German Chancellor Angela Merkel is a brilliant political tactician. After the latest EU Summit, it seemed she had capitulated after being rounded on by France’s Hollande in an effort by Italy’s Monti and Spain’s Rajoy to prevent the market for their government debt from collapsing. The talk was of a Spanish bank bailout with practically no strings attached. Understandably, Mariano Rajoy was speaking of the summit as a clear victory for Spain while Angela Merkel was pilloried in the German press.
But in the days since that summit, Angela Merkel has somehow forced Rajoy into a corner and he has now capitulated, completely reversing himself on taxes and adding a heap of new austerity measures as a pre-condition for bank bailout money that will still be guaranteed by the Spanish sovereign. Rajoy is promising 65 billion euros in austerity to close the budget gap by 2014, including new taxes that raise the value added tax from 18 to 21%.
This is an unmitigated disaster for the Spanish economy and will likely mean default unless Spain is bailed out. Because of this extraordinary situation, this week’s newsletter will yet again have to be about Europe, concentrating now on the potential paths that lie ahead for Spain.
Framing desired political and economic outcomes
Before we can understand what is likely to occur, we will need to frame the situation as it stands. I think it is important to first frame the desired political and economic outcomes that the various actors are striving for because that gives you a sense of where they are pushing and what the political and economic trade-offs are. Think of the situation in Spain as a two-sided negotiation between Spain and the EU/Germany. The goal of both parties is to carve out as much territory of the mutually agreeable political and economic outcomes as they can or fall back on their best alternative to a negotiated agreement (BATNA). And while the agreement will have serious economic outcomes for Spain and all of Europe, political goals play a very large role in the negotiation.
First, from a Spanish perspective, the Rajoy government’s overarching goal is to limit the economic pain that Spain must incur while being able to say that his government improved Spain’s finances. While Rajoy now knows that fiscal cuts will weaken the economy and increase economic pain, he believes they are necessary in order to minimise deficits and stabilise Spain’s government debt to GDP which is now above 80%. On the other hand, to achieve growth, the Rajoy government, like many centre-right governments, believes that labour reforms are vital as a means of lowering structural unemployment. Rajoy is concentrated on making it easier and less expensive for companies to cut wages and lay off employees. For example, Rajoy’s government has pushed through legislation to reduce mandatory severance pay from 45 to 33 days. These measures have been vehemently resisted by labour unions in Spain but as Rajoy has the highest governing parliamentary majority since 1982, he has been able to get these measures through. Rajoy’s biggest constraints are bank and local government insolvency. If he cuts to deep, it could then trigger contingent liabilities for Spain.
The EU, led by Germany, wants the same kinds of neoliberal political reforms and deficit reduction that Rajoy wants but it also wants to limit mutualisation of any liabilities that come due as a result of the economic weakness these measures cause. Finland has been particularly vocal in opposing any debt mutualisation and has specifically requested collateral in exchange for loans to Spain. Austria, the Netherlands, Germany and Slovakia are also known to be opposed to a transfer of Spanish liabilities to EU-level liabilities via the ESM/EFSF bailouts. So, while the political aims are similar to the Spanish government’s, the economic aims differ substantially. Moreover, with Francois Hollande, a socialist as French President, the EU has lost unanimity amongst the core euro zone countries backing harsh austerity and neoliberal reforms.
For efficiency, I would summarise the positions this way:
Spain: want neoliberal market reforms with a minimum of economic pain or increase in sovereign debt. In favour of banking union and debt mutualisation in exchange for less sovereign autonomy. Best alternative to a negotiated agreement is default and depression.
European Union/Troika: want neoliberal market reforms, but less concerned about economic impact. Greater concern about avoiding bailouts, debt mutualisation or contingent liabilities. In favour of banking union and debt mutualisation only after a long process of reform and political integration. This position is backed by Germany, Austria, Luxembourg, Netherlands, Belgium, Slovakia, Finland, and Estonia. Best alternative to a negotiated agreement is ECB/ESM sovereign debt purchases.
Periphery/France: forced into neoliberal market reforms to varying degrees as well but also concerned about economic impact and contagion. Therefore, in favour of infrastructure stimulus and relaxed deficit timetable for Spain. Much more In favour of banking union and debt mutualisation except France. This position is backed by Portugal, Greece, Italy, France, Cyprus, Malta, Slovenia and perhaps Ireland. Best alternative to a negotiated agreement is ECB/ESM sovereign debt purchases.
Effectiveness of policy platforms
Frankly, this is where the problem is. None of these political and economic platforms have any realistic chance of long-term success. Likely, they will make things much worse.
Neoliberal labour market reforms are essentially a tilting of the playing field toward employers and away from workers, giving employers more leverage and workers less. There’s no other way to look at it. Depending on your political leanings, one supports this or is opposed. But what is clear to me is that in a world of open borders, globalisation and global wage arbitrage, these reforms exert downward pressure on labour wage rates where employee protections prop them up, creating higher structural unemployment. Essentially, this is a political trade-off between unemployment and wage rates as a release valve in a world of global wage competition.
Spain’s desire for austerity and neoliberal reforms will weaken the economy in the short run. The socialist opposition is out saying that Rajoy’s labour reforms will add 172,000 job losses to the already deep losses because employers will be free to fire people more easily. This logic makes sense and means the reforms, irrespective of their long-term effectiveness, would deepen the depression in Spain.The wage and spending cuts in the public sector will add to economic weakness as well.
Right now, Spain’s problem is high private indebtedness and an insolvent banking system in a fixed exchange system that limits sovereign debt capacity. Weakening income in this environment means weakening consumption demand directly as well as indirectly through reducing the affordability of existing private debts. This will have at least three negative effects:
- Lower employment, wage rates, and income will reduce consumption and decrease government tax receipts and increase outlays. Rajoy has already said he is reducing unemployment benefits. Nonetheless, whenever government cuts it must factor in the effect of lower demand on its calculation of how much the cuts will reduce deficits. My sense is that the deficit targets that Spain has set will prove too aggressive.
- Importantly, austerity will also lower local government tax receipts and increase outlays. States like Valencia are in big trouble and have already asked for sovereign support in exchange for less autonomy. Rajoy is negotiating on this. The outcome is likely to be cuts at the regional level as well then. Defaults are a real possibility.
- Lower employment, wage rates, and income will reduce the affordability of existing debts and constrain demand for new credit. This will have a negative impact both on asset prices and on private sector defaults. Overall, the impact on Spain’s undercapitalised banks will negative and the likelihood of larger holes in their balance sheets emerging is high.
Spain has just embarked on a debt deflationary course then. And given how advanced the unemployment and capital flight problems already are, there is not much room left before the whole system unravels.
Handicapping economic paths
The model for Spain here is Ireland. It is clear that is where the Troika is guiding Spain, the establishment of a bad bank asset management company like Ireland’s being the latest clue. The hope therefore is that Spain can tread the path that Ireland is on. As Ireland has gone through austerity and cleaned up its banks, Ireland’s GDP has fallen by 15%, suffering a tremendous increase in unemployment and government debt in the process. But now manufacturing growth is at a 14-month high while the rest of Europe is contracting. Ireland has hit its fiscal targets. And Ireland has regained access to the credit markets, the first of the three countries in the euro zone bailed out by the Troika. In October, Ireland might even be rewarded with some debt relief to reduce the 60 billion euro burden that the state has taken over from the banks. This is where the Troika wants Spain.
However, Rajoy’s humiliating defeat to Merkel narrows options to bailout or default for Spain. Here’s why. Spain’s macro conditions are worse than Ireland’s when Ireland received its own bailout. Deficits are lower but unemployment and government debt are higher. The loss of deposits is more pronounced. The fall in the housing market and in bank balance sheets has further to go. Now, Spanish yields are above 7%. What this means is that Spain, an economy eight times the size of Ireland, is in a worse economic state than Ireland was when it was forced into a bailout.
Moreover, despite Ireland’s renewed success, it is likely that Ireland too will need a second bailout if it cannot get debt relief for its bank liabilities. Irish property prices are still falling. Irish bank debt has been so hopelessly commingled with sovereign debt that there is little chance for debt relief. And Ireland’s ability to return to debt markets permanently are tied to financial conditions in the EU as a whole, meaning contagion will always be a factor for all of these countries. So if Ireland is the model, Spain would expect a bailout that shuts it out of the bond markets for two years followed by a tremendous rise in government debt to GDP to over 100% from Spanish bank liabilities, a further rise in unemployment and a further drop in GDP. And this is a best scenario.
More likely, Spain will:
- Be faced with a choice of whether to bail out weak regional governments like Valencia or let then default
- Be faced with a choice of whether to wipe out bank common and preferred equity and haircut subordinated debt holders as greater bank losses are revealed
- Miss targets like Italy because the crisis is more advanced, more countries are in decline and Spain and Italy are bigger countries creating a larger downward drag
In the likely scenarios, Spain’s debt to GDP will rise to over 100%.
Political jockeying
Given this likely outcome, Spain’s deficit must rise and that means Spain will be forced to go to market for more debt than anticipated. Credit Suisse has drawn up the table below regarding Spain’s funding needs for 2012. (Hat tip Sober Look)
The chart sees Spain needing as much as 77 billion euros of funding in 2012 in an environment where LTRO funding will not bring Spanish banks to the table and in which external demand for Spanish debt is weak. So Spain will need assistance to get this debt out the door and that’s when the political jockeying will begin.
Clearly, a Spanish default would be catastrophic. So I expect the EU to work to avoid that outcome. But given the economic scenario I painted above and the funding needs that go hand in hand with it, bond yields in Spain will remain elevated. The ECB or the European bailout funds will then have to buy Spanish debt. The ECB has shown reluctance to support Spain by buying up debt in the secondary market and so the European bailout funds will be the first port of call until they run out of money. At this point, Europe will be at a political dead end because Spain, as the fourth largest economy in Europe, cannot be bailed out, especially as Italy will likely be in trouble as well. This is when the ECB would step in.
Of course, all along the way, there will challenges to the legality of all of the efforts to prop up the single currency. Some of these will be successful, forcing policymakers to find more creative ways to keep the whole thing from unravelling.
All of this will be happening against a backdrop of slowing global growth. I don’t see a lot of upside here. I think the potential for contagion is high. And while I believe Europe’s hand will be forced for fear of another Great Depression, we just don’t know what policy makers will do.
Going forward, I will need to spell out as Nouriel Roubini has done what the likely three or four scenarios for the euro zone are, give an approximate time frame, assign probabilities to those outcomes and outline trigger events that would lead in that direction. But what is clear now is that the austerity and reform efforts will continue in Spain. They will not be successful because they will add a debt deflationary impulse to an already precarious situation. It is this debt deflationary impulse which will force Europe to decide between bailout, monetisation and default or a eurozone breakup. Spain cannot make it on its own now.
Much more to come