This week’s newsletter was originally going to be on forecasting outcomes in the European sovereign debt crisis. However, as I began to write, I realised that much of this hinged on Spain. So I want to discuss Spain first because Spain is in big trouble and its policy prescriptions are going to make things worse. In my view, the potential for downside economic and portfolio risk has increased markedly as we realise that Spain is at risk and there is no plan B in the euro zone. This is very serious because Spain is an enormous economy. Spain could well become the euro zone’s defining issue.
A short history on Spanish debt
Before the financial crisis, Spain had a booming economy. Along with Ireland, Spain was seen as one of the fast-growing "tiger" economies of Europe, almost a model for others to follow. Both countries had prodigious GDP growth rates, low levels of government debt, and government surpluses in the period leading up to the financial crisis.
The financial sector balances approach
These figures don’t tell the entire story, however. And this is largely because government figures cannot be quoted without contextualising them with the external and private sectors within macro environment. The late economist Wynne Godley was a forerunner in championing this financial balances approach to macroeconomic modelling, which divides the macro economy into sectors whose collective deficits and surpluses must sum to zero.
Here’s what Godley’s approach looks like for any individual country:
Household Financial Balance +
Business Financial Balance +
Government Financial Balance +
Foreign Financial Balance = 0
This is a simple accounting tautology. But it is quite powerful because it reveals hard constraints that will impinge on economic outcomes. Put simply, "Government Deficits Translate into Surpluses for the Non-Government Sector". So, the problem for Spain is that the government’s surpluses and reduced debt were ‘financed’ by huge current account deficits and private sector dissaving and debt accumulation, particularly for property. Like Ireland, Spain experienced a mythic property bubble and the losses associated with that bubble are only just beginning. These are the problems that came to a head in the financial crisis, which created the macro environment which has led in turn to large government sector deficits and eye-popping increases in government debt.
Voodoo economics are the problem
Now, these problems can be overcome. But the financial sectors balances approach tells you that this can’t happen in the context of a fixed exchange rate system without fiscal transfers. In fact, Godley warned quite presciently in 1992 that a European currency without a common fiscal policy was destined for disaster. His argument was that governments need to act counter-cyclically and that EMU without a central fiscal agent would undermine this ability. I wrote about this problem last summer, highlighting that :
Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.
Certainly, if the ECB could provide liquidity to backstop euro zone sovereign debt. Euro states could deal with this volatility. It would simply mean lower growth and lower inflation as the downside swings would be more severe at business cycle troughs without any obvious upside impact during business cycle peaks. Take Spain, for instance. With an ECB backstop, the Spanish government would be able to run deficits without fear of default just as the Japanese, British and Americans can. Interest rates on Spanish sovereign debt would be considerably lower as well. Spain could "leg" into its deficit reduction over time.
The problem is that orthodox economic thinking, particularly in the euro zone core, sees these deficits as a potential source of inflation and currency weakness because the deficits would cause the ECB to intervene to purchase Spanish government debt, increasing the monetary base as it reduces Spanish debt available for private investors. So euro zone thinking sees the deficits themselves as bad irrespective of the context. And the goal of policy makers, even during a cyclical trough, is to reduce them as quickly as possible. This thinking is an outgrowth of the same kind of thinking that caused Paul Krugman to err here in writing as if banks are reserve constrained and cannot create money.
But this thinking is false in the extreme because we know from the financial sector balances that a government surplus it is matched by either the capital account or private balances. The same is true for deficits. Since Spain is forced to run austerity measures, this shifts government expenditure markedly down. Given Spain’s poor labour competitiveness, sticky wage prices and inability to depreciate the currency, all of the adjustment falls onto the private sector in the form of either reduced net savings and larger debt burdens, continued savings and reduced private sector consumption and reduced government tax receipts, or private sector defaults. The reason households and businesses are saving – and causing the government deficit – is because they are overindebted and are looking to reduce their debt service costs. They can reduce the debt service costs by either reducing the debt outright, increasing income to service the debt, or by defaulting. Irrespective of what government does, the private debt remains unless defaulted upon and written down. So the incentive to net save in the private sector through the national accounting tautology tells you that achieving aggressive deficit reduction targets is very unlikely in the absence of private sector income and revenue growth. So austerity alone leads to a debt deflation in which debts can’t be repaid and are defaulted upon.
What the Spanish government is trying
The Rajoy government is still banking on austerity though. Rajoy telegraphed the fact that Spain would miss its 2011 targets. And they successfully bargained for higher 2012 targets. But this has come with a cost as markets have become increasingly jittery about Spain and yields on long-term debt have climbed above the rate Spain paid before the ECB embarked on its LTRO liquidity. And so, the Spanish have had to re-double austerity efforts.
Just yesterday, it came to light that the government will attempt to reduce the deficit by another 10 billion euros by reducing expenditures and raising fees for healthcare and education. The plan will come forward in two weeks but the sketch outline I have heard about calls for increased fees to be paid only by the most affluent households. At the same time, the Rajoy government is trying to get local governments, particularly Andalusia and Catalonia, to bring their deficit spending down and are trying to come up with ways to force them into compliance.
The bottom line here is that Spain will cut fiscal outlays and attempt to increase the fiscal take from the private sector via taxes or fees. The question then is how do the external and private sector accommodate this? because Spain is in a fixed rate environment, there is not likely to be any serious currency implications in isolation. So the government actions will not have any direct external sector implications. However, the reduction in government expenditure and the hiking of taxes and fees will reduce household take home pay. Given the high levels of unemployment, stagnant income, and declining house price collateral in Spain to deal with high levels of household debt, it is likely that increased public sector austerity will be met with increased private sector austerity. Debt distress is a real problem and so the high private debt can only be amortised via reductions in discretionary consumption expenditure.
Conclusions
My conclusions, therefore, are that:
- Households will try to maintain savings. With interest rates increasing and high debt loads, the Spanish private sector can only reduce savings through defaults and credit writedowns. And so, the Spanish will make every attempt to reduce consumption.
- Spain will miss its 2012 deficit targets. The targets are too ambitious in the context of the advancing private sector needed deleveraging.
- Spanish property prices will continue to sink: Willem Buiter has already written on this. He looks at Ireland as a model and expects a significant amount of catch up property price declines in Spain.
I am negative on stocks tied to Spanish consumer cyclicals and discretionary spending as these are the items that will bear the brunt of declines in household consumption. On a valuation basis, Spain looks good here relative to the S&P500, however.
The biggest macro question is whether the crisis in Spain boils over into a bailout as Buiter believes it will. What would be the consequences of Spain’s fall? My view is that given the policy constraints facing Europe, a Spanish bailout is inevitable. The question is whether this will be via a more explicit backstop from the ECB or via the EMF/EFSF route. I think Spain is too big for the European bailout fund without more explicit ECB intervention. And I also believe that Spain is too big to fail, meaning that it’s implosion would mean almost certain economic depression globally. So that tells me that increased ECB intervention is likely, and this may put a floor on stocks. As the margin compression in the US takes form, we will have a good gauge of where value lies but I still expect Europe to outperform on valuation alone, even in a negative scenario for Europe because the US has further to fall.