Homeric Similes And Spanish Debt

"Nihil sapientiae odiosius acumine nimio" (Nothing is more hateful to wisdom than excessive cleverness)
Petrarch, "De Remediis utriusque Fortunae"

Like Leo Messi charging his way through a packed Real Madrid defence, twisting now this way, now that, never stopping without being stopped, so did the Spanish sovereign debt surge forward, breaking directly into the red zone near the penalty box, provoking confusion and consternation amongst horrified EU officials and regulators forced to look on as it blindly sought to touch down somewhere well beyond the authorised 100% finishing line.

Spain's deficit has been much in the news in recent days. Both the target for this year and actual details of last year's outcome have been the source of much comment, scrutiny, and consternation, but the deficit itself will not form the primary subject matter of this post. What we will be concerned with here is debt, sovereign debt, and the current trajectory of the Spanish variant. In a recent article in the Financial Times Victor Mallet draws attention to the situation and shows how an excessive emphasis on deficits may sometimes mislead people into missing the bigger picture, since at the end of the day deficits are only interesting as they add to debt, and in the long run what matters - as we have seen in the Greek case - is whether or not the debt itself is sustainable.

Now Victor quotes me on two counts: the real size of Spain's debt, and the effectiveness of Spain's institutions.

“Spanish sovereign debt is already over 80 per cent of GDP,” said Edward Hugh, a Barcelona-based economist. “I think it’s getting nearer 90 per cent"......Mr Hugh also said the situation in Spain could not be compared to the confusion in the public accounts of Greece because much of the Spanish data are public and made available by the Bank of Spain, or can be deduced from official sources. But he added that the centre-right government’s transparency risked curbing Spain’s room for manoeuvre should the crisis deepen further.

Well, while it's the first claim that is controversial and in need of justification (and believe me Victor Mallet demanded to see the justification for the numbers before putting up the quote) let's start with the second one first as it forms an important part of the background. I think it is very important to understand that Spain is not Greece, in the important sense that the people in change do in fact normally know what is going on. They have auditors and inspectors whose job it is to know, and they do do their job. So the Bank of Spain know virtually everything there is to know about each and every one of Spains many banks and savings banks, about the state of their balance sheets, about the level of bad loans, etc etc. Naturally, knowing what they do, what they tell you is another matter.

Similarly in the case of the public administration, auditors and controllers are in place to constantly measure and follow the exectution of the annual budget at all levels, but again what they know is often one thing, and what they actually say publically is another. When Spain's bank regulators become worried about specific cases they try their best to put on a brave face and maintain confidence while looking for solutions somewhere behind the curtain. Similarly with the public administration, although in this latter case there may well be political reasons for allowing an overspend to continue, or even for encouraging it.

Let me take another example, from an area outside the financial system and beyond the realm of public finance: migration statistics.  Between 2000 and 2008 around 6 million irregular migrants arrived in Spain attracted by the prospects of work in the then (house) booming economy.

We know with some degree of accuracy the number of such migrants present (although not authorised to be) in Spain due to the existence of a system known as the "Padron Municipal" (or Municipal Register) which is managed via an electronic database. So we know how many migrants register, but how do we know that the migrants always register? Well this is the part which is "typically Spanish", since a far from innocent circularity has been created - all those present in Spain are entitled to free health treatment in the public health service, but in order to have a health card you need to register with the Padron Municipal. In addition, registration adds to the possibilities of being able to regularise your situation later, so the first thing virtually every migrant does is go to register. You see, that way the central adminstration has all the data to hand.

Well, you may say, that is fine, but how do we know the register doesn't overstate the number of migrants? In fact, at one point it did, since migrants were only obliged to confirm their continuing presence every two years. That was when the focus was on measuring who was coming in, but since the economic crash and the massive surge in unemployment, for a variety of reasons the emphasis has moved towards measuring who is still here. So the interval for address confirmations and things like that has changed, and most of those who don't have residence rights are now required to confirm their presence every few months, which means that Spain has some of the most accurate data on migrant flows to be found within the confines of the EU (and possibly anywhere).

Now, you might say, why be so meticulous in collecting all this information, why not follow the UK example, and require all those who lack authorisation to be in the country to leave? Well, this is Spain and not the UK (or Greece) and this is the point of the present rigmarole I am explaining, to give an idea of how things work in Spain, not to offer an analysis of the migration policy. Understanding that you can accurately measure something that officially doesn't exist is the key to understanding how the financial and public administration systems work, and unless you "get" this part, you will be lead astray by almost everything else.

The Omnipresence of "Dinero B"

Now, on the public accounts issue itself , I actually started digging into all this in the summer of 2010, and indeed posted an interim "report" at the time. So it is something of a mystery to me why all the hedge funds, journalists and bank analysts have taken so long in waking up to the existence of  "Spain's regional and local debt problem", especially since all the information on the topic is freely available on the Bank of Spain website. It seems to me that people see what they want to see at any given point in time, and this is the point of the Petrarch quote which starts this post. It comes from an Edgar Allen Poe short story, the purloined letter, and to cut a long issue short, a letter goes missing which no one can find, and the reason they cannot find it is precisely because it is lying there, right before them, on the living room mantelpiece.

"Nothing" remember, "is more hateful to wisdom (astucia) than true cleverness", which means if you try to go rummaging round round Spain for Goldman-Sachs-style interest-rate-swaps you will almost certainly leave empty handed. Handiwork here is all much simpler, and more artesanal than that, and therein lies the beauty and the sophistocation of the thing.

Hence, if you are someone who is really interested in trying to answer the question about just how high the present level of Spanish sovereign debt actually is (officially it was to have been 67.8% of GDP in December, but that estimate was made before the latest set of budget deficit "revelations" and when the estimate of 2011 GDP was rather higher than it turned out to be, so it is probably nearer to 70% now, even on the official Eurostat EDP measure) you should start here, with the Financial Accounts of the Spanish Economy. The part you really need is Chapter Two the "Financial Accounts" - actually, I will add in a small but revealing personal anecdote here, since when I sent all these links off to the IMF Spanish Mission Head back in the spring of 2010 he mailed me back saying "thanks a lot" - he plainly didn't know that this sort of thing existed., although the Spanish head of Global Financial issues for the IMF  - ex Bank of Spain man José Viñals - most surely did, but he simply hadn't seen fit to brief his colleague. As I say, this is how Spain works, you have to ask the right person the exactly right question, and make sure you don't get sidetracked. Otherwise you will learn nothing apart from a lot of useless and most likely thoroughly misleading  information.

But before we did down any deeper, just to let us all see where we are, why don't we make a small detour to Chapter 11 of the Bank of Spain's Statistical Bulletin, on General government liabilities. Excessive Deficit Procedure (EDP) debt. Now if we examine section 11.3  Liabilities outstanding and debt according to the excessive deficit procedure. Absolute values, we will find this most iluminating table.

Two important points should be drawn to the attention of the studious reader immediately, the fact that the right hand section refers to the Excess Deficit Procedure (EDP or officially recognised Eurostat) debt, and that the totals at the bottom of columns one and 15 are different. The number at the bottom of column one is approximately 877 billion Euros (or around 85% of Spanish GDP) while the number at the bottom of column 15 is 706 billion Euros, and this is the official Eurostat debt. So what makes for the difference? Well, as we will see, there are three main items - unpaid bills, public company debt, and Spanish sovereign bonds which are in the hands of the Social Security Reserve Fund. Now before going into all this further, I do want to make clear that I am not saying that this 877 billion euros is the total Spanish debt which should be counted as such. The number is simply orientative - a lot, but not all, of this is debt which will need to be consolidated - but in fact, and in addition, there are other "contingent liabilities" which will also need to be added in to get a complete reading..

But let's go one step at a time, and why not start with those famous "unpaid bills". Well, according to the Financial Accounts, at the end of the third quarter there were 72.9 billion Euros in unpaid bills (around 7% of GDP) which were more than 30 days overdue owed by the entire public adminstration (see this file here, bottom right second page - in fact there is a total of 87.5 billion Euros owing, but 14.6 billion is still within the term of normal trade credit). This breaks down as 27.7 billion Euros on the part of central government, 20.8 billion Euros from the regional governments, and 14.9 billion Euros for the local authorities. Much of this debt has been pending for months, if not years. It also makes the number of 35 billion Euros which is being bandied about in Spain for the credit lines to local authorities and regional governments seem quite reasonable and realistic. Of course, the central government itself still will need to put its own house in order.

The second main area of non-consolidated debt is the money owed by public companies, many of them loss making, and often entities which have been created without rhyme or reason at both regional and local authority level. As of the end of the third quarter of 2011 this debt amounted to 57 billion Euros (or 5% of GDP - see the memorandum item on the far right in this file), of which 32 billion Euros was attributable to central government, 15.5 billion Euros belonged to regional governments, and 9.4 billion Euros came from companies created by local authorities. There is no plan at present for dealing with all this accumulated debt.

Then, thirdly, we come to the social security reserve fund. Ai, the social security reserve fund! This is where the Spanish are supposed to be accumulating resources to help pay for their pensions. But the Eurostat accounting system being what it is, this is the last thing that is happening. Now according to this last report from the fund managers, at the end of 2010 the fund had assets valued at just under 65 billion Euros under its charge. Of this sum 56.6 billion Euros (or over 5% of GDP)  were invested in Spanish government bonds, while 7.8 billion Euros were invested in bonds of other EU states (principally Germany, the Netherlands and France).

Now doubtless the only reason the fund decided to invest the money it was holding in Spanish government bonds wasn't to help the administration hide some debt, probably the fact that risky Spanish bonds pay more than less risky German ones was also a consideration. But this whole thing is a farce, since while the Spanish people innocently believe that they have a partially funded pension system, nothing could really be farther from the truth. In general accounting terms the whole security area comes under the general budget, as was brought to light in the recent deficit numbers the new government brought to light at the start of January. Out of a total of 2.5% of GDP in unexpected deficit, 0.5% came from issues associated with the social security fund - which anticipated a surplus of 0.4% of GDP but finally turned in a deficit of 0.1% of GDP, as can be seen in the nice chart provided by the Ministry (below).

The shortfall was due to a number of factors. In the first place those newly entering the system are paid far more than those who are leaving (due to death or other reasons) - 35% more in fact, since the average monthly payment in 2010 was around 800 Euros, while the average payment to new entrants was 1,100 Euros. Secondly Spain's demography is working against the fund, since as the number of those working falls, and the number of elderly dependents rises, the ratio between the two falls. It is currently at around 2.4, and many experts estimate that the pension system will turn critical when the figure drops below 2.

Currently there are just under 17 million contributors, but the position is worse than it seems, since of these three million are unemployed, with their contributions being paid by another department, and these contributions will terminate when the individuals concerned exhaust their unemployment entitlements. According to Spanish public pensions expert José Mario Paredes Rodríguez, "the data on contributor pensioner ratios is totally misleading" given that the government continues to count as contributors those for whom it is making payments the "calculation is completely unreal since what we need to know is how many people are actually working per pensioner being supported.

So we really have a clear "robbing Peter to pay Paul" type situation, where the numbers are juggled but the debt remains. This risks associated with this situation was brought to light in the recent Greek debt restructuring, since one of the key issues driving Greek politicians to the negotiating table was the threat of seeing their pension fund reserves going up in smoke in the event of a hard default.

According to the Wall Street Journal:

"The total portfolio of Greek bonds that the Greek pension funds hold  is EUR27 billion," Venizelos said. "That portfolio is being replaced  with cash, with new, better bonds of much higher net present value and, further, the parliament has already approved the creation of a special public body through which to transfer public assets to the  funds," he added.

And to Bloomberg:

"The dilemma we are faced with is cuts so that we can stand on our own two feet, to save the country’s pension system and pensions, or economic collapse,” Finance Minister Evangelos Venizelos told opposition party lawmakers in Parliament today. Without the debt swap, the country’s pension funds would be wiped out, he said. The country’s central government debt, which doesn’t include debt  from local government organizations, state-run companies or pension  funds, was 368 billion euros at the end of 2011, the ministry said  today, amounting to 171 percent of the economy, according to Bloomberg  calculations".

So just what is the current level of Spanish debt? Well, if we do a rough-and-ready back-of-the-envelope type calculation, and start from the fact that Eurostat debt is currently about 70% of GDP, then add on 7% for unpaid bills, and 5% for state company debt and 5% for debt held by the pension fund, then we come to a total of around 87%, which looks un-nervingly like the 877 billion Euros we noted in the Financial Accounts in the first place.

And Then There Are The Contingent Liabilities


The trouble is, this still isn't everything. We also have the contingent liabilities of the state to think about. This - a groso modo - comes in four forms: bank debt guarantees, exposure to the financial system via FROB, the government Instituto de Credito Oficial (ICO) and the Electricity Tariff Fund FADE.

On the guarantee side, the latest data we have is for a total of 88.6 billion Euros at the end of the third quarter of 2011, but this number is almost certainly higher now, since the government has been guaranteeing debt on a number of fronts with the unique and exclusive objective that they could be taken over to the ECB to post as collateral in the LTROs. In any event, it is the Spanish state (and not the ECB) that is finally responsible for these loans should the relevant bank or other entity be unable to live up to its commitments.

In the case of  FROB (Fund For Orderly Bank Restructuring) the true extent of the government's exposure is hard to measure, since while the quantity actually provided by the fund to date is not large (14.8 billion Euros - see this presentation - and 9 billion Euros of FROB debt has been pre-capitalised) a number of savings banks are effectively nationalised while others that are dependent on FROB for loans may well need further intervention. So all we can safely say here is that the number involved is hardly trivial, and on just how "non trivial" the final number is the whole future of Spain's soverign debt will ultimately depend.

As far as the ICO goes, the organisation currently has an exposure of 27 billion Euros, all guaranteed by the state. Now much of this money has gone out in lending, and much of that lending will be returned, which is why this is a contingent liability. At the same time the present administration clearly see an enhanced role for ICO (helping the regional governments clear their backlog of unpaid bills, for example), and it is likely that the volume of debt will continue to grow.

Finally, we have the so called Tariff Deficit fund, or FADE (Fondo de Amortización del Déficit Eléctrico). Now despite the name, one thing the debt generated by this body doesn't do is fade (away), since it is growing month by month and year by year. The position is described in the literature as a debt being accumulated by consumers (some 24 billion Euros of it) which is guaranteed by the government. Like the state of their savings in the pension system, most electricity consumers are totally ignorant of the fact that they are acquiring this debt, or better put, that it is being acquired on their behalf. Essentially the situation arises since the government is reluctant to charge an economic price for electricity. Naturally, in a country running an energy driven current account deficit this is a highly questionable practice, but then, there you are.

Basically every month less money comes in in bills than is attributed to the accounts of the electricity companies. The shortfall is made up by borrowing. This borrowing is serviced - you got it - by taking some of the income from electricity bills. But naturally, as the deficit grows - currently it is about 24 billion Euros - more of the income stream is needed to service the exisiting debt, and - yup, you got it again - the deficit grows. The only real solution to this mess is to raise electricity tariffs, but in an environment of rising unemployment and falling wages there are going to be limits to what the government can do in this regard. So while I am sure that the EU will eventually insist tariffs are raised, it is hard to see them being raised far enough to pay off the accumulated debt, and so the government will almost certainly need to "swallow" this, which means - yup you got it again - another 2% or so on the debt account.

Just to round things off, there are some other little details, like public private collaborations in infrastructure. Take motorways for example, many of these (especially around Madrid) were planned at the height of the boom, when traffic was intense - the private sector are of course paid according to the number of cars who use the motorway. Now with the crisis the volume of traffic has fallen considerably everywhere (this is one of the few advantages I have noticed of all this difficult mess, it is now much easier to move around in Barcelona). And with the fall in traffic, incomes have fallen, to such an extent that the participating companies are no longer able to service their debt. Experts suggest the total quantity involved is around 4 billion Euros - peanuts you may think in comparison with the other things we are looking at, but as they say in Spanish "todo suma".

Much Ado About The Deficit

Now as Victor Mallet says, the basic motivation behind recent moves on the Spanish adminsitration front would seem to be to start to move this large backlog of debt (especially at the regional and local government levels) onto the table.

Madrid plans to arrange payment of up to €30bn in overdue bills for rubbish collection and other services owed by municipalities, a move that will benefit suppliers but will also help to expose the true size of the country’s public sector debt.

“It’s about restoring order, it’s about knowing what’s there and dealing with it once and for all,” Maria Soraya Sáenz de Santamaría, deputy prime minister, said after a cabinet meeting on Friday that agreed the first part of the programme.

But the great risk they are taking in doing this is raising the acknowledged debt level, up towards the "high risk area" of around 100% of GDP. When you add all the debt up we are already in the high 80% range, and two more years of "normal" deficit plus more funding for the financial sector should take it through the psychological barrier. Naturally investors are noticing this, and Prime Minister Mariano Rajoy's "gaffs", and at the end of last week the Spanish ten year bond spread with the Bund equivalent went above the Italian one for the first time since last summer.

So Spain is on a bad course, with recognised debt about to surge rapidly, while investor confidence in the current administration is slipping. Time for another "gamechanger" I think, since otherwise this car is about to crash.

Her mind in torment, wheeling like some lion at bay, dreading the gangs of investors and bond traders closing their cunning ring around her ready for the finish, Angela thrashed around looking for the rules and pacts that would save her embattled army. To no avail, her chariot struck a a rock which, like the one to the west of Grosseto which saw-off the unfortunate Costa Concordia along with her Captain, was on no known map, having not previously been measured, and she went hurtling down that crazed path which leads only towards a preappointed destiny with both history and oblivion.

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

A Month In Spain That Didn't Shake The World

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

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

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

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

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

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

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

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

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

Complete & Perfect Knowledge

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


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

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

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

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


It's The Housing Bubble, Stupid!

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

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

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

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


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

A Country Fit For Young People To Stay In

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

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

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

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

No Money, No Credit, No Credit, No Jobs


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

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

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

As Charles Penty reported in Bloomberg last week:

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

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


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

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

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

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

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

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


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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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