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Friday, May 25, 2012

Reading The Writing On The Japanese Wall

The recent decision by Fitch Ratings to downgrade the Japanese sovereign by one notch, from from AA minus to A plus, has all the outward appearance of being a predictable non event. As the Reuters article reporting the decision puts it,  "Credit downgrades usually do not have a lasting impact on markets in Japan because its government bonds are mostly held by domestic investors".

Yet something somewhere fails to convince me that this nonchalance is really justified . Something tells me that this process of rising debt and falling credit ratings  cannot go on and on forever, and that at some point we will reach what Variant Perception's Claus Vistesen calls "the end of the road". In which case, we could start to ask ourselves, what then gets to happen next? Certainly there is nothing in conventional economic theory which can help us anticipate the answer, since this kind of end of the road point has not been forseen, anywhere, unless I am mistaken.

On one view, Japan seems to have invented what seems to be some kind of economic perpetual motion machine. Since the country has an external surplus, and can print its own money, there is a savings surplus, and no problem selling government debt, even at ridiculously low interest rates. And since the interest paid remains ridiculously low, then there is no problem servicing the debt, and if there ever was, why then the Bank of Japan could just buy even more of its own government bonds, effectively driving the interest rate even lower. In  theory there is no good reason why it couldn't even follow the lead being currently set in Germany, and push the rate into negative territory. Heck, the government would then be even earning income on its debt.

But somehow or other this view fails to convince, in particular it fails to get to grips with why Japan has gotten into this ridiculous situation. It also doesn't offer any kind of road-map for how the country could ever get back to the sort of monetary regime that was once widely considered to be "normal". Or are we all destined to slowly drift towards the financial equivalent of the world that was so ably described in Scott Ridely's cult film Blade Runner? 

But if there is no longer hope of exit, and we are now evolving towards what could be considered a brave new financial world, we could we at least spare the time to ask ourselves why this is happening. Certainly from a macroeconomic point of view the explanation "that's just how it is" feels far from satisfactory, while the argument that we just need to continue long enough and hard enough along the current path before  the Japanese economy somehow "rights itself"  - after more than two decades - appears to be based more on belief and hope than any thorough empirical analysis of the situation. As I keep repeating, we are entering terrain which was never really contemplated by neoclassical theory, in either its Keynesian or its Austrian variants.

Despite the frequent references to "Japan's lost decade", the country has now lost not one, but two - what was it Oscar Wilde said, losing one child could be an accident, but losing two has to constitute negligence -  and we seem to be all set to have a third one in front of us, as long markets and weather permitting, always assuming the Japanese government remains able to finance its debt.

The Deflation Issue

The argument that Japan's economic and financial system is simply undergoing a much needed correction after the unwinding of the excesses of a stock market boom (1989) and property bust (1992) as we enter the third decade of the problem doesn't, as far as I am concerned, seem credible. The heart of the problem has been the deflation issue. The Japanese economy first fell into some kind of deflation trap in the mid 1990s. Following a sharp reduction in interest rates and a massive injection of capital into the banking system in 1997 inflation briefly recovered, only to fall back into negative territory again at the turn of the century. The problem has persisted ever since, with the exception of a brief spell of inflation during the oil price surge in 2008 (see CPI chart below). However, even this timid inflation disappears if we look at the core (ex energy, ex fresh food) index, which never really left negative territory, and which was still registering a minus 0.5% annual rate in March (the latest month for which we have data). 

At the heart of the deflation problem in Japan has been the ongoing slump in land prices, which are now still stuck around early 1980s levels (watch out Spain). Land prices did briefly rise for the first time in 16 years in 2007 as a wave of speculative activity saw external investors flocking in to what they were promised would be a new boom (shades of Germany 2012), but then slumped back again in the "risk off" environment which accompanied the onset of the Global Financial Crisis. Prices have continued to fall, and if the metric of golf club membership fees used by Bloomberg reporters is anything to go by, 2012 looks set to be another bad year.

The result of all this deflation is that nominal GDP has fallen substantially in Japan since the 1997 high. In real terms, Japans GDP grew just just 25 percent between 1990 and 2007 while the contraction experienced during the recent crisis has sent 2011 real GDP back to its 2005 level (while nominal GDP slumped to 1991 levels).

Naturally, it is this fall in nominal GDP values which lies behind the massive surge in the government debt to GDP ratio, although as the IMF point out, the constant budget deficits and ongoing low growth have played their part.

The steady increase in primary deficits, from an average 1.7 percent of GDP in the 1990s to an average 5 percent of GDP in 2000–07, is reflected in the evolution of the net debt ratio, which rose from 12 percent of GDP in 1991 to 81 percent in 2007 (67 to 188 percent in gross  terms). Following the global financial crisis, net debt escalated sharply, to  117 percent in 2010.  - IMF report to the G20 "Japan Sustainability".

Now all these fiscal deficits are interesting, since the one thing they have not produced is growth. Japan's long term growth rate has been falling since it peaked in the late 1960s, and it continues to fall. The ten year moving average, after hovering round 1% in the mid 2000s hit 0.75% in 2011. This raises the more than hypothetical possibility that it will soon fall into negative territory.

Now, on one account, this situation is not as dire as it seems, since Japan's falling population means that real GDP could fall and GDP per capita actually rise. This argument seems very attractive at first sight, but when you come to think about debt, it is not quite so appealing, since even if GDP per capita stabilises, debt per capita continues to rise as population falls, and this impact is even more accentuated if we consider that the fall in working age population will be even greater. Fewer people paying more doesn't sound like a positive trend, and especially not from the viewpoint of domestic consumption.

Euro Look-alikes?

The curious thing about Japan is in fact how much it seems to resemble a more extreme version of what we have been seeing in Europe -  in countries like Portugal and Italy - over the last decade. Certainly the growth picture is quite similar.

As is the chronic dependence on fiscal deficits to achieve any semblance of growth.

Really it is hard to continue to call this ongoing dependence on fiscal life support "stimulus", clearly something new is happening here. What separates Japan from these two Euro look-alikes is in the first place they have been suffering from excess inflation, not deflation (so the debt has not ballooned the way the Japan one has) and secondly Japan used to be able to boast a significant trade surplus. I say used to, because this is no longer the case, with the post tsunami energy dependence  exacerbating a tendency which had already started to take root following the sharp rise in the value of the yen we saw in the wake of the Global Financial Crisis.

This means that over the years the Japanese built up a strong net external investment position which leaves the current account strongly positive despite the negative goods trade balance due to the high income flow from investments abroad. This is very different from Italy and Portugal, countries which have long run both trade and current account deficits and have very poor net external investment positions.

The real issue is for how long Japan can maintain its current account surplus, given its declining household saving rate, and the need of its growing elderly population to draw down savings. 

Savings Imbalances

As the IMF points out, Japan's high aggregate private saving rate masks a deep imbalance between sectors. "In particular, the aggregate rate reflects a high corporate saving rate, which trended up from 13 percent of GDP in 1981 to 21 percent in 2009, and a very low household saving rate, which declined from 10 percent of GDP to less than 3 percent over this  period".

The falling household saving rate is undoubtedly demographically linked (as populations age they tend to draw down on savings), although the downward pressure on wage income resulting from globalization also plays a part. The key issue is though, for how long will corporate saving, and the resulting income flow, keep the country's debt afloat.

As the IMF puts it:

"Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable. Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift. In Japan, two scenarios are possible. In one, private demand would pick up, which would lead the BOJ to increase policy rates, in which case the interest rate growth differential may not change much. The other is more worrisome. Market concerns about fiscal sustainability could result in a sudden spike in the risk premium on JGBs, without a contemporaneous increase in private demand. An increase in yields could be triggered by delayed fiscal reforms; a decline in private savings (e.g., if corporate profits decline); a protracted slump in growth (e.g., related to the March earthquake); or unexpected shifts in the portfolio preferences of Japanese investors. Once confidence in sustainability erodes, authorities could  face an adverse feedback loop between rising yields, falling market confidence, a  more vulnerable financial system,  diminishing fiscal policy space and a  contracting real economy".

In other words, a wrong combination of circumstances at an inopportune moment in time could easily send Japan spiraling to where Italy and Portugal are now, even without being in the Euro. In a recent in depth research report on Japan Variant Perception's Claus Vistesen put it thus:
"Japan will run out of savings to buy JGBs by 2016, but the market will respond sooner. Ifthe Japanese government continues to issue debt, the Japanese economy is going to run out of savings to buy the new debt. The share of government debt to total currency and deposits will soon reach close to 100%. At this point of the endgame, there is no way out for Japan: either the central bank or foreigners must take up the bid, or Japan must begin to sell off foreign assets. Markets will price in the endgame before it happens".

Demographic Drift

Japan's population - in median age terms - is the oldest on the planet. Median age is around 45, and it continues to rise. There is no real prospect of it coming back down again, since the process appears to be totally irreversible.

A large chunk of the debt problem is demographically related (see chart below). Since the early 2000s, Japan’s non-social security spending has been well contained and, at about 16 percent of GDP in 2010, was the lowest among G-20 advanced economies. Meanwhile, social security benefits have risen steadily due to population aging. Social security spending rose 60 percent in 1990–2010, accounting for about half of consolidated government expenditures in 2010. Moreover, a sustained increase in the old-age dependency ratio has implied larger social 
security payments supported by a shrinking pool of workers, which has  rapidly deteriorated the social security balance.

Unorthodox Policies

In an article published in the late 1990s and entitled "Japan: What Went Wrong?", Paul Krugman starts to wrestle with a problem which had evidently been bugging him for some time, as the title of the piece shows. The whole text is worth reading, as it gives important background over how the modern debate about what to do with countries who fall into a liquidity trap came into existence. In many ways it was Krugman himself who brought it back kicking and screaming into the current discourse. In fact, he asked himself a question which many others could have asked, but few have chose so to do.
"How could a wealthy, productive, sophisticated country have gone from enviable growth in the 1980s to stagnation in the '90s, and now be slipping into a downward spiral of recession and deflation?"
 In order to do this he looked at a number of the explanations that had been offered for the particular nature of the Japanese "malaise":
Explanation 1 is that it is mainly a financial problem. Japan's corporations are too burdened with debt, its banks too burdened with bad loans that have never been acknowledged. On this view, what Japan needs is a long, painful financial housecleaning.

Explanation 2 is that the problem is mainly psychological. When the "bubble economy" of the 1980s (remember when the square mile under the Imperial Palace was supposedly worth more than all California?) burst, goes the story, consumers and investors went into a funk that has depressed the economy, and the depressed economy has perpetuated the funk.
Well, of course, both of these explanations are immediately contextualiseable in the context of housing boom/bust societies like Spain or Ireland. The financial system got broken and credit dried up, at the same time consumers got frightened by continually falling property prices and started to keep their wallets wide shut. But leaving aside the issue of whether a "jump start" which was large enough and sustained enough would be big sufficient to return Ireland and Spain to a regular growth path, there was obviously something "funny" going on in Japan, which is why Krugman started to consider an Explanation 3.
Until recently I was more sympathetic to Explanation 2. But lately I have started to wonder whether the stubborn unwillingness of Japan's economic engine to catch is, as many foreigners seem to think, merely because the jump-start hasn't been big enough or sustained enough. And so (like a small but growing number of people, including at least one influential Japanese economist and I have started paying attention to Explanation 3--that Japan's troubles really stem from a subtle but deadly interaction between demography and ideology.

Here's the story: Japan, like the United States only much more so, is an aging society. Thanks to a declining birth rate and negligible immigration, it faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the countryshould save heavily to make provision for the future--and lacking the kind of pay-as-you-go Social Security system that allows Americans to ignore such realities, it does. But investment opportunities in Japan are limited, so that businesses will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession.
Well, all this sounds familiar, doesn't it? It sounds vaguely related to things you will find scattered across  my blog posts, and in fact this is not surprising, since it was reading this piece, and another one entitled "It's Baaack! Japan's Slump And The Return Of The Liquidity Trap" (see the appendix to my 2008 post "Did (or Didn't) Japan Just Re-introduce Quantitative Easing?" for the relevant excerpt), that really started me thinking that what was going on in Japan might have some sort of demographic connection.

But, as I argued in e-mail communication with Krugman at the time, if Japan is going to see a decline in working population over the next several decades (and possibly much longer, since so long as fertility remains below replacement rate each generation will be smaller than the previous one) and if this lies at the heart of the problem, then it means the problem is a deep structural one which won't be resolved by any kind of "kick start", however large. It isn't a question of a planet which has slipped off its orbit, and just needs a nudge to get it back on, it is a planet which has veered off onto a whole new trajectory, which leads who knows where. As I say, this situation was never contemplated by the founders of neoclassical theory, and yet, having started in Japan, the phenomenon  is now extending itself steadily across all developed economies in one measure or another. Curiously, while you will find these kind of reflections spread out all through my work, it has been many years since I have seen Krugman come back to the issue.

I think that Krugman's work at the time was truly innovative. He identified a problem, a country with an ageing and declining workforce, and he looked for a solution to that problem. This put him head and shoulders above the majority of his contempories. But he stopped short of digging deeper, and allowed his spade to be turned too soon. He could see that the problem was one of demand deficiency due to the changing balance between saving and borrowing, but he didn't follow this through and see that the problem was not simply temporary (even if decades long) but more or less permanent, and he didn't see that this demand deficiency results in export dependency (leveraging the global rather than the local economy in the search for customers), and that the only consequence of having permanent fiscal injections would be not to give stimulus, but rather an accumulation of debt that will be increasingly harder for those smaller and poorer (deflation) workforces to pay down in the future.

In similar fashion, those who urge a solution to Europe's imbalances via an increase in German fiscal deficits to stimulate consumption miss the point: arguably what people in these societies need to do is save more, not less, and certainly when it comes to the public sector. Which brings us back to Fitch Ratings and the Japanese downgrade. The core issue of the moment is the attempt by Japanese Prime Minister Yoshihiko Noda to raise the country's consumption tax from 5% to 10%. As Paul Krugman would tell you, such a move would bring in revenue, but would weaken internal demand even further. Effectively it amounts to austerity in a country which is "growth challenged" and just as in Portugal and Italy, austerity is not popular with voters. In a recent poll only 40% of those questioned were in favour of the measure, while 50% were opposed. As a result, and attempt to push through the increase could split the governing Democratic Party and bring down the government.

Meantime Former Japanese Finance Minister Hirohisa Fujii has warned that failure to pass the legislation will inevitably spark ratings agencies to implement further downgrades and yet more downgrades of the kind  which might eventually force banks to sell off their government bond holdings, making one of the IMFs nightmare scenarios come true. However, as Bloomberg's Isabel Reynolds points out:
Fujii’s warning is at odds with previous credit rating downgrades that have failed to result in higher interest rates. Japanese banks face a total of 6.4 trillion yen ($80.4 billion) in valuation losses on their holdings of government bonds if interest rates increased one percentage point, the Bank of Japan (8301) said in a report last month. Domestic deposit-taking institutions hold about 39 percent of JGBs, while about 8.5 percent are held by foreigners. Japanese government bond prices have so far been unaffected by the country’s ballooning debt. The country’s credit rating has been downgraded by Standard and Poor’s four times since 2001, and over that period yields have fallen more than 52 basis points.
Unfortunately, just because it hasn't happened yet doesn't mean it never will, as we saw with house prices that only went up. If the downgrades pile on fast enough, and junk bond status approaches, expect markets and banks to react. As Claus Vistesen says, they have four or five more years, and the clock is ticking away.

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

Sunday, May 20, 2012

Can This Really Be Europe We Are Talking About?

In recent days I have been thinking a lot, and reading a lot, about the implications of Greece's recent election results.

At the end of the day the only difference this whole process makes to the ultimate outcome may turn out to be one of timing. If  Alexis Tsipras of the anti bailout, anti Troika, party Syriza won and started to form a government then the second bailout money would undoubtedly be immediately stopped. On the other hand if the centre right New Democracy wins and is able to form a government, as the latest polls tend to suggest, then the country would quite possibly try to conform to the bailout conditions, but in trying it would almost certainly fail, and then the money would be stopped. Before the last election results, it will be remembered, this was the main scenario prevailing.

Indeed reports coming out of Greece suggest that the end point may be reached more quickly than even previously thought, since the main impact of recent events is that the reform process in the country has been put on hold, meaning that slippage on implementation by the time we get to June will be even greater than it otherwise would have been.

"The only thing we are doing is waiting," said a government official who declined to be named. Another Greek official close to bailout negotiations said ministers in the outgoing cabinet have not been authorised to negotiate with Greece's lenders since the May 6 election. A senior party official said the caretaker government would not publish any decrees and all tender procedures were suspended.

Even before the May 6 election, many reforms were put on the backburner to avoid antagonising voters, officials involved in bailout talks say. These include a plan to slash spending by over 11.5 billion euros in 2013-2014, which Greece must agree by late June to meet a key bailout target.

Other measures Greece should have taken by the end of June include a plan to improve tax collection by 1.5 percent of GDP in 2013-2014, a review of social spending to identify 1 percent of GDP in savings, and a pay cut for some public sector jobs by an average of 12 percent.

One key measure is the budget deficit. Athens was broadly on track in the first quarter with a primary surplus on a cash basis of 2.3 billion euros excluding interest payments on debt, versus a 0.5 billion primary surplus in the same period in 2011.

But low value added tax collection and increased transfers to the social security system to offset weak business and employee contributions continue to be soft spots.

Another problem - which the EU and IMF will check before giving any green light on the accounts - is government arrears. Unpaid debts to third parties for over 90 days stood at 6.3 billion euros at end-March or 3.1 percent of projected GDP this year, according to economists at EFG Eurobank.

EU and IMF policymakers, exasperated by repeated delays on all reform areas over the two years of a first, 110-billion euro bailout, have warned they will not deliver any more aid under the new bailout if Athens veers off the reform track yet again.
Looking at the above list, it is hard not to come to the conclusion that it might be in the interests of all concerned for Syriza to win the elections and force the issue. Putting together another weak government that can't implement will only lead to more fudging, and put us back where we are now in three or six months time.

Grexit Ahoy?

Either way, it is what happens next that leads to all the speculation. The international press has been full all though the last week of statements from one European leader after another suggesting that Greece may need to exit the Euro. The latest to add his name has been the Slovenian Finance Minister Janez Sustersic, but before him there has been a long list of leading personalities including EU Trade Commissioner Karel De Gucht who told the press that the European Commission and the European Central Bank were working on scenarios in case the country had to leave. European Central Bank President Mario Draghi even entered what are unchartered waters for the institution he leads and acknowledged that Greece could end up leaving the euro area, although if it did he stressed the decision would not be taken by the ECB.
While the bank’s “strong preference” is that Greece stays in the euro area, “the ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet,” Draghi said in a speech in Frankfurt today. Since the euro’s founding treaty does not envisage a member state leaving the monetary union, “this is not a matter for the Governing Council to decide,” Draghi said.
This is all a long long way from the days of "Hotel California", and the Euro as an institution where you can check in but you can't check out, and other such sentiments which typified the Trichet era, which now seems to far behind us. The decision would not be an ECB one, but what if preserving the integrity of the central bank balance sheet implied cutting of the lifeline to Greece's banking system? The decision might then be nominally Greek, but at the end of the day it would have been forced on the country by a proactive ECB.

In The Name Of God Go!

While Mario Draghi may have been being strongly diplomatic, ECB Executive Board member Joerg Asmussen was far less so, and told  Handelsblatt newspaper on May 8 that if Greece wanted to remain in the euro, it had “no alternative” than to stick to its agreed consolidation program. The influential German magazine Der Spiegel went even further. Under the header "Time To Admit Defeat, Greece Can No Longer Delay Eurozone Exit", the magazine said what had previously been the unsayable: "After Greek voters rejected austerity in last week's election, plunging the country into a political crisis, Europe has been searching for a Plan B for Greece. It's time to admit that the EU/IMF rescue plan has failed. Greece's best hopes now lie in a return to the drachma".

The inconvenient problem is that things don't look that way in Athens, where even the anti-establishment Alexis Tsipras is only talking about ending austerity, and renegotiating agreements, at the same time making it abundantly clear  he has every intention of staying in the Euro. The fact of the matter is that there are very few Greeks who actually want to leave, and it is hard to believe that those arguing the country's best hopes are either this, or that, really have the true interest of the country and its citizens at heart. The FT's John Dizard sums the situation up thus: "There has been an astonishing quantity of nonsense written in the past couple of weeks about the prospect of “Grexit”, or Greece's exit from the Euro".

One of the key additional reasons that much of what has been written has been "nonesense" is that few have stopped to think about what the real cost to core Europe would be of a Greek default (see below). But then, they never have been that strong on financial arithmetic in Berlin.

So whether push comes to shove at the next review, or the one after, no one is really clear what gets to happen next, and this is part of the reason why there is so much nervousness in the markets at this point. Many assume that after the tap is turned off the country would quickly run out of money, but there are a variety of devices that the Greek government, in conjunction with the central bank, could use to keep the cash flowing. Some think the country would follow the Argentinian example, and start issuing internally valid scrip money, like the ill fated Patacos or Lecops. But Argentina was not in a currency union with the United States, the country had simply unilaterally decided to peg the Peso to the Dollar. Argentina could not print Dollars, but Greece can - in a variety of ways, the best known being Emergency Liquidity Assistance (ELA) - generate its own Euros, and enable the government to, for example, sell T Bills to Greek banks in order to pay pensioners, civil servants, government suppliers etc.

Then, so the story goes, the ECB would have no alternative but to shut Greece off from the Eurosystem. To some this might seem like an act of war. This wouldn't be Greece leaving, this would be Greece being turfed out. Yet this secnario was just what the markets got a scare about this week, when the ECB announced it was cutting off liquidity to four Greek banks. Ominous echoes of Mr Draghi's words about the ECB protecting the integrity of its balance sheet. As it turns out, the move was less sinister than it seemed, since part of the problem was that the Greek government bureaucracy was inefficiently holding up the recapitalisation of some Greek banks, a move which had left them with negative capital, and the ECB was understandably reluctant to continue accepting collateral from them under these circumstances. Part of the problem here is that very few people, as FT Alphaville's Joseph Cotterill points out, really understand what ELA is, but this is not really surprising as the ECB itself has hardly been forthcoming with information and details on how ELA is being used.

In any event, continuing the supply of liquidity to Greek banks, and including or excluding the Greek central bank in/from the Eurosystem are likely to become key issues as we proceed. As Mr Draghi argues the issue is a political one, not a banking one, which means the bank is going to be very constrained if it wants to act as a bank without the relevant authority. This is the kind of hot potato which is likely to be passed from one desk to the next (Yes, Mr President, but...) with no one really being willing to go down in history as the person who might have torn Europe apart, which leads us to the conclusion that the "muddle through and fudge" stage might last quite a bit longer than many are expecting.

If I Owe You 10 billion I have A Problem, But If I Owe You 300 billion..........

As John Paul Getty famously said, "If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem". Never a truer word was said in the Greek case, and it is the reality that Mr Tsipras and those around him have, I suspect, understood. Now I fully appreciate that  the Troika are a group of people who are motivated largely by principles not by money, but when your principles could cost you, and those providing you with the money you spend, 200 billion Euros, 300 billion Euros, or whatever, then dare I suggest there is food for them to think.

Estimates of just how much the Troika are on the hook for should Greece default vary, but a common number is somewhere in the 200 billion euro range. Of course, some of this would eventually be recoverable, one day, and assuming Greece were able to pay, but in the meantime (given the super senior status of the IMF participation) it is highly likely that governments and taxpayers in the other Euro Area countries would need to cover the shortfall, and this, to put it mildly, is unlikely to be popular with voters. Yet another reason for "fudge and muddle through".

There are three main sources of Troika exposure to Greece, bailout loans, sovereign bonds owned by the ECB, and liquidity provided to the Greek central bank thorugh the Eurosystem via what is known as Target2. Now according to estimates by Commerzbank analyst Christoph Weil, between loans and bond purchases Greece owes a total of €194bn, which breaks down into €22bn owed to the IMF, €53bn to Euro Area countries, €74bn to the EFSF and €45bn to the ECB. On top of this there are Target2 liabilities of the Greek central bank vis-à-vis the ECB - and indirectly to the German banks -  to the tune of €104bn.

As Christoph says in his report: "It would undoubtedly be bitter for the German government to have to tell taxpayers they would have to fork out €75bn if the debts were not repaid, but the alternative of continuing to throw good money after bad, would not make it any more popular either". Methinks he is being a bit too blasé here, since while it is surely the case that a 75 billion Euro bill for the German taxpayer would cause a furore, I'm not sure he has grasped just what a problem this would then present for continuing with further bailouts as needed with other troubled countries.

Can This Really Be Europe?

Nonetheless, despite the fact that Mr Tsipras would now appear to have Germany's leadership by the short and curlies (something Barack Obama's US advisers will surely have been spelling out to them in Camp David this weekend), it is not at all clear what turn events will take from here on in. History is, after all, often more about the unintended consequences of unexpected accidents than it is about plans.

Nevertheless, several things are clear. In the first place, the Greek economy is in unremitting decline, under the weight of the healing measures being applied by the IMF and its European partners. GDP was down by approximately 17% at the end of 2011 from its Q3 2008 high. Not as steep as the Latvian 25% fall - but then the IMF are still forecasting a further 5% decline in 2012, and without devaluation don't expect any sharp bounce back. Both reputationally and infrastructurally the country is being quite literally destroyed. The medicine has evidently been worse than the illness, and maybe it is just coincidental, but the Marshall Plan type aid which the country now obviously needs was originally applied in Europe following the destruction of WWII.

But in Greece it's going to be worse, since no one back then had the kind of ageing population problems the country is now about to face. And while the problem remains awaiting resolution, industrial output and retail sales continue in what has all the appearance of terminal decline, while unemployment - which hit 21.7% in January, second only in the EU to Spain - is still on the rise.

So something patently isn't working, and excuse me for saying it, but I find it hard to think of a leading applied macroeconomist who wasn't warning about this right from the start. But no, the creed of the the micro people and their structural reforms (which, as I keep stressing, are needed) was preferred, and we have ended up where we have ended up.

Right now there are two, and only two, options on the table as far as I can see: help Greece with an orderly exit from the Euro (and crystallise the losses in Berlin, Washington, etc), or print money at the ECB to send a monthly paycheck to all those Greek unemployed. This latter suggestion may seem ridiculous (then go for the former), but so is talk of printing to fuel inflation in Germany (go tell that old wives tale to the marines). If Greece isn't allowed to devalue, then some device must be found to subsidise Greek labour costs and encourage inbound investment - and remember, given the reputational damage inflicted on the country this is going to be hard, very hard, work.

In fact, as I jokingly suggested on my Facebook (and this is a joke, really) on one reading you could come to the conclusion that what lies behind Paul Krugman's recent tantalising play on the association between Wagner (Eurodammerung) and Coppola (Apocalypse Fairly Soon), is Ben Bernanke's idea of a helicopter drop.

Could it be that the message he was trying to subliminally sneak in to camp David this weekend was that unable to afford either Greek exit (colloquially known as Grexit) or Greek Euro Membership, the world's leaders now find themselves trapped in a Gregory Bateson-type double bind. According to Wikpedia "a double bind is an emotionally distressing dilemma in communication in which an individual (or group) receives two or more conflicting messages, in which one message negates the other. This creates a situation in which a successful response to one message results in a failed response to the other (and vice versa), so that the person will be automatically wrong regardless of response. The double bind occurs when the person cannot confront the inherent dilemma, and therefore cannot resolve it or opt out of the situation".

The only viable way to cut the gordian knot without confronting and resolving the underlying problem which at the end of the day afflicts many of the countries on Europe's periphery (devaluation and aided default) would be the organising of weekly helicopter drops of freshly printed Euros all along the beaches of southern Europe (oh, we will fight this one on the beaches, and in the chiringuitos, Mr Tsipras told a shocked group of assembled journalists) at a stroke resolving a large part of the youth unemployment problem, and generating demand for products from core Europe (after all, who would go and work in a dreary old factory when you can get the same income lying on the beach). I can just here them over at the ECB, "whohay, am I on a roll man!", as the printing presses go to work.

And to cap it all, I can just see Paul requesting to fly one of the choppers. "The surfing looks pretty good down there at the moment, Mr President". As one commentor said, you can just smell those Euros burning through the morning mist.

But of course, joking apart, Krugman does have a point. The G8 leaders are now in a ridiculous situation, one they should never have put themselves in. Apart from the cost of disorderly Greek exit, just imagine how Spanish or Italian deposit holders would react to the sight of Greek Euros being forcibly converted into New Drachma, or some such.

Then there is the Guardian's Julia Kollewe, who last week spelt out for us a number of highly unpleasant consquences which would follow, including a rush for the door by a lot of young Greeks. Kollewe indeed paints a bleak picture of Europe's future:
The Argentinian example shows that a Greek debt default and exit from the eurozone are likely to have dire economic and social consequences, at least in the short term. The country will become isolated. With lending drying up and accounts frozen, small businesses will go bust, exports plunge and the country will lurch deeper into recession. "Consumption could drop by 30%," says Nordvig. "There will be some pretty extreme effects."

"Mass unemployment is likely, as is an exodus of young skilled workers. If tens of thousands of Greeks headed to the borders, they might even be closed. Greek soldiers patrolling the roads and ports to keep their fellow citizens in? It is not impossible".
In fact, the last time something like this happened – in Argentina in 2001 – 175,000 Argentinians arrived in Spain alone.

So I ask myself, is this Europe we are talking about here, or is this some kind of dream I am having? Is this where all those high minded ideals of a European Community have lead us, to a Greece where the young people get locked in, like in the old days of the USSR, or locked out as in the days before Schengen.  Is this what the real outcome of the election of Francoise Hollande as President of France is going to mean? I hope not, since if it is it would surely split Europe right down the middle, and not just by drawing a line running from East to West.

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

Sunday, May 13, 2012

It's Time to Stop Using Chewing Gum And Chicken Wire In Spain

"Every leg of the eurozone crisis has been marked by denial of the full scale of the problems. Whether Spain’s authorities have been deceitful or wilfully blind makes little difference at this point. The banks will need more capital; the government will need external help, with all the market uncertainty and strings attached that this implies. And the pain in Spain will only get worse".
The top Line, Financial Times

According to reports now widely circulating the Spanish press (in Spanish only), the EU is pushing Spain hard to accept EU aid on completion of an independent external evaluation of the problems in the banking sector that is to be conduced by Blackrock Solutions and Oliver Wyman. The evaluation has been imposed on Spain by both the ECB and the EU Commission following doubts about just how faithfully the numbers published by the central bank do reflect the likely losses to be sustained by the Spanish banking system. Following this weeks revelations about the extent of potential losses in Bankia (product of the fusion of a number of savings banks, and one of the country's largest financial institutions by assets) it is not hard to understand why.

Not only has the issue placed in doubt the capacity of the country's political and financial leaders to handle a crisis of this magnitude, it has once more raised question marks and doubts about the adequacy of data presented in commercial bank annual accounts. What brought matters to ahead was the publication on Friday 4 May of Bankia's unaudited accounts for 2011 wherein the parent bank BFA still valued Bankia, in its individual accounts, at book value. In fact at the time Bankia was trading at around 0.3 of BV, while listed stakes in companies like Mapfre, NH Hotels, and Indra were by no means fully marked to market. The reason the accounts remained unaudited was that Deloitte, the bank’s auditor during the time of the stock market listing, had refused to sign off on them.

In fact, not only is the bank suffering from the falling value of its property assets, it is also feeling the squeeze of the sharp fall in stock prices, which affect the value of its commercial holdings. The country's IBEX 35 Index hit its lowest level since October 2003 this week, and with holdings which some describe as the "jewels in the bank's crown" down sharply, bank capital has taken a hit. Bankia's holdings include a 5.4% stake in the troubled hydrelectric company Iberdrola, which is now only valued at 21 billion Euros, some 40% down from the 35 billion Euro valuation the company had only one year ago. A back of the envelope calculation suggests this drop alone has cost the bank 800 million euros, making it unlikely that a forced asset sale of all holdings  would bring in anything like the 3 billion euros some are estimating. However hard Mr Goirigolzarri, the new CEO, struggles to put a brave face on things ("contra mal tiempo buena cara"), and no one doubts his good will, the battle in front of him is enormous. Estimates in Spain suggest that in addition to the 4.5 billion Euros in Frob loans converted into equity, the bank may need a further 5 billion Euros in capital injection, just to cover the new provisioning requirements.

Concern about how the whole financial reform process was being handled by the Bank of Spain  only grew with the acknowledgement by Bankia itself that it had renegotiated €9.9bn of assets in 2011 to avoid them from going bad. This is a practice which external observers had often suspected regulators at the Bank of Spain were permitting, but the latest revelations only confirm suspicions and raise worries that more of Spain's  banks are  understating their problematic loans, particularly along the sensitive line which divides "good" from "bad" developer loans. Indeed, many ask how five years into the crisis there can still be good developer loans in the system once guaranteees are adequately valued .

Naturally the whole BFA/Bankia edifice is the first good example I will point to of the use of chewing gum and chicken wire in Spain, since it is hard to imagine a more complicated way of doing something that is almost guaranteed not to work. Basically BFA, the parent bank, was created as a bad bank, where the toxic property assets (largely land) of the seven participating savings banks were to be warehoused, supported by a mixture of preference shares, subordinated debt and own resources in terms of company shares, equity etc, plus a 4.5 billion euro "hybrid capital" loan from the government restructuring fund (FROB), which was to be paid 8% a year. Naturally the value of the toxic assets was bound to drop as time past, and I suppose the hope must have been to tranfer earnings from new ("better" - not "good") bank Bankia to both offset losses and service the FROB loan. But things weren't to work out that way (as could have been anticipated), since Bankia itself was created with its own property exposure (especially in the form of developer loans, many of which were on the point of "souring") as there simply were not enough resources available  to wharehouse everything. And when the new government introduced a law requiring more provisioning, well it was all over, bar the large injection of public money now needed to clean up the mess. Others were given the opportunity to kick the can a little further down the road by entering a merger, and thus offseting the write-downs against capital rather than having to charge them directly to profit and loss. But Bankia was already too big, and too about to fall over, to be able to find a "dancing partner".

Beyond the fact that what was created was a flawed structure from the start, especially given the lacklustre economic environment facing Spain over the coming years, and the ongoing downward adjustment in property values, the whole Bankia affair raises important issues. Just what did regulators at the Bank of Spain think they were doing when they gave approval not only to the bank's business plan, but to the stock market flotation? Didn't they realise there was a high probability of failure, and that hundreds of thousands of small savers - many of them clients of the bank itself, who were sold the idea of buying shares in their local bank on the basis of the promise that it was going to be a "great opportunity", especially when normal deposits were paying so little - would almost certainly lose a lot of their money. Weren't the Bank of Spain aware of just how vulnerable those "good" developer loans really were?

But the root of the problem here is not one irresponsible decision, it is a whole comedy of errors, going back to the early days of the financial crisis in 2007, and the constant declarations that due to their substantial provisioning programme, Spain's banks were among the most sound and solid on the globe. These provisions were indeed important, but their existence and the constant comparison with the property slump of 1992 to 1995 lead regulators at the central bank and policymakers in the Economy Ministry to have a false sense of security. They were simply determined to put that brave face on, keep trying to maintain confidence, and simply ride the thing out. How many times over these years have I heard bankers lament that one day all the property assets will offer a valuable legacy for their children if they can only find a way to get through the present storm intact. Unfortunately, looking at the youth unemployment numbers, many of their children will be long gone to work in another country by the time property prices start to recover, if - looking over at Japan - they ever do.

EU Rescue Needed

In one sense Spain is too big to rescue, but in another it is also too big just to let it go to the dogs. In fact, when I say it is too big to rescue, I mean it is too big to rescue using the now classic model put into practice in Greece, Ireland and Portugal. Spain and Italy are simply too large (both in terms of GDP and in terms of population) to put under the tuteledge of the Troika in this way. The political risks of facing a runaway train are just too great. In addition taking Spain completely out of the sovereign bond market, in the way Greece, Ireland and Portugal have been, would be very expensive, and is probably not necessary.

On the other hand, if we think about it, Spain has already had a partial bailout, first via the ECB SMP (the Spain government bond purchases,which began last August), and then via the more recent support for the banking system offered by the two 3year ECB "liquidity" LTROs. According to data from the Bank of Spain, Spanish banks have borrowed something like 316 billion Euros in these offerings, of which (and as of March) some 89 billion Euros had been left with the ECB deposit facility.

Also, when we talk about rescues, it should also be borne in mind that the EU is progressively implementing a whole new set of governance procedures which will leave individual Euro Area countries with a lot less freedom to decide for themselves on key economic matters, as Mariano Rajoy discovered to his cost when he went to Brussels and asserted that his country, being sovereign, could decide its own deficit target. So rather than one dramatic intervention what I expect to see is the application of a steadily tightening set of pincers, and a growing number of controls over the freedom of action of both the Spanish government and the Bank of Spain.

In essence the liquidity measures implemented by the ECB via the LTROs have solved one problem - the difficulties the country's banks were having financing themselves, and helped with another by enabling the banks to buy more Spain government bonds, although if the objective here was to resolve Spain's financing issues they have been less successful, since 10 year bond yields are still constantly pushing against the 6% mark.

On the other hand the LTROs have done nothing to help with the other key issue, the lack of credit in the economy. Indeed by making it easier and more profitable for the banks to buy government debt they have arguably made it even more difficult for the private sector to obtain credit. In some ways what we are seeing is truly a form of "crowding out" of new investment projects by a combination of zombie property developers and the public sector. According to data from the bank of Spain, credit to the private sector fell for the 18th consecutive month in March - by an annual 1.7% to corporates, and by 2.7% to households.

So obviously something needs doing to resolve issues in the financial sector, since in the meanwhile unemployment only goes up - for the 60th consecutive month in March (on a seasonally adjusted calculation) - hitting just under 25%, or nearly one in four of the workforce.

While house prices, the key variable around which the Spanish economy hangs, go down and down. It is impossible to say at this point just how far they will fall, this in part depends on how many years Spain needs to get back to job creation, and how many young people leave in the meantime, but 2002 looks to be a critical level in terms of the likely impact on the mortgage book.

Part of the solution to the problem, but only part of it, lies in cleaning up the balance sheet of Spain's banks. This is the part that Mr de Guindos is currently trying to address. The other part is the absence of solvent demand for credit, even were the balance sheet to be less encumbered, given the high levels of unemployment and corporate bankruptcy, and the low levels of income security prevelent in the current depressionary environment.

The main point which stands out is that Spain's banks badly need to deleverage, in terms of reducing their loan to deposit ratio - a hard thing to do when all the insecurity which accompanies the crisis is leading the system as a whole to lose deposits. The loan to deposit ratio is still way to high in Spain, and the banks need to deleverage in some way or other to bring this down on aggregate - liquidating toxic property assets from their balance sheets to independent management companies would be one way to start. Simply reducing credit to the private sector wouldn't be.

There are currently about 2 trillion loans issued by the Spaining banking sector, and about 1.2 trillion deposits. That's about 165% leveraging. The ECB LTROs are to some extent masking this situation by allowing the banks to refinance. The only way forward is to raise savings and hence deposits, and write down loans. Otherwise, Spain's banks may have a huge balance sheet, but be able to give few loans because one way or another large parts of it a permanently encumbered. It may, or may not, be obvious to those responsible for taking decisions, but from a macroeconomic point of view the key to achieving this balance sheet restructuring passes through having a lot more export capacity, and a large goods trade surplus.

In Ireland loans to deposits had reached 180% before the bailout. Here's what the central bank intoduction to the BlackRock stress tests says:

"The Central Bank has agreed with the External Partners that a sustainable Loan to Deposit Ratio for the aggregate domestic banking system is 122.5%, meaning a surplus of some €70bn of loans. Deleveraging these loans will reduce dependence on wholesale funding and set the foundation for a sustainable banking sector. It will help to create smaller, cleaner banks that are capable of providing the new lending necessary to support economic activity in Ireland".
I thoroughly agree with these Bank Of Ireland objectives, and these very same ones ought to be the objectives in Spain too. Removing the 90 billion euros in acquired real estate assets and the 400 billion in developer and construction loans (see Barcap Table below) from the books would be one huge step in the right direction, the trouble is the quantities of money required to finance this would need to come from Europe. The idea that foreign investors would put money in, if the assets weren't priced below 30 cents on the Euro, is simply laughable.

The background to the latest episode in the crisis is that Spain urgently needs to find the finance to completely clean up its banking sector, and not come up with yet another 30 billion euro chewing gum and chicken wire provisioning job simply to avoid EU involvement. There is too much at stake for everyone now.

And if all of this wasn't enough, the most tacky piece of chewing gum is still to come, in the form of the idea of leveraging Spain's Fondo de Garantía de Depósitos de Entidades de Crédito to finance an asset guarantee scheme for each of the banks that buys one of the more troubled ones which have been taken over by the FROB.  The FdGdD was set up in 2011 to, guess what, guarantee deposits. I think it is worth citing the actual objectives of this organisation as set out in the Decreto Ley which set it up:

El Fondo tiene por objeto garantizar los depósitos en dinero y en valores u otros instrumentos financieros constituidos en las entidades de crédito, con el límite de 100.000 euros para los depósitos en dinero o, en el caso de depósitos nominados en otra divisa, su equivalente aplicando los tipos de cambio correspondientes, y de 100.000 euros para los inversores que hayan confiado a una entidad de crédito valores u otros instrumentos financieros.
Well, I won't translate all the jargon, but what the Spanish says is that the Fund's objective is to guarantee deposits up to 100,000 Euros. This is the protection most Spaniards think they have, and they do, but how much is there in the Fund to guarantee those deposits? Well, almost nothing, since the money has been spent on paying off the FROB participation in CAM and UNIM when they were sold to Bank Sabadell and BBVA respectively, for 1 Euro in each case. And why was the financing of the operation done in this peculiar way, using a Fund whose intention was to guarantee deposits in case of bank failure? The answer is obvious, it was done in this way due to the high priority given by Mr de Guindos and the government he represents to trying to maintain that no public money is being put into banks. The FdGdD is financed by a 0.2% levy on bank deposits, and it is the income stream from this levy over the next 8 years that "experts" in the Economy Ministry are now reportedly thinking of securitising in order to pay for the coming Asset Guarantee Schemes. The banks are going, Baron von Munchausen style, to pay for their own clean up. Clever isn't it? So now you see why the I said the chewing gum in this case was particularly tacky. Yet one more piggy bank has now been raided, and the only guarantee for deposits will be the Spanish government, which itself has trouble financing. You see why I say they need to get into an EU harbour, and quickly.

Indeed such are the lengths to which Mr de Guindos seems prepared to go to fool all of the people all of the time when it comes to whether or not public money is being spent that last Friday he even burst through what the FT's John Dizard calls the Harold Wilson standard for  public doubletalk and evasion. The British Prime Minister, it will be recalled, told the British public that even though the Pound Sterling was being devalued by 14%, the pound in their pocket would not be affected. Well Spain's Economy Minister has now gone one better. To an astonished group of journalists at last Friday's government press conference he calmly explained how the new bank provisioning rules would not mean that any public money was being spent, since in the first place the estimated 15 billion Euros that FROB would inject into banks who couldn't manage from their own resources would be in the form of a loan at a penal rate of interest (and this is supposed to help them), while in the case of Bankia the existing FROB loan which was being converted into equity wouldn't be an injection of public money, since - drum roll - the money had already been leant to the bank. How you square these two statements, well, you'd better ask Mr de Guindos that.

How Big Is Big?

So, if the extra 30 billion Euros in provisioning is but a drop in the ocean, how much do the banks really need? Well the prestigious Brussels based think tank CEPS came up with a 250 billion Euro number during the week, and since they are not only geographically but intellectually close to the Commission, it wouldn't be unreasonable to think this number isn't far from what EU policymakers have in mind. Certainly 200 - 250 billion euros seems to be in the right ballpark, especially when you take into account not only the problematic developer loans, but also the stock of properties on bank books, the need to help householders who will increasingly struggle to finance their mortgages and the growing numbers of small and medium sized enterprises facing bankruptcy.

Over 1.5 million housholds in Spain now have no one working, and have exhausted their unemployment benefit entitlement. They simply live from savings, family support and the 420 euros a month minimum payment. Clearly it is hard for such people to meet there repayment commitments, and their number is growing. Finance Minister Noonan deliberately over capitalised the Irish banks because he could see this problem coming - even though even in that case more may now be needed -  and it would be a good idea for Spain to follow his lead. Spain's banks have more than a trillion euros in property-related assets, and simply deriding those who are pointing to the potential problem this constitutes by suggesting doing this is  stupid because "mortgages get paid in good times and bad", as Santander CEO Alfredo Saenz did recently, seems to me to be just another case of the kind of Spanish bank denial the country now needs to put behind it.

Then There Is The Deficit Issue

According to one popular current of opinion the Spanish economy is now rebalancing nicely, competitiveness is being steadily restored while exports are going well. The strange thing, if this is so, is how the economy continues to go so badly. Even though undoubted progress has been made with the trade and current account deficits, and exports have improved, there is obviously still a long hard road to travel. Indeed, in general terms the situation is worsening, and we face two years of recession at least, while 2011 saw very modest growth.

I don't suppose the continuing rise in unemployment and the ongoing fall in house prices have something to do with the way this bad outcome continues to go on and on.

On the "things are steadily improving" kind of view there is only thing, apparently, which is standing in the way of full blown recovery, and that is the lack of investor confidence. This, apart from limiting inward investment, is behind  the rising cost of financing government debt (the huge quantities of money the commercial banks need from the ECB - 220 billion Euros in March -apparently isn't that much of an issue to worry to much about in this context). So Spain needs help from European partners to bring down borrowing costs on government debt, then all will be well, and "comeremos perdices" (we will all live happily ever after).

The question I ask myself is which world these people are living in. The biggest source of increase in government borrowing costs comes from the rapid growth in the size of the debt. So why is the debt growing so quickly? Aha, that must be a trick question, since normally the argument gets stuck precisely at this point.

The sad truth is that despite all the marvellous progress, the root of the problem still lies in the fact that Spain's economy still isn't sufficiently internationally competitive for the export sector to grow fast enough to pull GDP growth forward. Blaming the problems the periphery economies are having on a negative external environment is to miss the point, since the real issue here is why some countries are able to maintain some semblance of growth even in this context while others collapse into full blown recession. The only explanation can be that those who don't fall back at the first hurdle are better able to survive in the negative environment because they are more competitive. People can show me all the charts they want showing what magnificant progress has been made on unit labour costs, etc, etc, but the real Northern Blot test is this one: who is growing and who isn't?

So while earlier levels of government spending which are now unsustainable steadily retrench, and the private sector deleverages from all that accumulated debt, the economy struggles constantly for breath, with the result that attempts to reduce the deficit prove to be a source of eternal frustration as revenue constantly falls faster than expected.

In this context it is hard not to see the latest EU forecast for Spain as an attempt to pile on the pressure, and force the country into some sort of rescue, and indeed this is how it is widely interpreted in many parts of the press.  The Commission said that without additional measures the country is set to have a budget deficit of 6.4 percent of GDP in 2012 and 6.3 percent in 2013, way above the agreed Stability Programme targets of 5.3 percent and 3 percent respectively. The 5.3 percent figure was itself an increase from earlier commitments, agreed with Spain's new government to give it some leeway. So it looks very much as if by drawing attention to the country's difficulties in the way Europe's leaders are trying to get the Spanish ones to see sense and come in and talk about things, and especially the needs of the financial system.

This looks doubly true when you take a hard look at the numbers for growth and gross debt, since the EU expect Spain to have a 1.8% GDP contraction this year followed by a 0.3% one next year. They also expect the recession to be at its worst in the second half of this year as the already-in-place austerity measures really start to bite, following the respite Spain leaders allowed themselves for the Andalusian elections in the first half.

Government gross debt, on the other hand, is expected to continue to rise, hitting 87% of GDP in 2013. This is getting near to the kind of numbers I was talking about in my recent post on this topic. Some of the unpaid bills have now been factored in, how many are left we will have to wait for future publications of the financial accounts to see. There is still of course the debt hanging about on the books of state owned companies like railway operator RENFE or airports controller AENA  (maybe another 5% of GDP) to be consolidated, and resolution of this will become especially important if any of these are ever to be privatised, as the government has said is its intention.

But more importantly than this I would draw attention to two additional  factors people need to think hard about, and these are the longer run impact of additional costs in the financial sector, and the consequences for Spanish debt if the country hits a bout of Japan style deflation  at some point. Both these risks are hard to calculate, but they do exist nonetheless. The Commission forecast is based on a no policy change assumption, which means they have not projected any additional impact on the debt of financial system reform. There will undoubtedly be some, but how much is a hotly contested issue, with estimates ranging from 5% to 20%. Given that everything we have seen in Greece, Portugal and Ireland suggest numbers suddenly go out when national accounts are subjected to intense scrutiny I would veer towards the higher end,  especially given the recent debt/deficit revelations together with the now known inadequacies of Bank of Spain public reports.

The second, the impact of low growth with deflation or strong disinflation with negative growth also seems to be a scenario which is not widely contemplated, but which has a probability well above zero. Indeed, in this year's projections for gross debt increase this factor is already at work, since nominal GDP will likely shrink (lowering the denominator in the calculation). If GDP falls by 1.9% and the GDP deflator only rises 0.9% then debt automatically rises around 0.9% as a percentage of GDP. What is hard to quantify is how important this factor might be between now and 2020. Certainly raising competitiveness implies disinflation/deflation while lack of competitiveness, debt and fiscal adjustment imply near zero average growth over a number of years, and, as we are seeing, more frequent than normal recessions.

Then there is another item I touched on in my recent Spain debt report, the impact of outstanding pension liabilities on deficit reduction efforts. In fact the Commission itself have explicitly singled this issue out in their forecast.
"Whereas the (5.3 percent) target of the central government should be within reach, deviations are projected at this stage for regional governments," the Commission said. "Moreover, the social security system is projected to record a deficit again this year in line with a deteriorating labour market outlook."
I will come back to the regional governments issue in a minute, but let's think about the other item, the social security system. I went into all this in some depth in my debt post, but basically Spain has a problem that as the economy deteriorates, fewer and fewer people are paying into the pension fund, while more and more people are retiring. In addition, more people are becoming entitled to pensions than are dying, and those who retire tend to be entitled to a significantly higher  pension than those who expire. Hence there is a growing annual deficit. The problem is structural, and not simply cyclical, given the ageing population phenomenon, but it is also doubly structural given the fact that any early recovery in employment is not to be anticipated.

Now normally, what would happen in these circumstances is that the social security system would dig into the reserve fund to cover the differences for a time. But, aha, this is just the issue, since the fund, which currently has a nominal 65 billion Euros in it, really has very little, since now something like 90% of the investment which has been made has been in Spain government bonds (see pie chart below), and due to the complicated accounting rules of Eurostat these bonds to not count towards EDP Spanish debt, unless, unless - wait for it, drum roll - they are sold externally, to a non government third party. In this latter case they raise liquidity to help pay pensions without impacting the deficit, but they do add to debt. So here comes another 5% debt to GDP at some point, not to mention the loss the fund may have to take in selling, and in the meantime (ie before a decision to bite the bullet is taken on this) the shortfall rows in the opposite direction  to attempts to reduce the deficit.
Obviously this is another case of chewing gum and chicken wire accounting, and it puts me in mind of the little child who tries to save money in a variety of piggy banks, but each time he/she wants an icecream or a visit to the fairground she takes some of the money and leaves an IOU. Hemmingway reportedly said the bankruptcy creeps up on you slowly at first, and finally seizes you all of a sudden. I guess it is due to the operation of this kind of process, with widespread recourse to robbing Peter to pay Paul accounting.

Spain's Regions
Spain's regions are widely held to be behind the "uncontrollable" deficit story. To some extent I have already gone over the topic in this post, and Raymond Zhong adds a local Catalan perspective here, but still, lets have a quick run over some of the ground one more time. The story so far was offered by EU Commissioner Olli Rehn at the economic forecast press briefing:

"The Commission has full confidence in the determination of the Spanish government to meet the fiscal target in line with the pact. For Spain, the key to restoring confidence and growth is to tackle the immediate fiscal and financial challenges with full determination," Rehn told a news briefing."This calls for a very firm grip to curb the excessive spending of regional governments."
The real question, however, is whether this overspending stems from the decentralised structure in and of itself, or is largely a consequence of the kinds of areas which the regions are responsible for together with the extent to which the central government itself adequately provides finance for these.

Obviously everyone has their favourite unnecessary airport story, and it is clear that during the boom years there was massive and irresponsible overspending. But it is important not to get carried away with all this. In a way I don't consider either the regions or the town halls to be the big culprits here. They are victims in the same way many ordinary Spaniards are. That is to say they are the victims of their own ability to borrow and spend during the good times without thinking about the future.

But they are not the big players in the Spanish story, and the issue in Spain is mainly in the private and not the public sector. Public debt is rising uncontrollably because the economy is bust, which is very different from, say, Greece, where the economy is bust because government debt is rising uncontrollably.

On the other hand I do think the way the Partido Popular  are leveraging the regions' situation is interesting, along with the growing power-elbowing going on inside the PP itself. President of the Madrid Autonomous Community  Esperanza Aguirre - a leading figure on the right of the PP, and a key actor in the background to the Caja Madrid/Bankia saga - has been out and about of late, campaigning for more centralisation. Now this - given her declared ideology - was not surprising, what was surprising was what she wanted to centralise - education, health and justice. What she didn't want to do was abolish 15 of the 17 regional parliaments, which is one of the things many observers consider could help. There is duplication of politicians all across Spain, and not all Spain's regions have a separate national identity like the Catalans and Basques do. Letting these latter two retain their poitical autonomy while centralising the rest of Spain would seem like national minority favouritism to the majority of Spaniards, so it is seen as politically undoable. But if a government had sufficient will it could happen. The UK has a decentralised health service without the need for so many parliaments, and it seems strange to me that someone wants to leave the parliaments and centralise health. Only Wales and Scotland have parliaments. Does anyone else smell a political agenda being advanced here?

The same thing goes for many of Finance Minister Montoro's proposals. Most of them are perfectly reasonable as techniques for getting spending in hand, but they end up leaving me with the feeling that he is just itching to get inside Andalusia (controlled by the opposition PSOE) and Catalonia (where the government is lead by the nationalist party CiU) and start laying the law down. Since some of the worst cases of extravagant overspending have been in regions contolled by the PP itself (like Valencia, which nearly had to go bankrupt around Xmas) it will be interesting to see just how impartial his actions are at the end of the day.

But the key point to "get" is that Spain's regions have a spending problem due to the competences they have - like heath, education and care of the elderly - which account for over 50% of their budgets (in Catalonia this year they amount to nearly 70% of the total). It isn't simply a question of them being spendthrift in these areas, but rather it is Spain's demography that is working against them. A growing elderly dependent population - ten years from now Spain could be the oldest country on the planet - means the health budget rises every year (possibly by 3%) just to offer the same level of care, while the recent influx of immigrants pushed up the birth rate and lead to more demand for education. This latter phenomenon, while being one of the keys to the solution in the long run, only adds to the country's problems in the short term since the dependent population is rising at both ends of the age scale. Now the crisis has once more reversed the birth trend, and new intake at the infant level fell last year for the first time in a decade, but it will still be another decade before the knock-on effect works its way through. Leads and lags in demography are much longer than in normal economics.

So the problem is not the regional structure, arguably this is a much better way to organise service provision, but entitlement, which is often decided at the national level, and which is often derived through rights guaranteed via the country's constitution. Central government passes laws, which underfunded regions then have to pay to implement. Take the new Care Law, which ratings agency S&P's warned in 2010 would lead to growing pressure on regional finances. This provides entitlement to assistance in the care of an elderly dependent relative or disabled person, it provides entitlement but it does not provide funding, which the regions have to find from their already overstrained budgets. And this is the main complaint you will hear from the regions, that they are systematically underfunded in a way which makes central government deficit figures look a lot better, and their's a lot worse. This is one of the key reasons that Catalonia is pushing for its own tax agency, so that it can raise the revenue itself - as the Basque region already do - and then forward to the central government what is agreed to each year.

So central government also needs to be more responsible. Spaniards have been lead to expect world class health care, and while this was possible during the boom years, it isn't now, given the economic slump and the growing demographic headwinds. But someone has to tell Spain's voters that their pensions, health support and aid for their elderly relative is going to be reduced, and since no one has the courage to come forward and do this we have the "regional overspending" issue on the table.

Austerity Weariness In Spain?

I think austerity and why it is necessary is largely misunderstood in Spain. No one likes pain, and it is nice to think that there is a way out of all this that is relatively painless. The fact that the insistence on austerity comes from Germany adds to the problem, since it only serves to highlight a religious fault line that has long divided Europe.

Next Tuesday will be the first anniversary of the foundation of the 15 May movement (known colloquially as the "indignados"), and young (and not so young) people are demonstrating this weekend in cities all across Spain. There are no burning rubbish containers for the international press to photograph and the marches are largely pacific and earnest in their expectations. My feeling is that they are quite similar in composition to the supporters of the Greek Syriza movement, who did so well in the last elections in that country. And with the Bankia scandal ricocheting around Spanish public life, and the government unable to identify anyone especially responsible for the mess, anger and indignation is growing even among the PPs own supporters, many of whom were enticed into buying Bankia shares.

Part of the problem is that this situation has all become so complex that it is hard for people to understand. There is the Euro, the developed economy debt, the rise of emerging markets,China and, just to confuse things further, plummeting house prices. There is little in the way of employment opportunities, and young people are being forced to leave in growing numbers and look for work abroad. To cap it all, Spaniards are now having to drive along their motorways at night in the dark. "Who turned the lights out" is the question they are increasingly asking.

Naturally arguments and countearguments abound - would, for example, Eurobonds hep? Some say they would, while other experts are totally opposed. The dividing line between political opinion and technical expertise has become totally blurred. The layman or woman has no way of making a decision over many of the issues presented. What we do know, however, is that popular sentiment will eventually tire of making sacrifices and seeing no progress. This is the key factor which makes me fear demagogic outcomes.

The situation in the United States is often contrasted with that in Europe, but it is far from clear that the US economy has actually recovered. This is an election year, and double digit deficits are still permitted, but what about next year? Somehow I doubt even the United States will be able to avoid its own share of austerity.

The recent general strike was understandable on the one hand, people are feeling frustrated, and sense that austerity alone won't work, but on the other the idea that the answer is more government spending also isn't too convincing. Japan has had expansionary fiscal policy for over a decade now. We have seen little in the way of sustainable economic recovery there, but we have seen a huge explosion in government debt. Is that an advisable path to go down? Is Japan stable in the longer run? There are too many questions lurking here to buy the simplistic solutions. Once you strip the anti-austerity arguments down, they are based on an idealisation of the US and Japanese experiences.

So Where Are The Long Run Solutions?

Well, my opinions on the solutions front haven't changed much in recent weeks. The scenario I outlined in my Wolfson prize submission is still my baseline expectation.  I think there are no perfect solutions, we are in the midst of a huge demographic transition which compounds the debt crisis due to its impact on population pyramids, on growth rates and on what is sustainable and stable in the longer run in terms of public spending. The Euro is not the root of the problem - which affects all developed market economies to a greater or lesser extent - but it is certainly an aggravational element. That is to say, the countries on Europe's periphery could be a lot more effective in confronting the problems they face if they weren't in the Euro, but they are, and we need to live in this world, not some imaginary one that would be a lot nicer. Leaving the Euro would be an option if it could be consensually agreed, with a sharing of the collective losses, but this isn't going to happen, since core Europe won't agree.

On the other hand, the austerity measures are dividing Europe down the middle, and the continents democratic foundations are being shaken. Hungary is an even clearer example than Greece. The Euro is a kind of Doomsday Machine which is neither stable in itself, nor can it be dismantled. As I have often said, whom the gods would destroy they first make mad. Funny how that is a phrase which has its origins in Greek literature.

Having said all of that, we here in Europe could be doing much better than we actually are. A common fiscal treasury and joint and several Eurobonds on their own won't entirely resolve the difficulties countries like Spain find themselves in - due to the existence of the competitiveness and growth problem - but both of these certainly would help. Another alternative would be a structural change in the Eurozone - dividing the Euro in two, for example. But, anyway you look at it, losses need to be crystalised, and shared, and hard core Europe isn't ready or willing to talk about this. And so we head for disaster.

While the attitude to Eurobonds could change following elections in France and Germany this year and next, I am not optimistic that the changes will move fast enough and deep enough to bring that much needed  relief. And meantime the "high noon" moment is fast approaching in Greece.

Democracy is coming under threat along the periphery as people become steadily more and more frustrated and search for alternative "unorthodox" policies that can offer a miracle cure. As Paul Krugman said in a New York Times Op-ed recently, "The question then was whether this brave and effective action (the ECB LTROs) would be the start of a broader rethink, whether European leaders would use the breathing space the bank had created to reconsider the policies that brought matters to a head in the first place. But they didn’t. Instead, they doubled down on their failed policies and ideas. And it’s getting harder and harder to believe that anything will get them to change course".

And Whither Spain?

In the Spanish case doing a bank recapitalisation which wasn't just based on working back from the number the country could manage to fund unaided would help a lot. The bank balance sheets need freeing up so the commercial banks can go back to their more normal activities, and help that part of the company sector which is able to grow and create employment. A large sum of money needs to be injected, and this can only come from a common European effort. Having the Bank of Spain accept two external valuations of bank assets and likely losses under a variety of scenarios is a step in the right direction. Having European auditors installed inside both the Ministry of Finance and the Bank of Spain would be another, given the doubts which have been raised about how Spain packages sensitive data for public consumption. Europeans who put their money in need some sort of guarantee about the effectiveness of implementation.

On the political level, Mariano Rajoy's leadership is obviously wobbling. This was always coming, but I hadn't seen it happening so quickly. But then I hadn't forseen the mediocrity of the present Spanish administration, and the difficulty they would have speaking with one voice. The latest performance surrounding the Bankia crisis, with Rodrigo Rato saying one thing (that he was forced to go) and Luis de Guindos saying another (that he wasn't) while the government have still not "detected any reprehensible behaviour" in the whole affair simply serves to underline the country's lack of credible leadership - a factor which only makes Europe and the markets even more nervous. Manuel Arias Maldonado, politics professor at the University of Málaga summed the situation up in a quote in a Financial Times article recently, “There’s no single voice explaining clearly to the citizens what’s going on,” he told Spain correspondent Victor Mallet, “I think Rajoy lacks the qualities needed for this job – to be self-possessed and clear, and to transmit the confidence that is needed now.”

Basically this administration has easily excelled the last one in its ability to contradict itself. Perhaps the best recent example was that of Jaime Garcia-Lehaz, Secretary of State at the Economy Ministry, calling for ECB intervention with bond purchases almost exactly the same time as Mariano Rajoy was in Poland arguing that Spain could manage on its own. “Talking about a rescue makes no sense", he told his audience, "Spain is not going to be rescued, Spain can’t be rescued. There’s no intention, and no need and so Spain will not be rescued.”

The bickering between PP aparatchick and Finance Minister Cristobal Montoro and the far more independent Luis de Guindos has been constant, and the big fear investors have is that the Economy Minister is not able to carry through the sort of financial reform he must be able to see Spain needs due to his being overruled by the Finance Minister, who is much more sensitive to what accepting a bailout and injecting public money into the financial system would do for his party's electoral outlook. 

Again arguing in public about the actual size of last years deficit didn't help. But surely the turning point in the perception of this government  came when Mariano Rajoy went to Brussels to give press conference asserting his country's sovereignty and his ability to decide his country's budget for himself. The irony, of course, was that he was in the EU capital to sign an agreement for greater cooperation between Euro Area member states, and he completely omitted to inform his peers of his intentions, thus highlighting the ineffectiveness of the measures being agreed to. The end result was to put in question both his abilities and judgement and the capacity of his country to fulfil its deficit targets. Since that day he has been fighting hard to recover lost ground.

Previously my hopes would have been on what people in Spain call a new version of the Pactos de la Moncloa, these were the agreements reached between all Spain's political parties and social partners in 1977 (with the King playing a decisive intermediating role) and laid the basis for the framework of the new Spain following the ending of the Franco dictatorship. I say previously because, apart from the apparent absence of anyone with the calibre and moral authority to lead the country in this difficult moment, a recent unfortunate accident in Botswana has effectively ruled out one of the key participants.It is hard not to get the feeling that Spain is "jinxed" right now, especially with Cristina Fernandez also deciding now is a good moment to start a vendetta with the country.

If at first you don't succeed................

In the meantime, this is now the fourth attempt at financial reform since the crisis started, and it surely won't be the last.  “All the previous efforts have been announced with a drumroll and a big clash of cymbals but they weren’t credible in the end,” Javier Diaz-Gimenez, an economics professor at the University of Navarra’s IESE business school in Madrid told Bloomberg news.

Dare I say it, the current proposals run the risk of suffering the same fate as all the earlier ones. There is a difference though, previous reform efforts had been based on working backwards from the level of provisioning the banking system could provide without breaking it. This one is based on a reverse engineering calculation about how much provisioning the Spanish state can afford to support without going to Europe for help.

What is needed now, however, as Europe's leaders are demanding, is a full, frank and independent assessment of the true extent of the provisioning needed to withstand a realistic shock scenario - real estate prices hitting 2002 levels and staying there, unemployment over 20% till the end of the decade, Spain's population falling by 2 million young people as they leave due to lack of work, etc - and then go and get the EU to provide the funds needed - under conditionality of close and constant EU inspection of Spain government and Spanish bank numbers, this is the only way to now get credibility back, and this way Spain could really demonstrate it is making the progress it claims to be making.

As a friend of mine said to me yesterday, the goalposts are moving, and that is good, but they still have some way to move yet awhile. Simply allowing Spain's reform efforts to degenerate into a debate between PP and PSOE about who is more responsible for the Bankia mess - Mariano Rajoy and Esperanza Aguirre (PP leaders who put Rodrigo Rato at the front of Caja Madrid) or Bank of Spain governor Miguel Angel Fernandez Ordoñez (a card carrying PSOE member, and former aide to Pedro Solbes in the 1990s) is a childish and stupid waste of time. All of Spanish society is somehow implicated here, since almost everyone either actively or passively (by not allowing themselves to see what they should have seen) has participated in the charade. Blimey, only a couple of months ago the Spanish press were even leading their readers to believe that BBVA in buying Unim were grasping a good business opportunity. And almost everyone was trying to argue that Spain is not Ireland, let alone Greece. Time will tell, but the bank numbers now look more and more like Ireland, while the statistical issues increasingly resemble Greece, even if the difference between Spain and Greece is that Spain's bankers and politicians do know perfectly well what they numbers are, they simply don't want to admit them in public.

Going back to gum and chicken wire, I remember reading in the report on the Three Mile Island nuclear accident, that in the run-in to the problem maintenance had either been neglected or was completely ad hoc. The archetypal example for this was the discovery that a hole in a cooling pipe had been plugged using a basketball. There you go Mr de Guindos, that's the missing link in your chain of half-thought-out botched jobs, go find a basketball!

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