A Month In Spain That Didn’t Shake The World

Journalists are undoubtedly  having hard time following official economic policy in Spain at the moment. The core of the problem they face is that we have a hydra headed government which speaks with many tongues. In some ways the lack of coordination can be put down to simple newness and inexperience, although it should be noted that all the principal actors were in action the last time the PP was in office, as part of  the Aznar government.

On the one hand there is Luis de Guindos, the former Lehman Brothers Spain CEO, who is now economy and competitiveness minister. Then, on the other, there is his dopellganger, Cristobal Montoro, long time professional politician with the country’s Popular Party, who is the country’s new finance minister. And then, of course, there is Prime Minister Mariano Rajoy who has decided he himself will personally assume overall responsibility for economic policy coordination and effectively be the country’s economy “supremo”, even though it is important to understand that he will normally communicate his decisions to us through the lips of his deputy prime minister, Maria Soraya Sáenz de Santamaría.

The key point to grasp here is what Soraya says goes.

Now having got that straight, and putting this important question to one side, we might like to consider other matters like economic policy, and how to handle that most serious crisis which Spain’s economy finds itself in. Here Luis de Guindos has recently been most helpful, since he decided to use the pages of the Wall Street Journal last week  to outline the general policy approach of the new government. As he tells us, “Fiscal consolidation is not a choice”. In other words, Spain was going to stand by its commitment to try for a 4.4% fiscal deficit in 2011. This reminds me of one of those old “billion dollar question” quiz shows, you know, will you go for the big question, even though if you get it wrong you might loose everything? Spain is, he tells us, going for it.

This public revelation was, to say the least, curious, since at more or less exactly the same time the “other” economy minister – Cristobal Montoro – was telling the Financial Times Deutscheland (that’s why I mentioned several tongues) that the government was having a rethink, and maybe in the light of such a strong recession in Europe, a slightly smaller deficit reduction would be more appropriate (for those who will loose the subtelty of the argument in the German version here is a brief English account).

Naturally – you already guessed – Soraya was quick to come out and make the position clear.

Hours later, the Spanish government scrambled to nuance the comments, which appeared to deviate from what has been a strict policy of deficit-cutting. Deputy Prime Minister Soraya Saenz de Santamaria said the government was determined to meet the 4.4 percent goal and if “more reforms and greater rigor” were needed to achieve it, they would be enacted.

Don’t miss that bit, more reforms and greater rigour. Spain is evidently being entered for the “iron man” contest, and indeed it wouldn’t surprise me to soon see references to our dear Soraya as the new “Iron Lady”.

Not that this was the first time the government had had to step in and separate the two apparently squabbling economy ministers. Signs of tension between their respective departments had already appeared during the first days of the government, with Cristobal Montoro claiming the 2011 deficit was 8%, a complete 8%, and nothing other than 8%, while Luis de Guindos heavily hinted that the final number was likely to be several tenths of a percentage point above that number. On this occassion it was not Soraya, but the interior minister Jorge Fernández Díaz, of all people, who came out, banged their heads together, and announced the official government version of 8.2%.

Complete &  Perfect Knowledge

Going back to the Luis de Guindos WSJ article, I would highlight a number of points. In the first place he makes a pretty strange claim.  “We perfectly understand,” he tells us, “the reasons our country has been brought to the outrageous situation of having the highest unemployment rate among developed economies.” Now I don’t know if I am alone in this, but I do find that a rather incredible way of putting things. The phrase is even more incredible given that it repeats almost word for word a statement Prime Minister Mariano Rajoy uttered earlier in the week. “My government,” he told his audience, â€œknows perfectly well what it needs to do to improve Spain’s reputation, stimulate growth and create jobs”.

At face value all of this seems an almost arrogant way of putting things, given that perfect knowledge is something we humans are not normally thought to have, and doubly so since even among “experts” there is still a huge debate going on about why Spain’s economy didn’t start to recover along with most other developed economies, but then it occurs to me that such a bold posture may be sheer bravado, and more to do with uncertainty and insecurity about what to do. The aparrent disarray among the various economy representatives does seem to give this idea some credance.

The suggestion that the Spain’s new government have been drinking the elixir of total knowledge looks even more questionable when we look at the next claim de Guindos makes:

“In Spain, we have inherited a very centralized wage bargaining system that establishes salary increases at the sector level. This system has proved to be one of the main reasons for the loss in competitiveness we have suffered during the last decade”.

This is a strong claim, a strong and highly questionable one. In fact I think Mr de Guindos is confusing two things here: why Spain lost competitiveness, and why Spain now has the highest unemployment rate in the developed world.

It’s The Housing Bubble, Stupid!

Simply put I think Spain’s centralised wage bargaining system can explain why Spain hasn’t had an internal devaluation and wage and price reduction of the kind Latvia, or even, Ireland had. Spain’s labour and product market structures are inflexible, and this is why the economy is having so much difficulty adjusting, and making the transition from a construction and consumer-demand driven economy to an export-driven one.

But this lack of labour market flexibility isn’t NOT the main reason competitiveness was lost before the start of the crisis. The reason competitiveness was lost was the availability of excessively cheap borrowing made available by Europe’s large and deep capital markets and cheap interest rates at the ECB. It was this massive and cheap liquidity which generated one of the largest property bubbles seen this century. The bubble created huge distortions (many of which have still to be unwound), and basically meant that it was too easy for everyone (workers and employers alike) to make money, so there was no pressure even on the employers themselves to address the fact they were paying increasing wages without getting increasing productivity. It was simply a “cool” time for everyone.

Other countries lost competitiveness during those years, but not all of them had the same labour laws or bargaining systems. The problem here is that if you don’t “perfectly understand” why the country had the crisis in the first place, then you may not be able to put the consequences straight. Spain’s problems have a clear European dimension, a dimension which goes well beyond the simple difficulty of selling bonds which forms part of the Sovereign Debt Crisis. Strangely Mr de Guindos’s article has little to say on this point, so here he and his government would do well to study a little more closely the playbook Mario Monti is working from.

Now obviously Spain’s labour laws and bargaining system needs reforming, and Spain’s economy minister suggests that his government is working towards the kind of single contract being proposed by the authors of this article. Certainly they make a convincing case for the changes they propose, but my feeling is that a reform of this type won’t be sufficient to dynamise growth in the way everyone is expecting, since the measure relies essentially on job churn to have an impact and this in an economy where employment is contracting, and likely to continue contracting over the next two years at least.

Evidently there is currently a high volume job churn in Spain, but this process is only taking place among those workers the authors term “ousiders” – the ones with secure long term contracts (the “insiders”) tend not to move (for obvious reasons, and naturally this is why the labour market is rigid and inflexible). Basically the present system favours older workers to the disadvantage of  younger ones, who have to face very high levels of unemployment (not far short of 50% in some age groups) and those who leave their studies with often excellent qualifications find few opportunities for rapid promotion and all the evidence suggest are voting with their feet and steadily leave the country, following in the footsteps of an Italian experience which was already very clear even during the first deacade of the century. If you are going to rely on labour market reform to carry out your competitiveness devaluation, then something much more radical needs to be contemplated: like resetting the whole current system of contracts and staring over again.

A Country Fit For Young People To Stay In

Naturally Spain’s political leaders are reluctant to contemplate this, since the response from older workers already benefitting from seniority would be monumental. The electoral weight of voters over 50 in a rapidly ageing country like Spain is very important, and as far as politicians are concerned their neeeds are much more “strategic” than those of the far smaller generations of younger voters. It is not without significance that one of the fisrt measures the new government announced, despite the existence of what they call a most grave financial situation, was to raise pensions by 1%.

Part of the problem with restarting a broken and structurally distorted economy like the Spanish one how to enable companies to restructure and downsize. In particular, if the country is to adopt a “new economic model” this process needs to be made much cheaper for the individual concern,  and wages need to be tied to productivity, not seniority, with compensation funds for redundancy being held by central government, and not at the individual firm level.

Spanish workers, like their Japanese counterparts, need to accustom themselves to the idea of adopting a second, less well paid, career in the 55 to 70 age group. We also need to get away from the idea that doing so-called “menial jobs” has some sort of social stigma attached. It sounds marvellous to talk about high-tech, high-value growth models, but the reality is that most of Spain’s 55+ workers lack the necessary skills to participate in this, while there are lots of socially useful jobs (looking after old people, which is now almost entirely done by recent immigrants who continue arriving) that people could take on. Subsidising people at 58 to go for early retirement is no substitute for a sustainable employment policy.

Naturally Spain is not alone in suffering from this growing brain and talent drain. There is a  steady flow of young talent away from Europe’s periphery, and it continues to cause controversy. Only this weekend Ireland’s finance minister Michael Noonan got himself into some hot water by saying that an important factor influencing young people in leaving the country was a lifestyle decision. Naturally there is a lifestyle choice involved, in particular since many of the young people leaving don’t want to spend the rest of their lives in societies driven by “depresssion economics”, accepting the kind of lifestyle their older compatriots seem quite content to vote for. They don’t want to first have to accept the main burden of the crisis (as the “oustiders” in all those inflexible labour markets), and then the cost of maintaining in perpetuity the various oversubscribed health and pension systems which Europe’s ageing societied are going to produce. Michael Noonan is quite right, leaving is a choice, and in many cases it is an appropriate and intelligent one. What is not appropriate and intelligent is the response of national politicians either denying the phenomenon doesn’t exist, or suggesting the consequences won’t be important.

No Money, No Credit, No Credit, No Jobs

Which brings us to the third strand of the new governments “gamechanging” policies, the reform of the financial system.
“The new financial reform we will launch shortly will oblige banks to increase their provisions sufficiently to cover any writedowns that may emerge on their real-estate-related assets and loans. Taxpayers’ money will not be used to finance the additional regulatory requirements arising from the reform. All the funds implied will have to come from the system’s own internal resources”.

What this basically means is that while the ECB’s 3 year LTROs will help banks with their liquidity problems, the banking system is going to be left to itself on the solvency related issues. Capital ratios have to go up, as will provisioning, and doing this without taxpayers mone lending will need to be cut back, there are no “ifs” or “buts”. But if lending is cut back, how do you get growth or job creation?

Why is it so obvious, you may ask, that doing Spain’s financial restructuring with only a minimum of government money will lead to a reduction in lending. Well actually, this idea is not so surprising, Spain’s financial system is struggling, and if you look at the charts below you will see that lending in Spain (to both households and corporates) is falling and has been doing so for some time.

As Charles Penty reported in Bloomberg last week:

Loans and deposits at Spanish lenders fell at their fastest pace on record in November and defaults jumped as Prime Minister Mariano Rajoy prepared measures forcing banks to recognize more real-estate losses. Lending fell by 2.94 percent from a year ago and deposits slid 2.99 percent, the biggest drop since the regulator’s records started half a century ago, the Bank of Spain said on its website today.

Basically the issue here is that most of the economies on the Euro Area periphery are currently over leveraged. That is to say the proportion of their TOTAL debt (public and private) to GDP is too high relative to their future capacity to pay, and this problem is really behind why we had the global financial crisis in the first place (in most developeed economies including in the US). If 4 years into the crisis people haven’t gotten thru to this simple point, then they can’t  have  been reading the right kind of material.It is important to understand that from this point of view it doesn’t matter whether the debt is public or private.

Now, and here comes the issue where there is debate, if you have too high a debt ratio (that is, if you are overleveraged) you can reduce it either by growing GDP (nominal GDP) or by reducing the debt. That is why Paul Krugman tries to ridicule those who say you can’t reduce debt by contracting more debt. It isn’t that simple. If you run a company, and you have a good product, then getting some working capital from the bank to let you produce, and even a subsidey from the government to get you started, then maybe by going to work you will be able to pay back more of what you owe. And as with the single company, so with the whole economy on aggregate.

But, here comes the rub: the countries on the periphery can’t get the growth they need until after they have deleveraged, since getting more credit will only make them even more leveraged  and since they have a competitiveness issue they can’t  expand their export sectors as fast as they need to to get traction. So they are stuck, and this – and not the credibility of some ratings agency or other – is what the whole Euro Area debt crisis is about.

Once these economies have deleveraged, which means the banks will have less credit on their balance sheets, then, of course, the banks can leverage again and offer new credit. This kind of deleveraging is long painful and arduous, since it also produces deflation (economies contract along with credit) but with time (let’s say a decade) competitiveness is restored. In the meantime it is not clear how many of the countries young people will have already thrown the towel in and left.

The other alternative is to write off bad loans, but this means accepting losses, and with these government intervention in the financial sector. So banks and governments are reluctant to do this, since it balloons the deficit (see Ireland), and prefer the slow process.

What I am saying is not that no new loans are possible, but that new loans can only be issued after old ones are paid or written off, and after the balance sheet has been reduced to deleverage a bit. Which means the quantity of new loans is not sufficient to produce growth or (in Spain’s case) stop unemployment rising.

This issue is deep structural (if complex) and there is no simple rule from a central bank which can produce new credit (although see my Masssendowngrade Effect post for more detailed explanation about bank “liability management”, and how this interferes with the process of “creative destruction”).

A Tripod That Doesn’t Work
So Spain’s government is basing its strategy on an attack on three fronts – the deficit, the labour market, and the financial system. They have made their analysis, and now they are going to work.

On the fiscal deficit, their argument is not, of course, incorrect. Fiscal consolidation at this point is not a choice but an obligation for Spain. However I can’t help asking myself, given that Spain’s debt to GDP at 70% is still significantly below the EU average, and given that the government isn’t going to use public money to help clean bank balance sheets (at least it is going to try not to, it remains to be seen if it can avoid this outcome) whether it wouldn’t have made sense to do what Cristobal Montoro was suggesting, and negotiate a bit more “wiggle room” with the EU on the 4.4% objective for this year, since really the cumulative effect of having a negative external environment, banks deleveraging and such drastic cutbacks will surely be – as I’ve been arguing – to send Spain into a serious economic depression (even the IMF now see Spain having a 1.7% contraction this year and a 0.3% one next, and the actual outcome could be significantly worse).

Spain’s economic problems are very grave. The country is facing a decade long depression, and if enough young qualified people leave during this period then the country could enter a negative dynamic from which it will never properly recover. At the outset (2007) I and others argued for a 20% internal devaluation to shift resources over to the export sector. This did not happen, and virtually no one is interested in the idea. The main priorities are still reducing the deficit, and restructuring the financial sector without injecting any significant quantity of public money. Both these policies are contractionary in their impact. In addition the proposed labour market reform is timid, and won’t act quickly enough to stop the rot on the growth front.

One of the key reasons given by Standard and Poor’s recently for downgrading the Spanish Sovereign by two notches was preoccupations about the growth outlook in the context of the cut-backs and recapitalisation. Investor confidence and credit ratings will come back up when economic growth is put realistically back on the agenda for Spain. I have a feeling S&P’s understand this reality a little more “perfectly” than Mr Guindos and his advisors do. In any event, at the end of the day we all live in an imperfect world where perfect knowledge is available only to gods not mortals.

This entry was posted in A Fistful Of Euros, Culture, Economics, Economics: Country briefings by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

11 thoughts on “A Month In Spain That Didn’t Shake The World

  1. Confronting

    “adopting a second, less well paid, career in the 55 to 70 age group.”


    “looking after old people, which is now almost entirely done by recent immigrants who continue arriving”

    I just wonder whether you realize the contradiction.

    One needs to be in good physical condition to look after old people. Because concretely it means carrying people from their bed to the bathroom, delivering groceries around, or making the house cleaning chores.

    The corresponding jobs are also frequently poorly paid — which all explains why those jobs are done by young, recent immigrants with few other perspectives.

    The idea that such jobs, in their current form, could be construed as a “career” is also very perplexing.

  2. It seems to me that, when you speak of the difference between “insiders” and “outsiders” in Spanish and Italian labor market, you imply that there is a “generational war” between older workers, who have better wages, benefits etc., and are protected by excessive pro-worker legislation, and younger workers, who cannot enter the job market and are stuck with sucky jobs.
    The implied logic of this seems that, in order to give space to younger workers, the excessive protections put in place for older workers should be removed: older workers should gain a bit less and have a bit worse jobs, so that younger workers can gain a bit more and have a bit better jobs.
    In my opinion, at least in the Italian case (but possibly also in other places), the story is quite different:
    Some time ago, I read on “la Repubblica” that while in the ’70s in Italy the share of wealth that went in wages was 80% (and 20% to profits), in the ’00s it was 72% (and 28% to profits). In other words, wages fell by 10% in relative terms (on the total of the economy).
    Since Craxi in the ’80s, the idea that the Italian labor market is not flexible took hold on Italian politics, and various governments put in place various “pro-flexibility” (read: anti-labor) laws. But since unions were still quite strong, those laws were made in such ways as to only impact on new (and thus usually younger) employees.
    The advantage of this increased “flexibility” however went mostly to capital (hence the increase of the relative weight of profits on wages), without decreasing unemployment or increasing productivity or competitivity.
    In my opinion, if the labor market is “reformed” by stripping older workers of their perks, productivity won’t rise, it is also possible that even competitivity won’t rise, just capital will have a bigger share of the pie (in facts this will happen anyway, as older workers phase out).
    This happens because the fall of the cost of labor doesn’t create any incentive to increase the productivity of labor (in facts might even produce the opposite incentives).
    This is more or less what happened in the USA in the previous decades, it will just happen to the EU now (beginning from the periphery).
    I will also add that, since “workers” have in general an higer propensity to consume than “capital”, if wage’s share of the economy falls aggregate demand has to be sustained by increasing leverage, leading to our current situation.

  3. “It seems to me that, when you speak of the difference between “insiders” and “outsiders” in Spanish and Italian labor market, you imply that there is a “generational war” between older workers, who have better wages, benefits etc., and are protected by excessive pro-worker legislation, and younger workers, who cannot enter the job market and are stuck with sucky jobs”.

    Well, I hope it isn’t a war, but if you mean do I think the “class war” has now been replaced by the generational one, I guess you are right, I do.

    I belong to a generation who more or less had it all, and then left a mess behind us. We even went around having very few children, arguing that it didn’t matter, since we were all going to be rich anyway, so what the hell.

    Now the unsustainable credit bubble has fallen apart round our heads, while emerging market economies are advancing at a lion’s pace. Our population pyramids, and with them our health and pension systems, are not sustainable. It’s called the Euro Area sovereign debt crisis.

    Those in their 20s today belong to the first generation in modern history who will be poorer than their parents. We have to learn to live with that, and find a way to manage the transition towards the society of “each time less”.

    Perhaps the zero growth ecologists will be pleased, but I only see problems at the social and political level.

    Not sure about your Republica quote. Sounds strange to me that nearly 30% of Italian GDP is profit. Are you sure you are not talking about labour and capital shares? That would make a lot more sense, since the Italian economy has become a lot more capital intesice since the 1970s.

  4. Basically the argument is quite simple. The labour productivity age function has the shape of an inverted “U”. Productivity is low when we are young (and even negative below a certain age, obviously) and rises to a peak somewhere around 50.

    After that it declines, and probably becomes negative again around a certain age.

    Wages and salaries should reflect this curve.

    Can’t explain more now, have to walk to catch a bus to Barcelona, and I can’t run, since I’m not as young as I used to be 🙂

  5. Edward, our expansionary austerity fans would tell you that you should run to stay young 🙂

  6. When you state that the wages fell in Ireland and Latvia, are you referring to the average wage or to the total mass of wages? Which indicators are you using?
    I don´t see an internal devaluation there, I rather see a great decrease in the income of the people, and also take into account that there the GDP fell by more than 10%.

  7. I think that the final signal of how doomed we are in Spain is that Edward Hugh seats in the board of a bank in Spain. Not just any bank but one of the few that has needed to tap money from the government. It is 90% owned by the state:


    I just wonder who could ever make the decision to appoint him? Are we really in the hands of such maniacs?

    And well, if Edward feels it proper to hang an old photograph of our new vice-president I am sure he will not mind if we watch this video were he announces that Spain was going to default in the summer of 2010. They also adventure the distresses that this was going to cause, including famines, violence, civil war…


  8. Re: total share of profits in Italy.

    Unfortunately I couldn’t find the Repubblica article I was referring to (I think it was more than a year old), however I found this pdf googling the web that puts the “profit share” for the USA at 36%, so that my number of 30% for Italy doesn’t look unlikely:


  9. I think the whole ”adjusting to the idea that we will be poorer than our parents” is actually bullshit. The rich have plenty money. It stands to reason that if we took all of it and distributed it (to the last dime) evenly, we’d all be well-off.

    It’s capitalism that needs to die. The younger generation shouldn’t make any sacrifices to save it.

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