Friday, June 08, 2012

Rocco Rossi is Wrong

The notion that the Spanish "socialist" government spent "well beyond its means" is silly. The Spanish were running surpluses prior to the down turn. Indeed, Zapatero's government ran a surplus in his first 3 years in office and in 2007 a surplus of 23.2 billion Euro was the biggest in the Euro zone. Spain's debt to GDP ratio was not a problem either. Spain's gross debt to GDP ratio was almost half of what it was in Canada in 2007. Spending did increase under Zapatero, but at a rate no more than under the previous regime. Government spending as percentage of GDP remained unchanged between 1999 and 2008. As for government spending as percentage of GDP, it was far less than any other major European nation and slightly less than it was in Canada.

Spain's deficit problem was not the cause of the crisis there. It was consequence of it. Spain had a massive real estate bubble and in 2008 it burst. This created the perfect storm. Hundreds of thounsands quickly lost their jobs and began collecting unemployment insurance (800,000 Spanish lost their jobs in first three months of 2009), government revenues collapsed and most important of all Spain's banks began to fail. Mountains of private debt was transferred onto the public balance sheet. In fact, Spain's 4th largest bank is nothing but bad private debts backed by the government. To add insult to injury much of Spain's growth in the boom years was fueled by huge influx of foreign capital from the center of Europe. Spain, like all of the so called PIIGS, ran a massive capital accounts deficit. When things began to go south and Spanish credit markets began to seize, that capital was repatriated.

Now, when the economy is in a crapper there are a number of things governments can do with respect to monetary policy. Most notably they can reduce interest rates, devalue their currency and they can print more money (so called quantitative easing). None of these things is open to the Spanish government. They surrendered their monetary sovereignty to the ECB and the ECB has done a terrible job managing the crisis. The ECB was slow to lower interest rates, even tried to rise them last spring and they have only allowed one round of quantitative easing. It should be noted that since the downturn deficits and or debt have proved to be a lousy predictor of bond yeilds. For example, both the US and Britian have deficit to GDP numbers that are as equally high or higher than in Spain, both have debt to GDP ratios that are far higher, but both can borrow at record low rates and well below the rate of inflation. Bank capitalization, unemployment and a lack of monetary sovereignty have proved to be far better predictors.

Given Germany's unwillingness to let inflation in the Euro Zone and Germany in particular to rise above 2%, the only option open to Spain is to try to deflate its way to competitiveness. This is not likley to work. Spanish workers already earn far less than German and French workers as it is. Spain needs to develop a more educated workforce and improve its capital stock to truly compete with Germany. This is not likely to happen in the current environment. Deflation also makes the debt crisis worse much worse.

It is thus not a surprise that Spanish yields are rising and that it can not afford a further 60 to 90 billion Euros to recapitalize its banks. The ECB is asleep at the wheel and more than anything else investors are worried that Spain is going to decide that things are so bad it might as well leave the Euro. This in turn would surely mean defaulting on its debts.

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