El Rosario De La Aurora

The exact origins of the expression are unknown. They are lost back then, somewhere in the mists of time. But the meaning of the phrase is perfectly intelligible. In Spanish "to end up like the Rosario De L'Aurora" (acabar como el rosario de la aurora), means to end up badly. Very badly. The Rosario in question is a procession (of the kind to be seen in this YouTube video) and aurora here is not a woman's name, but the Spanish word for dawn. According to legend, the procession which gave birth to the phrase was characterised by a dispute which developed into an outright brawl during which all those precious sacred artifacts being carried by the devout got unceremoniously destroyed.

One popular theory has it that two rival processions tried to advance in opposite directions down an extremely narrow street, with neither being prepared to give way. Similarities with what is currently happening here in the Euro Area is, of course, entirely coincidental. What with the quantity of alcohol that people wandering the streets in the early hours during fiesta time would likely have consumed, and the fierce rivalry between the two "comparsas", the outcome is surely not that hard to foresee, or that worthwhile explaining. We can leave such details to the imagination of the reader.

But moving forward in time, and while again the versions of the story may differ, there seems to be little doubt that Spain's economy is in bad shape. Very bad shape. Such bad shape in fact that, according to Tobias Buck in a recent article in the Financial Times, it has left most of the countries population "bewildered". Bewildered, and increasingly desperate and despairing, or as blogger Matthew Bennett puts it dogged by the feeling that the modern Spain they know and love "is in danger". Indeed if we aren't all careful, the country could end up in a worse state than the one which befell that legendary rosario.

You know the Modern Spain you love is in danger.  

Thankfully, you can still eat abundant amounts of tasty Spanish ham whilst drinking a decent Rioja, and the Spanish national football team is still beating all-comers at international level—a truly world class achievement—but in your heart of hearts, you know a cataclysmic future outcome is a plausible option for a Spanish society that is struggling to adapt to a new world economically, politically and constitutionally.  

What happens to a society when tens or hundreds of thousands of its own citizens abandon the country to go and live and work abroad, with the approval of parents, government ministers and even the king? When record numbers of citizens—25%, nearly 6 million Spaniards—are unemployed, with no economic recovery or new jobs visible anywhere on the horizon? When the 12th largest economy in the world is ranked 136 for ease of starting a new business, behind Burundi, Afghanistan or Yemen?  

What happens when Spain’s existing national institutions aren’t capable of offering all of its citizens and residents a prosperous existence, or when political leaders steadfastly refuse to listen to their voters’ repeated cries for change and prefer instead to repeatedly lie to the nation, ignoring their own electoral programmes?
 

Put The Telescope To Your Blind Eye And You Will Surely See Recovery Ahoy!

For all the nay-saying to which those who watch the country passing thorough its agony are now subjected on an almost daily basis, there can be no denying one point - better days Spain has surely seen. Despite the constant and repeated assertions that great progress has been made with the reform programme, or that exports are doing just fine it's hard to see evidence for this in the ever longer lines of unemployed, or the now daily diet of home evictions to be seen in neighbourhood after neighbourhood. The number of reported green shoot sightings to which we have been subjected must now surely exceed the long term total accumulated for that other legendary beast, the Loch Ness monster. Yet this most terrestrial and long awaited of all resurrections has still not taken place.

But while the self-deluded continually claim to be envisioning signs of recovery, the data tell us another story. Almost every indicator we have points to deterioration, and the forward looking ones we have suggest there is worse to come.

The latest in the long line of examples I could cite comes to us in the shape of the third quarter GDP results, announced last week by the national statistics office. Between July and September the economy shrank by 0.3% quarter-on-quarter, or by 1.6% when compared with a year earlier, making for the fifth consecutive period of negative economic growth. This put the Spanish economy back at a level approximately 4.25% below the highpoint achieved in the first three months of 2008, just before it entered the great recession.

But, of course, all of this isn't over yet. At the start of last week the Spanish newspaper El Pais published details of leaked EU Commission forecasts for the country, showing that GDP is expected to decline by 1.5% in 2013, scarcely better than a 1.6 percent drop this year. Growth of 0.5% is then expected in 2014, and even if this result is eventually confirmed, what about 2015? Who is to say we won't be back to minus 0.5% again, or worse? Spain's economy won't be surging back to life again, the accumulated debt problems and continuing competitiveness issues virtually guarantee that, and only those who clutch hold of some kind of "but economies always recover, don't they" quasi religious type of fig leaf can summon the energy to convince themselves otherwise. The data and the analysis almost all point in another direction.

Yet, just like those historical reports that lie behind the rosario legend,  this latest piece of economic data does inevitably allow for a plurality of alternative readings, and you can just glimpse a glass half full  if what you really want to do is convince yourself that what is so obviously happening to the country actually isn't . Some will make a great deal of play of the fact that the rate of inter-quarterly contraction slowed when compared with the April through June period. Even the EU forecast can be used to this avail, since the annual rate of decline would seem to fall by one tenth of a percentage point next year. So thing are getting better!

Others will rejoin by pointing to the slew of other economic data which points to continuing deterioration, while yet others will argue that the fact the contraction wasn't deeper suggests the possibility that the austerity programme hasn't been all it is being made out to be, with the consequence that the deficit correction process is surely once more well off course. Indeed the EU and the IMF seem to now openly recognise this. Plus ça change!

At the end of the day, however, all of these interpretations miss what is surely the main point - Spain is and will continue to be stuck in depression, and not simply passing through a garden variety recession. Growth may be minus 0.3% one quarter and plus 0.3% the next. Frankly that doesn't change anything.  Or at least not anything important. Without a more substantial set of growth restoring adjustments the economy will simply hover between growth and contraction for the rest of this decade, always assuming some major life-threatening event doesn't intervene first. The economy is broken, and there is no hidden hand at work on which to base expectations for an automatic fix. Recovery simply won't happen all by itself. That is to say, if someone somewhere doesn't do something to stop what looks set to happen happening, Spain and its economy can end up a lot worse off than even that famous rosario.

Let's look at some examples of what now seems to be more like a horror than an adventure story.

Credit, Houses and Jobs

The economic crisis afflicting Spain and its economy has many aspects, dimensions and layers, but through the fog three interconnected elements stand out clearly - the availability of credit, the stock and price of houses, and the levels of employment and unemployment. Whatever starting point you chose, the final outcome always turns out to be the same.

The country seems to be trapped in some sort of modern adaptation of the traditional children's game "ring a ring o'roses".  There is a shortage of credit in Spain because the economy is losing jobs, causing the demand for and prices of homes to fall, leading banks to accumulate unwanted assets and clock-up a growing number of bad loans which in turn makes them reluctant to advance new credit due to the fear of have to assume even more losses. But we could equally say that the economy isn't creating jobs precisely because of this shortage of credit, and that the rising unemployment is affecting the housing market. Or, if we are still not satisfied  we could put it like this: the fall in house prices is reducing demand for houses, and weakening household consumption (via the wealth effect - 75% of all household saving in Spain is held in the form of property). This drop in consumption is causing the economy to contract, with the result that it is constantly shedding jobs leading the banks to incur even more losses.

Whichever way you look at it these three interconnected components lie at the heart of the Spanish malaise. There will be no resolution of the Spanish "problem" without  a turnaround in  all these areas, and at one and the same time. Kick-starting the Spanish economy means inducing an expansion in the number of those employed, a freeing up in the credit gridlock and establishing a bottom in the downward march in house prices. At the present time none of these objectives are anywhere in sight. Unemployment is rising, and will continue to rise in 2013. People are leaving the country, credit is falling, and house prices have just had one of their biggest interannual drops since the crisis began.  This dynamic produces a vicious circularity which puts the country at risk of enduring the same fate as all those generations of children who have participated in the aforementioned ritual, namely that the climax is reached when everyone cries A-tishoo! A-tishoo! and then lies down.

Water Water Everywhere, But Not A Drop To Drink

The question of credit flow is an especially complex one, since it is both cause and effect of the depression. Linear thinking will always have trouble with this kind of phenomenon. The banking system cannot freely supply credit since such a significant part of its balance sheet is "encumbered" with existing loans, some of which are already none performing. But there are many more which are in danger of becoming "troubled" if the crisis continues through the years ahead. Yet it is this very encumberment which virtually guarantees the crisis will continue. The loans in question are not only those made to property developers (many of these have in fact already  been drastically written down). They are also syndicated loans to large companies, loans to small and medium enterprises, and loans to individuals for residential mortgages. As it is none of these portfolios are exactly going well, but the quality of the loans within them will continuously deteriorate for as long as the listless drift continues.

In addition, we need to remember that during the "good" years Spains banking system became considerably "overleveraged" - that is it gave an excessive number of loans in relation to the system's deposit base - in much the same way the Irish one did. So as well as working off distressed loans, the Spanish financial sector needs to reduce its leveraging which means (without a substantial increase in the volume of deposits) it has to cut back on lending. Naturally the kind of deposit flight Spain's banks saw in the first half of this year doesn't help matters.

So while the creation of the bad bank and the recapitalisation of the entire system will help clear some of the worst rubbish off the balance sheets, this doesn't necessarily mean that the clean up will lead to a flow of new credit, and indeed what has happened in Ireland (see chart below) tends to confirm this view. Irish banks handed over a large part of their distressed property assets to the bad bank NAMA, yet the interannual loan numbers continue to be in negative territory, just like the Spanish ones are.

To top it all, despite the fact that the country's banks had a net 378 billion Euros outstanding with the ECB in September credit is still not cheap.

Wholesale funding (where available) still comes at a hefty surcharge, and building the deposit base doesn't come cheap in a country where prices are rising at the rate of 3.5% a year. Typical fixed-term deposits now pay around 4%. Hence, according to the most recent ECB data (August) for lending rates to small and medium enterprises, German companies seeking a loan of €1million over a term of  between one and five years typically pay something in the region of 3.8% – a record low for the Euro era – while their Spanish equivalent  is paying 6.6%, the highest level since late 2008 when central banks cut rates after Lehman Brothers collapsed. So it isn't only wage costs that need to be reduced in Spain, capital costs need to come down to. This is naturally one of  the objectives of Mario Draghi's OMT programme, but Mariano doesn't want to play ball, a strategy which may seem politically convenient but which comes at a high price for Spanish companies and those forming part of Spain's growing jobless mountain.

The second major issue facing Spain is how to stop the fall in property prices. Residential housing has seen falls now for almost 5 years, and prices are down around 30% according to real estate valuers TINSA, dropping by an annual 12.5% in October. Put another way, prices have fallen from something over 2000 euros a square metre, to around 1500. Spain's banks hold roughly 600 billion in home mortgages, and back of the envelope calculations suggest that once prices hit the 1,000 euros a square metre level the whole system (on aggregate) will be in negative equity - that is that homeowners will be standing on values in  their property portfolio below the outstanding quantity owed in mortgage loans. At that point a critical moment will be reached, with the danger of implosion being much greater than "non negligible".

Spanish property prices have been being supported by a combination of three factors.

1) banks holding repossessed assets on their balance sheets
2) the illiquidity of the market, with very few transactions in new property taking place
3) a completely unfair distribution of risk between property developers (who can simply give back the keys) and those who bought the properties they built at the ludicrous prices they charged (who can't).

The nationalised banks are now set to move their "troubled assets" off balance sheet and into the newly created bad bank, Sareb. Although many questions still remain about the way Sareb will operate, its creation is unlikely to produce a turning point in the housing market, discounts may still not be sufficient to attract buyers in large numbers, and it is not clear how the mortgages those buyers who do appear will be financed.

Mortgages are not freely available in Spain, the volume of credit extended for house purchases is falling steadily year by year (see chart above) and attractively priced mortgages are normally only available to those buying properties on the balance sheet of the issuing bank. Those who seek mortgage finance for other property normally have to pay a hefty surcharge. Since Sareb will not be a bank, it will not have "own funds" with which to grant mortgages.

In the meantime Spain's unemployment continues to rise, hitting a record 25.8% in September. It is hard to say where this will peak, but the level looks certain to hit 27% in 2013.  More importantly, simply getting the level back down to 20% again looks set to be a mammoth task, and one which is unlikely to be achieved this side of 2020. So many more years of pain certainly await the country.

One of the reasons the unemployment rate should peak reasonably soon is that people are now leaving the country in growing numbers. With 52.9% of the under 25 population who would like to work now unemployed a lot of young people are simply giving up and voting with their feet. According to data from the national statistics office, in June this year a net 20,000 people left the country. That may not sound like much, but it is a rate of one quarter of a million a year, or a million every four years. More worryingly the rate of outflow is on an accelerating trend (see chart below).

Natrually this wouldn't matter so much if the Euro Area was one single federal state, since health and pension costs would be shared across the region, so it wouldn't matter whether people were paying taxes or social security contributions in one place or in another. Indeed such movement would be a rather positive sign of the existence of a single labour market, and labour force flexibility. But the Euro Area isn't a single state, and contributions and costs aren't shared. So some countries risk becoming unsustainable.

Several years ago, and according to UN estimates Spain looked destined to become one of the oldest countries on the planet come the 2020s. That picture changed dramatically during the first decade of this century as some six million migrants came to live in Spain and the population shot up from 40 to 46 million in just a few years.

Before the arrival of the migrants Spain's population was virtually stationary. Really it is impossible to give any sort of precise forecast at this point of the Spanish population in 2020, or the rate of ageing, since the size of the population is so obviously path dependent on the evolution of the economy. It shot up as the economy was booming, and now it is falling back again as the country languishes in depression. It is almost a certainty that the population will continue to fall (births are also down) but how far and how fast depends very much on what happens in the job market.

This population exit has two important consequences. In the first place it reduces the future demand for housing, thus making it even more difficult to stabilise the market. And in the second place it means the pension's system, which is already becoming a significant drag on the fiscal deficit will continue to weigh ever more heavily on public finances, and will surely lead to ever more urgent and drastic modifications to the parameters in the country's pension system at some point in the future.

Exports Looking Good

Well, that is all obviously extraordinarily bad news. But Luis de Guindos (the country's economy minister) would retort, that some things are going well. Exports, for example, have put in a strong showing in 2012.

Not only that the goods trade deficit is reducing:

The current account has also improved substantially, and in fact went positive in July and August for the first time in many years.

The improvement in the current account is evidently good news, and it is even better news that it is accompanied by a rise in exports, and not just a fall in imports as consumption declines. But the disappointing reality here is that even despite these improvements Spain's economy is still contracting, contracting and running an 8% fiscal deficit. The reason for this is that Spain's export sector is still way too small for the work it has to do. I have been over these arguments time and time again, so I don't propose to go into them here and now. You can find the issue thoroughly discussed here (from June 2011), and here (from August 2010), and all I can say is that the arguments I use are just as valid today as they were then. I'm not sure how many others can say the same.

With the private sector deleveraging, and the government trying to reduce spending the only thing which can really grow to the economy is the export sector, but until that is bigger the impetus given to the economy won't be sufficient to offset the drag from the other two sectors, and the economy will hover around the zero growth mark. One sign that things were really getting better would be a surge in investment, which would be reflected in demand for capital goods, but as can be seen in the chart below this demand just isn't there.

Where Is The End Game?

The future of Spain is now very hard to see (so "que sera, sera"), and with it rests the future of the Euro. Interest rates on Spanish debt may well come down eventually if Mario Draghi starts the OMT bond buying programme, but as I argued in this post, intervention from the ECB alone isn't going to solve the Euro Area's underlying problems, only closer political union will be able to begin to address these, and that seems farther away than ever (or here and here). At the present time everything seems to be on hold, with Mariano Rajoy on the one hand reluctant to formally ask for a bailout, while Angela Merkel on the other is in no rush to do anything till after the German elections are over.  Meanwhile those without work, and those about to be evicted from their homes  just have to wait and see.

Even the deficit seems to no longer be a priority. Olli Rehn announced last week that Spain will not be asked to apply any additional austerity measures until at least the end of next year, despite the fact that everyone acknowledges the country will substantially miss its deficit targets both this year and next. The most recent EU Commission forecasts see an 8 per cent deficit this year and 6 per cent in 2013, but even these may be to generous now that the straps are off.

Obviously this loosening in the policy stance could be seen as positive, if you thought that measures taken over the next two or three years would return the country to sustainable growth, but the sad reality is that the vast majority of the structural reforms being enacted are only likely to have marginal effects on the countries overall economic performance, and the one that could, the labour market reform, was described by the ECB in its August bulletin as being too little coming too late. As the bank puts it, "the authorities finally approved in February 2012 a far-reaching and comprehensive labour market reform that could have proved very beneficial in avoiding labour shedding if it had been passed some years ago." As it is, the bank continues, "given the low level of competition, further significant reductions in unit labour costs and excess profit margins are particularly urgent....To achieve this, first, flexibility in the wage determination process has to be strengthened, for example, where relevant, by relaxing employment protection legislation, abolishing wage indexation schemes, lowering minimum wages and permitting wage bargaining at the firm level".

In other words, the country needs to initiate some sort of internal devaluation process to restore competitiveness, something I have and others been arguing for over several years now. But looking at the political landscape inside Spain after five years of unending crisis, this policy is extremely unlikely to be implemented as the political will just isn't there. The recent attempt by the Portuguese government to try something similar was over in a week on the back of strike and protests.  Too much time has been lost, and too much weariness has set in. So the rot stays stuck in the wood, and one way or another we are on collision course.

But the biggest catch in the deficit loosening agenda is the impact this will have on Spain's debt trajectory.  As I argued in this post, putting the submerged part of Spanish government debt on the table was always going to be a risky move, since the debt level could rise dangerously near the critical 100% of GDP mark, above which no one in this crisis has yet risen and come back to tell the tale.

Well next year it looks very probable we will now cross that particular threshold, and what's more Spain's deficit will continue adding to the level for several more years to come. In addition there are still unquantified risks in the financial sector. Despite all the lauding of Mario Draghi's OMT programme, it could well turn out that Germany backing off from the June agreement on mutualising the bank recapitalisation costs could in fact mark the critical turning point in the debt crisis. One of two groups of people are going to be bitterly disappointed after the coming German elections - German voters who are being promised they will not have to bear part of the costs of recapitalising the Euro Area's troubled economies, or investment funds who are being constantly reassured in the background that once the elections are over this is exactly what is going to happen.

So this year Spain's banks are going to be adequately capitalised, but what about in 2014, or 2015, or later if the crisis drags on and on? The new banking union may well be in place, but if the principal of not mutualising legacy debt problems is maintained, then it is hard to see how the losses on debt obligations which are currently being rolled over - like the large number of residential mortgage resets which are being used to avoid eviction  - are going to be funded once the finally have to be recognised.

This week the tragedy of Spain's ongoing evictions drama has been in the news,  (and here), and a new code of practice for evictions  has been put in place by the government. But this is only scratching the surface. If, as seems probable, house prices continue to wend their way down then there really will be no way round the passing of some sort of new personal insolvency law to enable people to write down part of their mortgage, as we have seen in Ireland. The days of full recovery in Spain are numbered, since the social clamour, as in Ireland, will just become too great. Interestingly, ratings agency Moody's pointed out that in Ireland negative equity rather than unemployment was now becoming the main driver of mortgage default (and here) - and indeed they predicted that one in five Irish mortgages would be in default by 2013. This is interesting because the models used by Oliver Wyman and Roland Berger to stress test the Spanish banking system do not use negative equity as a parameter, relying mainly on unemployment levels and GDP movements for their default estimates. Spain's entire mortgage system is likely to fall into negative equity on aggregate within 2 or 3 years, meaning the capital requirements could then well be very different from the ones we are seeing now.

Then there are the regions. On the worst case scenario Spain could see a 20% drop in GDP as Catalonia exits stage left (elections are being held on the 28th - I have written extensively about this here, and the separatist case is put here), and if the Spanish government insists on carrying out its threat to veto continuing EU membership for any new state which might be created, the reality is that the rump country's debt level will surge to 125% of their remaining GDP, even assuming there aren't worse dislocation problems for the economy. Naturally one would assume that the Spanish government would negotiate rather than shoot themselves straight in the foot (typical prisoner's dilemma type stuff this), but you can't be sure, and maybe you should take them at their word. It doesn't matter it seems if the whole Euro project falls apart, if the Catalans vote to be independent they will not be permitted to remain in the EU.

Naturally, intransigence is seldom a good policy, and investors who want to take an interest in the issue might ask Spain government representatives who are locked in to their "total veto" and blocking strategy how, if they ever had to implement it,  they intend to get their exports out to Europe. The lines in blue in the chart below show the national rail network, and those who know some geography will quickly see that there are only two connections with France, one through Catalonia and the other through the Basque country. I have no idea whether Catalonia will be in or out of Spain 5 years from now, but what I am pretty sure of is that if the Catalans left the Basques wouldn't be far behind.

So there we have it. What we have is a country where not only are people of working age leaving in growing numbers, whole regions may want to go. A country where deficit numbers have been flouted time and again while bank interventions have been consistently implemented using the principle of always try to do too little too late. The country suffers from what the ECB calls deep competitiveness problems, yet there is not a single proposal on the table at present which would do anything substantial to correct this.

The pension system is spiraling quickly into a substantial structural imbalance, yet the government will hear nothing of any deep long-lasting pension reform. I could go on and on. I would like to be optimistic, but five years of watching this train crash in slow motion have left me with the feeling that this one now has no solution. The country's political leaders just aren't up to the levels of complexity involved (see this excellent summary of some of the "matters arising" in this regard from César Molinas here, and Europe's leader not only drag their feet, they stick their heads in the sand at the same time. The exact details of how and when escape me, but this situation now has all the hallmarks of ending up in the same way as that legendary Rosario whose untimely demise gave the title to this post.

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

Taking A Man At His Word

Legendary hedge fund supremo Ray Dalio is in ebullient mood. Following a series of moves by Mario Draghi to underpin European government financing Dalio told Bloomberg that, in his opinion, the euro will now “likely” stay together because existing growth constraining austerity measures will henceforth be balanced by money printing over at the European Central Bank. His statement was, of course, a response to ECB President Draghi's save the Euro pledge.

This story starts back in July, when Mario Draghi calmly informed a London investors conference that, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Since that time, of course, this gamechanging statement has been qualified and clarified, and re-qualified and re-clarified innumerable times, but still the essence remains unchanged. The ECB President wasn't talking, remember, about any specific programme of bond purchases or exceptional liquidity measures, he was talking about doing "whatever it takes", and Ray Dalio for one is taking him at his word.

What Bridgewater's founder was getting at when he made this assessment is that there is now no meaningful limit being placed on what the ECB might eventually do. Naturally there is the mandate to work around, but the mandate can always be changed if Europe's political leaders see fit, and who at this point in the crisis still doubts that if needs must they will see fit.

Indeed in many ways it is easier to envision a change in the EU Treaty to tweak the EU mandate than it is to envision one to establish, for example, a full fiscal union. Especially now the ECB has become the in-tray into which all the politically unpalatable and thus unresolvable issues ultimately get dumped. The most recent example of this is the suggestion that Spain applying for a precautionary credit line would be the ideal solution to the country's current dilemma since no money would actually need to change hands, making the move easier to sell to the German parliament.

No money would need to change hands because Mr Draghi and his governing council would be stepping up to the plate alone. This outcome looks and feels rather different to the "burden sharing" approach outlined by Mario Draghi during the August ECB press conference.It looks and feels different because it essentially is different, even if the two possible modalities of ESM action were laid out from the start. What wasn't envisioned was that NO ESM money would be used to buy bonds. That the ECB would be acting alone.

Of course any talk at this point about the forthcoming Spanish bailout means navigating in an ocean of uncertainty, but as far as we can see at the moment the end result of all the negotiations, crying wolf and procrastinating seems to be that the ESM won't be buying bonds in the primary market.

Instead some of the Euro Areas financial institutions (acting as brokers for the ECB) will do so and then re-sell them on to the central bank. This differs in substance from what some have referred to as ECB LTRO-style "QE by stealth" in that the central bank would be owner of the bonds, and not simply holding them as collateral. While adding considerably to central bank risk this procedure is seen as being politically more palatable in the north, and limits the sovereign bond/bank capital "death spiral" many worry about in the south, since it avoids the need for periphery banks themselves to hold more bonds on their balance sheet.

But whichever way you look at it we will still see significant bond purchases, thus maintaining a kind of strange fiction that Spain still remains "in the markets". Obviously, without ECB support in the form of LTROs and the OMT the country would be absolutely incapable of financing itself. So perhaps a better way of putting it is that "the ECB is in the markets" and hence Spain is able to finance itself.

We will leave aside at this point the rather byzantine issue of whether or not these purchases will constitute "money printing", since with the large quantities of money core European banks have sitting on deposit at the central bank the question of whether or not the purchases are sterilised seems to be a totally academic one.

Waiting For The Bailout That Never Comes

As London Thomas suggested in the New York Times recently, the classic work of theatre that is currently being performed on the Spanish stage does not come from the portfolio of Calderon de la Barca, but rather from an Irishman, Samuel Becket. It is entitled "Waiting For Rajoy". However, unlike the original this modern adaptation is unscripted, and resembles more a Cassavetes film where the actors constantly improvise. Naturally the markets are unsure how to trade the situation, but with the passage of the days, weeks and even months I am sure they are steadily learning and adapting.

In recent weeks an almost enless supply of ink has been spilt in the press about the kinds of conditionality which might be applied in the event of a bailout. Naturally there are questions oustanding which the Troika would like to address with Spain - the seriously needed pension system reform, for example, or the across the board wage reduction solicited by the ECB in its August bulletin - but this doesn't seem to be the priority at the moment. The number one objective appears to be getting a firm grip on a country which has proved more slippery than a conger eel when it comes to holding it down to firm commitments.

But, even if we are not party to the intimate conversations which take place on a daily basis between Mariano Rajoy and his chief economic adviser Alvaro Nadal (seen together in the photo below) it does look very much like Spain has been trying to play hard ball with Berlin. In the short term this strategy was used to some effect in Los Cabos (given the surprise element involved) and then subsequently at the June EU summit. However it now seems that this particular window was firmly closed by Angela Merkel at last weeks meeting. Over the weekend it must have been back to the drawing board time at the Moncloa, and the whole world is now waiting to see what the new approach will be. Prior to this I can almost imagine the tenor of the conversations which have been taking place. "Look Angela, cariño, you must have read your Margaret Thatcher. I don't actually pay these blasted interest costs out of my own pocket, you understand. They are supportable, at least for the time being. We are in no rush." Nervousness can only have been growing at the other end. The nearer we get to the German elections before the bailout comes, and the more deteriorated the Spanish economy at that point, the worse the headache for the CDU.

Arguably Mario Draghi's verbal intervention in the Bond markets has been almost too succesful. He has brought down interest rates without actually doing anything. Probably this is one of the most successful interventions of its kind in recent history.

But the result is that Spain is in no hurry to receive yet another Memorandum of Understanding, not to mention Italy where there is absolutely no interest at all. So we all finally got a free lunch, didn't we?

Well no, not exactly. The ECB is now committing the worst of all sins (according to the version of biblical law to be found in the EU treaty) and helping monetise Spain debt. Even worse, it is doing so with only a virtual intervention. There is no conditionality, and no support measure to withdraw, so no possibility of using a threat to do so. Mario Draghi can hardly go to the next press conference and say, "since there are no takers, the OMT programme is now formally closed".

Meanwhile Spain can continue to go happily along ignoring its EU deficit commitments, since there is no programme, there are no conditions and no sanctions, and the Spanish government are fully aware of just how reluctant both the IMF and Germany are to publicly criticise the country. No one wants to inflict the kind of reputational damage that has been uselessly inflicted on Greece.

Investors, on the other hand, don't want to get "burned" by Mario Draghi - intervention is, after all, just a phone call from Rajoy away, so they do the intelligent thing and stand back on the sidelines. Waiting for Godot (sorry Mariano Rajoy) to decide.

Is this a good outcome? Only if you think Spain is headed to some nice place to be.

So, since the EU has already approved Spain's adjustment programme, looking at the balance of forces and balance of interests I now think it is unlikely very stringent additional measures will be required when finally the big day comes. But this isn't the point. There will be a Memorandum of Understanding, there will be supervision, and there will be reviews. This is what this tug-of-war is all about. This is why Angela Merkel went before the Bundestag last week to explain that she would propose the EU seeking powers to intervene (regardless) in countries who habitually fail to comply. She didn't spell out S-P-A-I-N, but she didn't have to. When the next MoU is nicely in place failure to comply with the objectives which are laid down (highly likely) will then trigger more measures during the review process, as we have seen in Greece. So there will be plenty of opportunity later. What the Troika representatives want at the moment is to get their claws on, and firmly locked into, their prey.

As I say, the bailout one will not be the first such MoU Spain's present leaders have signed, and with progress on determining bad bank asset handover prices painfully slow, while progress on the "burden sharing" involved in the preference-shares-haircut is seemingly non existent, the men on the other side of the table will surely now be adopting a "once bitten twice shy" approach. Troika representatives are caught between the rock of having to talk up Spain and the hard place of coming to terms with the country's continuing non compliance and deteriorating reputation. I am sure Alvaro Nadal is well aware of this, hence the hard ball, and hence the leverage he is able to apply. Contagion, what contagion?

But moving away from Spain and returning to the opening theme: Ray Dalio's ebullience. The whole issue of the OMT is mere detail, but a tiny comma in the already voluminous history of the Euro Area crisis. What has market participants really whetting their lips is the idea Mario Draghi is willing to do anything, literally anything (within the mandate, but then, if things get desperate what exactly does that mean?) to save the Euro. And believe him, it WILL be enough. If you follow my line of argument, what was meant as a threat becomes a promise. Just imagine how male eyes light up when a woman says she is willing to do absolutely anything for him to save a relationship (or start one). (Incidentally this should not be read as displaying gender bias. No woman would still, in this day and age, believe any man who said the same, at least not unless she wanted to).

So investors have backed off on periphery spreads, and on the Euro. Gravy there will be. Enough to go round everyone. But leaving all that aside, what about Ray's stronger line of reasoning that the promise of all this market fun changes the outlook for the Euro in the longer term? Does it hold?

Or Mario's promise, is it valid? Does he really have it within his power to deliver? Many men promise before the altar that they will be faithful to their wives. Often they aren't. Later some of them learn you shouldn't make promises you can't keep. Can Mario keep his promise?

Let's see.

Deactivating the alarm system, not defusing the bomb.

Perhaps the view of the Euro as some kind of unexploded bomb just waiting to go off isn't a new one, indeed in my Dr Strangelove CNN blog post I have already likened the currency union to the famous "Doomsday Machine", designed in a way which means it will eventually blow up, but also designed in such a way that any attempt to disarm it will produce a similar outcome. But tired as the metaphor may now be I still think that it is a valid and useful one since this is still exactly the situation we are all in.

One of the peculiar things about the Eurosystem is that, just like any garden variety virus that surreptitiously enters your computer hard disk, it has the power to systematically disable all the potential warning signals which could alert you to impending danger.

Perhaps the best example of this unsung virtue has been the way in which central bank FX reserves - a traditional indicator for up and coming balance of payments problems - were rendered all but irrelevant, even though there were in fact no joint and several agreements in existence to guarantee the external debt of any of the participating, but independent, sovereigns. We all now know what got to happen next - countries which had been sustaining unsustainable current account deficits suddenly found themselves with funding problems associated with massive balance of payments crises.

It was at this point that financial markets stepped in to replace an EU system of governance which had been shown to be incapable of either controlling or regulating dysfunctional behaviour on the part of the participating member state governments. At first these moves were welcomed, especially at the central bank, since they had the potential to force the reluctant back into line. But eventually matters got out of hand, and now those very market forces which were once seen as the cure have become part of the problem.

So what do we do? We disconnect the cables (via OMT) which served as the transmission mechanisms for the warning signals being sent by the markets, that's what we do. This naturally puts a break on one "self fulfilling" component of the financial crisis - the one which follows the reasoning chain whereby excessive interest rates on excessive debt can drive a country into insolvency, while fear about the possibility of such interest rates in and of itself drives up interest rates, sending the country over the cliff in any event. Clearly, given this analysis, what you need to do is disconnect the worry factor. Some mistakenly call this "restoring confidence".

So the central bank intervenes to buy government debt, and stop interest rates becoming excessive, then things are just fine, aren't they? But what about the excessive debt which caused the surge in interest rates in the first place? And what about the fact that it is not sustainable. And then there is the lack of economic growth which was producing the fiscal deficits in the first place. Are these problems fixed by the bond buying programme? Of course they aren't. That's why people talk about OMT buying time, and why I talk about deactivating the alarm system. The bomb has still to be defused. But where are the bomb squad? Oh yes, I forgot, they are called the "men in black", and a good job they have been doing of it in Greece.

Printing Money Is Inflationary And Good For Growth?

But let's leave all these secondary issues to one side, entertaining as they are, and go right back to Ray Dalio's best and strongest argument (since I'm sure he agrees with much of what I have just said). The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren't necessarily doing when they increase their balance sheet) ain't seen nothing yet. That's what the "it will be enough" promise means. None of this is in the mandate yet, naturally it isn't, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you're crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back.

As the US saw in Vietnam, the deeper you get in the harder it is to get out, since you plough-in ever more resources simply to go the course, and the losses you would have to accept to leave keep growing and growing, so you keep deciding to do whatever it takes.

So let's imagine this is what happens, and the ECB really goes to the imaginable limits and beyond.

Will it work? Will it be enough? Well this is where I think I find a flaw in Ray's argument, and it is a very common flaw to be found in the thinking of those educated in the US monetary tradition. Ray is assuming the ECB's eventual "money printing" will produce inflation, and that this inflation will help burn down the debt (often today this is termed "financial repression"). Whatever the pain this entails for bondholders, since in this case it is the central bank that is going to be the main bondholder (in our imaginary thought experiment) the outcome may not seem so objectionable from an investor perspective. After all, there are other assets they can get into.

Inflation, always and everywhere, so the argument goes, requires money printing to happen (whether via private or public debt), and in fact it seems to be the case of so far so good, it is almost self evident.

But is the argument symmetrical? That is, does it work the other way round?

Let's give an example. If I want to suffocate myself I need to deprive myself of air. If I don't deprive myself of air I won't suffocate. Fine. And if I deprive myself of air, does that mean I will suffocate? The answer is it depends, the absence of air is a necessary but not a sufficient condition. I need more conditions to be able answer adequately, even though I find it impossible to imagine myself suffocating without a lack of air.

Something similar happens with the inflation and money printing argument. It is unthinkable of having inflation unless someone somewhere is printing money, but does that mean that printing money always and everywhere leads to inflation. No it doesn't.

Worse, in one developed country after another across the globe a lot of money printing is going on, we just aren't seeing the inflation. Why could this be?

What's Going On In Japan?

Well arguably we have a canary in the coal mine here, since Japan has been printing money for more time than I care to remember, and we still see no sign of inflation. Quite the contrary, the country is plagued by deflation, and by the permanent threat of relapsing into recession. So, in this case at least, printing money is not self evidently being inflationary, neither does it seem to be working wonders for growth.

Really Japan is quite a remarkable case, since neither fiscal nor monetary policy seems to be working to achieve the anticipated results. This year Japan will have a fiscal deficit of around 10% of GDP and gross government debt will hit 235% of GDP, yet the country is still struggling to find growth. Instead of reiterating old dogmas (whether they come from Keynes or from Hayek) more people should be asking themselves what is happening here. This is not a simple repetition of something which was first time tragedy and is now second time tragedy, it is something new, and could well be a harbinger for more that is to come, elsewhere. Oh, why oh why are economists not more curious?

At the start of this century, at the end of the internet boom, some economists were warning that other countries could end up like Japan. Ten years have now passed and they have. ZIRP was once an oriental curiousity, now it is the central banking norm, and there are few signs of early exit.

Will Europe Follow Japan?

Basically I think it is only necessary to ask this question to have already found the answer. If Japan's demographics have got some important part to play in the drama which is unfolding there, then it is Europe which is most likely to follow, since the continent's demography is the closest to the Japanese one. Printing money would not be inflationary on the periphery, because there is little solvent demand for credit to generate it, domestic demand remains depressed and this situation isn't changing in the foreseeable future. And it won't be inflationary in Germany, because German domestic demand is just as exhausted as the Japanese variety is in terms of becoming a driver of the economy there. Indeed some peripheral economies have such rigid labour and product markets that headline inflation has stayed above that in Germany almost throughout the present crisis. Naturally, this is hardly good news.

So Will The Euro Likely Stay Together?

Which brings us to the crux of our problem, will money printing at the ECB (lot's of it, helicopters galore) save the Euro, or simply put back the "sell by" date? Really at this point in this blog post I don't want to reiterate the arguments I advanced in my Wolfson Prize entry, but I do consider they are more valid today than they were at the time I wrote it. The core of the issue is this. All participants ahve sunk costs from participation (whether hidden or self evident) which makes it very difficult for members states (at either end of the spectrum) to actively take the decision to leave.

On the other hand, few are convinced that the measures taken to date will actually resolve the underlying problems. They have simply stabilised the situation, and bought time. But time to do what? For the ECB to print money, if Ray Dalio is right. But as I am suggesting, the money printing will not resolve the issue, but will simply buy even more time.

However, when we come to consider how the story will end, many of the traditional versions of the future seem to have been disactivated. Countries will not leave in an orderly way, and markets will not be able to win the war with Mario Draghi. Ratings agencies remain a problem, but at this point they are unlikely to be decisive. But let's step back a bit. The Euro is a political project, and will sink or swim politically. Indeed, perhaps the most perceptive critic of the Euro experience in this sense has been Marty Feldstein, since he took the view from the outset that while the intentions of Europe's leaders was to use the common currency formula to bring the continent closer together politically, a more likely outcome would be that it drive the member countries apart.

This, indeed, seems to have been an insightful analysis, since even while Europe's leaders give the impression of unity, what is actually going on is a constant process of, often bitter, haggling (video link here). Haggling in which moral hazard type threats play a not insignificant part.

And the issue doesn't stop with the (often visible) disagreements between the various leaders, there is a growing distance between politicians and the voters they represent. The world's press are making great play today of this weekend's victory by Mariano Rajoy's Partido Popular in the Spanish region of Galicia, but perhaps the most significant point about these elections is that around half the voters didn't vote. Another example of a similar disconnect would be Wofgang Munchau's recent description of Bundesbank president Jens Wideman as the unofficial leader of the German opposition. So even if Europe's leaders give the appearance of moving closer together, it is quite apparent that the people they represent - whether in the core or on the periphery - are moving farther apart. The classical fault lines of European politics are disintegrating, and democracy is weakening not being strengthened.

To Vote Or Not To Vote In Catalonia?

The most recent, and perhaps clearest, example of this process is to be found in the growing tensions between Catalonia and the Spanish central government. This situation has more general interest for the current evolution of the Euro Area than the simple desire of one of Spain's regions for independence. It has more significance, since the frustrations currently being felt in Catalonia stem from the situation of being one of Spain's richer regions and having to bear what is perceived as being more than a fair part of the cost of the failure to resolve the Euro crisis. Catalonia is a net contributor to the Spanish fiscal system, and wants to make, at least, a smaller net contribution. The situation has been brought to a head by the fact that the region's income-to-debt ratio has risen to the extent that government bonds are ranked at junk status by ratings agency Standard & Poor's. Shut as it is out of the markets Catalonia has been forced to ask for a financial rescue from the central government, a rescue most Catalan's consider to be ridiculous given they feel they are only asking for some of their own money back.

Catalonia's economy has collapsed along with that of the rest of Spain, but the debate becomes a particularly poignant one given the growing feeling of desperation in the face of the inability of Spanish governments of varying political complexions to take the steps necessary to move the country forward. This frustration is now coupled with the growing awareness that more and more austerity is not the formula needed to restore the region to economic growth. As former Catalan President Jordi Pujol put it in an interview with the FT's David Gardner, “Europe without solidarity would not be possible, but at the same time an excess of solidarity would make Europe impossible.”

He was re-iterating here the view of German foreign minister Guido Weterwelle, to the effect that German pockets are not bottomless. What Mr Pujol was inferring is that Catalan ones aren't either. Naturally behind the Catalan independence drive there are also many identitarian issues, issues which are not easily soluble and which are making for a highly combustible environment inside Spain. But underlying the independence debate there lies a much deeper question. If Europe is moving towards a deeper banking, fiscal and political union, but moving far too slowly, why should an unfair share of the burden fall on the richer areas of the countries in the greatest difficulty? Why should more of the burden not be shared more equally and more quickly. This is not a uniquely Catalan problem, since similar issues are arising in Belgium (Flanders) and Italy (the Veneto among others). Europe is a continent of nations, and the Euro crisis is opening up the fracture lines.

My feeling is that market participants are not taking all this too seriously, and that could prove to be a risky bet. The consensus view was recently expressed in a research report from UBS analyst Matteo Cominetta (summarised by CNBC correspondent Liza Jansen here). The title of the report - Can Catalonia leave? Hardly - is suggestive, and reflects what I perceive to be the present market consensus.

The ins and outs of the issue are complex. Who, for example, would end up with responsibility for Spain's massive debt burden in the event of separation? Probably Spain it seems, unless it were willing to recognise the new state. In the event of non recognition, what sort of bailout would Spain need, and would the EU be willing to provide it if Spain didn't want to recognise its new neighbour? Would an independent Catalonia be inside or outside the EU and the Euro? This is at present unclear, the legal issues are tricky, but I think it should be remembered here that the ECB's initial legal report on Euro exit concluded that a country leaving the common currency would need to exit the EU, and I think there is now a consensus that this wouldn't need to be like this.

Largest of all looms the question of whether the new country (were it to exist) would automatically belong to the Euro, and have access to Eurosystem liquidity. Common sense says it would, whatever the letter of the law, since the region has a financial sector in the region of 500 billion Euros (or 2.5 times Catalan GDP - ie significantly larger than Greece) and some, at least, of the institutions concerned could be considered systemic. So unless you want systemic institutions collapsing........

Perhaps Cominetta's clinching argument (for him) is that the Spanish government has the legal right to prevent a referendum, or veto any forthcoming law on popular consultations (of the kind which just took place in Island). In fact, to prevent an "irregular" consultation the Spanish government could go further. As Cominetta points out, according to article 155 of the Spanish Constitution, Spain's central government has the power to stop a vote from going ahead if “a regional government does not comply with constitutional law” or “acts against the general interest of Spain.” “The Spanish government could even suspend Catalonia’s regional government".

Well, that's fine. The ECB could also expel Greece from the Eurosystem, but will it? And is this the best way of going about things? Arguably suspending Catalan autonomy and introducing direct rule from Madrid would be the quickest way of convincing those who are still in doubt that they want to vote for independence. Naturally the has to be an easier way of handling this problem than simply uping the ante, and hoping the whole Euro Area doesn't fall of a cliff in the ensuing uncontrollable and unpredictable chain of events.

Matteo Cominetta concludes his report as follows:

"We think after the Catalan elections on November the 25th the word “independence” will become suddenly rarer in Mas’ rhetoric".

In fact here he is already somewhat behind the curve. The word "independence" only appeared momentarily in President Mas's rhetoric, around the time of the September 11 demonstration. Since that time Mas has only spoken of Catalonia as"a nation which is now arriving at full maturity", a nation which to express that maturity will need what he terms the "instruments of a modern state."

Now the language he is using is very conscious language, and very precise. It should not be interpreted, as radical separatists in Catalonia are already doing, as some kind of backsliding. What lies behind his point, and it is a theme he stresses continually, is that the term "independence" is something of a historical anachronism in the context of the modern EU and Euro Area.

What Catalonia wants are the same instruments of state as all the other nations in the Euro Area have, nothing more and nothing less, but this doesn't necessarily mean "independence" as many have traditionally understood the term. It does mean, however, and for example, that as long as there are still national central banks to intermediate regional (by regions here I mean places like France and Germany) financial systems, then Catalonia as a nation which in coming to full maturity wants one too.

Naturally all this looks like a huge mess, and a growing one across the Euro Area. That is just the way it is going to be, but people should have thought about all the longer term ramifications before creating the Euro, since whichever way you look at it, the Euro and its problems form the backdrop to what is now happening in Catalonia. If full political union had been achieved first, this kind of thing would never have started happening. But it is happening, and the will of a people to express themselves in a vote won't be stopped by simply telling them they can't have one, a point which President Mas iterates and reiterates constantly.

So, the 65 trillion dollar question is, does President Mas have the majority of the Catalan people behind him when he advances along this road to acquire the institutions which go along with statehood? My opinion is overwhelmingly yes. About 75% of those expressing an opinion in the polls are saying they want a vote on self determination, even though Madrid is stressing that this vote would be made illegal.

How then does all this now start to pan out? Well first we will have elections next month. President Mas's party, CiU, will win, and the only issue is really whether they have an absolute majority or not. Between 60% and 70% of the deputies in the new parliament will be in favour of holding a vote, and of voting yes. And on the question of the vote the CiU programme is very clear, one way or another it will happen, and indeed they are holding these elections exclusively to get the mandate needed for that vote. So if they didn't have one the electoral process would have been meaningless.

But in one sense Cominetta is right. The coming confrontation isn't going to be about money, it is going to come be the right to have a vote. In my opinion the outcome of that vote when it is held is not really in doubt. However, instead of going off into the realm of conjecture, and speculation, and coming up with ever more grotesque scenarios, I think it is better to await developments, since they surely won't be that long in coming. The only sensible way forward I see here is for the EU, when it takes Spain in for a bailout, to act as intermediary, take the head of the table, and organise negotiations between the two sides. I think if they can't do that, then the Euro may well come under threat much sooner than anyone is contemplating.

So to answer the my own question set at the outset - "can Mario Draghi keep his pledge?" I would say, go ask the Catalans. There are some problems that simple money printing won't solve, and the quantity of these problems in the Euro Area is growing, almost by the day.

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

The Owl Of Minerva

Last week was the fifth anniversary of the outbreak of the global financial crisis. Not uncoincidentally it was also the fifth anniversary of continually rising unemployment in Spain , since it was in early summer 2007 that seasonally adjusted Spanish unemployment embarked on its steady upward path. And after it started climbing, naturally it hasn't stopped since. Indeed we seem to have at least another year of growing unemployment before us, maybe more.

Anyway, as if to celebrate this uncanny anniversary the Spanish government has decided to take the bold step of officially requesting an EU loan to recapitalise the country’s banking system. In addition, part of the money will be used to set up some form of bad bank with the objective of cleaning up some of the toxic property and other assets off the bank balance sheets. Smart moves both of them. Pity the people responsible weren't prepared to accept the need to do this five years ago, when unemployment was only running at 8%, and when the economy and Spain's citizens were better placed to accept the kind of burdens that are now about to be imposed upon them.

Just to round the commemorations off, in the August edition of their monthly bulletin the ECB finally let out that dirty little secret than every insider in the know has already discounted.  The Bank have finally accepted that the much heralded Spanish labour reform isn't going to work. At least not as planned. As the Financial Times put it, the Spanish labour market reform approved in February was “far-reaching and comprehensive” but came too late, the ECB implied, saying it “could have proved very beneficial” in avoiding job cuts if the measure had been passed some years ago.

Exactly. But once we recognise this point, isn’t that rather leaving the Spanish economy adrift in stormy seas without a rudder? Simply cutting the deficit back and cleaning up bank balance sheets won’t get the economy back to growth.

Indeed this habit of continually getting behind the curve, and trying vainly now that the economy is spiralling almost out of control to introduce measures which should have been brought in a decade ago extends well beyond the issue of labour reform. Take reducing the generosity of unemployment benefits. This is also something that should have been done years ago, since the two year allotment really did encourage people to refrain from actively seeking work in times of relatively full employment. But cutting benefits now, as the Rajoy government has just done, when unemployment stands at 25% and rising seems insensitive and even cruel. A government’s job is to introduce policies to create employment, not to cut benefits going to those who cannot find work in an environment where total employment is falling and has been doing so for five years. Quite frankly, if cuts have to be made, better to reduce pensions, but that is political dynamite, so it doesn't happen.

Again, reducing the fiscal advantages of home ownership made mountains of sense during the years of the property bubble, but it didn't happen. Now, with around two million housing units (between finished and uncompleted) needing to be found purchasers removing tax benefits on mortgages, increasing VAT rates on property transactions and raising the local property taxes - all of which make buying a homea lot  less desirable - looks very much like trying to shoot yourself in the foot. There is a lot of merit behind the desire to stabilise Spain's public accounts, but shouldn't we also try to remember why the country has this crisis in the first place?

Anyway, having recognised that the labour reform comes to late to really change course decisively this deep into the crisis - something incidentally which we much maligned macroeconomists have been arguing all along - what does the ECB propose to supplement it? Well, according to the bulletin "countries with high unemployment also needed to abolish wage indexation, relax job protection and cut minimum wages." Indeed the bank went beyond its usual practice of avoiding country specific commentaries to issue a direct prescription, saying it expected a “strong decline” in wages in Greece and Spain, countries which have the highest levels of youth unemployment in the eurozone, with more than 40 per cent of under-25-year-olds in the labour force out of work.

This strong decline in wages does not, mark you, form part of the kind of "internal devaluation" some of us have been arguing in favour of  for some years now, whereby a battery of measures are introduced to try and bring down both prices and wages at one and the same time. Not at all. July inflation in Spain was running at 2.2% compared to 1.7% in Germany. Prices in Spain are going up, largely due to all those tax increases laid down in the adjustment measures. Annual inflation will probably surge by around two percentage points in September as the new consumption tax rates fall into place. So it is only wages which are likely to be coming down, and this makes it all feel much more like 1930s type wage deflation than the sort of internal devaluation that has been being advocated (see my January 2009 piece "The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation" as a harbinger of all this).

Well, if you let things go to hell for the best part of five years, naturally the patient is in a poor state and in need of radical surgery. I won't say "I hope they know what they are doing," since I am pretty sure they don't. Perhaps I would rather say I hope Mariano Rajoy knows what he is letting himself in for when he asks for help from the ECB.

Talking of which, and turning to another of the "troubled" countries, Italy, I see Finance Minister Vittorio Grilli has come out today and confirmed two issues I was conjecturing about in my blog post only yesterday. In the first place he admitted in an interview in the newspaper La Repubblica that it was unlikely the country would meet this years deficit target due to the depth of the recession, and in the second one he confirmed my fear that getting agreement to ask for EU help would be much more difficult than Mario Monti recognised during the press conference he held with Mariano Rajoy at Spain's Moncloa Palace. Italy plans to wait for the ECB to act, and see what the measures look like, despite the fact that Mario Draghi has made it quite clear he will only do so after a request for assistance goes to the EU.

So instead of preparing a “battery of measures” to go to the root of Italy’s problems it looks like we what we may well face is protracted debate about how to avoid making any kind of formal  request. The latest idea to surface is that of trying to get ECB agreement for the Cassa Depositi e Prestiti, a state-financing agency controlled by the Treasury and managing some €220bn in postal savings deposits, to be allowed to use its banking licence to secure loans from the central bank in order to explicitly buy government debt. As the saying goes, this one can run and run.

Which all brings me to the main point I have been thinking about all weekend, which is why it is that policymakers find it so incredibly hard to see situations coming, and to take corrective action before the train crash occurs?

"One more word about giving instruction as to what the world ought to be. Philosophy in any case always comes on the scene too late to give it... When philosophy paints its gloomy picture then a form of life has grown old. It cannot be rejuvenated by the gloomy picture, but only understood. Only when the dusk starts to fall does the owl of Minerva spread its wings and fly".
G.W.F. Hegel, Preface to the Philosophy of Right

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

Rescue Me

I guess we will never know whether or not Mariano Rajoy uttered the two magic words so effectively immortalized in song by Fontella Bass that Saturday afternoon in late May as he cruised down the Chicago River in what Spanish media called a "Love Boat" ride, but one thing certainly is now clear, Angela Merkel has finally and definitively accepted Spain into the German embrace. Whether it will be a tender and loving one remains to be seen.

What is obviously true is that Spain is in trouble, and needs help. Five years after the Global Financial Crisis broke out unemployment is at 25% of the labour force (and rising), house prices continue to fall, non performing loans continue to rise in the banking sector, bank credit to the private sector is falling, and, as Finance Minister Cristobal Montoro said two weeks ago, the sovereign is having increasing difficult financing itself. Hence the bank bailout. On top of which Spain's economy is once more in recession, a recession which will last at least to the middle of 2013, even on the most optimistic forecasts, and is in danger of falling into the dynamic which has so clearly gripped Greece, whereby one austerity measure is piled onto another in such a way that the economy falls onto an unstable downward path, as austerity feeds yet more austerity. Spains citizens are naturally nervous, anxious and increasingly afraid. Hardly a dynamic which is likely to generate the kind of confidence which is needed for recovery to take root.  

The economy is steadily seizing up as the release of pressure (which was previously facilitated through the devaluation mechanism) which it badly needs cannot take place. All the dials move to red, but there is no safety valve available to drain off steam, so the danger of the boiler exploding through the giving way of one joint or another grows with each passing day.

No Mea Culpa From The ECB

Advocates of the proposed Euro Area debt redemption fund - which would pool all government debt over the 60% of GDP permitted under Maastricht - do so using the argument that we should treat the first ten years of the common currency's existence as a "learning experience". Fine, but what exactly have we learnt? Surely almost everyone who has read at least one article on the Spanish crisis now knows that the issue in Spain is private not public debt. But just how did countries like Spain and Ireland accumulate all this debt? Well one thing should be clear by now, part of the responsibility for the situation lies with the ECB who applied (as they had to) a single size monetary policy even though this was clearly going to blow bubbles in the structurally higher inflation economies. And so it was, Spain had negative interest rates applied all through the critical years, and now we have the mess we have.

Back in 2006 inspectors at the Bank of Spain sent a letter to Economy Minister Pedro Solbes complaining of the relaxed attitude of the then governor, Jaime Caruana (the man who is now at the BIS, working on the Basle III rules) in the face of what they were absolutely convinced was a massive property bubble. Their warning was ignored. What could have been done, many say. Well, at least two very simple things could have been done, and well before things got out of hand - on the one hand apply much stricter loan to value and income documentation rules which offering a much higher proportion of fixed interest rate loans (quotas could have been applied), and on the other insist the Spanish government run a much higher level of fiscal surplus to drain demand from the overheating economy. Of course, the politicians were not interested in hearing about any of this, since as measures they would have been highly unpopular, but where were M Trichet and his colleagues? They were too busy presenting Euro Area aggregate data to be willing to warn about growing imbalances between the individual economies. Now of course, the imbalances are undeniable, and the ECB is having to implement an asymmetric set of collateral rules (among other things) to try to counteract their impact.

The Root Of Spain's Problem Was The Property Bubble, But The Key To The Solution Is Restoring Competitiveness

Internal demand in Spain is imploding. This is not surprising, with household debt just under 90% of GDP and private corporate around 120%, it is clear that both sectors badly need to deleverage. Classically the way to do this is by devaluing and boosting exports to sustain growth. But Spain is in the Euro, and has no money of its own to devalue. The common currency makes it very easy to generate distortions, and much harder to correct them. In that sense it is systemically biased towards negative outcomes, something the founders of monetary union didn't give enough thought to. The key institutional stabilisers - a common banking system, a common treasury, and a central bank capable of targeting interest rates on all the participating sovereigns - weren't in place from the start, and even now are considered controversial, so the constituent economies have a lopsided tendency to veer either one way or the other.  

Spain's export companies have put in a heroic effort since the crisis began, and export levels have well surpassed their pre crisis peak. The problem is simply that, after years of neglect, the sector is now just too small to do the job which is being asked of it. Exports surge, even while the economy does not.

A very different state of affairs from that seen in Germany, where a revival in exports leads to strong growth. Advocates of the "competitiveness" of Spain's economy should ask themselves "why the difference?".

 

Another interesting comparison comes from a nice measure of capital goods investment - spending on machinery and equipment. In the German case such spending recovered sharply after the crisis, even if it has recently tailed off again as the global economy has steadily slowed.

In the Spanish case however, the recovery was muted, soon ground to a halt, and then tapered off again. That's what competitiveness means, ability to sell in sufficient quantities in global markets. Germany has it, Spain doesn't, and all the rest is simple pedantic casuistry. Or ask yourself, why is Germany bailing out Spain, and not vice-verse? Come on!

Half Finished Business
In fact, Spain has clearly carried out part of the needed correction. The current account deficit is less than half of what it was.

And the trade deficit has been reduced.

 

But all of this is relative. There is still a long way to go. If we look at industrial output, we will see that far from having revived it is way below the pre-crisis level, and is now falling back again.

And its the same picture wherever you look. Unemployment keeps rising.

And in recent months, as the country falls back in recession, it has been doing so at an accelerating rate.

House prices keep falling, and again at an accelerating rate. According to real estate valuers TINSA they have now fallen something like 30% from peak, and credit rating agency S&Ps estimate they have another 25% to fall, although the truth of the matter is no one really knows, since stopping the housing slide involves fixing the economy, and fixing the economy involves stopping the housing slide. Such is the double bind which Spain economic policy finds itself in. And the problem posed by falling house prices is an important one since, as we will see, the whole effectiveness of the bank recapitalisation process involves putting a floor under house prices.

Meanwhile there is little sign of credit moving in the economy, and mortgage lending outstanding is dropping by something like 2% a year.

With the evident result that there is little sign of house sales improving, despite the fact that there is now a backlog of something like 2 million unsold homes either finished or in the process of being built.

Naturally in this environment it is not difficult to understand that people are having difficulty paying their bills. Bad debts held by Spanish banks rose to yet another 17-year high in March. According to data from the bank of Spain, 8.37% of the loans held by banks, or EUR147.97 billion, were more than three months overdue for repayment in March, up from 8.3% in February--the highest ratio since September 1994. The total number of non-performing loans is now almost 10 times higher than the level reported in 2007, when Spain's decade-high property boom peaked. And of course, this steady increase will continue for as long as the economy is not fixed.

And to cap it all, the uncertainty over the future of countries like Greece and Spain is now bringing the whole global economy steadily to a halt, and this is boomeranging back on Spain, since it hits exports directly. In fact, Spain's exports have been down on an annual basis since February.

What's In A Name?

Whatever name you give to the EU financial support for Spain, one thing is clear. Spain alone was unable to go to the financial markets and raise the 100 billion Euros or so it needs to meet the capital requirements of its banking system for 2012/2013. The country’s leaders wanted one of the European funds (the EFSF perhaps) to inject the money directly into the banking system, but Europe’s leaders said no, it would need to be the Spanish sovereign that borrowed (via its bank reorganization fund FROB), and responsibility for repayment would lie with the Spanish state.

So, five years after one of the largest property bubbles in history burst, with an economy which has fallen by around 5% from its pre crisis peak and is now expected to contract by around another 2% this year, while unemployment is hitting the 25% mark, Spain has finally had to accept that it cannot manage alone.

Whatever way you call the aid Spain is now receiving from Europe it is clear that this is the beginning and not the end of what is likely to be a long process, one which will now inexorably lead to either the creation of a United States of the Euro Area, or to failure and disintegration of the Euro. There will be no middle path, so the stakes are now very high for all involved.

Unfortunately Europe's leaders are still too busy thinking short term, and practicing one step at a time-ism. In a pattern that has now become so familiar since the crisis started back at the end of 2009 with the Greek deficit problems, they are so concerned about negotiating the details of how to handle the next stage that they tend to miss the bigger picture. Essentially there are three key players in the present situation - the EU in Brussels, the German government in Berlin, and the Spanish administration in Madrid.

All three have probably walked away feeling satisfied they have gotten something out of this latest deal. The EU leadership in Brussels have long wanted to draw Spain in. After months of issues about number quality relating to both public finance and the financial system, they will now feel they have a firmer grip on the situation. They will also be perfectly well aware that Spain's financing needs go well beyond the 100 billion euros which has been agreed to as the current ceiling.

At the time of writing it still isn't clear just how much of this will be injected initially. Press leaks suggest that the figure could be between 60 and 70 billion Euros, slightly more than the 40 billion euro number recently given by the IMF. This is more or less in line with a recent report from Standard and Poor's, which said they anticipated losses in the Spanish banking system before the end of 2013 of between 80 and 112 billion Euros. Naturally recognising these losses up front now will present Spain's banking system with a difficult challenge. As Standard and Poor's say:

"In the event that banks are required to recognize provisions for 2012 and 2013 already this year, the amount of capital support that the banks could require could be substantial. This is because banks would face greater difficulty to absorb the impact of required provisions in such a short period of time with anything other than excess capital over the regulatory minimum. In this scenario, and assuming no changes to minimum regulatory capital requirements of 8% or 10% of core capital plus the buffer established by the Royal Decree 2/2012, we would expect that only Banco Santander, Banco Bilbao Vizcaya Argentaria, and CaixaBank would have capital levels comfortably above the regulatory minimum. The remaining banks in the system would likely face significant challenges to remain compliant with the abovementioned minimum regulatory capital requirements, in our view "

Three points need to be made here. The first is that what we are talking about is provisioning against anticipated losses and writing down problematic assets over the two year 2012/13 period - if the economy doesn't recover and house prices continue to fall (both highly probable given the policy mix currently on the table) then further injections will be required over the 2014/15 period - although this is very academic, since the future of the Euro will more than likely have been decided one way or another by that point.

Secondly, there is the issue of how those banks who don't apply for government funds will do the necessary provisioning. Apart from operating profits, the only real measure on the table is what is colloquially know as a "bail in", whereby owners of hybrid instruments like preference shares and subordinated bonds are forcibly converted into equity. Now Spain is already reeling under the scandal of what many consider to have been regulatory negligence as the insolvent bank Bankia was allowed to go to Initial Public Offering on the Spanish stock exchange. As the Victor Mallet writing in the Financial Times put it:

The Bankia saga has prompted thousands of angry savers to consult lawyers and pressure groups, and is expected to lead to a flood of lawsuits that will cause new headaches for the government, as well as for banks and regulators already struggling to deal with the eurozone’s sovereign debt crisis. This and other cases involving billions of euros worth of products sold by Spanish banks to their retail clients will complicate any effort by bank managements or European regulators to impose losses on shareholders and bondholders to reduce the bill paid by Spanish and other European taxpayers for bank bailouts.

The debacle at Bankia, however, is merely the latest and most grievous blow inflicted by banks and cajas on Spaniards who were sold or mis-sold lossmaking financial products by their local branches.

In March, a court in Alicante ruled that Santander should return money to a client who invested in its so-called valores bonds, of which it issued €7bn in 2007 to finance the purchase of its share of ABN Amro. The Santander bonds are typical of the controversial convertible products sold by many Spanish banks, except that they are due to convert into equity at a fixed price of over €13 per share in October – and because Santander shares are now worth just over a third of that, the 139,000 retail clients who bought them stand to lose most of their capital.

While details of the bank rescue package and its impact on bondholders have yet to be worked out, most analysts are busy speculating that subordinated debt holders will be forced to contribute to the recapitalisation effort. But as I say any such "bail in" would involve subordinated debt holders - and in particular holders of hybrid instruments like preference shares - taking losses. The hierarchy is just like that, you can't haircut seniors before you have hit "juniors".

These are the banks own customers, who were basically sold the instruments on the understanding that they were "just like deposits" and very low risk. Bank of Spain inspectors warned Minister Pedro Solbes in a letter in 2006 that these very instruments were being sold to finance high risk developer loans, but no action was taken. Far from making irresponsible investors pay this measure would penalise the very people who help keep Spain's banking system together, those small savers who forwent going for holidays on credit to Cancun,Thailand or Japan, and failed to increase their mortgages in order to buy lavish SUVs in an attempt to save for their retirement. These are the people who now face the prospect of losing their precious savings to cover the losses generated by those who did both of the above.

Hence the sort of bank "bail-in" EU regulators want, is politically impossible in Spain, especially after the Bankia scandal, and Mariano Rajoy knows this only too well. Only the Swedish path of direct nationalisation and subsequent resale is open to Spain. Unless, of course, your objective is to totally politically destabilise the country. As is evident, Spain's developers who offered no guarantee for their lending beyond the property are now handing back the keys and assets as fast as they can, while individual mortgage holders who guaranteed the mortgage with their lifetime salary struggle to pay down mortgages which are often now worth twice the market value of the property they are associated with. If this manifest injustice is also followed up with a wipe out of small savers while large institutional bondholders walk away scot free, well I think the next best thing to a populist revolution is what you are likely to see.

It is still unclear what conditions will be attached to the loans to cover capital needs which total around 60-70 billion euros, according to a source close to an audit of Spanish banks due to be completed on Monday. Forcing losses on junior bondholders is currently illegal in Spain, but legislation could be rushed through in an emergency situation, as it was in Ireland, lawyers and economists say. However unlike Ireland, where junior bondholders suffered losses of up to 90 percent at Allied Irish Banks and Bank of Ireland during state bail-out processes, a large part of Spanish banks' subordinated debt was sold to bank customers as savings products. Barclays estimates 62 percent of subordinated bank debt is held by retail investors in Spain, stripping out Santander and BBVA, compared to 34 percent in Ireland. Sonya Dowsett and Helene Durand writing for Reuters

Naturally, the details of the loan conditions are still being negotiated, and will be become clearer as time passes. At this point I would simply emphasise three things. Firstly the money the country has asked for is not a problem fixer. It is a stopgap to enable Spain's banks to maintain capital levels as losses are crystalised over the next two years. In this sense the money addresses one of the symptoms of the problem, but not the root of the problem itself. What we can now certainly say is that Spain's banks will be well capitalised through to the end of 2013.

But credit isn't flowing to the private sector in Spain, and these funds will do little to change that situation. So this is the second point I would make, to get credit moving again a necessary (but not sufficient) condition will be deleveraging the banks - which have a loan to deposit ratio of something over 175% at present - and achieving this deleveraging most certainly means taking some of the problematic property assets off the balance sheets, to be "ring fenced" and deposited in a Nama style bad bank, for example, following the line of the reports the Spanish economy Ministry were recently reported to be studying. Doing this will need finance even after these troubled assets have been written down - it is hard to put a number till we know the extent of the write down, but 200 billion Euros would be a conservative estimate, so furbishing that finance may well be the next stage in the bailout.

Then, thirdly, we have the sovereign funding issues. As is well known foreign investors have been exiting their Spanish debt holdings, and there is no reason to imagine this posture will change. Spain's banks have been filling the gap by using LTRO liquidity to buy government debt, but there has to be a limit to this process, otherwise the banks will be as bust with the bonds as they are with the property. In fact Spain's bank dependency on the ECB is growing with every passing month, and hit 288 billion Euros in May.

But the inescapable error is in failing to inject the money directly into the banks as equity, routing the money instead through the Spanish government. By doing so, the European authorities are intensifying the “doom loop”, as one analyst puts it.


That link was already redoubled when the European Central Bank’s December and February longer-term refinancing operation led to Spanish banks, far more than most, recycling the cash into sovereign bonds – buying €83bn since December. Spanish banks account for a more than a third of Spanish sovereign bond ownership, nearly double the tally five years ago.


The increase has helped offset international investors’ dimming faith in Madrid – making Spain’s banks a valuable stabilising force in the country’s economy. Without them, Madrid would have little hope of financing itself. But it is a delicate and dangerous balancing act, for the banks and the country. And this bailout could be the tipping point. As well as cementing the government’s vulnerability to the banks as it transmits the bailout money to the weakest operators in the sector, there could be yet another layering of sovereign investment going the other way.
Patrick Jenkins, writing in the Financial Times

So financing Spain's bond redemption needs between now and the end of 2015 – something like 200 billion Euros - plus the deficit (another 100 billion Euros, at least) will be the third bailout stage. Royal Bank of Scotland analysts headed by Alberto Gallo put the full ESM package size needed to get Spain through to the end of 2015 at between €370billion and 455billion. This seems a perfectly reasonable estimate to me. As I said, removing property related assets from the balance sheets is a necessary but not a sufficient condition for getting credit flowing. The other condition is having solvent demand, which means getting the economy moving again, and this means addressing the competitiveness issue. If the economy isn't turned round then property prices will continue to fall, and the banks will continue to have losses, which means at the start of 2014 we will need another round of capitalization just to cover for the losses to be anticipated in 2014/2015, and so on.

Approaching The Psychological 100% Debt To GDP Threshold

As I have been saying, Spain's debt problem was primarily one of private debt. In 2007, when the crisis started, Spanish sovereign debt was a mere 36% of GDP. This year, once the 100 Billion Euro loan for the banking system has been accounted for it will probably be very near to 90%. At the very latest it will pass through the 100% level in 2014 (that is to say, assuming there are no more "unexpected losses" to be added in the meantime - for a full account of the background to all this, see my Homeric Similes and Spanish Debt post). And it won't stop there. As long as the economy isn't fixed and returned to growth the level of public indebtedness will continue to grow, as private debt steadily gets written down and shuffled across to the public account. If the country moves to budget deficit zero, then if the competitiveness problem remains the economy will simply contract, and probably contract and deflate, which will mean the ratio will rise even without more deficits, as we are seeing right now in Italy.
 

But we are getting ahead of ourselves here since we still don't know how Spain and the Euro are going to get through to the end of 2012, let alone where we will be in 2014. Obviously accepting that Spain needs a full bailout is going to be hard for the German leadership, but the alternative of Spain Euro exit and default will probably prove even less appetising for them. After several years of neglect and refusing to face up to issues, talk is in the air of internal devaluation to address the loss of competitiveness Spain suffered during the boom, but so far nothing has been done. Maybe this is the next reform Brussels should be discussing with Madrid, the most recent IMF proposals certainly point in this direction . Beyond all the talking, if Europe's leaders really do want to save the Euro, and not have Spain go back to the Peseta to devalue, then one day or another this internal devaluation will have to happen or the Spanish economy will simply never recover. If it doesn’t recover then the issue will not be simply saving Spain but rather how to save the global economy when the Euro then finally falls apart. Time is now running out, as Christine Lagarde recently reminded us. I think she and Soros are being a little unfair - they have till Christmas.

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