Again, a sign that the decoupling may now not be holding.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

The Great Greek And Spanish GDP Mystery - One Hypothesis

2011-05-15T13:01:00.000+02:00

Many an economic eyebrow must have been raised last Friday when Europe's first quarter GDP data was released, and people discovered that the Greek economy had suddenly surged forward, rising by 0.8% over the level it had attained in the last three months of 2010 (or at a 3.2% annual rate, or faster than the US). Since almost everyone with knowledge of the situation is forecasting a further contraction in the economy this year, the result may have been thought to be a surprising one.

Well, there is no need to call in Sherlock homes just yet, or even the strong-arm boys from Eurostat, since I think I may have worked out what happened to Greek GDP in Q1, or at least I have a good working hypothesis. In the process we will also examine why it was that, against all prognoses, and against a colossal amount of anecdotal evidence that the Spanish economy is falling back towards recession, Spanish GDP actually accelerated.

But first, a brief intro to Econ 101 macro. It is important to grasp the fact that GDP isn't the be all and end all of economic analysis, and certainly doesn't give us a complete measure of economic activity. Indeed there are many economic processes which may be of interest to economists - levels of indebtedness, for example, which are simply not captured by the measure, since GDP is what it is: a measure of domestic value added, according to the following formula:

GDP = Consumer Demand + Investment Demand + Government Spending + Net Trade (change in exports minus change in imports) + Net Change in Inventories

Now, in general we know that the first three items on the list are falling in Greece. even if there does seem to have been some slight improvement in retail sales during the quarter, after a very steep fall in the autumn.

But what about the net trade component? Well, before going further it is important to consider is how this calculation works. Basically net trade can improve either by the rate of export growth accelerating, or by the rate of import growth decelerating. Now in Greece we know that exports have improved, but Greek exports are proportionally so small, and form such a limited part of total economic activity, how can they possibly pull the economy upwards in this way (causing a 0.8% q-o-q increase in GDP)? Well, looking at the chart for imports it can be seen that just as exports have been accelerating, imports have been decelerating, so the combined impact might be quite large (please note we don't yet have the March data).

This impression that it was as much a drop in imports as a rise in exports that was behind the sharp quarterly rise in GDP is further reinforced if we look at the year on year performance of the two variables. In recent months Greek imports are sharply down y-o-y (despite the surge in energy prices) while exports are up.

So GDP rose, but what about does this tell us about living standards? Well, this is just the point. Since the fall in imports reflects a fall in demand, it implies a fall in living standards,and this is the strange thing about what GDP measures and what it doesn't measure. GDP can rise sharply, even when unemployment is rising, and people are getting poorer. This is largely because one of the things GDP doesn't measure is the evolution of what some call the "financial balances" (for more explanation of this idea see the pioneering work of the Canadian economist Rob Parenteau (here in somewhat polemical form, and here as a more technical explanation).

In countries running an ongoing trade and current account deficit, the rise in living standards which comes from an increasing excess of imports over exports figures in national accounts as an output negative (apart from the transport and retail outlet activity which are a spin-off), and the counter party to all that "living beyond our means" feel-good added credit-driven purchasing power really only shows up as a negative item on the financial side of the accounts, as money borrowed from the exterior, money which is used to finance the deficit. It is a negative item, because all that potential capacity to spend is being diverted away from national activity to external activity. So while you pay for the products consumed (through debt) others get the long term benefit of your spending. Which is why it is such a bad idea to run sizeable current account deficits over any great length of time, since they are financed by credit, and credit is only a way of transferring demand from the future to the present, which means you will feel richer now, and poorer in the future, and this is exactly what is happening to Greece. It is also why the only way to put the situation straight is to export more, and run a trade and current account surplus, since then the value of your net external debt falls. So the correction is necessary and inevitable, although the curious thin is that while it is taking place, and while exports are rising and imports and living standards falling GDP rises, even though people feel much worse off.

Obviously, having an economy appearing to accelerate like this is a bit counter intuitive. Evidently it is not the same as having a devaluation-induced import-reduction with demand remaining equal, and more productive activity taking place inside the country as relative prices result in steady import substitution, but then demand deflation policies have these peculiarities attached. Maybe we could think of the type of correction Greece is engaged in as less future demand being brought forward to today, under the hope that the subsequent path of the economy will eventually be on a higher level than it otherwise would have been. Pay now, live later.

In the Greek case, since private sector borrowing is at a total standstill, and public sector deficit borrowing is being steadily reduced, the current account deficit is being forced to close, with the consequence that since exports can't rise much (due to competitiveness issues, and their low base) imports will need to fall while unemployment will probably continue to rise.

If this analysis of what has been going on in Greece is correct, then it can also help us understand the latest set of Spanish GDP numbers a bit better. According to the latest data, in the first quarter of this year Spain's GDP rose by 0.3% over Q4 2010 and by 0.8% over the year earlier quarter. This surprised many analysts since the Bank of Spain has previously estimated growth to be around 0.2%, and a number of 0.1% was often anticipated.

In theory the Q1 performance marks an acceleration over the 0.2% quarterly rise registered in the last quarter of 2010. Such an acceleration seems odd, since all the recent data, industrial output, retail sales, unemployment has been negative, and doubly so since the government is in the process of a very sharp (3.2%) fiscal adjustment process.

Yet, if we come to look at the relative import/export performance, we will see a milder version of the same phenomenon. It seems exports rose and imports fell in the first quarter, creating a very special kind of "win-win" situation.

This is a much milder version of the Greek story, but possibly similar processes are at work in both cases, as Spain's previously large current account deficit is also being steadily forced to close.

On the other hand, in Spain's case other factors might be at work, like overspending before this month's regional and local elections. In any event, I am describing all the above as a hypothesis because we still don't have either the March trade data or the detailed GDP data. When we have access to both of these we will have a better idea of just how valid this hypothesis of mine actually is. At the end of the day, one swallow doesn't make a summer, and one month's GDP surprise is simply a drop in the ocean in relation to the major challenges which face these economies in the quarters and years ahead.

Another Lesson In How Not To Go About Things From The EU Commission

2010-11-29T16:47:00.007+01:00

The present generation of European leaders will doubtless be remembered for many things, but somewhere high up there on the list will be the appauling sense of bad-timing they seem to have when making critical announcements. The confusion caused by certain ill-considered remarks from Angela Merkel about how private sectors bondholders would need to participate in future EU bailout processes is evidently one good example. Another, without doubt is going to be the decision by EU Commissioner Olli Rehn to appear before the world's press today (yes, today of all days, one day after the sensitive announcement of the Irish Bank Bail-out plan and the decision to create the European Financial Mechanism), and inform the assembled throngs that as far as the EU Commission could see Spain will not be sticking to its 6% of GDP fiscal deficit committment next year, simply because according to EU calculations the deficit is going to be 6.4% - unless, of course - there is another round of fiscal reduction measures.

I think Spanish has a suitable word for this kind of persistent badtiming: "gafé". But the thing is, if Europe's leaders insist on continually showing the markets just how "gafé" they all are, then we are never going to find our way out of this hole we have all dug for ourselves.

And so it was, that by 16:30 this afternoon the yield on 10 year Spanish bonds hit 5.5% (up from around 5.2 at Friday's close), and the spread over equivalent German Bunds hit a Euro-era record high of 273 basis points. These sort of numbers were totally unimaginable at the start of 2010.

The root of the problem comes from the fact that the EU Commission had identified today as the day when their economic forecasts for national economies were to be published, and so it was. As part of the forecast the commission fractionally lowered its 2011 growth outlook for Spain, to 0.7% from an earlier expectation of 0.8%. Hardly earth-shattering news, and not normally the sort of thing to send bond yields off into a "death spiral", but given the times we live in, markets are extraordinarily sensitive to any such revision. In fact, a downward revision of 0.1 percentage point is well within the bounds of any reasonable margin of error, and no one really has the foggiest idea of what Spanish growth will actually look like next year beyond the most approximate of approximate guesses. This is because the degree of uncertainty is unusually high in the external environment, and the impact of the very strong fiscal correction that is planned (from this years 9.2% deficit, to next years 6% one) is very hard to evaluate. Personally I think it will be very hard for Spain to get positive GDP growth at all next year given all we are seeing, but I certainly don't want to engage in a Dutch auction with the Spanish authorities on this point.

But in fact the potential difficulties for Spain to achieve the 6% target for 2011 were already reasonably well known. I had already written about it in this post, were I pointed out the difficulty Spain's regional and local governments were having this year in meeting targets, and how important it was going to be to stick by the letter of next years budget plan if the administration did not wish to face the wrath of the markets.

My points were backed up the day after by Bank of Spain Governor Miguel Angel Fernandez Ordonez, who told a Spanish parliamentary committee that:

“Recent budget data point to the achievement of objectives for 2010, at least for the central government.... but (as far as the regional governments go) my impression is that the measures [they've announced] are far from sufficient”

The Bank of Spain governor reinforced this point by adding that in a highly decentralized Spain, where the central government directly controls less than a third of spending, and lacks sufficient means to supervise the fiscal policies of regional and local administrations, it was extremely difficult for the central government to get an exact result. His opinion was that these august bodies be required to publish budget data in a more timely fashion and be given an annual spending ceiling. In fact, these days the Spanish government cannot afford to ignore what the Governor of its Central Bank says, and so the administration has gone some way to putting such controls in place, but whether they are sufficient to do the job or not still remains to be seen.

Mafo's point was backed up later the same week by former Bank of Spain deputy governor and current IMF Official José Viñals, who stated "Spain should be willing to carry out additional fiscal adjustments to achieve a budget deficit of 6 percent of gross domestic product by 2011 because markets have “zero tolerance” for failure to meet stated targets."

So these issues are already known, Spain may well need to formulate a plan "B" if the governments hand is forced, but it was a pity to unsettle the markets just one more time by raising them again precisely today.

Not everything in the report was bad news for Spain, however, since the commission did improve its forecast for this year. The EU now expects the country's GDP to contract by 0.2% in 2010, compared with the 0.4% contraction it had projected in the spring forecast, giving a little more power to the elbow of a struggling Elena Salgado who has recently been belabouring the point that her forecasts are better than those of the EU and the IMF. But next year will be the "test of fire" on this front, since it is starting next year that all those rather optimistic expectations on domestic consumption start to lock-in.

Having said that, the EU now predicts that annual average unemployment will rise again next year, and hit 20.2% (above Salgado's forcecast). In fact this may well be an underestimate, since the September figure was 20.8%, and at the present time unemployment is still rising, and not falling. Indeed Olli Rehn himself stressed that there were "significant but balanced risks to the baseline scenario." And in particular he pointed out that further drops in house prices could lead to a "deeper-than-expected adjustment in construction, dent household wealth and sap consumer confidence." And yet that is just what Spain seems to continue to be facing, a slow drop-by-drop downward trickle in house prices.

So what can the Spanish government do to stop the rot? Basically at this point very little. The ammunition has nearly all been fired off, and most of it has been wasted. And yet one more time we all seem to be in agreement. When asked what Spain and Portugal should do to stop the so-called contagion, I was quoted by the Financial Times as saying: “Not do anything wrong..... The only thing you can advise these people to do at this stage is to be absolutely frank and stick absolutely to what they say.” “From this point on, the more you do fiscal austerity, the more you contract and the less you can pay".

The following day Manuel Campa, Spain's deputy finance minister for the economy was quoted by Bloomberg in a similar vein as saying that the best thing “to generate credibility in the Spanish economy is to execute the measures we have announced at the time and in the way they were announced, and that implies not taking additional measures.”

And as luck would have it Miguel Angel Fernandez Ordonez was back before the Spanish senate the following day (his timing, unlike that of Olli Rehn, seems to be impeccable), telling all those senators that “We have to convince people that we’re going to do exactly what we said we were going to do.” Seems logical, doesn't it, I mean whyever would they imagine you might not do what you say you are going to do? Whatever put that wicked thought in their heads?

And Mafo was also on this occasion perfectly frank about the growth situation: "The outlook for a gradual recovery is surrounded by uncertainties," he told the senators."In an environment where financing conditions will foreseeably remain restrictive and in which the public and the private sector have a pressing need to clean up their financial position, we can expect the pace of recovery in household consumption to slow versus the first half of the year."

I couldn't have put it better myself.

So, summing up. Spain is suffering from the serious restrictions imposed on trying to make a major economic correction while participating in a monetary union (Paul Krugman is once more making similar points in today's New York Times). In particular this means that not only does the country not have a currency to devalue, it does not have a central bank with capacity to print money and buy its bonds. It also has a very substantial exposure in terms of the external position (ie debt) that makes it dependent on international financial markets for funding in a way that means that the extremely low interest rates that are on offer at the ECB are not really (beyond some limited non standard liquidity measures) passed on to the countries banks, her citizens, her companies or her government.

Spain has the benefits of neither expansionary fiscal or monetary tools in the midst of a huge output slump, where the underlying contractionary tendencies in the economy are still substantial. Given all of this, and given that Spain's leaders have at last shown some signs that they are aware of the seriousness of the situation that faces the country, I think it is being cruel beyond belief to haggle over whether the deficit next year will be 6% or 6.4%, let alone send Spanish bond values into a suicidal downward spiral that risks destroying what is still left of the countries banks over the issue.

Spain needs to stick to its deficit reduction targets, but it also needs more help from those who are running the system by which it is trapped and which it is struggling hard to defend. Pile the pressure on and the country is only going to crack. What Spain needs is to get back to growth, and to put people back to work, then the deficit problems will sort themselves out almost on their own. And in this sense it is the authors of the latest EU forecast, and not those who run the Spanish administration who are the unrealistic ones. Spain is in a corner which it can't get out of alone. She needs help, and that help is going to have to come from the top.

As Krugman says:

If Spain still had its own currency, like the United States — or like Britain, which shares some of the same characteristics — it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available. Instead, Spain must achieve “internal devaluation”: it must cut wages and prices until its costs are back in line with its neighbors.

And internal devaluation is an ugly affair. For one thing, it’s slow: it normally take years of high unemployment to push wages down. Beyond that, falling wages mean falling incomes, while debt stays the same. So internal devaluation worsens the private sector’s debt problems.

Internal devaluation is coming, there is now no avoiding it. When I advanced the idea for Spain some three years ago it wasn't some sort of contribution to a collective brainstorming session, it wasn't just one option on offer together with a whole series of others. What I was saying was if we don't go down this path then would would inevitably end up where we are now. But as Krugman points out, seeing it through means the private sector debt problem will only deteriorate, which is why we need help, to share the burden. The other alternative, of seeing the Euro fall apart, is in the interests of no one. Not even the Germans, who would soon see the current record growth in their exports shifted into reverse gear as the new DeutscheMark was quoted at values (as is happening to the Japanese yen right now) which robbed the country of all semblance of competitiveness.

Well, today we have a new government in Catalonia. So maybe its time to change. Maybe finally we could now start to address the problems of the Spanish economy head-on, and put the future of the country on a sound and sustainable footing. It's certainly worth a try, and, at least, as the English saying goes: where there's life, there's hope.

Spain's Troubling Unemployment Statistics

2010-10-31T19:57:00.009+01:00

Spain's statistics office continue to issue worryingly confusing press releases. The latest example is one published in connection with the quarterly labour force survey which came out last Friday.

Now the data the INE assemble in their report is very interesting, and as many observe, the complete survey gives far more reliable data about the state of the labour market than the monthly labour office signings do.

But the way they present the data isn't interesting, in fact its downright misleading. In particular they chose not to seasonally adjust the data - which in a seasonally driven economy like the Spanish one with significant ups and downs in tourist activity doesn't make much sense - and this omission is not only lazy, it is negligent. As I say, it is misleading, in the same way the information on VAT returns and deficit reduction progress issued by the Ministerio de Economía y Hacienda is misleading (they do not, for example, clarifying the changed VAT refunds procedure), or in the same way the notarial contracts data gives a completely topsy turvy view of movements in Spanish house prices. At best such data gives completely meaningless information, and at worst it leads reporters who cover the Spanish economy hopelessly astray.

Thus Reuters:

"Spain's unemployment rate fell to 19.79 percent in the third quarter, the first drop since the second quarter of 2007, the National Statistics Institute said on Friday".

In fact Spain's seasonally adjusted unemployment (and this is the relevant number, as explained to everyone who ever attended a class in Econ 101) did not fall to 19.79 at the end of the third quarter (ie by September), but rose from 20.5% in August to 20.8% in September, the highest rate in the European Union, and probably in the developed world (you can check the complete Eurostat report on the September Labour Force Survey results here - the numbers are provided by the INE, even if they do not see fit to publish them in their own report).

And in fact, far from creating jobs during the quarter, and as can be seen in the Ministry's own data if you look hard enough, seasonally adjusted the economy lost 30,000 jobs, and the number of unemployed grew by 65,000 (the apparent discrepancy between these two numbers is accounted for by movements in the size of the economically active population).

Even more importantly, and as reported by the Spanish website Cotizalia, of the 92,900 increase in salaried employment reported in the unadjusted data, 90,300 jobs were supplied by the public sector (and this during a deficit reduction exercise where staff contracts are in principal frozen), and only 2,600 came from the private sector.

Indeed, when we take into account the seasonal increase in tourist related employment during the summer, underlying employment in the private sector evidently shrank significantly, as suggested by the fact that (on an unadjusted basis) Spanish industry employed 18,300 people less at the end of the quarter than it did in June, and this is the sector which has to lead - through exports - the Spanish recovery.

Now let's go back for a minute to something Monsieur Trichet said in a recent speech on Euro Area statistics. Reliability, clarity and ease of interpretation have to be key cornerstones of national statistics office policy. As he says:

"First, the reliability of the general government statistics underlying the Excessive Deficit Procedure and the Stability and Growth Pact must be guaranteed when they come out. While the government finance statistics of the overwhelming majority of the Member States is reliable, this does not yet apply to all of them. Yet as we are in a highly integrated union, we need reliable statistics not just from the majority of Member States we need it from each and everyone, no matter how large or how small the country is. We have seen that the potential for loss of credibility affects the entire union."

and then

"we must have full assurance that the statistical indicators supporting enhanced macroeconomic surveillance are robust and timely available. We must have assurance that indicators – such as international indebtedness, unit labour costs and other indicators of competitiveness – are firmly based on accepted statistical methodologies, ideally already legislated, and that the degree of estimation in compiling them is limited".

Essentially, the point I am making here is not that Spanish statistics are simply "falsified" in the way many argue that Greek ones are, but that insufficient effort is put into producing high quality and reliable data which helps investors, analysts and policy makers to measure what is going on, and take the appropriate decisions. Economic statistic production is not a game where you attempt to fool as many people as you can as often as you can. Nor is good statistical work a question of simply mechanically churning out reports to comply with legal requirements, without consideration of what use the end product will be - the INE's monthly retail sales and industrial output reports come into this category, since without seasonal adjustment (which again they do not publish even though again they provide the relevant corrected numbers to Eurostat) it is impossible to tell what is happening on a month by month basis. Indeed one cannot escape getting the impression that, when we are talking about Spanish statistics, where the opportunity arises to send journalists heading off on an informational wild goose chase, this opportunity is rarely missed.

Data needs to be credible, informative, and helpful to outsiders who wish to evaluate, and take decisions. As Monsieur Trichet says, if this is not the case, the consequences can affect all members of the monetary union. Unfortunately, all too often, Spanish statistical presentations fall woefully short of these required standards.

Those wishing to read the original INE press release on the Q3 employment data, and see for themselves just how uncritically that drop in unemployment to 19.79% was reported, can find it here. Enjoy the read.

What Goes Up....

2010-10-31T19:12:00.005+01:00

Spain's troubled banking sector is back in the news again. Despite the apparently succesful stress tests carried out over the summer problems persist, and don't seem likely to go away soon. Foremost among these is the steady rise in problem loans which have now risen to an all-time high, potentially endangering the credit rating of the country's financial institutions, according to a recent report from the credit ratings agency Moody's.

In fact distressed loans in Spain's banking system reached 102.5 billion euros as of August, according to the latest Bank of Spain data. At 5.6% of the total this is the highest proportion of overall loans since 1996. "The performance of the commercial real estate sector has been the main driver of overall asset quality deterioration," Moody's said in their report. Evidently asset quality deterioration in Spain's banking system is likely to continue both this year and next, driven by oversupply in the property market, the impact of the real estate crisis on the larger economy, and the continuing high unemployment levels.

The warning about the potential impact of the continuing rise of so called “non-performing” loans has also been reiterated by the Bank of Spain itself, who draw attention, in their latest Financial Stability Report, to the fact that the banking system is very likely to face a further increase in problem loan ratios in coming quarters, an admission which effectively constitutes a revision of last April’s IMF forecast that such loans would peak in the third quarter of 2010. Unfortunately the number of distressed loans continues to rise, and the end of the problem is not yet in sight.

Indeed the latest Moody’s report comes at a time of growing uncertainty for the sector, with Spain's two largest banks - Banco Santander and Banco Bilbao Vizcaya Argentaria - both releasing earnings results which disappointed the markets and gave evidence of the significant pressure they have on their margins. A further indication of the pressure they are under can be found in the fact that they have publicly attacked the slow pace of reform among the savings banks, arguing that these are using the billions of euros from the public restructuring funds to compete unfairly by offering uncompetitive rates to attract deposits. Cajas are offering rates of up to 4.75% in order to build their deposit base, which they urgently need to do given the difficulties they have attracting finance in the wholesale money markets. The large banks argue that such campaigns are bound to generate losses in the longer term and that such behaviour is unacceptable for institutions receiving public aid.

Emilio Botín, Santander's chairman, was first out of the box with a speech to business leaders which criticised the “inadequate” speed of restructuring at the cajas and called for more concrete plans to cut capacity and improve margins. Then Angel Cano, chief executive of BBVA, added his voice calling for a speedy completion of the restructuring process so that bankers could begin 2011 “with equal conditions and on a level playing field”.

In another sign of the pressure they are under Spain's banks are starting to sell-off some off their most valuable branches. One popular way of doing this is to sell them and then lease them back again, a move which allows them to record a short-term transaction gain, one which can then be used to absorb and conceal losses sustained in their mortgage loan book.

According to an analysis carried out by the Wall Street Journal BBVA is about to register a gain of €233 million on a sale and leaseback of offices and buildings to a real-estate investment consortium led by Deutsche Bank AG's RREEF. The proceeds will then surely go directly toward into the bank's provisions against bad loans. Banco Sabadell also completed a similar €403 million deal in May, in which it sold and rented back 378 offices and other properties. And Caja Madrid, one of the country's largest savings banks, is reportedly looking at similar deals, following its own branch sales last year and a separate €108 million, 30-year sale-and-leaseback agreement with a unit of the German fund S.E.B. Asset Management AG in May. According to the WSJ Caja Madrid is currently in talks with investors to sell a somewhat larger package of branches, valued at €300 million, according to a spokesman for the savings bank.

And a further sign that all is not well - the banks are still having difficulty issuing covered bonds, with Spain's domestic banks currently paying a full two percentage points above the bank borrowing benchmark, as compared with a mere 0.20 percentage points before the European sovereign debt crisis erupted, according to Barclays Capital analysts Carlos Cobo Catena and Tom Rayner.

This difficulty is underlined by the evident fact that Spanish banks are falling behind their counterparts across Europe in reducing their dependence on emergency central bank funding. While Euro Area banks cut their collective borrowing in September to 514.1 billion euros, the least since the Lehman Brothers collapse in September 2008, Spain’s banks continued to borrow 97.7 billion euros, still well above the 85.6 billion euros they borrowed in May this year, just before the debt crisis broke out.

With the Bank of Spain pressuring them to increase their provisioning for properties held on their books, the banks have been vigorously attempting to move it off them, often promoting attractive property deals on their websites, and in some cases even offering 100% financing and other deals on mortgages in an effort to sell their growing mountain of real estate, which normally comes to them through debt for asset swaps or foreclosure. But, with the sales market sluggish to virtually non-existent, banks are increasingly looking towards renting a part of their empty stock, on occassion transferring the targeted property directly from the developer to one of their off-balance-sheet subsidiaries. Banks aren't required to set aside as many provisions for assets which carry a rental stream, and none at all for assets they do not formally own.

The absence of a liquid market in Spanish housing is causing more and more problems. Before the crisis set in, homeowners who found themselves in financial difficulties had, for example, been able to sell their houses relatively easily, repay their outstanding debts, and start all over again. However, times have now changed, selling the property at a price which lets them clear the mortgage is increasingly difficult, and the banks, under pressure from their bottom line, are increasingly resorting to mortgage foreclosure. "Although lenders have historically not particularly liked extra judicial enforcement, it has become a solution among Spanish lenders in areas where the courts are saturated by cases and the foreclosure of a property may prove more speedy than the traditional enforcement procedure" says Alberto Barbachano, a Moody's Vice President and author of a recent report on the subject.

The volume of Spanish foreclosed mortgages that were taken to court grew by 126% in 2008 and 59% in 2009 on a year-on-year basis. In the first three months of 2010, 27,561 mortgages were foreclosed, a record since the economic downturn started in 2007.

In fact Moody's argue that the very high reported number of foreclosed mortgages that have been taken to court in Spain since 2007 underestimates the actual number of properties that have been repossessed by Spanish financial entities for two reasons. First, because more than one property may have been involved per individual foreclosure process. And second, because Spanish mortgage lenders have generally become more willing to sign up to voluntary agreements, accepting the property as payment in kind and then releasing the debtor from the debt.

At the present time the consumer protection organisation Adicae estimate that 1.4 million Spaniards are facing potential foreclosure proceedings, and the number is likely to continue to rise in the months to come. A recent Standard & Poor’s report found that 8 percent of Spain’s housing is now worth less than the value of the mortgage, and with prices continuing to fall, and some experts believe that figure could rise to 20 percent before the price contraction is over. So with unemployment, problem loans, and property foreclosures all rising, the only thing that seems to be falling steadily towards earth is the level of bank profitability. It is only to be hoped that with their untimely descent Spain's banks don’t bring the whole edifice of Spanish economic activity (and with it the institutional structure of the Eurozone) crashing down behind them.

Mr Zapatero Said What..........?

2010-10-17T22:05:00.000+02:00

Spain's Tinsa Price Index was out last week, and showed Spanish property prices fell again in September, and at an accelerating rate. As Tinsa point out in their report, both "Metropolitan Areas and municipalities on the Mediterranean Coast," whose rates experienced a significant drop from the previous month, have contributed decisively to this steep decline".

In fact, looking at the chart the other way round, prices have now fallen some 18% from their December 2007 peak.

The strange thing is that the latest Tinsa data contrast sharply with the most recent finding of Spain's National Institute of Statistics (INE) on the subject, since they suggest in their latest report that Spanish property prices actually rose in the second quarter (quarter-on-quarter) (and for the first time in the best part of 3 years), but this finding rather than reassure us that all is well (and as it should be) only serves to cast further doubt on the ability of the INE to maintain adequate statistics on the state of the Spanish economy, or at least to interpret the data they collect. This latest piece of statistical wizzardry lead Spanish property expert (and author of Spain Property Insight blog) Mark Stucklin to say "If you believe that, you’ll believe anything". Frankly, I'm inclined to agree with him.

Of course, it has become rather fashionable to question INE data interpretation of late (and I personally have had my problems with the seasonally adjusted employment numbers - in fact see these collected screenshots of the the backward revisions that were going on in the data as evidenced by Eurostat monthly reports) but this latest "faux pas" does make you want to ask "can't they get anything right"? In fact the Statistics Office house-price-data, is full of incredible and eye catching details, like the suggestion that new build sale prices only peaked in the third quarter of 2008, following which they only fell back 7.77% from peak, before taking off again, if we are to accept the official data version of things. So this must have been the "bottom" that Mr Zapatero refered to in his CNBC interview (see below). And this, as Mark Stucklin notes "despite a glut of up to 1 million newly-built homes, and discounts of up to 20pc or more on any developer’s price list you care to look at". So is this how one of the greatest housing busts in living history ends, with a whimper and not a bang? Somehow I doubt it.

Naturally, I'm sure its a pure coincidence that this latest "surprise price reversal" data came out just before Jose Luis Rodriguez Zapatero went to New York to kindly inform all concerned that the Spanish property market is now on the mend. In an interview with CNBC (see this official Moncloa transcription of the interview if you have any doubt), Prime Minister Zapatero repeated the INE claim, stating that house prices are beginning to rise in some areas, though not, he admitted, in the case of holiday homes. “In fact, in the last 2 to 3 months, we have seen that prices are not only not falling, but even rising in certain parts of Spain, where people buy their first home,” he told CNBC's Maria Bartiromo. This, he argued, shows that “demand appears to be on the rise.”

MS. BARTIROMO: Are you expecting real-estate prices to continue coming down? Have they hit the bottom or not yet?

PRIME MIN. ZAPATERO: I think that the price of housing has hit the bottom. It won't go down any more. For the past two or three months, what we see is that not only has it not dropped. But in certain parts of Spain, the price of housing has gone up. This is especially the case in those areas of -- not where people are buying their second house, if you like, with the prices there have still gone down a bit, but rather where they're buying their first, there the prices have gone down in the housing sector. So in general the prices have been stable recently, and they've even been increasing. So demand seems to be ticking up again.

Now, as that posse of irate INE defence vigilantes who may come chasing after me on this will no doubt tell you, the methodology they use is different from the Tinsa one, since it based on registered Notarial transaction prices, while the Tinsa index is based on asking prices, but come on, house prices rising again in Spain? Which world are we living in?

Of course, there could be another explanation for this seeming discrepancy (apart from fudging the numbers that is) and that would be that many of the actually new build transactions are not real transactions at all, but rather paperwork ones, as the banks move over the developers unsold property onto the books of their special purpose subsidiaries, and don't mark down the price since they prefer not to show losses. Then, of course, the very same subsidiary offers the property for sale at a sizeable discount (and it shows up with the Tinsa index as an asking price), but since there are very few real new-build sales at the moment, these number never show up back in the notaries office, where all is quiet and orderly.

Sure, the data show that new house sales "seem" to have bottomed, and even picked up a bit (see chart below), but talking to developers and estate agents out on the street, this doesn't seem to be the result of any real pick up in end user demand. It is more a question of banks responding to pressures from the Bank of Spain by moving their properties "out of sight" (if not out of mind). Meanwhile, the typical Spanish buyer is adopting a watch-and-wait approach, and will need a lot of convincing that they really have stopped falling before they move back in. Even the "experts" employed by the EU Commission are not convinced either, since they just published a report stating that Spanish property prices were still 17% too high.

But if you want one, there is something more like a smokin gun out there which should tell us that this whole Spain property market recovery story is a bit strange, and that is the Bank of Spain data for total mortgage lending. This has hardly moved since the start of 2009 (see chart below) so it is far more easily reconcilable with the properties being transfered over to bank subsidiaries (complete with their "developer" mortgages) story, than it is with one of rising sales and rising prices.

More than the house price story itself, which is hardly pleasing to the eyes, what I find most worrying is the way the Spanish administration seems to be boxing itself into a corner with its use of data. During the interview. Mr Zapatero also said the following in a response to a question about the outlook for the Spanish economy: "Well, our estimate is that we won't have any more quarters where growth will go down. We think that growth will continue to improve, and this will also improve confidence in the Spanish economy". But none other than Bank of Spain Governor Miguel Angel Fernandez Ordoñez recently asserted that the Spanish economy had visibly weakened in the third quarter, and the data we have certainly seem to back him up. And the fourth quarter outlook looks even worse. So which is it, will Mr Zapatero be able to eat humble pie, or will an army of bank analysts and hedge fund investors end up spending the whole xmas period going through all the Spanish data with a fine toothcomb? Mr Zapatero also says: "What's happening is that our plans are being fulfilled to the letter". This reminds me of other statements from other national leaders in other times. Would that those beyond the confines of his own small closed inner circle could find themselves able to agree with him when he makes such an assertion!

An Unusual But Interesting Argument Which May Help To Understand Why QE2 Is Now Almost Inevitable

2010-10-16T22:53:00.001+02:00

For reasons which aren't worth going into now, I'm reading through a recent report by Deutsche Bank Global Markets Research entitled "From The Golden To The Grey Age" this afternoon. The report (all 100 pages of it, many thanks to researchers Jim Reid and Nick Burns who produced the thing) looks at the extent to which a variety of macro indicators - like GDP growth, inflation rate, equity yields, etc - may have been influenced by demographic forces over the last 100 years or so. It is certainly one of the most systematic reports of its kind I have seen, and well worth losing a Saturday afternoon to read.

But in the middle, there is an argument which caught my eye, and I thought it worth reproducing. Basically the starting point is this chart, which if you haven't seen by now (or something like it) I'm not sure where exactly you've been during the last 2 or 3 years.

Obviously, just the most cursory of glances at the thing should lead even the most untrained of eyes to get the point that what is going on around us is not some passing phenomenon, and that there are deep structural factors at work.

As our Deutsche Bank researchers put it:

As can be seen (from the above chart) there was a step change in the US economy’s indebtedness from the early 1980s onwards and then an additional one in the late 1990s/early 2000s. A similar picture is apparent across most of the Western World.

Basically from the early 1980s to the onset of the Global Financial Crisis the economy added on more debt every year and business cycles were extended as a result. Indeed the Fed and Central Banks around the world were afforded the luxury of operating in a secular falling inflation regime (globalisation) that allowed them to cut rates, further allowing the accumulation of debt, every time the economy may have naturally been rolling over into a normal recession consistent with those seen through history. This debt accumulation undoubtedly helped smooth the business cycle and contributed to the period being known as the ‘Great Moderation’. This period came to a spectacular end with the onset of the crisis and it is possible that going forward we will revert to seeing business/credit cycles more like they were prior to the ‘Great Moderation’.

Now here comes the clever part. Our researchers then go on to take a look at the the average and median length of the 33 business cycles the US economy has seen since 1854. For the overall period they found the average cycle from peak to peak (or trough to trough) lasted 56 months (or 4.7 years). However, the averages are boosted by an occasional elongated "superbusiness cycle", and thus the median length is a much smaller 44 months (3.7 years). As they comment, such numbers must look very strange to those who have only ever analysed business cycles over the last 25-30 years. Within these 33 cycles the contraction period lasted 18 months on average or 14 months in terms of median length. This equated to the economy being in recession 31% or 32% of the time depending on whether you look at the averages or the median numbers. Taking just the period before the “Great Moderation” the average US cycle lasted 5 months less at 51 months (or 4.3 years) with the median at 42 months (3.5 years). Over this period the US economy was in recession 35% and 36% of the time respectively depending on whether you look at averages or the median.

Now we used to think that all of that was behind us, but then we used to think that the "Great Moderation" had gotten things under control, and not simply temporarily extended the cycle length by facilitating long-term-unsustainable levels of indebtedness. So in fact, given that, as they say some sort of cycle or other has been with us since at least biblical time, what we might now expect are more "normal" cycles (in historical terms), which put a little better means shorter ones with more frequent recessions.

"Given all we know about the ‘debt supercycle’, it is likely that the onset of the Global Financial Crisis ended the “Great Moderation” period. Unless we find a way of continually adding more debt at an aggregate level in the Developed World it is likely that we will see much more macro volatility and more frequent business cycles going forward. Given the fact that Developed World Government balance sheets are under pressure, and given that interest rates around the Western World are close to zero, the post-crisis ability to fine tune the business cycle is extremely limited. We may need to put an immense amount of faith in the experimental force of Quantitative Easing to deliver economic stability. This will be an experiment with little empirical evidence as to how it will turn out. For now the base case must be that we revert more towards business cycles more consistent with the long-term historical data".

So then our authors do their calculations concerning the average length of US cycles since 1854 in order to make a rough estimate of when the next few US downturns will start, as illustrated in the following chart.

Now, without dwelling on the gory details, if we look at the spread between the upside, median, and downside cases, we could pretty rapidly come to the conclusion that the next US recession has a high probability of starting sometime between next summer, and the summer of 2012 - which, as you will appreciate, isn't that far away. I am also pretty damn sure that Ben Bernanke and his colleagues over at the Federal Reserve appreciate this point only too well, and hence their imminent decision on more easing, since a recession hitting the US anytime from next summer will really come like a jug of very icy water on that very fragile US labour market, not to mention the ugly way in which it might interact with the US political cycle.

I think the mistake many analysts are making at this point is basing themselves on some sort of assumption like, "if the recession was deep and long, then surely the recovery should be just as pronounced and equally long", but, as the DeutscheBank authors bring to our attention, business cycles just don't work like that.

Now, why I think this is an interesting argument is that the starting point for looking at the recovery is rather different from the norm, in that instead of peering assiduously at the latest leading indicator reading, they do a structural thought experiment, and work backwards from the result. Now, one thing I'm sure Ben Bernanke isn't is stupid, so it does just occur to me that either he, or someone on is team, is well able to carry out a similar kind of reasoning process.

Watch Out, Here Comes The QE2

In fact, it would be an understatement to say that the forthcoming QE2 launch is causing a great deal of excitement in the financial markets. As the news reverberates around the world, it seems more like people are getting themselves ready for some kind of "second coming". Right in the front line of course are the Europeans and the Japanese, and the yen hit yet another 15 year high (this time of 81.11 to the dollar) during the week, while the euro was up at 1.4122 at one point. Greeks, where are you! Can't you engineer another crisis? We need help from someone or we will all capsize in the backwash created by this great ocean liner as it passes.

But joking aside, a weaker USD is going to be both the natural and the intended consequence of the coming bout of additional QE by the Fed, and it will have a strong collateral effect on the already weaked and export dependent economies of the EuroArea and Japan.

With this prospect as the background, it should not come as a surprise that talk of currency wars and competitive devaluations is rising by the day. Japan only last week threatened "resolute action" against China and South Korea, Thailand has placed a 15% tax on bond purchases by non resident investors, and central banks from Brazil to India are either intervening to try and keep their currency from rising too fast, or threatening to do so.

And the seriousness of the situation should not be underestimated. Many have expressed disappointment that the recent IMF meeting couldn't reach agreement, and hope the forthcoming G20 can do so. But really what kind of agreement can there be at this point, if the real problem is the existence of the ongoing imbalances, and the inability or unwillingness of the Japan's, Germany's and China's of this world to run deficits to add some demand to the global pool. Push to shove time has come, I fear, and if this reading is right then it is no exaggeration to say that a protracted and rigourously implemented round of QE2 in the United States could put so much pressure on the euro that the common currency would be put in danger of shattering under the pressure. Japan is already heading back into recession, as the yen is pushed to ever higher levels, and Germany, where the economy has been slowing since its June high, could easily follow Japan into recession as the fourth quarter advances.

Indeed, I think we can begin to discern the initial impact of the QE2 induced surge in the value of the euro in the August goods trade data. The EuroArea 16 have been running a small external trade surplus in recent months, and to some extent the surplus has bolstered the region's growth. It is this surplus that is now threatened by the arrival of the QE2. The first flashing red light should have been the news that German exports were down for the second month running in August, but now we learn from Eurostat that the Euro Area ran a trade deficit during the month.

"The first estimate for the euro area1 (EA16) trade balance with the rest of the world in August 2010 gave a 4.3 bn euro deficit, compared with -2.8 bn in August 2009. The July 20102 balance was +6.2 bn, compared with +11.9 bn in July 2009. In August 2010 compared with July 2010, seasonally adjusted exports rose by 1.0% and imports by 1.8%".

Basically the eurozone countries had been managing to run a timid trade surplus (see chart below, which is a three month moving average to try and iron out some of the seasonal fluctuation) and this had been underpinning growth to some extent. Now this surplus is disappearing, and with it, in all probability, the growth. Maybe we won't get a fully fledged "double dip" in the short term, but surely we will see a renewed recession (and deepening pain) on the periphery and at the very least a marked slowdown in the core.

In fact the current situation is extraordinarily preoccupying. We are now in the fourth year of the present crisis (however you choose to term it, the second great depression, the very long recession, or whatever) and there seems to be no sustainable solution in sight. The underlying problems which gave birth to the crisis are excessive debt (both private and public) and large global imbalances between lender and borrower countries, and neither of these issues has so far been resolved, nor are there proposals on the table which look capable of resolving them.

And unemployment in the United States (which is currently at 9.6%, and may reach 10% by the end of the year) is causing enormous problems for the Obama administration. The US labour market and welfare system are simply not designed to run with these levels of unemployment for any length of time. In Japan the unemployment rate is 5.1%, and in Germany it is under 8%. So people in Washington, not unreasonably ask themselves why the US should shoulder so much extra unemployment and run a current account deficit just to maintain the Bretton Woods system and the reserve currency status of the US Dollar.

My feeling is that the US administration have decided to reduce the unemployment rate, and close the current account deficit, and that the only way to achieve this is to force the value of the dollar down. That way it will be US factories rather than German or Japanese ones that are humming to the sound of the new orders which come in from all that flourishing emerging market demand.

I think it is as simple and as difficult as that.

The problems created by the way the crisis has been addressed now exist on a number of levels. In emerging economies like Brazil, India, Turkey and Thailand, ultra low interest rates in the developed world are creating large inward fund flows which are making the implementation of domestic monetary policy extremely difficult, and creating sizeable distortions in their economies.

At the same time, a number of developed economies like Spain, the United States, the United Kingdom became completely distorted during the years preceding the crisis. Their private sectors got heavily into debt, their industrial sectors became too small, and basically the only sustainable way out for them is to run current account surpluses to burn down some of the accumulated external debt. Traditionally the solution to this kind of problem would be to induce a devaluation in the respective currencies to restore competitiveness, but in the midst of an effectively global crisis doing this is very difficult, and only serves to produce all sorts of tensions. As Krugman once said, "to which planet are we all going to export".

At the same time, two of the world's largest economies - Germany and Japan - have very old populations, which effectively means (to cut a long story short) they suffer from weak domestic demand, and need (need, not feel like) to generate significant export surpluses to get GDP growth and meet their commitments to their elderly population. The very existence of these surpluses also produces tensions, and demands for them to be reduced. But this is just not possible for them, and Japan is the clearest case. For several years Japan benefited from having near zero interest rates and becoming the centre of the so-called global "carry trade", which drove down the currency to puzzling low levels, and made exporting much easier. Large Japanese companies were even expanding domestic production and building new factories in Japan during this period (a development which had Brad Setser scratching his head at the time, trying to work out how the yen could have become so cheap).

Then the crisis broke out, the Federal Reserve took interest rates near to zero, and the United States became the centre of the carry trade. The result is that every time the Fed threatens to do more Quantitative Easing the yen hits new 15 year highs, even while the dollar continues its decline, with the result that Toyota are having a change of heart, and are now thinking of closing a plant in Japan to move it to Mexico. The present situation is just not sustainable for Japan, which is basically being driven back into what could turn out to be quite a deep recession.

Unfortunately I think there is no obvious and simple solution to these problems. As we saw in the 1930s, once you fall into a debt trap, it can take quite a long time to come out again. You need sustained GDP growth and moderate inflation to reduce the burden of the debt, and at the present time in the developed world we are likely to get neither. In the longer term, the only way to handle the presence of some large economies which structurally need surpluses is to find others who are capable of running deficits, but this is a complex problem, since as we have seen in the US case, if the deficit is too large, and runs for too long, the end result is very undesireable. Basically the key has to lie in reducing the wealth imbalance which exists between the developed and the developing world, but this is likely to prove to be a rather painful adjustment process for citizens in the planet's richer countries, so policy makers are somewhat relectuntant to accept its inevitability.

Basically, the structural difficulty we face is that all four major currencies need to lose value - the yen, the US dollar, the pound sterling and the euro - and of course this basically is impossible without a major restructuring of what has become known as Bretton Woods II. The currencies which need to rise are basically the yuan, the rupee, the real, the Turkish lira etc. But any such collective revaluation to be sustainable will need to be tied to a major expansion in the productive capacity of the economies which lie behind those currencies.

In fact, the failure to find solutions is increasingly leading to calls for protectionism and protectionist measures. The steady disintegration of consensus into what some are calling a "currency war" is, as I said above, another sign of this pressure. On one level, the move to protectionism would be the worst of all worlds, so I really hope we will not see this, but if collective solutions are not found, then I think we need to understand that national politicians will come under unabating pressure from their citizens to take just these kind of measures. The likely consequence of them succumbing to this pressure, which I hope we will avoid, would be another deep recession, possibly significantly deeper than the one we have just experienced. And, not least of the worries, the future of the euro is in the balance at the present time.

The structural imbalances which we see at the global level, between say China and the United States, also exist inside the eurozone, between Germany and the economies on the periphery (Ireland, Portugal, Spain, Italy, Greece). These latter countries failed to take advantage of the opportunities offered by the common currency to carry out the kinds of structural reform needed to raise their long run growth potential, and instead they simply used to cheap money available to get themselves hopelessly in debt. At the same time the crisis has revealed significant weaknesses in the institutional structures which lie behind the monetary union, weaknesses which go way beyond the ability of some members to fail to play by the rules when it comes to their fiscal deficits. Steps are now being taken in a night-and-day non-stop effort to try to put the necessary mechanisms in place, but it is a race against the clock, and it is not at all guaranteed that the attempt will be succesful, especially if the volume of liquidity about to hit the global financial system drives the euro onwards and upwards beyond supportable limits.

All For One And One For All - "We AreThe Eurozone"

2010-10-02T17:12:00.000+02:00

One of the worrying things about the handling of the current European crisis is how many of those responsible for taking the decisions seem to view the Eurozone in a way which is every bit as rigid, timeless and dogmatic as the thinking of those old school scholastics whom Galileo, in his time, found himself battling against. Rather than facilitating a dialogue, and a free and open discussion, the guardians of fortress euro seem to want to keep the doors slammed tight shut, just in case any strange and unwanted ideas should inadvertantly slip in without them noticing.

Take the issue of Eurozone aggregate data. Treating the countries that constitute the bloc as one homogenous entity seems to have become a sort of shibboleth which it is impossible to question, even though it is patently evident to all concerned that there are often enormous differences between the economy of one member country and another. Inflation is the prime example. What seems to interest members of the ECB Governing Council when they have their monthly meeting is that somewhat abstract entity, the average EU16 inflation rate, while what is obviously interesting to follow from a policy point of view (just look what happened to Ireland, Spain and Greece in the years before the crisis - see Spain chart below), is the degree to which inflation rates in individual countries diverge from the mean.

Another example would be current account balances (see chart below). Eurostat publishes data for the EuroArea 16 on a monthly basis, but I think I am right in saying they never publish the national-level breakdown (certainly I have never seen it, and that hasn't been for want of trying). But, of course, now we find ourselves with a whopping set of internal imbalances between those countries running large surpluses and those with large deficits - which the financial markets are becoming less and less willing to fund - and no one seems any too clear about what to do to restore the balance. But how were the imbalances allowed to build up in the first place? Did they creep up on us by stealth, or was no one really looking?

Exactly the same issue arises with the national breakdown of bank borrowing from the ECB. As if living in a theoretical cocoon, decision makers at the ECB move forward in way which makes them seem completely impervious to the problems posed by the way banks in one country are more dependent on funding than are those in others (M Trichet repeatedly refuses to answer questions on this kind of issue at the monthly press conference) and hence remain walled-in from the issues which actually exist in the real world which surrounds them. When pressed they simply state that there is no problem since an EU country is in principle just like a US state - try telling that to Ireland or Greece. Or try telling it to German voters when they are asked to contribute to bailouts.

The issue is of course a very telling one, since basically the whole present Eurozone debt crisis has the inter-country imbalances as its backdrop, hard as the members of the ECB Governing Council may try to avoid admitting it, prefering instead to focus attention on the fiscal profligacy (of which, naturally, there has been a good deal) of the national members state governments. In other words, the problem is not of their making, oh deary me no!

Rivers Of Liquidity Here, Credit Drought There

National divergences in bank lending constitute another very good case in point. Despite the fact that the current crisis has become known as a Sovereign Debt One, it isn't always fiscal spending and public sector debt which lies at the heart of the problem. In fact, private sector debt is often as much of an issue, and the private sector in some EuroArea countries is heavily indebted, while that in others is not. It is important to discover who is who here, and to distinguish between them, since if you don't it will be impossible to decide prescisely which kind of policy mix is appropriate in each and every case (but, of course, our modern scholastic dogmatists will tell us there are no such things as "cases" here, and continue to insist there should be no distinction between countries at the level of policy). Yet just when you need the fine grained detail, what you get are more aggregate numbers and a bunch of platitudes which really tell you very little.

Thus, in the August edition of their publication "Monetary Developments In The Euro Area" we learn from the ECB that bank lending to euro-zone businesses increased in August by €17 billion as compared with July, a rise which more than reversed the €11 billion decline in July over June. What this increase meant was that the annual rate of decline in corporate borrowing was only 1.1% in August versus a 1.4% annual drop in July. That lending to corporates is falling less rapidly is good news, but it is still falling on an annual basis.

Aggregate lending to households also picked up, rising €14 billion during August compared with a €5 billion monthly increase in July. This lead the annual rate of growth to rise to 2.9% from 2.7% in the previous month, which produced a lot of "at last" type comments in the press. And putting the two numbers together, we find the annual rate of growth in loans to the entire private sector was up at 1.2% in August from 0.8% in July. Relief all round, surely, since we are going the right way.

Unfortunately nothing is ever so simple, and once we start to dig down we find large and significant disparities - disparities which may well produce monetary policy decision conflicts for the ECB in the months to come - hidden away in the aggregates. In France, for example, lending for house purchases was up an annual 6.5% in August, and indeed over the last three months such lending rose at a 7.9% annualised rate (ie lending growth for housing is accelerating), while in Spain total house lending was only up 0.6% on the year (in July, we don't have the August data from the bank of Spain yet, but it won't be very different).

When we come to total lending to households we find the pattern repeated, since this was up 5.4% in France in August, and only 0.5% (in July) in Spain.

And when we come to corporate borrowing, this was up an annual 0.4% in France in August, while it was down 1.9% in Spain (in July).

But then, you may want to ask, at the end of the day just why would anyone in Spain want to take on more debt? Since the Spanish stock of corporate debt is around 1,300 billion euros, while the French equivalent is only 771 billion euros (and the country is about half as big again as Spain), French corporates could certainly take on some more debt (if circumstances like market and investment needs warranted) but Spain's heavily over-indebted corporates simply need to pay their debt down. In the context of Spain's shrinking economy, more credit for Spanish corporates simply means more indebtedness and more interest-roll-up loans of the kind that "gather no loss" (at least at the balance sheet level), hardly a desireable development at this point.

Evidently I have taken the two polar cases here, borrowing in Italy and Germany is much weaker than in France, while the situation in Ireland, Greece and Portugal will look more like Spain. But this is part of the point, France is the one large EuroArea country where domestic demand still has real life to it (for a variety of reasons it wasn't blown out by a bubble during the last round) but for just that very reason it would be absolute madness to turn the goose that can still lay golden eggs into some kind of "foie gras" by feeding it up with massive doses of liquidity it evidently doesn't need.

Looking at the inflation differential between France and the Eurozone average matters aren't getting out of hand yet, although French inflation is above the average in a way in which it has not been before, and the situation now requires careful monitoring.

Forward looking inflation expectations have risen in France in recent months, but they seem to a stagnated of late, so again, at this point there is no need to panic.

But the situation is one where - now what is the expression - "extreme vigilance" needs to be exercised, since naturally there is no reason why a country that didn't have a bubble last time round won't develop one next time. So perhaps one of you journalists who attend the post-meeting press conference might like to ask M Trichet whether this is the kind of approach he has in mind, and what policy options are open to him should the worst case scenario (on the upside) really start to materialise. In the meantime, all I can do is shrug my shoulders and mutter under my breath "ma eppur si muove".

Is A 6 percent 2011 Deficit Realistically Within Reach For Spain?

2010-09-28T20:11:00.019+02:00

Last Thursday Moody's Investor Service cut Spain's Sovereign credit - to Aa1 from AAA - thus removing the last of the country's highly-valued triple-A ratings. The move really surprised no one - in this case the Moody's rating could be regarded as a lagging indicator on the health of Spain's finances - since the two other "majors" (S&Ps and Fitch) had long taken the decision, and the market predictably shrugged off the news, as if to say "what else is new". But there was one small detail in the report which should have attracted more attention than it has: the agency explicitly stressed that it was the government's show of determination to reduce its very large fiscal deficit in the near term which influenced their decision to limit the downgrade to just one rating notch, and this was also the reason the rating had been assigned, for the time being, a stable outlook. Which means, of course, that should there be any slippage in that determination, any wearying, or falling asleep at the wheel, then the outlook would rapidly move to negative, and more downgrades could be anticipated.

This creates an interesting situation, since I am by no means as convinced as many conventional journalists seem to be that the present fiscal situation is entirely under control. And since I do think Spain is going to come under increasing scrutiny from all points of view as we enter 2011, especially if Ireland and Portugal are ultimately forced to seek some sort of financial rescue, then any "accidental" slippage this year will inevitably mean even deeper cuts and a lot more pain next year, since Elena Salgado and José Luis Zapatero very definitely have pinned their shirts to the mast on the question of getting the deficit down to 6% of GDP in 2011. If this target is not achieved, and in a way which satisfies reasonably close inspection, then I think the country really will face the wrath of the markets, and in this sense the destiny of the 46 million odd people who live in the country very much is harnessed to the credibility and realisability of the budget plan Elena Salgado is about to present to the Spanish parliament.

The Story So Far

According to most of the reports you read in the press these days market confidence in Spanish debt is rising based on the growing conviction that the Spanish government will be able to comply with its deficit commitments. I somehow doubt that this is the complete story (as I explained in this post), and think it is as much a case of markets being focused at this point on whether or not Ireland and Portugal will ultimately be forced to have recourse to the European Financial Stability Facility (EFSF), and that they are being detached from Spain as much as Spain is detaching itself from them. At this point in time Spain is simply in the waiting room, in a state of grace or being given one last chance, and if the opportunity is not clearly seized with both hands then downgrades and widening spreads will almost certainly follow.

Now, according to the "official version" what is happening if that Spain's fiscal deficit is steadily coming nicely under control as the economy returns to growth and the government squeezes its spending harder and harder. There are only two difficulties with this story. In the first place Spain's economy already appears to be moving back into contraction (the Bank of Spain is now talking of a "weakening" of GDP in the third quarter, and only last Friday the government itself revised up its unemployment forecast for 2011, from 18.7 percent to 19.3 percent to reflect the way the impact of the spending cuts is expected to hit growth). Indeed Moody's itself stressed their scepticism over the government's growth forecast. “Over the next few years the Spanish economy is likely to grow by only about 1 percent on average,” according to Kathrin Muehlbronner, a Moody’s vice-president and lead analyst for Spain. And this is more optimistic than S&Ps, who seem to think trend growth in the years to come will be more like 0.7 percent.

Secondly, and this is the important point at this stage, the part of the deficit which is apparently reducing at this point is the central government one: we are simply not being given the necessary information on the state of Autonomous Community and Local Authority finances to know whether their deficits are reducing, or even if they are increasing. Spain's central government has targeted a deficit of 6.9 percent of GDP this year, with the rest of the adminstration being supposed to limit themselves to 2.4 percent to bring in the 9.3 total promised to the markets.

So despite the fact that we only really have limited information at this point, here is how Reuters reported the news.

Spain's Jan-Aug govt deficit falls more than 40 pct

* Deficit down 42.2 percent from same period last year

* Higher tax take of 33.4 percent in period

* VAT hike from July having effect

MADRID, Sept 27 (Reuters) - Spain's central government budget deficit fell more than 40 percent for January to August compared with the same period last year, thanks to a higher tax take, leaked data from the Economy Ministry showed on Monday.

The January-August deficit, which does not include the balances of the social security system or provincial governments, would be equivalent to 3.3 percent of GDP.

Spain has promised to cut the public deficit to 6 percent in 2011 and to an EU-guideline of 3 percent in 2013 -- forecasts many economists have said they doubt are possible in a low-growth environment.

The central government deficit in the first eight months of the year totalled 34.85 billion euros ($46.50 billion), data from the ministry published on the website of financial newspaper Expansion showed. That was 42.2 percent lower than the same period last year.

The improvement was helped by a 33.4 percent higher tax take, buoyed by a 2 percentage-point rise in value-added tax from July 1.

Still, the January-August figure marks a smaller improvement than that logged in the January-July period, when the deficit came to 25.77 billion euros, down 48.2 percent from the same period last year. That data was welcomed by markets who saw signs that Spain was getting its fiscal house in order.

Now I am calling this the "official version", but I could, rather less charitably call it the "data engineered" one - since the people who are circulating it either don't understand how to read the official monthly updates on bugdet implementation, or they are intentionally trying to mislead. As I will try to show below, the sort of story being reported by Reuters represents a very tendentious reading on the numbers to say the least, since when you come to look at the fine print the real underlying deficit is not down over 40 percent from last year, the tax take is not up 33.4 percent on 2009, and the VAT increase is not having its effect (yet) since as the Agencia Tributaria (Spain's tax office) explain in their report, due to the August holiday period they haven't even processed the returns yet, and the only item they have data for is VAT paid on imports - which has brought in an estimated 100 million euros extra so far.

"Julio y agosto recogen los primeros impactos recaudatorios de la subida de tipos, pero sólo en el IVA Importación, que se valoran en unos 100 millones (0,8% del incremento total)." Agencia Tributaria - August report.

So, what we have is not a lie, or even a damn lie, but it is a very studied and judicious use of the statistical data available. Put politely, the data we have been served seems specifically designed to confirm the idea that Spain is, finally, getting its fiscal house in order. Unfortunately, this is not the complete picture. What we are getting is the truth, and nothing but the truth, but what we aren't getting (yet) is the whole truth.

As I say, the detail here, as always, is in the fine print, although the big point - that we don't know about regional government spending - really should be very obvious to anyone who is even vaguely aware that Spain is a fairly decentralised state, and thus it should stand out like a smoking gun that in all the articles you read about the deficit, the reference is to Spain's "central government" deficit, conveniently forgetting that a significant part of the total - and this year probably an even larger part than normal - comes from the regional governments and the municipal authorities - as I have already tried to explain in this earlier post. If we have leaned anything about Spain during the present crisis it surely is that nothing, but absolutley nothing that is to be found in a government press release should be accepted at face value without further checking. I don't think Spain's government simply blatantly and obviously falsifies its data, but I do think that data is often presented in a way which, if you don't follow all the methodological procedures which lie behind it, can give a totally misleading impression about what is going on, and I am not convinced that this outcome is completely unintentional.

Luckily for us however, the body which is responsible for following the progress of the annual government budget as it is implemented - a very austere sounding entity known as the Intervención General de la Administración del Estado (or IGAE) - publishes a fairly readable and easy to understand monthly report (latest issue available here), and if more journalists who wish to report on Spain took the trouble to read and study it for themselves, then perhaps they wouldn't be so easily taken in by the latest government press handout as they evidently have been up to now.

The first thing to note, as the IGAE themselves emphasise is that when it comes to following the annual execution of the budget it is important to compare like with like, and not, as it has become fashionable to say these days - apples with pears. In this case we need to distinguish between harmonised and non harmonised accounts. That is to say, when there has been a methodological change which influences the data the raw numbers (which you can find on page 9) can be very misleading, and you need to follow the harmonised data (which you can find in page 11). Thus, the raw data suggests that indirect taxes (impuestos indirectos) were up by 39.9% between January and August when compared with the previous year (seventh row, end column), while the harmonised (or adjusted) figure is 29.9% - meaning the real improvement is only 8.049 billion euros, and not 13.164 billion the raw number suggests.

But even this is not the complete picture, since if we now go to the latest monthly report (here) from Spain's Agencia Tributaria (the tax office), we find (page 16 in the acrobat reader), that one of the big differences in the VAT numbers between 2009 and 2010 comes from the much smaller volume of refunds in 2010.

Refunds fell from 43.525 billion euros in the first 8 months of 2009 to 33.087 billion in the same period of 2010, that is to say by 10.438 billion euros. In their methodological commentary the Agencia Tributaria (on page 5) put this reduction in refunds down to either money owing from previous fiscal exercises (4.4 billion euros) or refunds which had already been paid in 2009 (5.6 billion euros) due to a policy change which meant that refunds started to be made on a monthly basis. Be all that as it may, the real net increase in tax income from all sources so far this year is something like 6.9 percent according to the agency, and the net increase in IVA (adjusted for refunds) may be more like 5.4 percent, and not the splendid looking 47.5 percent figure which appears on page 11 of the IGAE report.

Las devoluciones de IVA Anual 2009 caen hasta agosto un -60,9% (en consonancia con el menor importe solicitado), y las de IVA mensual apenas crecen un 0,3% porque las mayores devoluciones realizadas este año del ejercicio 2009 (por la generalización del sistema de devolución mensual) se compensan con el menor importe solicitado del ejercicio 2010. La única novedad que aporta agosto en cuanto a los ingresos brutos es el IVA Importación, que registra un aumento del 18,0% hasta este mes en sintonía con la marcha de las importaciones de terceros no energéticas. En total y antes de empezar arecoger el impacto total de la subida de tipos, el IVA bruto ya acumula un incremento del 5,4%. Agencia Tributaria Report, my emphasis.

Now, if we move over to the expenses side, we see that staff costs are up (2.3 percent) in the first eight months of the year, but this number is a little deceptive, since salaries were originally increased 3 percent in January of this year, and then cut in the May measures by an average of 5 percent as of 1 July, so evidently as the year advances the total increase should fall steadily, and may even arrive below zero by the end of the year. More importantly (for next year) freezing salaries for 2011 will represent a real reduction in salary 2011/2010 since the base to be applied on 1 January 2011 will be the level of 1 July 2010, which means during the year their will be a commensurate drop in Spanish domestic consumer demand.

But the big reductions on the spending side for 2010 come in capital spending (infrastructure works etc) which is down 7.9 percent (or 500 million euros, about 0.05 percent of GDP), and in transfers to Spain's local authorities - which are down by around 1.3 billion euros (or about 0.13 percent of GDP). Transfers to the autonomous communities are in fact up, but interpreting this involves a complicated calculation, since there have been recent changes in the financing arrangements.

On the other hand, Spain's regional governments, far from reducing their deficits are in fact increasing them like never before. In fact total autonomous community debt hit 104 billion euros (0r 10.4% of GDP) in June according to the latest Bank of Spain data, up from 82.9 billion one year earlier. That is to say, the regional governments increased their debt by nearly 25% year on year, and there is no sign so far that they are putting the brakes on.

Of course, the regional governments only accounted for about 14% of last years deficit, so even if their deficit does shoot up, it won't be a determining factor, but it will make it much more difficult for the total deficit to fall within the targeted limits.

The local authorities, on the other hand, have things a lot tougher, since their revenue from central government is significantly down, and they find it very hard to increase their borrowing from banks, so their rate of new debt accumulation is definitely slowing.

Difficult Times Ahead For The Regional Governments

On 4 August 2010 Fitch Ratings placed four more Spanish autonomous communities on a Negative Rating Outlook, which effectively meant that all Spain's autonomous communities are now on Negative Outlook. According to the rating agency this move reflects their view that their budget balances will remain fragile in the medium term, while their debt will continue to increase. As they say, some indication of regional governmment intentions to curb expenditure have emerged, but in the majority of cases the measures still need to be detailed and implemented, a process which could take considerable time, and will certainly see us well beyond the 2010 fiscal exercise before their impact is felt. According to the terms of the recent Royal Decree the maximum deficit allowed for the Autonomous Communities during the 2010‐2012 period has been reduced by 0.5% of GDP. But this decision comes just one year after the Council for Fiscal and Financial Policy (CFFP) authorised the autonomous communities to exceptionally raise their deficits to 2.5% of the GDP for 2010, 1.7% for 2011 and 1.3% for 2012 in order to counterbalance the revenue shortfall being created by the crisis. So we can imagine some kind of chaos may well have ensued when those responsible for implementing their budgets learnt of the new targets.

What is worse for the regional governments, as Fitch point out, the smaller deficit allowances introduced in June 2010 do not take into account the negative tax settlements related to excess transfers made by the state during 2008 and 2009 to try to help the beleagured regional governments. Although the amount of this excess funding temporarily transferred to autonomous communities by the central government has yet to be confirmed it is clear that now having reduced entitlement to funding will only make an already difficult position worse.

What happened was that the 2008 and 2009 budgets’ tax forecasts were over‐optimistic and the autonomous communities received greater advance tax and sufficiency fund payments than warranted by the amounts actually collected, and the autonomous communities will now have to return the excess (see chart from Fitch below).

Fitch’s calculates that the excess allocated to autonomous communities in 2008 was something like 7 billion euros, and that in 2009 the number may have hit 21 billion euros. According to the new financing agreement with the central government, the regional governments can make repay in 60 monthly instalments starting in January 2011.

Fitch is of the opinion that the increased financial pressure all this will produce plus the stricter control over debt authorisations introduced under the new financing agreement will definitely create heightened liquidity pressure for the regional administrations. Most of the autonomous communities have budgeted for a deficit equivalent to 2.4% of their GDP for 2010, however, since the central government is now only likely to authorise them to issue new debt equivalent to a maximum of 1.95% of GDP, they will have to fund a gap equivalent to a minimum of 0.45% of GDP without new borrowing. The most likely scenario is that their cash reserves will decline and that delays in paying suppliers will increase.

In fact only this week, the Economist quotes Juan Bravo, who is in charge of finances for the city of Madrid, as saying that the city’s income will not return to 2007 levels until 2016, and in the meantime the only way he can survive is to delay payment. “Last year I paid bills in 60 days, now I am paying in six or seven months,” he said. (Or see this report in the WSJ)

And to make matters worse, significant doubt exists about the achievability of Spain's GDP growth forecasts. Finance Minister Elena Salgado said last Friday that she was confident the country's economy would grow in line with government forecasts but most analysts feel the forecasts of a 0.3% contraction this year,followed by growth of 1.3% in 2011, 2.5% in 2012 and 2.7% in 2013 are far too optimistic.

The bottom line here is that Spain's real commitment to meet its targets is still on trial. Pressure from financial markets may well mean that the fiscal effort made in the second half of the year will be much greater than that in the first, but all in all, achieving the 6% target for 2011 looks to be an extraordinarily difficult task, given everything we have seen so far. As one investor put it recently “We are still skeptical as to whether they will really take all the austerity measures or only go as far as the market forces them, and when pressure abates they’ll let the deficit slip again. It seems they want to do as little as needed to relax the markets.”

And, of course, if all this wasn't enough, even if the fiscal effort is made as the government is promising, this still doesn't solve the deep-seated underlying problem. Just what is the plan to put sufficient dynamism back into the Spanish economy in order to produce those lovely growth numbers that we would all so much like to see?

And Then There Were None

2010-09-27T12:15:00.001+02:00

According to Spanish Prime Minister José Luis Rodríguez Zapatero speaking in an interview with the Wall Street Journal last Tuesday the European sovereign debt crisis is over. "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said.

This is excellent news, but it comes with just one proviso, and that is that despite all such reassurances most financial market participants seem to be far from convinced that he is right. True Spain recently raised nearly €4bn in a successful government bond sale, with some observers suggesting the sale constituted but one more sign that what is still the eurozone’s fourth-largest economy had finally broken free from the group of “peripheral” European economies who have severe economic problems and whose debt is viewed by investors as especially risky.

In fact Spain managed to sell €2.7bn of 10-year bonds and almost €1.3bn of 30-year bonds while at the same time bringing yields down noticeably from their earlier highs - to 4.144 percent in the case of the 10-year issue ( from 4.864 percent in June), and to 5.077 percent for the 30 year issue (from 5.908 percent in June). But, at the same time, in the background the extra yield that investors demand to hold Spanish 10-year bonds over German bunds has been steadily creeping back up again, and as of last Friday (24 September) it stood at 183 basis points, below the 220 level being asked in June but still more than double what it was at this point last year.

Yet, despite all those nice words we hear from him, one of the things that is worrying investors right now is the real depth of Mr Zapatero’s commitment to reducing the deficit as planned, especially after he unexpectedly stated on August 10 that in his opinion some of the planned infrastructure spending cuts could be reversed, while on September 10 he reiterated the point, saying that lower borrowing costs may enable the government to "ease up" on some of the projected spending cuts. In fact the extra yield offered on Spanish debt has risen 33 basis points over the period since he started to mention the possibility.

On top of which all the short term indicators we have been seeing suggest that the Spanish economy started to contract again in the third quarter.

Spreads Rising Across The Periphery

Of course it isn't only Spanish bond yields which have been sneaking back up of late. Greek 10-year bonds as compared with equivalent German bunds still offer around 950 basis points (or 9.5 percent) of additional yield, only around 20 points below the all time record they hit on May 7, at the height of the Sovereign Debt Crisis

Indeed spreads on government bonds all along Europe's periphery have been rising steadily back towards (and even in some cases beyond) their May levels in recent weeks. Most notably the last week has seen both the Irish and Portuguese government 10-year bond yields surge to euro era records levels, in a way which could lead us to ask whether, rather than Spain snuggling back into the main group the big picture story at this point might not be that it is Irish and Portuguese sovereign debt that is being prised apart from the rest.

So rather than being over, what the debt crisis now may be entering is a new stage, where one sovereign bond after another is being chisled out and sent off to join their Greek counterpart in the isolation ward. Actually, in this sense the present European Sovereign Debt situation does rather resemble the plot of the well known Agatha Christie detective novel "And Then There Were None". As told by M. Christie a group of ten people, all of whom have in one way or another been previously complicit in an earlier death, are somehow tricked into travelling together for what was intended to be a short stay on a secluded island. Once there, and even though the guests are apparently the only people on the island, they are - somehow, and one after another - systematically murdered. So, in a way which may eventually come to foreshadow scenes from the forthcoming meetings of the European Financial Stability Facility management board, each morning one guest less shows up for breakfast. One by one, and little by little, each participant becomes mysteriously overcome by a seemingly inexplicable bout of some fatal variant of what could be termed "systemic instability syndrome".

As I say, Irish and Portuguese yield spreads are significantly wider than they were May 7, the last trading day before Greece finally agreed to go for their €110 billion bailout package and the European Central Bank announced the initiation of its ongoing program of purchasing EuroArea government bonds in the secondary markets.

And despite holding what was considered to be a "succesful" bond auction at the start of last week Irish 10-year bond yields, shot up`once more during the remainder of the week, hitting a new record high of 6.34 per cent (see Bloomberg chart below), while yield spreads over benchmark 10 year German Bunds spiked to 416bp, euro era another record. At the same time Ireland 5 year CDS shot up to 461 bps, which meant the cost of insuring Irish debt was $461,000 for $10m of debt annually over five years.

At the same time yields on Portuguese 10-year bonds over comparable German bonds hit a record of near 4.25 percentage points Friday, while the Portuguese debt agency paid a euro era record of 6.24 percent to holders of its 10-year bonds and 4.69 per cent to holders of the four year-bonds in its own bond auction this week. In last equivalent auction, Portugal had paid 5.32 percent on 10-year bonds and 3.62 percent on four-year bonds. Portugal’s budget gap widened in the first eight months of the year, indicating the government may struggle to rein in the euro-region’s fourth-largest deficit as its borrowing costs surged to a record.

Portugal and Ireland "Decoupling"?

In each case the issue is different, since in the Irish case it was a sharp and unexpected contraction in the economy which became the major concern while in Portugal's case it was an apparent inability to reach the political agreement necessary to get the budget deficit under control.

Data out during the week for second-quarter gross domestic product showed the Irish economy has never really left recession, since GDP contracted by 1.2% compared to the first three months of the year, following a downwardly revised 2.2% expansion in the first quarter. Irish GDP has now contracted on a quarterly basis for 9 out of the past 10 quarters, and there is no evident end in sight.

In addition Ireland’s central bank governor Patrick Honohan saw fit to give a rather ill-timed press conference (unless he objective really was to force the country's government into the arms of the EFSF) where he urged the government to implement even deeper fiscal cuts to restore balance to the budget in what seems at this point to be a virtually unrealisable bid to regain investor confidence. All of which left many observers wondering just what the country can do in the present situation, since the budget is evidently deteriorating due to the severity of the economic contraction, and further cuts in spending by anyone (households, companies, government) are only likely to feed the contraction even more, in their turn making even more cuts necessary.

Obviously Ireland is rapidly approaching a situation where it cannot move the situation forward based on its own resources. This feeling is only added to by the persistent rumours that subordinated bond holders to Anglo Irish bank may well not get re-imbursed in full. These rumours have found some confirmation in a report which appeared in the Irish Examiner suggesting that the Irish Finance Minister Brian Lenihan had given a strong hint that the riskiest lenders to nationalized Anglo Irish Bank may not get all their money back.

Mr Lenihan apparently explained to the paper that the bank guarantee program which will be extended once it runs out at the end of September may only cover deposits and not subordinated debt. And if the interpretation put on events by the FTs John Dizard's is correct Mr Lenihan's delay in clarifying the situation is due to the fact that the Irish government is awaiting an EU Commission ruling on exactly this issue. His most recent official statement on the topic was that the Aglo Irish wind-up plan “is being prepared for submission to the [European] Commission for approval”.

At the same time the EU’s Competition Commissioner, Joaquin Almunia, issued a statement that “a number of important aspects need to be clarified, and a new notification received, before the Commission is in a position to finalise its assessment and to take a decision”. Which Dizard interprets as meaning that while Anglo Irish might propose a buy-back of its subordinated bonds, and that buy-back might be included in an Irish government proposal, Brussels might, in the end, not approve the plan. Since this would effectively the first time in the current crisis that a significant group of investors did not have their losses underwritten (apart, of course, from the rather unfortunate Lehman incident), decision makers may be rather apprehensive, since no one really knows how the financial markets would react. Yet speculation some such decision will be taken remains rife, as witnessed by the decision by Moody's rating agency to downgrade Allied Irish ratings. Moody's cut Anglo Irish's senior bonds by three notches to Baa3, the last level before junk, but the markets' main focus was on the deep, six-notch cut in the bank's subordinated debt, to Caa1, which indicates that bondholders will be forced to pay for some of the expected bailout.

Deficit Worries In Portugal

In the Portuguese case it is the budget deficit issue which is unsettling the markets, with the spread widening sharply following the revelation that far from the deficit being reduced is was actually increasing. According to the latest data from the Finance Ministry the central government’s shortfall during the first eight months of the year rose to 9.19 billion euros from 8.74 billion euros over the equivalent period in 2009. Previously the 2010 deficit had been almost exactly tracking the 2009 one (see chart from Societe Generale below).

Portugal’s borrowing costs surged to record levels on the news, and while the spread subsequently eased back to 388 basis points, the level is still close to the zone in which Greek bonds were trading in April just before the EU offered the country emergency loans to avoid default (see Greek 10 year spread chart below).

What this means is that this year's overall public deficit could well come in at around 9 percent of gross domestic product unless there is a radical change in policy during the last few months of the year.

According to its commitments to the EU Stability Programme, the Portuguese government should be aiming to reduce the overall deficit to 7.3 percent of GDP in 2010 from last year’s 9.3 percent. The government has pledged to reach the target, with Finance Minister Fernando Teixeira dos Santos saying that the country “can’t afford” not to, but so far there is little evidence that it will be able to do so, and especially with all the political bickering that is now going on in the background.

In all these cases, including the Greek and Spanish ones, this issue is not simply one of stimulus versus austerity (always a false polarity when it comes to the situation on the Euro periphery). The real issue is how to restore growth to highly-indebted and structurally-distorted economies, since without growth the debt to GDP ratios will not come down, and the burden of the debt will not be reduced.

So more borrowing is not what these countries need right now (other than to aid short term liquidity). What the countries involved all need is more exports and larger industrial sectors, and no one seems to be very clear how they are to achieve them. Simply running a double digit deficit to generate less that 1% (in the best of cases) GDP growth is not exactly a "wise" use of resources. Evidently using deficit spending to cushion programmes which would lead to a surge in exports would make sense, but in no case is this really being done, and all the emphasis is simply going on what may turn out to be a rather fruitless and self-defeating programme of achieving fiscal rectitude.

The result is that the peripheral countries are one by one being steadily "decoupled", with Portugal and Ireland now moving up towards Greece, as the following two charts from Citi Research clearly show.

For quite a long time the Irish and Portuguese spreads simply moved in harmony with the Greek ones, widening as the Greek spread surged upwards. But now it is Greek debt which can be adversly affected by sentiment over the situation in Ireland or Portugal, and not the other way round, and meanwhile the other two countries slowly but surely are moving on up there to join their Greek counterparts as the second of the two charts (which show the recent relative movements in Greek and Irish spreads) seems to demonstrate.

Vigourous Action Needed

Naturally the ongoing deterioration in the situation requires bold and far reaching action from the Commission and the ECB. Obviously we should expect to see renewed activity on the part of the ECB, buying an increasing number of eurozone periphery government bonds. Their activity on this front has been increasing of late, but weekly bond purchases are still well below 1 billion euros a week level seen at the height of the crisis in May and June. Evidently we will see calls for more of these purchases in the days and weeks to come, but what is striking at the present time is just how ineffective they have been in containing the damage.

The ECB’s bond buying program is effectively the second pillar in the EU crisis containment mechanism established in May. The other one is the Luxembourg-based 440 billion-euro European Financial Stability Facility, headed by former European Commission official Klaus Regling. Mr Regling has also been actively campaigning to calm markets in recent days. "It would be preferable if we didn't even have to intervene," he told the German magazine Der Spiegel in an interview, "In fact, I believe that's the most likely scenario." His hope then is that the very existence of his organization will bring calm to investors and deter speculators. "If that's the case, we'll close up shop here on June 30, 2013," he said.

Morgan Stanley’s Chief Global Economist, Joachim Fels remains pretty unconvinced by all of this. “Strains,” he wrote in a recent research report, have now reached a point where "one or several governments" may soon have to resort to the rescue mechanism. "Neither the European sovereign debt crisis nor the banking sector crisis has been resolved and both continue to mutually reinforce each other," he said, adding that the EU's stress tests for banks had manifestly failed to restore the necessary confidence. Fels's conjecture didn't need that long to get some confirmation, since according to the German newspaper Handelsblatt the ECB was last week actively considering recommending that Ireland avail itself of the fund. The Central Bank declined to comment on the story, and simply pointed out that any decision on the matter was a question for national governments, which is formally correct (and obvious) but doesn't mean that they wouldn't in fact have recommended such a move if asked.

So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it. Indeed Mr Regling’s optimism that his organization may quietly disappear from the scene is not generally shared by investors, who as we are seeing seem to be continuously pricing in an ever greater likelihood of intervention.

Meantime, according to a report in the Financial Times over the weekend, Europe's leaders are once more at odds among themselves about just how much carrot and how much stick the various national governments need to get their economies back into line. Predictably it is Paris talking about carrots, and Berlin who is talking about sticks.

But all this talk of what to do about those countries who in the future fail to stick to the new set of rules which are apparently being prepared monumentally misses the point: what we need are some policies which help the most affected economies get out of the mess they have found themselves in following the way the monetary and fiscal policy rules were implemented last time round.

According to one popular analogy currently circulating , the EuroArea countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers - Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding him dangling there, however uncomfortable it may be for them, but they cannot quite manage to pull their colleague back up again. So, as the day advances, others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, getting nearer and nearer to the abysss with each passing moment. And just behind Ireland comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others who have already lost there footing. But if Spain cannot hold out, and all four finally go over, each dragged down by the weight of those who preceded them, then this will leave some 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will certainly find that the quiet life has come to an end for him, and that he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don't need while we sit here biting our nails is to be told by someone who manifestly has no idea what he is talking about that the danger has already past, even as we slide, inch by inch, onwards and downwards towards the chasm that gapes beneath.

Spain's Economy Re-enters Contraction Mode In The Third Quarter

2010-09-03T12:26:00.010+02:00

Well, that didn't last long, now did it. Two consecutive quarters of minimal GDP growth seem to have exhausted the forces of a more than fragile Spanish economy. All the post June data we are seeing suggests the economy has now turned the corner (in the bad sense), and we should expect a negative quarterly GDP reading in the July to September period.

Perhaps the clearest indicator we have so far of the shape of things to come is offered by the August services PMI reading, which shows the sector went back into contraction in August, a performance that for a country which depends to some significant extent on tourism is really pretty striking.

As Andrew Harker, economist at Markit and author of the monthly report commented:

“Months of broadly stagnant demand have now resulted in a decline in activity in the Spanish service sector, albeit a marginal one. It looks increasingly likely that the anaemic GDP growth seen during the second quarter of the year marks the high point of the recovery for the time being. The recent rise in VAT has further added to problems for service providers as weak demand has largely forced firms to absorbcost increases.”

The manufacturing sector continues to turn in a very slight positive reading, but both new orders and employment are falling.

Car sales were down 25% in August over August 2009, due in part to the withdrawal of the "cash for clunckers" programme, and in part to the rise in VAT, and finally industrial production data showed that output even fell very slightly in June.

Unsurprisingly, retail sales fell back sharply in July (by 3% month on month) following pre VAT rise purchases in June.

And unemployment, which is now heading up over and beyond the 20% mark (20.3% in July) was up again in August (even by 12,000 on a seasonally adjusted basis.

We don't have the July construction data yet, but the position with retail sales is likely to be repeated, following a strong 7% (month on month) pre VAT surge in June.

Exports did recover to some extent during the "good times", but to nothing like the extent they did in the more strongly competitive exporting countries.

And in fact, as we saw in a previous post, the net effect of the stimulus was to temporarily widen the trade deficit (strange, Monsieur Trichet on being asked by a journalist at the last ECB press conference when he planned to withdraw his stimulus, was most adamant that the ECB non-standard measures did not constitute "stimulus" - I guess it's lucky for US citizens that Ben Bernanke doesn't see things that way). Now, whether from the ECB or the Spanish government, the outlook is for gradual withdrawal of stimulus, which means the only realistic outlook for a badly structurally distorted Spanish economy is towards a slow but steady decline.

Spain's Unemployment Continues To Rise

2010-08-31T14:16:00.004+02:00

Spain's EU harmonised seasonally-adjusted unemployment rate (which is the interesting number) rose again in July, according to the latest data from Eurostat. It rose to 20.3% from 20.2% in June.

So despite a double digit fiscal deficit, Spain has not yet succeeded in putting a brake on the upward drift in the headline unemployment number.

And the number of those officially working continues to decline, according to the data on those paying insurance contributions from the Social Security Ministry.

Clearly having broken the 20% barrier the number looks like heading up even further in the second half of the year, although quite how far up is hard to say, since my feeling is that some of the increase in unemployment is now being offset by the silent march of feet, heading for the door, and looking for employment abroad.

On The Shoulders Of Giants - How Spain Is Destined To Follow In Germany's Footsteps

2010-08-31T11:25:00.000+02:00

The current generation of policymakers seem to be like Captains of large ocean liners, out there on the high seas, bereft of either compass or adequate charts, trying hard to calm there worried passengers by telling them nothing is amiss. But the charts are there, if only they would look at them, and in the present Spanish case, unlike the old refrain, the future is ours to see, and it has a name: Germany.

For those willing and able to examine our present situation with a reasonably open mind, a comparison of the recent history of the Spanish and German economies can prove illuminating, especially since, as I will argue below, there are strong structural homologues to be observed in the evolution of the two.

This post will contain comparatively few words (what a blessing!) since I will try and let the charts themselves tell their own story, in the hope that concepts which seem to be difficult to convey verbally, may be easier to grasp visually.

Consumer Boom

The first myth I would like to debunk is that it simply is not true that the Germans are a group of "non consumers", and inveterate savers. Back in the 1990s German private consumption enjoyed a huge boom, a boom which ground itself to a halt around the year 2000. It is only since 2000 that German private consumption growth has been lacklustre, and incapable of driving the economy. (I am using a Bloomberg chart here, since I don't have a long enough time series to hand to make my own version).

Now if we look at the same chart for Spain, we can see that private consumption growth enjoyed the same kind of "blossoming" that German consumption did between roughly 1999 and 2007.

Driven By Borrowing

But more than the phenomenon of the consumption boom in and of itself, what is interesting is what was driving it. Unsurprisingly we find the "usual suspect" - rapid increases in credit. Again, the following charts belie the idea that Germans have always been a nation of meticulous savers.

And again, the Spanish charts for mortgage increases tell a very similar (if even more exaggerated) story.

And it wasn't only households, corporates were busy at it too. Interestingly, corporate borrowing seems to have had a brief renaissance in Germany on the back of the current crisis.

Yet again, the only area in which Spain distinguishes itself is in the magnitude of the phenomenon. Spanish corporate indebtedness is a much, much more serious problem than German corporate indebtedness ever was.

When we come to look at the last set of loan charts, I would point of two features. In the first place, total private sector debt is not that different between the two countries, despite the fact that German GDP is around twice as large as Spanish GDP.

And in the second place, look at the long tail on German year-on-year borrowing, this is the point where those with eyes to see should be able to discern something of the future which awaits Spain. Interannual lending in Spain isn't going to climb back up again, and we should expect it to trawl around the zero percent level for many years to come, as Spain's private sector deleverages itself.

From Current Account Deficits To Current Account Surpluses

Which brings us to the next point, the association between lending booms and current account surpluses. As we can see in the chart below, Germany was no exception to the rule here, and all through the duration of the consumption boom the country ran small current account deficits. Deficits which then became surpluses after the huge structural adjustment the country went through in the transition from being a consumer driven to being an export driven economy.

And this is the path that Spain will now surely have to follow, but just note the massive difference in scale between the two. Spain's adjustment will need to be enormous. And how could this have happened we might like to ask ourselves? Were all the relevant drivers fast asleep, lurched over their wheels? How come no one "saw this coming"?

Given the magnitude of the correction, it is not really surprising that the IMF seem to want to hope against hope that it really won't be necessary. As the chart below illustrates, they seem to be hoping markets will sustain the current account deficits all the way through till 2015. As can be seen, Spain is the worst case offender, and the country where the structural transformation will need to be largest. So why do the IMF continue to believe in something which is scarcely credible? It could be that they simply accept the Spanish government's own optimistic idea that private consumption will come back to the 2% growth level again, kick started by a surge in borrowing. But a study of what happened in Germany makes that highly unlikely. Spain's banks are having trouble enough financing themselves as things stand, are people seriously suggesting the markets will now fund another bout of additional leveraging?

And if the private sector isn't going to do the borrowing, then who is? Since simple book-keeping tells us that having a CA deficit on the one hand implies capital flows on the other to fund it. The only conclusion I can come to - and this is what I argue in this post - is that we are assuming the government is going to continue to run a sizeable deficit, or that there will be straight fiscal transfers from other parts of the Euro Area to Spain. Otherwise the numbers simply don't add up.

Worm Into Butterfly?

What I have been arguing so far should be relatively uncontroversial for anyone with a sound grasp of applied macro. What comes next is more of a hypothesis. As we have seen, economies seem to transit from being consumption driven to export driven, so we might like to ask ourselves, is the process merely random, or are their underlying structural dynamics at work. As I am trying to argue in the German case, the shift doesn't seem to be a cultural one, and if Spain follows Germany down the same road then we will certainly know it isn't.

So what could be driving all this. Well, as Claus Vistesen and I have speculated, ageing populations and the demographic transition may well have something to tell us here. Using Modigliani's life cycle saving and borrowing idea, and the Swedish demographer Bo Malmberg's idea of population "ages" (child, young adult, middle aged and elderly), Claus has prepared the following chart in an attempt to illustrate the process.

Of course, all of this at the moment remains at the levl of hypothesis. I tend to use median population ages as a rough and ready measure of ageing, and (even though I wouldn't want to claim any precision here) it is interesting to note that both Germany and Spain have started to transit off towards export dependence at around the 40 median age point.

Still, this is early days yet, and we will know a lot more in this regard when we see how the different countries all along Europe's periphery perfom in the years to come. Will they, as the IMF and the EU Commission seem to assume, go back to being consumption driven, or will they be condemned to follow the German path? Certainly Hungary, to take just one example, seems to look more and more as if its economy which desparately trying - but so far unable - to transform itself into yet another Germany.

Real Devaluation

The worrying thing looking at the above inter-country comparison is how much larger Spain's correction is going to need to be than Germany's was. As Wolfgang Munchau pointed out in the FT yesterday, Germany entered the eurozone at an uncompetitive exchange rate and embarked on a long period of (quite painful) wage moderation and deep structural reform. In fact, Germany entered the Euro with an excahnge rate which was too high, give the new role exports were going to play in economic growth. The German adjustment can be clearly seen in the REER chart below, as can the very large adjustment that Spain will have to make in comparison with the German one.

When macro economists say this will be "painful" they don't do so to be sadists, they say this since they know this is going to be hard, very hard. And doubly so when almost all those responsible for taking policy decisions at all the respective levels seem to deny that it is going to be necessary. I have advanced two suggestings (a systematic reduction of 20% in wages and prices in Spain, or a temporary exit of Germany from the Euro Zone). Since neither of these have gained any traction at all, it is reasonale to assume they are now not going to happen (at least in any orderly way). But the car is still heading full speed towards that brick wall. When it finally does crash, will the Queen of England once more say to Luis Garicano, "but tell me Luis, just why was it no one saw this coming?".

Chart Of The Day: How Spain's Stimulus Money Helps Germany Achieve Record Growth

2010-08-26T15:35:00.003+02:00

Well, here's a nice way of putting things. Spain did less badly than expected in Q2 2010 as compared with a year ago, since in Q2 2009 it actually did worse than it initially appeard (following a downward revision in the data). Well, that's one way to improve, push the past backwards.

On a more serious note, the detailed data on the second quarter are now available for Spain, and interesting reading they make. Basically, what little improvement Spain did manage to achieve (0.2 q-o-q, -0.1% y-o-y) came from domestic demand and not exports, while the external trade balance deteriorated. Exactly the opposite to what you want to happen.

As the statistics office (INE) say: "On analysing the two large components of Spanish GDP from the perspective of expenditure, a similar pattern of performance could be observed as in the previous quarter. Thus, on the one hand, the negative contribution of domestic demand to GDP decreased two points and three tenths in this quarter, from –2.8 to –0.5 points. Whereas, in contrast, foreign demand decreased its positive contribution to the aggregate growth one point and one tenth, from 1.5 to 0.4 points".

In other words, all that deficit spending money is simply getting wasted, and there is no competitiveness correction taking place. In the midst of a huge potential export boom, Spain's economy is growing thanks to domestic demand, as the trade deficit deteriorates.

So one very simple way of putting this, so everyone can understand, is that the Spanish government is running a double digit deficit, and one part of the money spent is going straight out in additional imports which (among other places) come from Germany. That is, Spain is getting itself even more into debt to lend a kindly helping hand to the German economy. In theory, the exact opposite was to happen, and the German expansion was supposed to help Spain's net exports. But Spanish industry isn't, well you know..

And just to remind us, here are the respective industrial output charts I published in this post.

So when are people at the EU Commission and the IMF going to finally wake up to reality? This isn't going to work like this, and Spain needs to adopt concrete measures to restore competitiveness, and not find ever more ingenious ways to kick the can even further down the road. Either that, or we will all live to regret our own inaction one of these fine days.

New Series Of Spain Podcasts

2010-08-26T15:34:00.000+02:00

The first in a new cycle of Spain economy related podcasts I am doing with Matthew Bennett is now up.

Here's a sort of summary from Matthew of what goes on.

The short version: market reaction so far this year has, as always, been irrational, underlying indicators are not in a good place and Spain has no plan to replace the construction industry as the engine of its economic recovery.

* Spain, Greece and the EU bailout package;

* The madness of the markets and rational analysis of underlying factors;

* Is there any basis for the current apparent economic and financial calm?

* Important changes in the role of the ECB and its relationship with sovereign states;

* The impact of cuts announced by Zapatero in June;

* Spanish banks reliance on ECB funding and moral hazard;

* The civil service wage cut announced in June is not really a wage cut;

* Car sales in July were down 30% on June, after the Spanish version of cash-for-clunkers was withdrawn and VAT rose 2%. Is that indicative of what the rest of the economy might look like if we took away government stimulus?

* The effect of the VAT rise on consumer behaviour and the real-estate market;

* Inflation, deflation or stagflation?

* There’s no plan to replace the weight of the construction industry in the make-up of Spanish GDP. Could tourism replace the construction industry in Spain’s GDP?

* Europe and the IMF are not being harsh enough on Spain;

* The Spanish government’s hope of reaching 2.7% GDP growth and 3% deficit targets by 2013 is totally unrealistic;

* The north-south economic divide in the eurozone;

* What happens to Spain when the ECB starts raising interest rates and monthly mortgage payments start rising again?

How Many Times Can One Driver Fall Asleep At The Same Wheel (And Live)?

2010-08-22T13:42:00.003+02:00

“Break the thermometer, then you won’t have a fever.” - Former Polish President Lech Walesa

Watching the TV news here is Spain at the moment is often a rather discomforting and sad affair. The normal menu seems to consist of a constant stream of ministers who have to appear before the cameras and the public to explain something that they, in all fairness, don't really understand themselves. And so it was on Saturday, as I tucked into my early morning breakast of sausage and beans (Catalan style) in the village near my mountain retreat, there in the background I could see the face of Spain's Labour Minister Celestino Corbacho (photo above), giving details to the assembled press corps of the latest government decision to make another six month extension for the 426 euro monthly "exceptional" payment for those whose unemployment benefits have run out. Why there are so many unemployed in Spain, and why renewing this subsidy is now an almost permanent necessity (this is now the third time that this "temporary" means of support has been extended), or what the real prospects of creating enough jobs to start reducing the unemployment mountain any time in the foreseeable future, was not explained. Well, the future is not ours to see, so "que sera, sera".

Of course, the decision to extend the payment is to be welcomed not rebuked, but it is the set of circumstances which makes the measure necessary which is so worrysome, and the feeling that the country whose economy these ministers are responsible for managing is now more akin to a ship in mid Ocean, where the steering tackle is jammed and the captain has neither the faintest idea in which direction land is to be sought, nor knowledge of the appropriate wavelength across which to send out a Mayday rescue call.

Truth be told, the same could be said about the Spanish government decision - announced last Wednesday - to restore some €500m cut from the state infrastructure investment budget for next year as part of a slight "easing" of its austerity plans. An easing which Minster Salgado was only too quick to inform us would not change the governments "complete and unwavering" commitment ti fulfil its promises by reducing the annual budget deficit in line with agreed targets.

Of course, this increase could easily be justified as a measure to take some of those unfortunate people who find themselves stuck on the unemployment register out of the never-ending dole queues, but still the doubts remain. Herman Van Rompuy admitted earlier this year that the Euro Area administrators had "fallen asleep at the wheel" over the last decade in allowing the severe competitiveness problems many economies now face to come into existence in the first place. But, following the calming of the markets in May with the ECBs decisions to maintain emergency liquidity provision and intervene in the secondary bond market, together with the creation of the European Stability Fund, could it not be that the drivers are not one more time lurching soporifically over those very same steering wheels?

Certainly there is a real nonchalance at the moment about budgets which are based on hopelessly unrealistic government growth forecasts, but then again, as Mr Zapatero well knows, any oversights can well be contained by balooning just a tad more Spain's rising mountain of off balance sheet debt (see my extensive post on this last week). Or then again, as PSOE Municipal spokesman Antonio Hernando explained to the press agency EFE in an interview today, the government is planning to make credit lines available for Spain's hard pressed local authorities to pay off some of their short term arrears via an institution known as the Instituto de Crédito Oficial (ICO), so effectively debt will be melted down in one place, only to be accumulated in another.

Of course, as Economy Minister Elena Salgado stressed when announcing the extra package (which for its magnitude is, of course, sheer tokenism) the additional €500m in spending – which represents only about 0.05 per cent of the country’s gross domestic product – has been made possible due to the falling cost of servicing Spain's debt as interest rate spreads drop back from their May highs. But isn't this, surely, short-termism and short-sightedness at its very, very worst.

And especially if you look at how the spreads are being reduced. In the first place Spain's banks have been massively increasing their borrowing over at the ECB.

And in the second place, as explained in this article here, the government has been increasingly resorting to the social security reserve fund to buy its bonds.

In fact, the argument about Spanish bank borrowing over at the ECB provides us with one good illustration of the quaint Spanish custom of permanently moving the goalposts in argument when the going gets tough. Back in June 2008 MAFO (Bank of Spain Governor Miguel Angel Fernandez Ordoñez) was arguing that Spain's Central Bank was meticulously targeting around the 8.3% of total borrowing level which constituted the % participation of the BdE in the ECB capitalisation. He did so when speaking before the Economy and Taxation Commission of the Spanish Congress (June 24 2008 - see this file page 9) and he stated explicitly that Spanish banks had increased their participation in eurosystem fundings, "without going far beyond the equivalent participation in the key of the Bank of Spain in ECB capital". As he says in Spanish "elevando su recurso al Eurosistema...sin alejarse de la participación equivalente a la “clave” del Banco de España en el capital del BCE".

Well when this target didn't hold, we moved on, and by March 2010 José Viñals (the Bank of Spain's "man" over at the IMF) was arguing that such ECB dependence on the part of Spain's banks was not really troubling, since it was, after all, only proportional to the share of Spanish GDP (13.5%) in total Euro Area GDP. Fair enough, you might think, but then in June this year the proportion shot up to 24%, and then in July to 30% (no wonder interest spreads have been coming down), but all, I am sure is "normal" and explicable, if only you are constantly willing to move the goalposts far enough.

But just to show us that not everyone is currently falling asleep at the wheel, the Euro did hit a five week low of 1.2673 to the USD on Friday, after European Central Bank council member Axel Weber said the ECB should help banks through their inevitable end-of-year liquidity tensions before determining in the first quarter of 2011 when to withdraw emergency lending measures. “Most of these discussions about the continuation of the exit I think will be focused on the first quarter,” he said in an interview with Bloomberg Television in Frankfurt. “It’s clear that we need to re-embark on a normalization procedure.” Re-embark would be the keyword here, since it implies that at the current point we aren't on one, nor is it envisaged we will return to one anytime this year.

Indeed Weber added that it would be “wise” to keep full allotment in weekly, monthly and three-month refinancing operations until after the end of the year, while six-month loans should be allowed to expire. Monsieur Trichet and his governing council have guaranteed unlimited seven-day loans, the main plank of ECB’s emergency policy, until October 12 and unlimited three-month loans until the end of September. Additional details on the bank’s timetable after that will await, in his preferred expression, "rendez-vous" in September.

Going back for a moment to the Spanish administration's tendency to move the goalposts, we have also seen a permanent chorus of complaints from them that using Reel Effective Exchange Rate data to assess competitiveness is not valid or relevant in the Spanish case (those on whom this data fall negatively rarely are prepared to accept it has any), since Spain's export sector has been well able to retain its share in global exports despite the distrortions produced by the property boom. Fine! Perfect! But then how the hell do you explain the difference between these two charts?

The difference is evident, even to the least well-trained eye. Spain and Germany face the same external demand conditions, so why is German industry reacting like a rocket launching itself off a ramp, and Spanish industry responding like a limp dinghus in receipt of only the mildest of mild stimulation? Come off it, Spain's industry has a long (or as Jimmy Cliff would have it "hard") road to travel before it can step into the ring with its German counterpart. All that the arguments we have been hearing so much of recently actually do is encourage complacency (you know zzzz at the wheel), while what Spain needs is a call to action.

But going back to the pension system, the reserve fund this year has something like 64 billion euros at its disposal. In 2007, the share of the total which was invested in Spanish bonds was somewhere under 50%. At the present time this proportion has shot up to nearly 90%.
At the end of 2009 (when the fund held 58 billion euros on behalf of Spain's pension contributors) some 44.53 billion (or 76.27%) were in Spanish bonds. This left 13.486 billion euros which was distributed between Dutch (39.56% of foreign holdings), French (30.49%) and German (29.95%) bonds.

So the proportion of domestic bondholdings has been creeping up during the crisis, and his year, the Comité de Gestión del Fondo de Reserva has, in its wisdom, decided to go even further, and invest another 5.191 billion euros in bonds. At the same time some 3.256 billion euros currently invested in foreign bonds will mature. According to official sources, cited by the Spanish publication Cinco Dias, the combined total will be invested in Spanish government debt, and as a result, according to estimates from the Secretary of State for Social Security, Octavio Granado, nine out of every ten euros of Spanish pension savings will be invested in domestic government debt. Whether Spain's future pensioners have their savings adequately hedged at this point, I will leave you to judge. The key point to grasp, is that these 58 billion euros or so (nearly 6% of Spain's GDP) do not count towards the Maastricht debt (EDP criteria), simply because they are help by another government agency.

So, let's be very clear what is going on here, as we now enter the fourth year of the crisis in Spain (with no end in sight), Spain's banks (aided and abetted by their representative at the IMF, José Viñals - see the Global Financial Stability Report he editied, with the Appendix on Spains banks prepared under his auspices last April,) are taking a huge gamble on behalf of the 46.9 million Spanish residents (and the rest of the citizens in the Euro Area when you come to think about it). Viñals in the GFSR seems to pretty much buy the line that banks are good managers of real estate and that prices will eventually go up again. As the report says: "Over the last two years, given the ailing state of the real estate and the construction sectors, Spanish banks have increased the use of debt-for-property swaps to manage their credit portfolios efficiently, trying to maximize asset value recovery. This practice helps banks in managing of their credit risk portfolios and minimizes losses, provided that property prices stabilize in the medium term and banks can sell those assets at their book value."

So what the spokespeople for the Spanish banking system imagine is that what we have in front of us is a repetition of the crisis which hit Spanish property (after the end of the Olympics boom) between 1992 and 1995, and it is this feeling of "self certainty" which encourages them to continue adding to their property holdings almost indefinitely (since after 1996 they were even able to sell the property accumulated at a profit). They refuse to accept that this time it IS different, they cite the presence of a global crisis almost as an excuse, refuse to see that this makes it far more difficult for Spain's economy to recover, refuse to accept that Spain's industrial infrastructure has become badly distorted in a way which will require years to put right (given the limitations of the Eurosystem), and feel cushioned by the large reserves the built up under the dynamic provisioning system they instituted following their earlier experience, and, most importantly of all, they want to hear nothing of any possible 20% reduction in prices and wages (internal devaluation), which would, of course, lead to a huge impairment in their mortgage book.

Naturally, what is going to happen if we reach 2015, there is still no sustained return to growth, unemployment remains near today's very high level of 20%, and house prices keep falling (and incidentally, not all offialdom buys their "this time it's the same argument - here's a link to a recent working paper from the Bank for International Settlements which predicts a fall in Spanish property prices of some 75% between now and 2050, simply for demographic reasons) they don't seem to ask themselves. Or maybe they do. Maybe at that point they will simply come out and say, sorry we made a miscalculation, can we have a bailout please (knowing that Spain is, effectively, "too big to fail"). So they are effectively playing Monte Carlo rules, with all the risk being assumed elsewhere (including, as I say, by those who week-in week-out are contributing to the pension system).

So the interests of Spain's bankers (and the government which seems to be bending to their will) and those of the Spanish population at large (which are for a rapid return to economic growth, and job creation) couldn't be more diametrically opposed at this point.

Coming back now to the delicate issue of pensions, it is interesting to note that only last week a group of EU member states in central and eastern Europe, plus Sweden, made a direct appeal to Europe's leaders to take into account the cost of pension system reform when assessing debt levels.

Basically the issue concerns those countries who have, in recent years) introduced funded pension schemes (or second pillars) that invest and generate money to future pensioners using the funds saved by contributors over the course of their professional careers. This is a major departure from the so-called pay-as-you-go schemes, where the money contributed by employees is immediately distributed to pensioners as payments.

Now, as all parties recognise, the phasing-out of the pay-as-you-go system will take decades. Once it’s over, governments should be able to play a much smaller role in making sure there’s enough money to pay pensions. In the meantime, the state has to subsidize the old scheme that’s left without much of the current revenue from people in the productive age. In most cases, governments issue more debt to keep monthly payments going to current pensioners.

The problem is that during the transition period a double burden falls on the pension system, since contributions are diverted (or at least partially) to fund future liabilities, while current liabilities still have to be met. Simply passing all this over to taxation is not desireable, since after years of ultra low fertility many EU countries now have very "thin" younger generations, and the burden falling on their shoulders may either make job creation very difficult (due to the prohibitive costs) or lead many younger people to emigrate to "younger" countries where the burden is lower, producing negative feedback effects, which ultimately may make default inevitable.

So Lithuania, Latvia, Bulgaria, Sweden, Slovakia, Hungary, Poland, Romania and the Czech Republic have made their appeal, as the WSJ blog report on the topic says, they are effectively asking for the accruing debt to be swept under the carpet (just like so much of the other debt we are looking at), but as the countries concerned stress, they are effectively being penalised by the Eurostat criteria for carrying out reform.

This means those who have not reformed have little short term incentive to do so. Which brings us back to Spain, and its much vaunted pension reform. Spain's system is effectively a hybrid one (in the sense that there is a small reserve fund), but given the massive ageing which is about to take place in Spain, on the existing parameters the fund won't need that long to start going into negative numbers (there is quite a lot of dispute about exactly how long - obviously this depends on the level of economic growth and the number of contributors).

So the plan is to increase the working life for each contributor (retiremnet age rises from 65 to 67), and reduce the level of pension (in relation to lifelong income), by changing the credit criteria. Well, all this is fine, but what Spain really needs is a full second pillar (along the lines say, of the Dutch or Norwegian ones), with an independently administered fund (ie one which doesn't invest all the savings held on behalf of Spain's citizens in Spanish government bonds). But as the Eastern countries suggest, the short term costs of the transition rise as the population ages, so countries (like Spain, unfortunately) get locked-in to the current, ultimately unsustainable system. Even though life expectancy rises, potential active working life does not seem to lengthen to the same extent, so there are limits to how high you can keep pushing the limit.

As a piece of short term expediency, Spanish policymakers effectively turned a blind eye to the massive irregular inward migration which occured during the early years of this century (and there were ultimately two "amnesties" to resolve the problems which were building up).

This worked for as long as it did, but now the migrant flows are begining to reverse direction, as able bodied migrants head elsewhere looking for work, while dependent relatives arrive as part of the process of family regroupment.

My point here is not an anti-immigrant one - having an inflow of migrants can help sustain the elderly dependency ratio while the pension transition takes place (if it takes place) - but if you have an unsustainable economic model, and then you enter denial when it becomes clear that this model is unsustainable, then obviously simply encouraging inward migration does not solve your problems. Especially if the job market collapses, as it has done. As we can see in the chart below, the number of contributors to the Spanish Social Security System has been falling continuously since th start of the crisis, and there is no sign of this trend turning the corner.

So to come back to the original issue, Spain's debt to GDP is obviously, in reality, rather higher than is being admitted publicly (or measured by Eurostat).

A request for clarification from the Bank of Spain as to the methodology involved in the Financial Accounts they published, both clarified and didn't clarify the key topics. The Bank say that there is no available document which briefly explains the differences between the concept of debt according to the Excess Deficit Procedure (EDP) and total liabilities shown in the financial accounts. However,they do say the major differences are due to fact the EDP debt that does not include accounts payable, that liabilities are deducted for debt movements between public authorities (the social security fund issue)and liabilities are valued using their nominal values rather than their market values.

On the other hand, they make plain that the debt of public corporations is not included in the EDP calculations (nor it seems in the Financial Accounts). So there is something like 50 billion euros in debt (or 5% of Spanish GDP) lingering around on the public corporation balance sheets.

The Bank of Spain also state they do not keep any data on PPPs. At the present time I am trying to identify who exactly does in the Spanish case.The issue of PPPs is a complicated one (I have a post on the whole topic here). Basically PPPs often work on the basis of accounts receivable (see this wikipedia entry for a description of what is involved, and this supplement on "factoring" since PPPs in many cases with public authorities are a form of factoring). Basically, PPPs work like this. You want to build a new motorway, or a hospital, or a "city of justice" (the Barcelona case), and you either don't want to, or can't, accululate more debt. So you seek private finance (Berlusconi's bridge to Sicily probably incorporates some element of this) and agree to pay for the use of the facility (per user), with the unusual detail that, as opposed to the typical "toll" system, where there is a stream of income from the users, the public agency meets the obligations out of current income. This system (in the toll road case) is known as "peaje en la sombra" (or shadow toll) in Spain.

Of course, although no debt is formally incurred, the "virtual" debt still has to be serviced, which means there is a constant drain on revenue, and since the securitisation normally implies some sort of "super senior" status for loan, then what happens is that paying these become a priority, while obligations to real current suppliers, where there is no such securitisation, go to the back of the queue, with the obvious consequence that arrears in the normal accounts payable simply pile up.According to Spain's Financial Accounts, there were some 73 billion euros (7% of GDP) of these in the entire government system at the end of Q1.

For those who are still not clear what this is about, here's a chart I found from a road show promoting the PPP model, which shows a list of advantages and possible applications. And among the advantages of the system is, of course, that it largely falls outside the current Eurostat EDP accounting system.

And here is a photo of Spain's Public Works Minister José Blanco (and friends) beaming away at the camera over at the offices of the Instituto de Credito Oficial (ICO) after signing a PPP type deal with banks and builders to reinstitute 17 billion euros in cuts from his department via another route. The agreement was signed in April (see Spanish press release here, strangely there was no version of this on the English language website), and although the plan seems to have been temporarily shelved at the moment, it wouldn't be surprising to find - during the renewed bout of "sleeping sickness" from which our institutions all seem to be suffering - the plan were being suddenly reactivated again.

So, as I ask at the start of this post, just how many time can one driver fall asleep at the wheel and live? Well, looking at Mr Zapatero and his administration the answer obviously is, many. They seems to have more lives than the proverbial cat. And when we come to those inspectors at Eurostat, and the new debt vigilantes at the EU Commission, the answer would also seem to be, quite a few, since the loopholes described here are obvious, and must be known to all, and yet nothing (so far) seems to be being done.

Spain's debt for 2010 according to the EDP is expected to reach around 77% of GDP (EU Commission spring forecast), and while we feel it is still possible to agree with the IMF when they say that that "Spain’s (public) debt ratio is low compared with many other countries in Europe", it is only possible to do so if we do not forget that if we add in the 6% that is held by the Social Security Fund, the 7% that has built up in Accounts Payable and the 5% owed by Spains Public Corporations, we end up with a total of something like 95% debt to GDP, which is, of course, above the average. And this is not to even begin to count all those impending pension liabilities.

But getting through to the bottom line now, my big beef in all of this is not that the Spanish government has been spending so much money to address the current crisis, it is that it has spent so much money, and NOT EVEN BEGUN to address the roots of the crisis. That is the ultimate condemnation of what has been going on in Spain, and is the question which generations of Spaniards to come will be wanting to put to their predecessors.

Controlling The Uncontrollable: Spain's National Addiction To The Use Of "Dinero B"

2010-08-18T07:09:00.001+02:00

Well, before we go any further, I would like to make clear that what I am going to talk about in this post is not anything illegal, or even irregular (things like this must be going on in almost all Euro Area countries even as I write). Bending of the rules? Perhaps. Taking them to their limit? Certainly.

What Spain's central, local and regional government does is take advantage of loopholes in Eurostat accounting regulations to generate debt that really is debt, but is not classified as such according to the Eurostat excess deficit criteria. Key areas involved are debts on the balance sheets of state (or regionally, or locally) owned companies, overdue payments for receivables (very common practice in Spain), and public-private-partnership-type leaseback-arrangements. None of these are (typically) classified as debt, though they do all have to be paid at some point, which means there is a stream of revenue (flow) impact rather than a debt (stock) one (unless and until Eurostat changes the rules). Which means that while they do not impact that critical debt to GDP number, servicing these liabilities does exaccerbate the annual fiscal deficit one. Which is why ultimately bringing Spain's fiscal deficit under control will almost certainly prove to be much harder work than it seems.

We are able to make this comparison since the Bank of Spain effectively maintains a double entry book keeping system, whereby it keeps one record under the National Financial Accounts of the total debt , while at the same time keeping a separate record of debt as classified for the EU Excess Deficit Procedure.

As we can see in the chart below, total gross government debt in Spain as classified in the Financial Accounts was some 751 billion euros (or around 75% of GDP), as compared with the 585 billion (or around 58% of GDP) in gross debt recognised under the EU excess deficit procedure classification.

Now if we look at the chart below, we will see that the proportion of Spanish national debt which remains outside the Eurostat classification system has risen since the introduction of the euro - from 14 to around 23 per cent - but most of the increase actually took place in the run up to the crisis. So as Spains funding problem has deteriorated, there does not seem to be any direct evidence that this has impacted the level of "non-accounted" debt, it has simply remained the same (in % terms). Of course, as the debt itself has balooned, so too has the "dinero B" part.

In the case of the regions (Spain's Autonomous Communities) the position is not that different - the % has increased from 12% in 2000 to around 25% at the present time - even if there is rather more evidence of "stress" on their finances after the start of 2008 (see chart).

The position of Spain's local authorities is also similar - with the proportion of "non-accounted" debt rising from 14 to about 23% - although again, there is even more evidence of post-crisis financial stress if we look at the gap between the two lines, and how it widens, which is none too surprising when you consider that it was the local authorities who lost the biggest chunk of their financing with the collapse of the construction boom. Indeed, it is my impression that in this case the gap only hasn't widened further due to the fact that very few people are now willing to give any sort of credit to Spain's local authorities.

As I indicate, one of the easiest ways of "kicking the can down the road" in terms of public finances, is to delay payment on receiveables (if you are not sure what receivables are, check this wikipedia entry), and the following charts show the relentless use of this procedure in Spain, despite the promise of Spain's government to bring short term credit under control by 2013, there is no sign of this happening to date.

The other big area of "non-accounted" debt, is that accumulated by governmentally owned or "satellite" companies (who may for example run public transport, or outsourced cleaning services for local authorities). As can be seen from the charts below, this debt has increased massively since the crisis started.

As I say at the start of this post, none of this debt is hidden, nor is it illegal under Eurostat regulations, so there is nothing (in principle) out-of-order here. This fact doesn't make the situation any less preoccupying, since one way or another all this debt will have to be paid. What its continuing presence does, I think, indicate, is the existence of some degree of "laissez faire" attitude towards fiscal targets on the part of the EU Commission and indeed the IMF (as I argue in this post, it is hard to understand the IMFs own Spain growth forecasts and CA deficit levels if they are not assuming a rather higher level of indebtedness into the future than anyone is prepared to admit right now) . The May measures are deemed to have worked. Europe's Soveregin Debt Crisis is, if not over, at least in abeyance.

Symptomatic of the current "relaxed" state of things is the fact that only last week José Luis Rodríguez Zapatero, the Spanish prime minister, even started to air the possibility of reversing some of the spending cuts his government announced in May. In a cautious statement, which the FTs Victor Mallet reports was apparently aimed at testing the mood of financial markets, Mr Zapatero said the government expected to restore some suspended infrastructure investments if – as the government anticipated – renewed financial stability left room for manoeuvre in the 2011 budget. There is nothing here about growth, please note.

“In 10 to 15 days we will be able to give some positive news in relation to restoring investment activity in infrastructure, which will affect most regions and would provide relief, an important boost, to construction companies,” he told a news conference in Mallorca after meeting King Juan Carlos at the monarch’s summer residence.

A €6bn cut in public sector investment was among the biggest austerity measures announced by Mr Zapatero in May to coincide with the EU and IMF announcement of a €750bn financing facility for the eurozone.

Despite the fact that among the evident losers in what was effectively a "U turn" at the ECB in May were the monetary hard-liners like Jürgen Stark and Axel Weber, you obviosuly can't keep a good man down, and European Central Bank Executive Board member Stark was out again on Monday, warning in the columns of the Financial Times that the European Union is all set to ramp up economic surveillance to prevent a repeat of the region's recent debt crisis. "A new framework for macroeconomic surveillance will monitor whether national trends are compatible with those that are appropriate for the Union as a whole", he said. "This framework will allow both targeted peer pressure and differentiated and more binding recommendations on follow-up action at the national level."

All I can say looking at the above numbers is, there isn't much sign of any of this being operational yet, but then, as I say, the Jürgen Starks of this world have rather had their noses pushed out of joint in recent weeks.

One Chart To Rule Them All, One Chart To Find Them (Out)

2010-08-07T22:10:00.002+02:00

Look, if there is one simple chart which sums up everything that is wrong with current thinking at the International Monetary Fund, then it is this one.

Basically, I spent much of the day yesterday scratching my head, trying to work out how the hell the IMF could be forecasting Spanish GDP growth of 1.7% in 2012, of 1.9% in both 2013 and 2014 and 1.8% in 2015. And now it has dawned on me how and why they can. Quite simply they are forecasting current account deficits for Spain of 5.3% of GDP in 2010, 5.1% in 2011, 5.0% in 2012, 5.0 in 2013, 5.0% in 2014%, and 5.0% again in 2015. In other words, the assumption is that nothing fundamental is going to change in the post 2008 world, when compared with the years that preceded it. And this is clear when you come to look at the whole structure of current account balances revealed in the chart above, which are based on the IMF forcasts through 2015 as set out in the April 2010 World Economic Outlook. It is a case of plus ça change.

And all this becomes even clearer when we see that it isn't only Spain where the current account deficits are going to persist, since they are also expected to continue in the US, and the UK. The structural surplus countries China, Japan and Germany - will also continue on their path, as if nothing important had happened. Which means the global imbalances will remain just the way they were, untouched and unmolested by the crisis - OK, some of Spain's most severe "excesses" will be gone, since the deficit will fall from 10% to "only" 5% - and I can't help asking myself, wasn't that how we got here in the first place?

The thing about these CA deficit assumptions is that they effectively make the argument a circular one. You don't start with the real growth potential of the Spanish economy (that was what had me scratching my head yesterday about the degree to which the export sector could rise to meet the challenge). Now I realise I was wasting my time. The export sector isn't going to have to grow, since Spain is going to continue to run a trade deficit, out into the future and as far as the eye can see, it seems.

But the interesting question to ask is what exactly the current account deficit is going to be for. I mean, who exactly is going to be doing the borrowing that it will be funding? What has happened in Spain has been the result of what some have termed a "causal reversal", since in the current case it is the capital inflows (borrowing, made possible by structural surpluses elsewhere in the Euro Area which lead to comparatively cheap interest rates) which produce the current account deficits, rather than the the normal balance of payments problem where growing deficits lead to the need to borrow. And it isn't hard to see evidence for this kind causal reversal in the Spanish case. Under normal circumstances when a growing current account deficit produces the need for external borrowing, the exchange rate tends to fall, and the interest rate charged rises. In causally reversed situations, the currency tends to rise, and the central bank holds rates down to try and discourage the arrival of evn more liquidity.

In Spain, there is no exchange rate to fall, and interest rates are set elsewhere - over at the ECB, and in the Euro Area interbank market - but still the funds arrived (via the interbank market) to meet the mortgage needs of a Spanish citizenry who were rather light on savings. Spain is, in fact, relatively insulated from current account pressures on both the above fronts, or at least it was. Then, of course, what was called the "European Sovereign Debt" crisis set in, and the interbank market seized up (effectively closing its doors to Spanish banks) while spreads on government bonds started to rise. In the Spanish case the term "Sovereign Debt" crisis is a complete misnomer, since as many commentators tirelessly point out, Spanish sovereign debt (at this point) is comparatively low by European standards, and what Spain is suffering from is a "Private Sector Indebtedness" crisis. Which is what makes the assumption of ongoing current account deficits look rather odd, because it leads me to ask: who exactly is going to be doing the borrowing that will produce the current account deficit, the private or the public sector?

If it is to be the latter - and I can't avoid the conclusion that it is going to have to be - then it suggests to me that the IMF are already assuming that Spain's fiscal deficit is going to be above the 3% level for considerably longer than up to 2013. Let's have a look and see.

Private Sector Debt

Spain has accumulated a very high level of net external debt. It currently hovers somewhere around 90% of GDP (see chart below), and continues to rise (naturally, that current account deficit), even as GDP hardly moves.

Private debt (both corporate and household) is large, and shows no signs of reducing significantly. Corporate debt currently stands at around 125% of GDP, and while it is down slightly (2.1% in June) on an annual basis, it has remained pretty stable during 2009 and 2010. With Spanish company indebtedness well over the European average, and the economy at best lithargic, their accumulating more debt at this point seems very unlikely.

Household debt stands at around 85% of GDP, and while it has been more or less stationary since mid 2008, even this has started to rise again even if ever so slightly (it was up an annual 1% in June). Some see this as a sign that credit is moving again, and thus a positive feature, but if Spain got into the mess it is in becuase its households became overindebted, accumulating yet more debt seems an unlikely solution.

The Dependence On External Credit Grows, Rather Than Reducing Over The Forecast Horizon

As I explained in this post, the slight GDP growth which was obtained in the first quarter of 2010 was primarily as a result of improved internal demand, and the net trade impact was negative (see chart below).

And this is hardly surprising given that the trade deficit has deteriorated.

And it would not be surprising to see the same pattern (of slight growth, largely supported by internal demand) being repeated in the second quarter, given that the trade deficit seems to have deteriorated further. And of course, the improvement in the current account position that was so evident in the middle of 2009 has now come to an end - but then the IMF seem (at this point at least) to be more or less resigned to this situation (although I can't for the life of me understand why they are).

Basically, the only serious reading which can be given to the IMF current account deficit forecast is that someone - the ECB or that new European Financial Stability Facility which conveniently came into official existence on Friday - will be intervening in the markets to provide the liquidity to make it possible to fund the deficits, although again, and for the life of me, I can't understand why they should want to do so.

And as I suggest above the only sense I can make out of those 5% annual current account deficits is that the government will be doing the borrowing to make them possible (via larger fiscal deficits than are currently formally anticipated) since I can't realistically see the private sector being willing and able to assume the debt that will be required - and especially if they start to raise interest rates at the ECB. Really I am not sure what is going on here, since I'm sure I can't be the only person around who is capable of making these (fairly reasonable) deductions. So if it is the investing community you want to convince, rather than the general public with nice headlines, something a bit more rigorous is really required.

But then, at the end of the day, the forecasting process probably got itself stuck, between the need to show reasonable growth rates, and avoid consumer price index readings that smell of deflation - so they end up projecting inflation of a little over 1% a year between 2011 and 2015 - and of course, if you do that, there is no way you are going to get a goods trade or current account surplus, since the misalingment in Spanish prices is just to great. So here we are. My feeling is that all this will only go on for as long as it does, and one of these days the Spanish government, the IMF and the EU Commission will find themselves trapped between an angry group of those so-called "bond vigilantes", and an even angrier group of Spanish voters, who will be demanding "Hungarian style" just why so many years of crisis and austerity have only served to get them even deeper into debt. At that point I don't think I especially want to hang around to see what gets to happen next.

Postscript

Of course, another way to get demand side growth is to get job creation, but this is a chicken and egg argument, since you are not going to get job creation without an increase in final demand to encourage employers to take on the extra labour (with or without the tepid labour market reform which will only influence flows and not stocks). This is the error that many micro-economists who only focus on supply side issues fall into - they forget the key role played by aggregate demand.

The latest news on this front is that affiliates to the social security system continue to fall (on a seasonally adjusted basis), and hit 17.6 million in July - down by just under 10% from the 19.4 million peak in January 2008.

Evidently, failure to reverse this trend has implications for the social security system as well as for growth, which brings us to another curious detail about the IMF forecast, they make no projections for employment or unemployment post 2011, which makes you wonder where exactly the growth forecasts come from, since if you don't assume job creation, and I think they are right not so to do, then the relatively strong GDP growth projections stand out even more strongly.

Too Soon To Cry Victory?

2010-08-06T22:09:00.000+02:00

Confidence Has Returned To Europe’s Financial Markets, But Lasting Economic Growth May Not Be So Easy To Achieve

ECB president Jean-Claude Trichet was in rather optimistic, one might even say jovial, mood at the press conference which followed this week's central bank rate-setting meeting. Second-quarter GDP growth in the 16-nation euro zone would prove "really exceptional," he stated, while the July bank stress tests marked “an important step forward in restoring market confidence.”

And it wasn't only that pre-holiday bonhomie - as Ralph Atkins also reports M. Trichet was about to head off for some well earned rest in the Brittany seaport of Saint-Malo - which was lifting M. Trichet's spirits, recent data - especially from France and Germany - has been reasonably encouraging. Indeed, M. Trichet’s comments came just hours after Germany reported a stronger-than-expected 3.2 per cent rise in industrial orders in June, which came hot on the heels of some pretty strong PMI readings and a further rise in confidence among those living in the Euro Area about the immediate economic outlook, which hit its highest level in more than two years in July according to the EU economic sentiment indicator. Nevertheless, as the EU Commission itself points out, a substantial part of the most recent improvement is due to the improved mood in Germany.

But this is still very much a tale of two Europes, with German industry receiving a large boost from growth in emerging markets, and France consumers taking advantage of the ultra low interest rates on offer to go on a spending boom, while, on the other hand, the overindebted peripheral economies - Greece, Ireland, Portugal, Spain and Italy - still struggle to find growth.

The German July manufacturing PMI showed strong growth

as did the French services one:

while Spanish services registered only feeble growth:

and Greek manufacturing continued to contract:

And despite attempts by IMF and EU representatives to put a positive note on this growing divergence, nothing here is going to be easy. Despite the important progress being made by Greece in implementing its emergency economic restructuring programme, it is still widely anticipated that the Greek economy will shrink by anything up to 4% this year, and possibly by another 2% next year, making for the worst recession in the country's history.

Although the IMF recently lowered its 2011 growth forecast for the Spanish economy to 0.6% – down from the 0.9% it predicted in April - and warned the any recovery in Spain "is likely to be weak and fragile" their medium term forecasts still look rather optimistic, especially given the heavy levels of indebtedness in the private sector, and the underlying weaknesses in export competitiveness.

Not unrealistically, the IMF predicts the Spanish economy will contract by 0.4% this year, but looking farther ahead it goes on to forecast growth of 1.7% in 2012, of 1.9% in both 2013 and 2014 and a 1.8% expansion in 2015. Certainly the numbers look very nice, but it is hard to see the Spanish economy enjoying trend growth of just under 2% in the coming years, given the size of the correction which is still to occur, and the concern is that these numbers may spur complacency, rather than acting as a call to action.

It's The Export Share Silly!

To offer just one example of the problems which lie ahead, while Spain's exports have grown more or less as fast as German ones in recent months (on an interannual basis), Spain's exports only amount to around 16% of GDP, while German exports account for more like 40%. Now that Spain's economy depends much more on exports than it did (construction activity is not coming back as a growth driver), the rate of growth in exports in Spain needs to be much more rapid than in Germany.

Does this seem like an extremely difficult task? Then this is exactly why it is hard to be optimistic about trend growth for Spain in the coming years. Put another way a 17% increase in Spanish exports (more or less the interannual rate in May) is an increase over 16% of GDP, or has an impact of around 2.7% on headline GDP, whereas a 17% increase in German imports is an increase over 40% of GDP, which exerts a 6.8% upward push on GDP. Of course, what matters is the net trade impact, but in any event the point holds, Spain is trying to leverage over a much smaller part of her economy, and in doing so cannot hope to equal the results obtained in Germany.

All this worked for as long as it did, and for as long as international markets were willing to fund an internal consumption boom in Spain. This is now no longer the case, and Spain is thus forced to rely on its export sector to drive the economy, and this is going to be difficult given how small it is (even allowing for the role of the important tourism sector). What is even more difficult is to see how expansion in this sector is going to give the kinds of rates of growth the IMF are assuming over the time frame in question. Spain's export sector needs to expand to occupy between 25% and 30% of economic activity if the economy is to expand fast enough to enable the debts to be paid down, and I don't see how there is any real way round that reality.

So while the export charts don't look that different, there is a huge difference in the industrial output ones.

This evident difference is due to the fact that Spanish industry is far more geared to the domestic market than it is to the external one, and the domestic market is Spain is weak, and will remain so for years to come, while in Germany, even though the internal market is weak, the export orientation of the economy means that growth elsewhere pulls it along. I don't think the different current growth performances need any further explanation at the macro economic level. What I think someone somewhere needs to explain is how - other than via what is, in reality, a rather tepid labour market reform - Spain is conceivably going to arrive at the sort of rates of growth between now and 2015 that many seem to be assuming. The Standard and Poor's estimate of an average of 0.7% between now and 2017 seems much more realistic, and even that only assuming that nothing seriously untoward happens between now and then (which it easily might).

Another interesting detail about the German differential performance is the way in which German industry has sidestepped the apparent weaknesses in demand in Southern and Eastern Europe by expanding its markets elsewhere. Thats what competitiveness means, agility and the ability to adapt to changed circumstances. As Unicredit's Alexander Koch points out (see chart below), a glance at the recent German foreign trade figures reveals that while the most important export market by far remains the European Union, growth has been coming from elsewhere. In the first five months of this year, more than 60% of all merchandise exports were shipped to neighboring countries. Asia (including Japan) had a 12% share, the US a 7% one and Latin America a "measly" 2.5%.

But recent reports from German export firms suggest that these weights are shifting drastically. Above all in the key vehicle manufacturing sector, additional demand from emerging markets currently plays a decisive role. Vehicle exports to China have jumped by as much as 170% so far this year (over the equivalent period last year). Koch's chart shows us the difference between current export levels and those which existed in 2007. Over this time frame Emerging Asia has gained more than 3 percentage points – of which the vast majority is accounted for by China (2.5 percentage points). Also Latin America recorded a significant increase, a rise which more or less compensates for the decline in the US share. In fact Central and Eastern Europe was the only emerging country region which didn't increase its importance - a reflection of the serious economic crisis which still pertains in most of the region.

The sizeable drop in the export share going to the Euro Area (down by 2.5 percentage points) is largely accounted for by the periphery countries. Greece, Ireland, Portugal, Spain and Italy together currently make up 11.5% of German exports down from almost 14% in 2007.

Differential Credit Impacts

More evidence of the disparities that exist within the Euro Area can be found in the lending data for house purchases which on an aggregate level rose at an annual rate of 3.4 per cent in June – the fastest since September 2008. But while in France such lending was up by 5.3%, in Spain the change was only 0.9%.

Much as expected M. Trichet continued to brush aside concerns expressed about this kind of disaggregated data, along with the apparent credit tightening revealed in the second quarter bank lending survey, by arguing (not altogether unreasonably) that the survey had been conducted at the height of the European sovereign debt crisis, and before the publication of those famous stress tests. But still, credit seems to be flowing in some countries, and not in others.

Still Under Stress?

As for the stress tests themselves, are they working? Well the evidence is mixed. Certainly the atmosphere in the short-term European interbank market has improved, and there is some evidence that, little by little, things are improving. On the other hand we also have the recent surge in 3 month Euribor rates, which rose above the 0.9% threshold for the first time in over a year on Thursday. Twelve month Euribor is also on the rise, and stood at 1.373% in June, up from 1.281% in May. Still it remained 0.039% below the level of June 2009, but the rise seems relentless, and this is not without significance, since it is the benchmark from which over 85% of Spanish mortgages are set.

So, are these movements, as some claim evidence that the market is finally functioning, and that demands for loans are on the rise? Or do they, as others claim, reflect continuing nervousness about the decisions the ECB will eventually take in connection with its short term liquidity provision to banks? Remember, borrowing by Spanish banks from the ECB shot up in June, and September will see the final bout of three month tenders, which were introduced by the ECB in June to ease the pressure on Europe's banks given the tensions in the interbank market. Seeing whether the level of dependency of Spain's banks on the ECB can be substantially reduced will offer us one measure of the degree of success of the confidence raising exercise which lay behind the stress tests.

Whichever version of the story has it right, there can be no doubt about the consequence of this inching upwards in rates, the interest rate differential with the US Federal Reserve continues to rise, and with it the parity of the Euro, which is now being valued at over 130 to the dollar, following hitting a low of 119 back in May. What this will do for the Eurozone’s export-lead recovery remains to be seen. M Trichet is probably right to be nervous about the kind of slowdown we could see in the third and fourth quarters of the year.

In fact the ECB President effectively denied that the higher market borrowing costs and recent rise in the euro constituted an effective tightening of monetary policy, one which would ultimately slow the recovery. Indeed, he saw “exactly the contrary”, arguing that such developments reflected growing confidence and thus boosted Euro Area growth prospects. Let’s hope, like Nelson before him, he wasn’t holding his telescope up to a blind eye when he was looking.

At this point in time the differences in posture between the ECB and the Federal Reserve remain marked, and while the European bank left its main rate unchanged at the record low of 1 per cent for the 15th consecutive month, its President continued to emphasise the process of policy normalisation, resisting all questions which invited him to speculate about future decisions either on interest rates or on liquidity provision. The difference in tone with a US central bank manifestly concerned with perceived weaknesses in the recovery and the deflation danger could not be greater at this point.

Yet, as M Trichet acknowledged, while some of the worst of the financial crisis has now abated it is definitely far too soon to “cry victory” in the battle against Europe’s sovereign debt woes, and the second half of 2010 may well not be anything like as positive as the first half has been in terms of the real economy. Still, as Europe’s citizens lie outstreched on their beaches of preference, or search for the cooler climes of those mountain peaks, maybe it would be better for them to contemplate the recent performance of some of the continent’s key football teams, and leave the dreary task of preparing for their autumn “belt tightening” until their return to the fray in September. As I say at the start of this post, Jean Claude Trichet, for his part, informed us that after the meeting he was headed straight for Saint-Malo, and I wish him a very restful “time-out” there, recovering all that energy that he is most certainly going to need for the difficult decisions he will have to take in the months to come.

Stressing the European Stress Tests

2010-07-27T20:07:00.002+02:00

Guest Post by Jordi Molins Coronado

The stress tests corresponding to the European financial system have been already published by CEBS. The total recapitalization needs for the whole 91 banks included in the tests, accounting approximately two thirds of the European financial system, is about €3.5bn.

I urge the reader to read again the last statement. Yes, €3.5bn. Not €35bn or €350bn. To put figures into perspective, €3.5bn is the bonus pool of a few big European banks.

Can anybody believe that with an additional recapitalization of €3.5bn, the European financial system would be sound again? That the blockade we have had in the wholesale and money markets could have been avoided by a recapitalization of €3.5bn?

One cannot say the calculations performed by the CEBS, with the support of the ECB and the EC, are wrong. I have been able to follow some of the presentations of the results, and they are quite sound. One can see that a lot of great work has been performed, and brilliant minds are behind the calculations.

How can it be then that the final result is an absurd one?

And definitely one can state the result is nonsensical. I understand that European governments already recapitalized their domestic financial systems with about €200bn. I understand that these stress tests only consider solvency risks, not liquidity risks. And from solvency risks, some of them are discarded (eg, sovereign risk in the banking book, even though officially policymakers argue on the contrary).

One can critize other aspects of the stress tests: tier I capital has been used instead of core tier I, the usual measure of capital among financial analysts, with the argument that there is no common, accepted definition of core tier I capital across European nations. I prefer the argument that Commerzbank, for example, has a core tier I capital of about 3.5% and a tier I capital of 10.5%.

I have seen all those criticisms. However, I do not think they are the core of the problem. In fact, policymakers have been diverting the problem towards a sovereign one, when in reality, it is a banking book one. Well, that is not true in all cases. For example, Greece has a serious problem of sovereign debt. French and German banks are loaded with periphery sovereign bonds, whose haircuts would imply heavy losses for them. But the key of these stress tests is not Greece, but Spain.

Spain is on the core of the problems within the European financial system. Greece, Portugal and Ireland are small economies. Spain is a big European economy, and highly interconnected with its Central European counterparts. And definitely, the main problem of Spain is not a sovereign debt one, but a private debt one.

My main criticism to the stress tests is the treatment of the loan book. To make a long story short, losses in the banking book are computed in the standard way in the credit arena: exposure at default times probability of default times loss given default. The crux of the matter is how PDs and LGDs are computed: in the stress tests, one takes an estimation of PDs and LGDs as per their realized value on 2009, and then computes a regression that determines the macroeconomic relationship between PDs and LGDs on one hand, and on the other hand, macroeconomic variables like GDP, interest rates or unemployment rate.

Once this relationship has been entertained, one can 'stress' the macroeconomic variables (-2.6% GDP, shift upwards the interest rates by 75/125bp ...) and find, through the macroeconomic relationship, which impact there would be on PDs and LGDs if such a macroeconomic shock were realized.

Then, using those PDs and LGDs, calculating expected losses in the loan book is just a question of doing the arithmetic right.

What is the problem with this approach?

The problem is that in order to compute a regression, one needs historical data. As such, the results are dependent on the previous relationships among the variables, in our case, PDs and LGDs vs GDP, interest rates and unemployment. A regression gives us the 'best' (in a technically defined sense) relationship among those variables in the past.

However, in practice theory is challenged through the so-called 'outliers'. Outliers are data points that are not well represented by the regressed relationships. An outlier is a PD or an LGD that is very far away from the predicted value, assuming a set of macroeconomic data. And clearly there are outliers all the time, especially when the economic environment changes, for example when there is a financial crisis.

I have not done the math, but I would be extremely surprised if the 30%-40% loss rates in US subprime, or the 47% haircut in commercial real estate in the Irish NAMA, could have been explained with a regression using macroeconomic data. These data points are outliers because once a financial crisis bursts, the dynamics linking the economic variables (PDs and LGDs vs macroeconomic data) changes dramatically, and the past relationships break down completely during the crisis.

Which are these new dynamics? This is a very hard question, but I would like to stress at least a part responsible of the change. Non-linear network effects. For example, when Detroit lost approximately about half of its population, it was not (at least, not only) because of the unemployment rate of that city spiking up. It was also because if your brother or your friend left the city, why should you stay there? Definitely, macro effects continue playing a role. But the dramatic outliers are caused by positive/negative feedback loops, created by network effects leading to non-linearities.

If you allow me to be a bit pedantic, I would like to present an analysis from physics I like very much, and it could shed a bit of light why a macroeconomic regression between PDs and LGDs vs GDP, interest rates and unemployment rate could not be the meaningful way to forecast PDs and LGDs in a stressed scenario.

The analogy is a piece of iron. A piece of iron can be modeled as many atoms of iron next to each other. Simplifying as much as possible, each atom can be in two 'magnetic' states, up or down. The analogy in the credit world would be that an economy can be understood as a series of 'atoms' (households and / or corporations) that can be in two states: default or non-default.

Things start to become more interesting when a magnetic field is applied to the piece of iron. The magnetic field makes that most atoms take a preferred direction, say 95% of them are in the up state (and 5% in the down state). The analogy is that in an economy, say 95% of households and corporations are in a non-default state, and about 5% are in default.

This magnetic field, in the case of the economy, would be the result of the regression: given an array of macroeconomic data, say GDP, interest rates and unemployment rate, PD is given, and as such, the percentage of households and corporations in default is fixed.

In fact, if one uses a well-known model from statistical physics under this same situation that most physics undergraduates learn to compute, the final function is the same as one of the formulas for PD for credit risk in Basel II.

Until now, we have not done anything new: we have just renamed things from our framework (credit risk) into a new framework (the physics of solid state). However, a solid state physicist would soon point out that this model is not interesting at all, and that interesting models include not only magnetic fields, but most importantly, network effects among the iron atoms.

This is easy to understand in an economic environment: a company may have a probability of default given the economic environment, ie if the economy is going great, the probability of default is very low. Instead, if the economy is tanking, the probability that it defaults increases. However, companies depend on other variables than macroeconomic ones: even though the economy may be running at full speed, if an important provider defaults (for any reason) the company may be on the verge of bankruptcy.

And in the same way, even though the economy is in recession, if a given corporation receives a new important contract (or equivalently, an important competitor defaults) its probability of default decreases.

As a consequence, a default in a given company can lead to a domino effect for other corporations that are linked through a supplier chain with the first one.

My intuition here is banks are the most important nodes in an economy. Banks have very strong links with many corporations, many more links than a usual corporation has with other counterparts, and more intense at this. If a bank defaults (or stops providing financing) these effects spread out to many of its clients. At the same time, if corporations fail to get new financing, this may affect other corporations, which will have an influence on other banks, and so on.

This kind of strong chain of relationships is well-known among condensed matter physicists: the Ising model (and variants). The Ising model includes not only a magnetic field (a macroeconomic variable that affects all the agents in the economy) but also direct relationships among the agents. To describe the overall behaviour of the Ising model is out of the scope of this note, but just let me state than once one includes direct relationships among the agents, the simple behaviour of the model under a magnetic field changes dramatically.

Under only a magnetic field (and no direct relationships) the behaviour is simple and predictable. As we have discussed above, undergraduates in physics may compute that relationship easily. However, once one includes direct relationships, everything changes. The relationship between the variables (ie, the dependence of PD or LGD vs the macroeconomic variables) stops being a linear one, and they become highly non-linear. In particular, there may have phase transitions: a small change in a macroeconomic variable may lead of an abrupt change in PD. This is not unlike to the case when a small change in temperature leads to water to freeze.

A study on these lines, that relates these physics models with credit portfolio models, was analyzed by Eduard Vives, a physics professor and myself, and can be found here. I do not argue this is the last word on the relationships between PD and macroeconomic variables, but apart from the appealing theoretical framework around it, one can see that it introduces the possibility to deal with outliers, and to try and understand how is it possible that loss rates in the US subprime and the Irish commercial real estate were so large, when no macroeconomic model could have forecasted such jumps.

The final suggestion, using the physics analogy, is the following: once network effects are present (mainly through the strong relationship lender - borrower) the traditional macroeconomic relationship between PDs and macroeconomic variables breaks down, and a more complex dynamics is required to model such a new reality.

To sum up:

a macroeconomic model like the ECB one relating PDs and LGDs with macroeconomic variables will never be able to model big jumps in PDs and LGDs, as they have occured in the past with the US subprime or the Irish commercial real estate experience. These models are too slow to accomodate abrupt regime changes. However, there is a series of models, coming from condensed matter physics, that have the potential to accomodate such changes, and that comprise the regression macroeconomic models as particular cases.

This is essential due to the fact that recapitalizations coming from the stress tests, even though very small (€3.5bn) are the difference of two very big numbers. For example, the Bank of Spain has computed recapitalization needs as (simplifying) the difference between gross impairments and available resources. Available resources are more or less well-known (provisions, both specific and general, net operating income, capital gains, tax impact ...) but gross impairments are highly dependent on the PDs and LGDs chosen to perform the exercise.

For example, the most toxic exposure in Spain, developer loans, assumes in the BoS calculations a 17% haircut. However, other estimations, like Luis Garicano's one, with a PD of 70% and LGD of 70% for that portfolio (as such, total losses around 50%), would immediately increase (without taking into account any other changes in other parts of the loan book, that could also add to the recapitalization needs) the recapitalization easily to the €100-€150bn mark.

As such, this strong dependency of gross impairments on the estimated PDs and LGDs in the adverse stress scenario leads us to suggest that a better model than a simple macroeconomic regression like the one used by CEBS should be entertained, especially models that could accomodate outliers like the US subprime or Irish commercial real estate ones. But for that, one would need non-linear models that could explain and predict abrupt regime changes.