Whither Spain – Towards Finland or Argentina?

Well, here I am spending my last day in Sitges, attending the annual meeting of the Circulo de Economía (which is why I have been so silent of late). This annual meet-up tends to attract many of the leading participants in Spanish economic and political life. To give you some idea, in the session before mine the Industry Minister Miguel Sebastian gave his version of where we are (which was in fact the toughest statement I have heard from any PSOE representative in recent years), while I shared the platform with Cristobal Montoro (who is PP candidate for Economy Minister). I have been here since Thursday, and in my presentation stressed the need for some sort of internal devaluation. This in fact got me a lot of headlines in the Spanish press the next day (or here, or here, or here). These have been interesting days for me, meeting and talking to a lot of people. I even got to meet the legendary Catalan President Jordi Pujol for the first time in my life. In the lift on my way to bed last night I found myself in the company of Banc Sabadell CEO Josep Oliu. I was tempted to share with him my views on the problems facing Spain’s banking system (which I am sure he is only all too well aware of), but decided discretion was the better part of valour, and limited myself to a simple “bona nit” as he got out of the lift.

As a sign of the times, Alfredo Pastor (who introduced me) pointed out, “what Edward was arguing six months ago seemed to be “catastrophist”, now it has become the consensus”. And indeed if you look at the arguments presented by Fitch for their latest downgrade – including the demographic ones – they are not that far from arguing what I am arguing: the fiscal measures may work, but where the hell is the growth going to come from!

Interestingly, Dani Roderik, who has also been here, and spoke yesterday, has come to very similar conclusions: “Spain’s needs a 20 % internal devaluation” (or in his opinion should leave the Eurozone – I don’t agree with this part), and he basically arrived here by a process of steady elimination, examining all the other options and deciding they wouldn’t work quickly enough. Keeping ahead of the curve, I am now starting to argue – as previewed in my latest AFOE post – that either we move soon on this, or Germany will inevitably have to go back (hopefully only temporarily) to the Mark. The system won’t hold otherwise. Given that opinions have changed so radically here in Spain in just six months, nothing can be ruled out at this point.

Not even Zapatero stepping down. It is interesting to note that CiU gave him till the end of the year – he will not be able to pass a budget for 2011 – to do this, or there will be elections. So let’s see if the leaders of PSOE are able to “factor in” what will inevitably happen, and take a decision now.

Spain does not need elections. Spain needs a change at the top, a consensus government supported by all the main parties, and a swift internal devaluation.

Interestingly a lot of people have spoken to me here over the last few days, and all the comments have been positive. Many of the people here seem to read me in La Vaguardia (Dinero supplement) on Sundays. I never realised I was so popular, in fact I had quite the opposite impression.

Below you will find the English version of my press release. I entitled my presentation “Spain – Finland or Argentina”. I think the reason for this should be fairly clear. Back in the early 1990s, following an uncontrolled credit boom, Finland underwent a deep depression as its GDP dropped by around 14% and unemployment rose dramatically from 3 to almost 20%. Initially the Finish government refused to recognise the severity of the situation, and the economy failed to recover. Then they took the “bull by the horns”, carried out a series of deep structural reforms and as a result the country is now widely recognised as a model of flexibility and good practice.

The other path is to do very little, live in hope, and expect the worst. This is the road to ruin and decay. The Argentine path.

The Finnish case was of course a little different from the situation Spain now faces, since Finland had its own currency, and was thus able to restore competitiveness through a substantial devaluation, a devaluation which then required the creation of a bad bank to relieve lenders of toxic assets produced by the rapid rise in non perforing foreign currency loans.

To many in Spain this kind of radical price and wage adjustment proposal is simply unrealistic. But at this point there are few remaining alternatives. Spain is gradually replacing Greece as the focus of global investor concern, and while people in Spain may have little appetite for such drastic changes, they should never forget that across in Germany, where people are now being asked to authorise funding for substantial loans to be used on Europe’s periphery, support for proposals that the country return to the Deutsche Mark is growing by the day. As the IMF point out, any comprehensive strategy to move the Spanish train along the track which leads to the Finland station requires broad political and social support, while time is of the essence.

Spain – Finland or Argentina?

“Spain’s economy needs far-reaching and comprehensive reforms. The challenges are severe: a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness. Ambitious fiscal consolidation is underway, recently reinforced and front-loaded. This needs to be complemented with growth-enhancing structural reforms, building on the progress made on product markets and the housing sector, especially overhauling the labor market. A bold pension reform, along the lines proposed by the government, should be quickly adopted. Consolidation and reform of the banking system needs to be accelerated. Such a comprehensive strategy would be helped by broad political and social support, and time is of the essence”.
IMF 2010 Article IV Consultation Spain Mission Statement

Following a decade long housing “boom” Spain now has an enormous debt problem. The combined debt level of Spain’s households, companies and government now amounts to some 265% of GDP.

However, in contrast to the situation in countries like Greece and Italy, Spain’s endebtedness problem is not principally one of massive public sector debt. The main component of Spanish debt is private – between households and companies accumulated debt amounts to some 210% of GDP.

Spain is not, by a long stretch, the only country to suffer from such a high level of private indebtedness. There is, for instance, the example of the United States, where total indebtedness now significantly exceeds the 300% of GDP level, a threshold which many consider to be highly structurally significant. The sheer fact of knowing you share this problem with other larger, and richer, countries may be soothing, but it should also give an indication of the kinds of difficulty Spain may experience in interacting with the external environment, since solutions will need to be found which fit the needs not of one isolated country, but of various countries, all at one and the same time.

Stabilisation….But At A Price

After an extremely severe recession the Spanish economy has now been stabilised.

Industrial output has stopped falling, and retail sales have even started to rise slightly.

Output in the bloated construction sector, as was to be expected, continues to fall, as do house prices. Unemployment has stopped rising, although employment, and participation in the Social Security system continues to fall.

At the same time the previously large migration flows have now all but dried up.

But this stabilisation comes at a price, given that is the result of a dramatic surge in current government spending and a huge liquidity support operation for the financial system being supplied by the ECB.

Deficit and Debt Dynamics

As is by now well known, this increase in public spending has produced a further problem – one of a large government fiscal deficit – and this development has served to attract the attention of the international investors on whom Spain depends for its financing at precisely the time that the issue of sovereign debt in the ageing societies of the economically developed world is starting to become a cause for concern in the financial markets.

The principal difficulty facing the Spanish economy at the present time is that while the emergency measures have served to buy time, this time has not been wisely employed, and the measures have simply served to exaccerbate the underlying structural problems rather than resolve them.

According to the National Statistics Office (INE), the slight economic expansion that was achieved in the first quarter of 2010 (0.1% growth) was the combined result of an increase in internal demand and a worsening of the net impact of external demand – precisely the opposite of what you would want to achieve. In other words, while Spain’s exports did increase, the growth in domestic demand in conditions of limited international competitiveness meant that imports increased even more. On an interannual basis the negative impact of national demand reduced (from -5.3 percentage points to -2.5 percentage points – see chart below) while the positive impact of external demand fell (from 2.2 percentage points to 1.2 percentage points). To be clear, growth in the first quarter of 2010 was due to rising domestic demand, and not rising exports, which means the real impact of the increase in government spending and the liquidity measures applied by the ECB since June 2009 has been to reverse the positive trend in the goods trade deficit which had been seen in earlier quarters.

As the Spanish government stresses, the country’s share in world exports has remained more or less constant since the start of the century, but at the same time Spain’s share of world imports has increased. Put another way, thanks to the foreign funds which flowed in to finance the housing boom Spain became a major imports powerhouse, with the consequence that both the trade and the current account deficits deteriorated sharply, while a significant part of Spanish industry simple died. One of the major tasks of any recovery programme is to bring this industry back to life. In this sense what Spain’s economy needs is not rejuvenation but resurrection.

With a highly integrated global economy as the background, Spain’s seemingly insatiable demand to build and buy ever more housing units was satisfied via the massive entry of migrant labour (5 million immigrants in 10 years), and substantial ongoing capital inflows (a current account deficit of around 10% of GDP), which both served to raise the short term capacity of the economy, but lead to the consequence that Spain today is a highly over-indebted country – net external debt is around 90% of GDP – while a large part of the manufacturing base which would have facilitated paying down the debt now no longer exists.

As a result – and as Mr Zapatero repeatedly stresses – it is the case that the accumulated debt of the Spanish government is not (yet) inordinately large when compared to that of its peers, although as a share of GDP it has been increasing rapidly in recent quarters.

To reduce this debt burden the Spanish economy needs two things: inflation and growth, although it should be stressed that competitiveness can only be restored by some form of price and wage deflation.

In a modern, mature, economy growth in aggregate demand only comes either via an increase in the level of credit, or through an increase in exports. The problem that Spain faces is that, on the one hand all sectors of the economy (households, companies and government) are now heavily over-endebted and deleveraging as fast as they can, with the result that – on aggregate – they are demanding less (not more) credit. On the other hand, the Spanish economy is not sufficiently competitive to be able to grow simply by relying on exports.

In addition, systematic dependency on external financing is never a good thing, since your creditors can always impose conditions on you which may not be to your liking. Despite the fact that the commitment to reduce Spain’s fiscal deficit by 5% of GDP in 2 years is, in and of itself, a very strong one, the country actually has to make a far greater fiscal effort than it seems, due to the commitment contained in the recent Ley de Economía Sostenible to reduce substantially the quantity of unpaid receiveables on the public sector account books. Spain’s Autonomous Communities alone have some 30 billion (or around 3% of GDP ) in payments oustanding as of the last quarter of 2010 – which means there will need to be a reduction in spending of something like a additional 1% of GDP a year over the adjustment period under this heading alone.

The need to restore order to Spain’s public finances will mean that the adjustment will be even more painful than generally envisaged, and that the impact of the correction on the economy generally will be more severe. Thus, it is rather unlikely that the Spanish economy will grow in 2011 as many expect. Weighed down by a heavy fiscal correction, an unacceptably high level of unemployment, private demand in slight contraction and a weak growth rate in exports, it is probable that the economy will once more contract, possibly by between 1% and 2%.

To conclude, Spain stands at a crossroads, and important decisions need to be taken. A fiscal adjustment is necessary, but the country also needs a competitiveness adjustment in the form of a substantial reduction in the wage and price level (possibly by 20%). If this is not implemented the dynamic of Spain’s debt will surely become unsustainable. Spain has two – and only – choices at this point. It can follow Finland’s example in the 1990s, take the bull by the horns and use the present crisis as an opportunity to transform the Spanish economy into a new economic miracle, or it can remain in denial about the severity of the problem, let things drift until they can do so no longer, and then follow Argentina down the road of ruin and despair.

To cite the words of the latest IMF report: “Such a comprehensive strategy would be helped by broad political and social support, and time is of the essence.” Ladies and gentlemen, enough is enough. Nearly three years have now been wasted, and it is time to act.

This entry was posted in A Fistful Of Euros, Economics and demography, Economics: Country briefings, Economics: Currencies 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".

27 thoughts on “Whither Spain – Towards Finland or Argentina?

  1. Pingback: Twitter Trackbacks for Whither Spain – Towards Finland or Argentina? | afoe | A Fistful of Euros | European Opinion [fistfulofeuros.net] on Topsy.com

  2. Hi,
    Thanks for the article. I wonder if we know just how bad the situation is with the Spanish banks and how much of it ZP has sold to the Chinese..

    Perhaps you can explain how Spain would go about wage/price deflation?

  3. I second Alex on both counts, thanks for the article, and how is an internal devaluation to be carried out? Perhaps a decent subject for another blog post.

    As a hegelian antithesis:

    If an internal devaluation occurs, wont this massively decrease wages available for debt repayments, causing further defaults -> bank balance sheet issues -> bank runs -> bailouts?

    Even demanding loan haircuts to domestic loans on a 1-1 basis with any wage devaluation would likely cause most Spanish banks to collapse (I base this on the recent mergers of smaller banks in Spain, and absolutely no fundamental anaylsis).

    Also, I can only assume this would be seen as an aggressively protectionist move within and without the Eurozone, treachery in fact, by the coalition of the willing (Sarkozy, and er, Merkel?) for the Eurozone project. Is it politically tenable to have the recent “all for one” measures if everyone is attempting to effetively slash wages and gain comparative advantages?

    Assuming it’s not, would this internal devaluation only realistically by solved by a devaluation of the Euro as a whole, massively unpalatable to Germans and their fear of money printing madness, and also everyone else in the export driven world?

    Seems like a no win situation: Discuss 🙂

  4. Sorry, but I do not understand comparisons with Finland. In 1990-ies Finland took severe devaluations of its currency. Finish goods regained their competitiviness in pre-Nokia rubber boots era through devaluations. What the morale here?

  5. The issue of Kanallis-Osake (Volks-Sparbanken) is represented here also not exactly right. The emergence of Merita and later Nordea was something similar with spanish Cajas, but the whole process was driven not so much by solvency, but perceived improvements in competitviness creating the mammouths.

  6. So many statistics, so little insight.
    If you have a single currency, and your industry is less competitive than elsewhere, your industry will die. Very simple.
    You say that industry needs to be resurrected, at the same time as the country undergoes an “internal devaluation”, which is just jargon for crushing wages and destroying domestic demand. So, absent that demand and a currency devaluation, how exactly is that industry going to come back???
    Finland had a currency. Spain doesn’t. That single difference will destroy any attempt to revive the country.
    Spain needs to leave the euro. Germany has a choice, Spain doesn’t. It has to get out.

  7. An euro region wage arbitrage from core to periphery? Exporting of jobs to the periphery to manufacture goods more cheaply to be imported to the core nations to stimulate consumption in the core? The west simply can’t compete with Asia in this regard. I’m afraid that it’s a quick death from protectionism or a slower death from a decade of stagnation, defaults, deleveraging. The so called “developed” nations will soon have to make a choice. Pick their poision.

  8. My feelings about this article are already covered in the comments section. Regarding the insanity of internal devaluation policies, I”d like to point out that these policies never worked anywhere. Deflation within the Gold standard, the closer historical similarity to this strange experiment called Euro, was a disaster when it was carried out, in UK in the 1920s, in Germany in the early 30s, in France in the mid-30s.

    I also would suggest to have a look at Ireland. Ireland was hit quite early by the financial crisis and has dutifully applied the internal deflation recipe since. It has been a success, in the slightly surreal Brussels definition of a success: the patient has taken the pill and hasn’t died.
    Well, success it is not. Ireland deficit is still way above 10% and doesn’t show signs that it will decrease rapidly below the 3% magic limit. Meanwhile the collapse in nominal GDP has mechanically made the relative debt higher.
    Note that Ireland had been an early and enthousiastic adopter of the so-called ‘labor market reform’ policies. They work very well, especially in books written by economists.

    The quest for deflation is a dangerous folly. It has never worked. Why expect that it will this time? ‘This time is different’, anyone?
    UK exited its 1920s’ deflation by a huge devaluation of the pound, in fact exporting its problems towards its neighbours. I believe they decided it was a success, so they applied the same solution this time. France had political troubles that ended with the Front Populaire government and serious divisions that let the country totally unprepared to deal with the German response to deflation, which was quite different, and slightly more unpleasant, than that of UK or of France.
    The proponents of economic suicide by deflation might want to consider the political consequences.

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  10. Pubilc policy is often a matter of figuring out what is inevitable, and getting out in front of that.

    Spain, Greece and Portugal, if acting in their own short-term interest, will logically exit the eurozone. Thus that is the most likely outcome, especially after a few months of austerity harden the hearts of voters. Get out in front of the inevitable.

  11. please show proof an internal devaluation of 20% will actually help the Spanish economy. I don’t buy it. Especially since wages are already low.
    As if the world suddenly starts to buy Spanish products when wages are lowered. The most succesful export economies in the EU, Germany and The Netherlands, have had the most strong currencies for decades. With your logic this can’t be possible, because how could they compete with such strong currencies?
    As you say yourself, the problem was not export, but import. They bought and built too much with debt. The solution: restrictions on loans, mortgages, and new housing. There is a reason why some countries have a housing bubble and others don’t: regulation. And if you want to improve export, you need to restructure your economy, no internal devaluation is needed for this.

  12. I think you forgot that in 1993 – the global economy was in different shape as of today. On top US, UK, China were out the 1990 crisis in a good shape, economically and financially.

    Finland was lucky – I think it is more luck than a serie of smart policy (as if a small country could control its external environment).

    I’m not sure if Spain will be that lucky whatever mechanism is chooses to use (be it in or out the Euro – the result could be the same)…unless it’s export component improve massively? but again what are its main export partner and in which shape they are?

    I am afraid, this time, past may not be very of use…

  13. What the reson of all speculations of Spain going the Finnish path, if the absolute ultra non plus of competitiviness regain in Finland was the severe devaluation of the national currency.

    The Finland is exactly the biggest counterexample to policies of internal devaluation, because in the period 1990-1993 indeed Finland tried deflationary policies. All of them failed completely.

    And at the day when Finnish markka was devaluated, Finland was rescued.


  14. Finland was a drop in ocean in markets of 90’s. If the only problem today was Spain(it is still another ballpark with more than double Finland population) or Greece there wasn’t a big issue. Finland got it cheap since financing near top of the bubble is no big deal, but they did have to correct the underlining problems.

    The only thing to make this problem to not repeat is to stop so much lending.
    But the Social Democrat State needs all lending it can get and more. So don’t expect that the Bank capital to go to 15% instead of 8%. Or that at least the banks in commercials start to announce different levels of depots covers.

  15. I do not see this getting better. Spain needs a major dosis of self-awareness before it can fix many of the problems it has. There is no opportunity for growth, does not matter what you do you can NOT become “donald trump” -unless you come from money.

    Spain needs a good dosis of self -awareness and transperancy, more, it needs to find a way to be re-born in a way, they can figure what they do wrong (no exports, redundant adminstration, archaic educational system based on memorization not “applied learning”, no entrepeneur spirit, etc) and how to do it right. Spain of 2010, is no different from Spain of 1970s. They think they are, but they are not. Thanks for this blog, i appreciate it. Someone makes sense after all.

  16. Keynes recognized Spain’s adjustment problem as sticky wages. Workers do not willingly accept a decrease in wages and benefits. Keynes’s solution was devaluation of the currency, raising prices of imported goods thereby shifting demand from imports to domestic production and while keeping nominal wages stable, decreasing real wages. This only works if a country has its own currency and control over its one monetary policy.
    As your other readers have recognized, the efficient and effective solution is to leave the Euro zone, declare Soverign default, have the creditors take a haircut on Spanish external debt and get on with it.

  17. Why Germany would leave the Eurozone and return to the DM is beyond me – they would want a strong currency during deflationary times? To leave France with holding the bag? And would their return to the DM imply some kind of default or restructuring of their Euro debt? If not, then stop the posturing.

    The PIIGS need to leave the Eurozone en masse – restructure the debt shoved down their throats by “Northern” European pigs and maintain some level of aggregate demand.

  18. “Initially the Finnish government refused to recognise the severity of the situation, and the economy failed to recover.”

    Oh, but they did see it, very quickly the Finnish government adopted the mantra “no options” as they followed the neoliberal economic textbook. Finland started out with a national debt of only 11%. Plenty of room for stimulus, but instead cuts followed cuts, creating a typical hooveresque demand-destroying spiral. This worsened the economic situation, eroded the tax base while increasing welfare costs which eventually pushed national debt to over 70% in any case. All these cuts were made in the name of not spooking the markets by piling on too much debt (oh the irony).

    Likewise the Finnish government and the Bank of Finland refused to devalue the currency because it would spook the markets. The markets, in the form of currency speculators, bit them in the arse anyway and forced the dreaded devaluation (which all in all was a good thing, hooray unlikely alliance of speculators and obstinate unions). Make no mistake, devaluation was definitely not some thought-out policy response, it was forced on an extremely reluctant government.

    To me it’s clear a depression was avoidable, that the downturn could have been kept at the level of a severe recession if politicians hadn’t been so determined to play tough. Restructuring would have happened anyway, just at a much lower cost to ordinary Finns.

    At least the Finnish government seems to have learned something from that fiasco, as they finally dared open the stimulus money taps this time around.

  19. Is the deleveragement an impediment to economic growth? The real thing is that in the present circunstances, such a process, and even more in its actual form, is only the manifestation of the absence of growth.

  20. “At least the Finnish government seems to have learned something from that fiasco, as they finally dared open the stimulus money taps this time around.”

    Are we blinding ourselves?

    What effect would internal stimulus in a totally export oriented economy would be? after all it’s all about the strenght of the global economy.

    Just imagine, the situation where Europe, US, China – India where to slow down considerably. Oil price going sub 30 dollar and contration in major economies…

    Then, I think 1990 was a “club Med” event, compare to could happen in the next 2-3 years.

    So far the stimulus has only shifted private debt into the public domain and delayed the consequence of 2 decades of regulation blindness, political goldilock and a rampup of a speculative oriented financial markets.

  21. Edward,

    You seem to accept the claim that Spain has not lost global export market share. I questioned this claim some months back and to my surprise found it is plainly wrong. While by 2008 market share was the same as in 2000, it was dramatically down on 2003 market share. The conclusion is simple: loss of competitiveness has had a significant impact on exports since 2003. This chart is self explanatory:


  22. “the commitment contained in the recent Ley de Economía Sostenible to reduce substantially the quantity of unpaid receiveables on the public sector account books”

    Translate please. Are unpaid receivables sums of money owed to the public sector which have not yet been paid ?

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