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.
Spain Real Time Data Charts
Edward Hugh is only able to update this blog from time to time, but he does run a lively Twitter account with plenty of Spain related comment. He also maintains a collection of constantly updated Spain charts with short updates on a Storify dedicated page Spain's Economic Recovery - Glass Half Full or Glass Half Empty?
Monday, November 21, 2011
Wednesday, August 17, 2011
Going Dutch - One Possible Solution To the Euro Debt Crisis?
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:
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".
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".
Wednesday, August 03, 2011
Spain's High Risk Election Process
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:
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:
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".
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".
Monday, July 25, 2011
Recession Warning On Europe's Periphery
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:
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".
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".
Saturday, June 25, 2011
Nine Reasons Why Spain's Economy Is More Different Than You Think!
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.
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.
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.
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.
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.
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.
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 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.
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.
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".
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".
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