What developments in Spain and the Netherlands mean for European policy outcomes
I have a number of links coming up in today’s daily commentary. The likely topic will be US interest rates. But there is a second topic I wanted to riff on so I am posting here separately. I have just finished reading a Wall Street Journal article on the Netherlands and their fiscal woes. The article reads:
The Netherlands—By reputation one of the euro zone’s strongest economic powers, the Netherlands is succumbing to some of the same problems afflicting the currency bloc’s weakest economies.
The European Union expects the Dutch economy to contract 0.9% this year: In the euro zone, only Greece, Portugal and Spain are expected to perform worse. And that contraction could turn out to be deeper after the government enacts about €15 billion ($20 billion) in new austerity measures to bring its budget deficit in line with European Union rules.
The Dutch government, one of the euro zone’s most enthusiastic advocates of austerity, has little choice but to take the medicine it has prescribed for the euro zone’s troubled governments. And new EU rules championed by the Netherlands now give the government little wiggle room to avoid budget edicts from the European Commission, the bloc’s executive arm.
This is serious stuff. As I mentioned in my article on Spain earlier in the week, "countries like the Netherlands which have proved deficit fetishists are also in jeopardy. I anticipate the Dutch will redouble efforts and will require the same of the periphery." If you think about the likely policy paths and the constraints on those paths, it makes sense that Europe must continue down the path of more cutting and more missed fiscal targets as the cuts in both the core (Netherlands, Belgium, Austria and France) and throughout the periphery are going to combine to lower growth and tax receipts.
What will this mean? Well, the second article to note is from Sober Look on Spain (The escalation of Spain’s regional debt). It goes into a lot more depth about the regional government problem I mentioned briefly in the Spain article. And it has some nice charts.
a more dangerous development in Spain’s fiscal conditions is the increasing leverage of regional governments, which account for close to half of public spending in Spain. As the central government tries to reign in spending, the local governments attempt to pick up the slack. Regional government debt as a percentage of regional GDP has spiked materially in the last few years.
And the situation seems to be getting far worse with current regional budget balances all in the red.
Spain’s central government is trying to pressure regional governments to contribute to the overall debt reduction. But the regions’ local politicians are often not incentivized to comply. The tension between the regional and the national governments have been escalating.
Now, if you think about the situation in the Netherlands, where deficit hawks are going to be forced to consolidate because they must to put the proof in the pudding regarding their previous deficit rhetoric, then it is clear Spain is a problem. I see Spain as the biggest problem right now (or as Marshall Auerback puts it: The Elephant in the Room Is Spain, Not Italy). Oh how things change! The Sober Look analysis tells you that Spain is not going to make its targets, in particular because of regional governments. The country had a major general strike just yesterday. That tells you that Greece-like rioting would not be out of the question if the planned austerity and labour reform goes through. And this kind of chaos can only lead to a lack of consumer confidence. So, you’re looking at a very combustible situation in Spain.
My conclusion: Spain will miss its targets. Spanish bonds will react negatively. And with consumer confidence low, housing and land prices will decline, causing the banking system to weaken as its collateral diminishes in value. This will probably force Spain into some sort of bailout. The Netherlands and other pro-fiscal consolidation governments will not give Spain the break it received earlier and so austerity will be crushing and lead to the same outcome we saw in Greece.
My hope is that this policy path has more flexibility to it than seems to be the case. But we have already witnessed the recrimination over Spain’s having missed targets in 2011. I doubt that they will get another chance to adjust their target upward without a severe penalty. All of this has to weaken the sovereign bonds. I fail to see the upside here. Spanish bonds should be avoided as should other bonds in the periphery. The yield play from the ECB’s monetisation schemes I forecast last November is definitely over for now until the ECB becomes more explicit about its backstop as I predicted early this year.