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".

Grexit? Spexit? Let's Call the Whole Thing Off

One thing we've learned as the euro crisis has unfolded is that the enthusiasm of experts in London and New York for offering advice to the struggling countries on Europe's periphery is matched only by their passion for awkward neologisms. The world was just getting used to "Grexit" (Get it? A Greek exit from the euro!) when "Spexit" began to rear its ugly head in the financial press.

Naturally, the events of recent days have brought Spain back to the forefront of the debt crisis, generating insecurity about the reliability of the official fiscal deficit numbers, the validity of central bank statistics, and new numbers showing capital flight reaching alarming levels. Only this week, Spain announced that the central bank governor, Miguel Angel Fernandez Ordoñez, will be leaving early as part of a government effort to restore its credibility. Some are now anticipating that Spain's exit from the eurozone will come before Greece's departure.


I would hope that those clamoring for these countries to go their own way are at least better intentioned than they are informed, since normally they exhibit a singular lack of understanding about how political systems in southern and eastern Europe actually work.

It is now essentially conventional wisdom in the British and American press that Greece needs to return to the drachma. British journalists are even racing to hunt down the London printing works that have supposedly been given the contract to print New Drachmas, the putative local replacement for the euro. The only snag is, according to all opinion polls, the Greeks themselves are not happy with the euro but have no interest in dropping it. (Perhaps the perfect Solomonic solution here would be to have the New Drachma introduced as a non-convertible currency for use only within Fleet Street bars and the boundaries of the City of London.)

The Greeks, naturally, are tired of austerity, and of a stupid EU/IMF bailout plan that has only served to totally collapse their economy, explode their debt, and destroy what semblance of external reputation Greek companies had. The Greeks are tired of austerity in the way many in the United States have tired of fiscal stimulus in the run-up to the next presidential election. But no one would suggest that this weariness is an indication that Americans want to drop the dollar.

As an economist, I have always argued that the common currency was a mistake. I am a "euro" skeptic, but not a "Euroskeptic," and I think it important that people outside Europe understand that this distinction exists. There is no doubt that the euro, like Dr. Stangelove's doomsday machine, is an infernal device destined to blow up one day, but also so designed that any attempt to dismantle it simply detonates the bomb. This is why, tired as they may be, those who live on Europe's southern fringe have little appetite for leaving or taking part in yet another experimental new currency order. Better put, they have little appetite for leaving in a disorderly fashion. And disorderly the leaving would have to be, since if core Europe has little appetite for assuming the cost of keeping the eurozone together, it will surely have even less for paying the much larger bill associated with exit and default.

The media's increasing scrutiny of Spain is similarly misguided. Despite the many voices now recommending a "Spexit," few are really knowledgeable about daily life here in Spain, and even fewer are actually to be found inside the country.

The story of how Spain got to this point is well-known. There was a huge property bubble (could we say the mother of all of them?), a decade of above-EU-average inflation, a massive loss of competitiveness, a huge current account deficit, and an unprecedented stock of external debt. All of this now needs to be unwound, but here's the rub: It is very easy to structurally distort an economy within the framework of a currency union, but very difficult to correct the distortions once generated. This is why so many rightly say that in Spain it is all pain as far ahead as the eye can see. It is not that the Spanish people like this, but just that they don't see any clear and better alternative. And indeed, while only 37 percent of Spaniards believe having the euro is a good thing, according to a recent Pew poll, 60 percent favor keeping it.


The departure of Ordoñez, the central banker, may seem more dramatic from the outside than it does from within. Certainly Mafo, as he is called, bears a heavy responsibility for Spain's continual failure to get a grip on the rot in its financial system, and for the disastrous decision to allow the insolvent Bankia conglomerate to go to IPO last year, losing shareholders more than $2 billion and badly damaging the credibility of the country's banking sector. But his is only one name on what should be a very long list of putative villains, including members of the present government, the previous one, the EU Commission, the European Central Bank (ECB), and last but not least the IMF, where ex-Bank of Spain deputy director Jose Viñals has been busying himself for months writing reports suggesting the condition of Spain's banks was not all that bad.

The real question is what happens next. Spain, like the euro itself, is both too big to rescue and too big to fail. Spain's banks need capital from the government, but the government itself can't finance them. Foreign investors are leaving in droves, but no matter how many liquidity offers they get from the ECB, the country's banks simply can't buy all the debt. So the country needs European (read: German) money. The problem is that if this takes the form of an injection of bank equity, then Germany could end up all but owning Spain's banks, which would expose German taxpayers to considerable potential losses should the situation deteriorate further. At this point Berlin could firmly put its foot down, and we will have another impasse.

At the end of June, Europe will face what many consider to be a perfect storm: results of the Greek elections and details of the new, independent, Spanish bank valuations, which are sure to find that significantly more money will be needed for recapitalization. This will undoubtedly be a make-or-break moment in the ongoing debt crisis, and, if things were to spiral hopelessly out of control, a Spexit could become a real possibility. My advice to all those external well-wishers would be: Be careful what you ask for, since you might not like what you finally get.

This article originally appeared in the magazine Foreign Policy.