Raising Taxes In Spain Is Not A Solution!

Victor Mallet had a piece on public works minister José Blanco’s Thursday speech in the FT yesterday. My feeling is that the Spain of Zapatero looks more and more like the Hungary of Gyurcsany with every passing day, and I say this more from the point of view of the twin deficit problem, and the impression the administration gives of things being totally out of control and no one knowing what to do, than anything else.

I am not at all party political, and my observation should in no way be read in that sense. The situation has only deteriorated since Solbes and Vergara were ousted, and the only mystery for me is why exactly they were replaced with a team who have no understanding of macro economics whatsoever. For the record, I predict the IMF will have a permanent delegation in Madrid before 2011 is out.

As the following chart – from Dominic Bryant at PNB Paribas – makes clear, while Spain’s households and corporates are busily deleveraging, government finances are deteriorating in a totally unsustainable fashion.

On the details of Blanco’s statement, I would simply make three points.

Firstly, it is far from clear that this is a serious proposal. There must be a battle royal going on inside the PSOE even as I write, and this proposal may well have more to do with internal party debates than anything more substantial. Economy Minister Elena Salgado has been notably silent, so one possibility is that Blanco made the speech simply to “test the ground”.

Basically, the current Spanish administration want to hear nothing of internal devaluation, and will try anything to avoid that going down road. The biggest issue they have is growing deflation, and falling revenue as prices drop. This has been a common picture across Eastern Europe, it is just that the states in the South of Europe are rather richer, so there was more flesh on the bone when the crisis broke. They have a salary increase for public servants pencilled in for next year, and this, of course, is a commitment which it will be impossible to honour in the present climate.

Secondly, the biggest unspoken issue we are seeing in one economy after another is the retreat of a lot of activity back into the informal sector. So called economic “greying”. Just look what is happening to revenue in Italy. Again, we have seen this happening throughout the East. The contractions in the Baltics are nowhere near 20% in my view (although they are, of course, very large), people simply are declaring less and less. This is a problem the IMF are struggling with day in and day out in Latvia. But this whole process makes things very difficult for government finances, as we are seeing. More tax increases on the very rich and professional middle classes will be entirely unproductive as they will only accelerate this process.

Lastly, increases in VAT. These are again very counterproductive, since they hit consumption directly, at a time when consumption is declining anyway. All such increases do is accelerate the contraction (IMHO the IMF is wrong to be advocating this in the East, but undoubtedly they feel they have little alternative if they wish to preserve some minimal semblance of social services, which they need to do to get the population to agree to their packages in the first place). I wouldn’t even mind betting that a VAT hike would be nearly revenue negative, for the consumption drop it would produce and the retreat into the informal economy it would accelerate.

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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 “Raising Taxes In Spain Is Not A Solution!

  1. I note from your graphs that the Budget Deficit in Spain is much less than half that of the UK.

    Should we deduce that the comments you make about the Spanish Government, its tactics and the possible remedies, apply doubly so to the UK Government?

    All I can see before my eyes (in the UK)is a very substantial brick wall, fast approaching.

  2. The Novum in the Baltics, resulting from greying of the Economy, are the “dry” stimulus measures (means without additional funds). In my professional opinion Baltic States have to leave, at least temporarily, European Union. Because these stimulus measures will make totally awkward precedent in the EU and can be enormously misused by any EU businesses:

    1) replacing en mass proportional taxes with flat sum fees, to an unprecedented extent,
    2) massive definition of new “bounty” type taxes, as the real estate tax planned in Latvia,
    3) massive closure and liquidation of social infrastructure, reduction of all social benefits, therefore making it totally unappealing to pay any social taxes.

    This all means that in Baltics with bottoming of economy, the functional character of economy will become absolutely inelastic. This means that in case export demand will increase, the economies will be insensitive to that.

  3. John,

    I would dearly love to answer your question, but I hate to comment on things I know next to nothing about (same case US economy). All I have is a general impression, and that makes me nervous, but it is hard to say more.

    The UK’s problem, at least as I grew up with it, is rather different from the Spanish and Irish ones, since while there was an increase in house prices on a large scale, there was not an equivalent increase in construction activity as there was in Spain. I seem to remember the Economist saying that between 2002 and 2008 (or something)construction sector activity had gobe up 12% only in the UK and around 130% in both Spain and Ireland. Indeed, many people from the UK (who are undoubtedly very overleveraged) actually came to Spain and generated mortagages to buy second homes.

    So the problem in the UK was maybe excess demand relative to supply (due to planning regulations etc). Things here in Spain were more like the wild west, and the queue of corruption cases is now growing fast.

    So the two things are not comparable in that sense.

    As I understand it, much of the UK problem comes from bad decision taking in financial intermediation (similar in that sense to Iceland) with the houshold indebtedness thing being rather like icing on the cake. I also think – whether you love or hate Gordon Brown – a comparison of the UK system of governance with the Argentinian one would be a touch far fetched. In my view we her in Spainare rapidly going towards where Argentina is in our political manipulation of data, pressure on the central bank and judicial system etc, denial of bad loans in the banking sector and indeed denial of the extent of the crisis in general, in a way which I personally find quite frightening. Maybe if I was in the UK I would be seeing the twist in UK politics as turning it into the new Ukraine, I don’t know, somehow I think not.

  4. John and Edward, the budget deficit is not the problem. This crisis is not a public deficit crisis (yet), it is a private sector deficit crisis. The figure you should be looking at is the current account deficit where Spain beats UK by a comfortable margin USD 145bn vs USD 105bn (IMF 2007).

  5. Does it make sense to look at the current account deficit in absolute numbers?

    Secondly, if you want to fight deflation and cannot print money, isn’t the VAT the only option left?

  6. José,

    I completely agree with you that private debt HAS been the problem, but as you rightly point out, this private debt has created a huge level of national indebtedness, which of course the private sector now cannot pay. So the debt simply gets transfered over to the public debt. That is how things work.

    Look at Latvia, in 2007 Gross debt to GDP was around 12% (ie virtually nothing), then banks households and corporates went bankrupt, and now Gross debt to GDP is predicted at 80% in 2010 and rising – ie they cannot enter the euro due to this problem. I agree completely about Spain’s CA deficit. Spain needs to pay 3 billion euros a month on the income account just to pay the interest.

    “More important than the absolute level of debt is the absolute level of deficit; here Spain is second behind the US. This deficit has been financed by a pretty novel and opaque system: Spanish banks have tapped the Euro capital markets (born 1 Jan 1998) via securitisations, bonds, cedulas and other instruments.”

    I absolutely agree on all this, see my Spain economy watch blog, and my post (identified in the top of the sidebar) on cedulas hipotecarias.

    I don’t entirely agree with this:

    “The main culprits of this drama, i.e. the govt and the banks, are hoping that the deposit to loan ratio can hopefully be reestablished closer to 1 in the next few years.”

    The main culrpits here (although they were obviously aided and abetted along the way by a motley assortment of banks, builders,developers etc), were all the Spanish people who told me incessantly that property prices could never come down in Spain, and bought flats, houses, stud farms whatever and remortgaged and remortaged furiously to buy SUVs and 4 wheel drives, on the back of this mistaken new religion.

    I think the Spanish citizenry is in complete denial about its own part of the responsibility here, and while there are many others obviously to blame for this huge tragedy, the first thing that has to happen is that people who are bankrupt have to recognise that the buck stops where it stops, and not try to shift the blame onto others.

    I’m afraid you can’t post presentations directly onto a blog. Find a link to it, or upload it yourself at eg, Google docs, and then post a link.

  7. Small remark about Latvia: The main cause of private debt conversion to public one is the bank bailout program and state guarantees to banks for their part of syndicated loans. This bailout program is imposed entirely by the EU in order to avoid potential butterfly and contagion effects. In comparison, the 1995 total banking crisis in Latvia had very low impact because the government stayed away from bailout programmes.

    What is the trickiest issue in Baltics – why ALL Baltic countries have such enormous GDP falls? In Lithuania it fell y/y in Q2 -22,4 %, in Estonia -16,8%. On this basis Latvia with its -19,1% seems surprisingly well. In Lithuania there are no bank bailouts and the indebtedness of the private sector is pretty low due to the fact that already during the Soviet period Lithuania’s building industry was so efficient in satisfying all the demand. In Estonia there is the much spoken about “e-government”, all banks are foreign owned and the government has clearly declared there will be no bank bailouts on the costs of Estonian taxpayer, anyway, the GDP fall is not much less as in the case of Latvia with its crashed banking system.

    The problem of Estonia is its enormous dependence on exports; the demand for Estonia’s products abroad has just ceased to exist. It will not return earlier as there will be a significant revival of the global business activity.

    Lithuania is suffering extremely from the Polish devaluation inducing an absolute outcompetition of Lithuania’s goods in the region. The markets for Lithuania’s goods have imploded not only in Baltic region, but also in CIS countries.

    So, there are very different situations in Baltic countries. Only Estonia has an instrument somehow non-dangerous in the present setup: by dropping the EUR accession target and increasing its present 0% sovereign debt up to 40-50%, in order to set up an internal protectionist stimulus plan. Latvia could maybe drop its bank bailout program, because butterfly effects have expelled and also EU countries as UK are seriously thinking to free the path for normal bank bankruptcies (no more “too big to fail”). Lithuania can not be helped if its currency peg to EUR is sustained. Not surprising, that Lithuanian parliament has already proposed a law amendment where the currency board is moved out of the institutional supervision of the Bank of Lithuania. Not surprising that ECB has gone to barricades against it.

  8. Edward, my reading of Blanco´s comments regarding higher future taxes is that the EU has privately held talks with the govt. and announced to them the maximum level of deficit that they are prepared to tolerate. Since Maastricht no longer applies and deficits have theoretically no limits in the EU, these issues are being held case by case behind closed doors.
    Spain is clearly the most worrying partner for its size and problems. My open question is simply; What is the limit that the EU has informally impossed the Spanish govt. regarding the public deficit?
    Once we have an answer to that question we can make our own calculations as to how long the govt. can sustain the financial system, new unemployment benefits and public works (among others).

  9. Given the crash in indrect and direct tax receipts in Spain, the budget deficit will be worse than expexcted. That is a given. I don’t understand why Blanco is the one throwing out these reamrks as it’s not his portfolio.

    There was a great article in The Economist a couple fo weeks back about Zapatero and his inveterate inability to say no : “All have won and all must have prizes” (From Alice in Wonderland).

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