“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 billion 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“.

Grezxit path: election, default, exit, capital controls, deposit freeze, drachmatization of euro claims, depreciation, return to growth/jobs

Bada bing, bada boom, and it’s peace and jobs and freedom all the way up. Dr Doom makes it all sound so simple, stuffed into 140 characters. Now, I’m sympathetic to the Greeks here, and I think that, for example, the idea of imposing nominal wages cuts across the private sector is not just counterproductive but getting on for gratuitiously cruel. But I think we could do without 140 character eurozone exit plans.

What is being suggested here is a stupendous exercise in sheer administration and logistics. Apart from the problem of issuing a new currency, it’s probably going to be necessary to pull this off as a surprise. Obviously nobody will be very surprised, but there is such a thing as tactical surprise as well as strategic surprise, and although the capital flight is inevitable, less of it would be much better. All kinds of contracts must be re-written, and it’s important to get it right first time in order to minimise the amount of vulture-fund tiresomeness down the track.

Setting up capital controls basically means shutting off international payments, and without fucking up so badly that it will be impossible to start things going again. There are all sorts of trappy administrative details – what happens to OTE’s balance with their roaming partners? Olympic Airways aircraft down-route? And there’s the oil question. Some people seem to think motor fuel rationing is literally the worst thing in the world, some would disagree, but nobody would argue that a good, solid, tested contingency plan is vital.

These are all the kinds of questions Sir Humphrey Appleby would have asked. I was wondering what the Greek equivalent of Sir Humphrey was, until I realised that of course the concept is absurd. Humph is a satire of a powerful, independent, professional, and highly competent civil service, and if Greece had anything like that, it might not be in this mess.

J. K. Galbraith remarked that poverty is an equilibrium state. Now, a government that literally can’t bring in the taxes with a gun to its head isn’t something that arises by accident. There is a qualitative difference between one that could perhaps do more to collect on super-rich individuals who go to expensive and inconvenient lengths to pay no tax (like, for example, Sweden), but generally collects every damn penny it can, one that is a bit flaky but which will, by default, collect your income tax routinely (like France), and one that makes it harder to pay your taxes than not. Being that perverse takes effort, and it happens for a reason, that being “keeping the political nation together and keeping politics mostly non-lethal”.

We could go on, and we’d discover that the history of how things got this way places a lot of responsibility on the UK, Germany, the Soviet Union, and other major world powers with highly effective civil services. But none of this is going to solve anyone’s problems. Neither is barking at the Greeks to bring in the taxes, because their institutions weren’t designed that way. Trying to convert the Parthenon into a supertanker is an insane project no matter how much you need another tanker.

So much for the austerity plan.

But Dr. Doom’s plan-in-a-tweet could be expanded to Jim Hacker sending Sir Humphrey an e-mail like so:

“All the economic policy decisions since 1979. I want you to reverse them, over a Bank Holiday weekend. Can I have a brief on one side of A4 for the Cabinet? Thx xoxo PS THIS MUST NOT LEAK”

Now, well, quite a few people would say that rolling back every economic decision since ’79 sounds great. Some of us have had that feeling for much of the intervening period. But I think everyone would agree that it’s quite the project. In fact, if it came from a left-wing political party we’d probably think it unrealistic, romantic, and impractical. Which of the French Trotskyist presidential candidates was it who wanted to use war emergency powers to requisition the banking sector in its entirety? These days, it’s hard to tell them apart from Roubini and I for one think this is an improvement.

I reckon the UK civil service might be able to come up with a roughly workable contingency plan, and shut up about it. I think this because, at least into the 1970s and possibly later, they regularly maintained an economic analogue of the military’s War Book mobilisation and transition-to-war plan covering the case in which the UK had to quit the multilateral clearing system, never mind the ERM. (And they didn’t leak it.) With all due respect, I’m not so sure about the Greek civil service.

As a result, I’m forced to consider that this might be more bish bosh, loadsa money than bada bing, bada boom. And any half decent civil servant would point out that if your policy advice is impossible to implement, that’s not something you can just laugh off. Plans that cannot be implemented are so much wind, whether they come from Roubini, Syriza, or the European Central Bank.

If you want a one sentence answer-in-a-tweet, Greece doesn’t need the EU to send it a tax commissioner. It needs the EU to send it a default commissioner.

So momentum is weakening across the entire global economy at the present point, not just in say Europe, or China. Global output is still growing but it is growing at an increasingly weaker pace. What could change that? Well QE3 naturally. Why do I say that?  Well look at the three significant surges in the chart. The first coincides with QE1, the second with QE2, and the third, much weaker one, fits in with the so called Operation Twist.

This tells us a number of things. In the first place these massive liquidity injections are not self sustaining, ie they give things a hefty push forward but even so they  don’t manage to jump start the various economies, especially in the developed world. They work for a bit, and then run out of steam. The fact that they systematically run out of steam tells me, at any rate, that something somewhere is broken, and that re-iterated injections on their own won’t sort the problem out. 

In Japan this very same “something” has now been broken since 1992, and continual liquidity injections and mounting government debt have not made it better. This is not the point to go in depth into what the something is, my story on this is scattered here and there across the various pieces of analysis I write. Suffice it to say that excessive debt and rapid population ageing have to form part of the picture. Both constitute an important drag on growth. But the principal aim of this post  isn’t to add to the debate about what it is that broken, it is simply to plead for a recognition that something is, and that, as a result, the situation won’t simply “right” itself. This time there is no hidden helping hand.

What the various liquidity injections do do is buy time. Some people scorn that, and would rather take their armageddon full face and now. Each to his taste. If I get to die tomorrow and rather than  today I am not ungrateful.

Liquidity injections are not quite the same thing as debt generation, although obviously there is a link – injections which involve straight monetisation of government debt (ECB LTRO lending against government guaranteed bank bond collateral in order to enable the bank to buy government bonds, for example) are clearly facilitating the generation of debt. While liquidity provision for its own sake in a deflated economic system is generally positive, debt generation for its own sake isn’t necessarily so, since someone, someday, will have to pay it back, and if in the meantime we don’t fix the problem (that “something” that is broken) then the somebody may be poorer than we are, in which case we are directly transferring income intergenerationally, from them to us. Debt to buy time for something which won’t fix itself is not justified, and the money should be spent structurally, on implementing a fix. Grandiose infrastructure plans which have no real efficiency componenty were tried in Japan in the 1990s, and they didn’t work.

“Even today, Japan is having trouble climbing out of its cement pit. At its high, in the mid-1990s, infrastructure spending accounted for 6 percent of its gross domestic product, double what the United States allocated for infrastructure in the ’90s and still higher than what politicians are considering spending today. In estimates of national debt, the world’s second-largest national economy is near the top of the list, perched between Lebanon and Jamaica. Last year, Japan’s public debt was far greater than the size of its economy, a burden that makes its demographic challenges more difficult to address”.

We face a situation which seems neither to have been contemplated in either the Austrian or the Keynesian theoretical frameworks (since both assume some sort of homeostatic corrective mechanism is ultimately at work) or in the any of the various versions of neoclassical growth theory, where some sort of semi-constant equilibrium growth path is assumed to exist, and be recoverable via the application of an appropriate set of structural reforms. Yet the three oldest societies on the planet – Japan, Germany and Italy – have been losing growth momentum for decades now, and it is quite possible will drift into negative average growth rates at some point in a non too distant future. Traditional theory never really contemplated this possibility (for a brief summary of my argument on this, see this recent interview I did with Andrew Pollen).

Now for my second main point. Where’s the missing link? That is, where is the link between the Feds quantitative measures (or those of the other main developed economy  central banks for that matter) and global economic momentum? Well, that’s a bit of a longer story – although empirically I think it is easy to see the link is there. Basically the story has to do with international “carry” (borrowing cheap in one currency to lend dear in another, preferably with the value of the first currency falling, and the value of the second currency rising, a set of relations which “carry” itself propagates in good circular fashion), and risk sentiment. The liquidity injection makes people more willing to take on risk (think ECB and the 3yr LTROs), and the existence of the carry trade enables them to do it. Nothing new here, banks by their very nature are about intermediation, and leveraging spreads, its just that in an age of financial globalisation that intermediation has a lot more distant geographical reach.

And then of course, all that extra money helps people from Rio to New Delhi and from Ankara to Jakarta borrow up to the hilt to buy themselves a nice new flat, or SUV, or whatever.

Across Latin America’s largest economy, record prices for the country’s commodities and surging foreign fund inflows – what the International Monetary Fund calls “favourable tailwinds” – are driving a historic boom. Property prices are soaring, consumer credit is booming and bank profits swelling. But there are growing concerns over whether Brazil is becoming addicted to this windfall of easy money. Increasingly, there are fears that Brazil is heading for a bubble.

So excess liquidity which finds no outlet in developed economies floods into emerging markets, provoking unsustainable surges in demand and fuelling inflation, which leads the local central banks to penalise borrowing in one way or another, and bring the whole dynamic to a halt again. At which point we get another liquidity injection in one of the major developed economies, and off we go again.

It is perhaps a sobering thought  that households will be about as indebted in Brazil coming in to the next football World Cup as they were in Spain at the time of the 1992 Olympics, and then remember what happened next in the latter case. Brazil isn’t facing a devastating bubble yet, but it could be one day if we don’t find a better way of doing things.

Global Manufacturing In LimboLand

Even if it was services activity, rather than manufacturing, that showed the greatest global weakness during April, manufacturing was only able to gouge out a minimal improvement on what was already a weak March performance, and even then what growth there was was  very unevenly distributed.

Overall output, new orders and employment all continued to rise during the month, but there was a marked divergence between the world’s two largest industrial regions, the US and the Eurozone. In fact, the US remained one of the principal spurs of global manufacturing growth in April, with the US PMI rising to a ten-month high, provoking indirectly yet more debate about the desireability of austerity across the EU. Nonetheless, as can be seen from the chart, the surge in manufacturing output remains modest when compared with the two earlier waves, which is why I am among those who think that the arrival of some sort of QE3 is now only a matter of time.

The Eurozone manufacturing PMI, in contrast, posted its lowest reading in almost three years, as operating conditions deteriorated across all of the  big-four Euro economies (Germany, France, Italy, and Spain). The US PMI is currently 8.9 points above its Eurozone equivalent, the greatest divergence in favour of the US since Eurozone data were first compiled in June 1997.

Meanwhile the Asia PMIs remained mixed with solid growth being signalled in India against only modest expansions in Japan, Indonesia, Taiwan and South Korea. Conditions also remained weak to subdued in China. So at this point in time, even the Asian economies as a group are hardly “powering ahead”.

The most marked feature of the April reports as far as Europe is concerned is certainly the way in which conditions in core Europe continue to worsen. As the monthly report said,”the April PMIs also indicated that manufacturing weakness was no longer confined to the region’s geographic periphery. The German PMI fell to a 33-month low, conditions deteriorated sharply again in France and the Netherlands also contracted at a faster rate”. The rate of decline in new orders accelerated, and jobs were lost in German manufacturing for the first time in two years.

Indeed it is the state of the once mightly German economy that is now starting to give cause for concern. The economy suffered a mild contraction in the last three months of last year, and the possibility exists that this will be repeated in Q1 2012, in which case Germany will also be technically back in recession. Whether or not this is the case we will know in a week or so, but either way, the fact that it is a close call, and that things are evidently getting worse as we enter the second quarter certainly undermines some of the force in Angela Merkel’s argument that austerity leads to growth.

As Tim Moore, senior economist at Markit and author of the German manufacturing report put it:

“Germany started the second quarter of 2012 with its worst manufacturing performance for almost three years, as another month of weaker order inflows finally brought production levels back into contraction. With backlogs of work failing to support output volumes in April, manufacturers cut their staffing numbers for the first time since March 2010.

“The investment goods sector was at the forefront of the downturn in April, as jitters about global economic conditions meant clients in export markets sought to delay large scale spending decisions. Investment goods producers saw export orders fall at the steepest pace in nearly three years, and in turn job losses were the most pronounced of the three main market groups monitored by the survey.

Germany’s economy is export dependent. This export dependency comes from having a very high median population age. It is not a cultural quirk of the Germans. There is no fundamental issue with German competitiveness, there is not some major structural reform that is missing, there is not even over indebtedness in the public or private sectors. The only reason the German economy has fallen back into recession is that demand for its products among customers has dropped off, while the long awaited second pillar of domestic demand has once more failed to appear. It is as simple as that.

With the results of the recent French elections in the forefront of their minds, people are now starting to ask themselves just how Germany will respond to a Francois Hollande Presidency, forgetting that elections are also looming in Germany next year, and that the CDU is busily loosing ground. Whether or not Germany technically confirms a recession when the results for the first three months of the year are out in a week or so, the performance of the economy is visibly worsening and German leaders are under pressure to show they are willing and able to respond. Otherwise Angela Merkel may face wrath not only from those irritated by the having to contribute towards the bailouts, she will also have to contend with  those irritated by her economic ineffectiveness back home. And in any event, the party which would gain from a Merkel electoral defeat – the SPD – are not that far from seeing things the way Monsieur Hollande does.

Which is why Angela Merkel’s approach was always far too simplistic. As I have said a number of times, I think she he right to search for some sort of financial stability in the face of the ageing population issue, but the best way to get from here to there is not necassarily to walk in a straight line.  Naturally, austerity is a relative concept, but whether you are cutting your deficit from 10% to 9%, or from 3% to 2% as you go into a recession you still hit short term growth with a double whammy, as Italy is currently discovering. As can be seen in the chart below (which is the April Italian services PMI) domestic demand is plummeting on the back of the latest round of austerity, and this is leading the main centre left party in the government to at least cry ouch!

At the very least European fiscal policy needs to allow for a counter cyclical component, even as you pull back from a very high deficit level, and not, as at present, insist on an entirely pro-cyclical one in a recessionary environment, thus magnifying the amplitude of the demand swings. If an economy needs more than 5% deficit (or more than 10% for that matter) simply to get meaningful GDP growth, then you need to understand why this is and find solutions, since as I say above debt itself doesn’t cure anything, and arguably as our populations age accumulated debt only makes things worse. But if one of the engines on the plane starts to malfunction, the objective needs to be to get the passengers to the ground safely, and not necessarily by the most direct route.

Naturally infrastructure work on the periphery which needed German technology would help German export companies, so it wouldn’t be that hard to sell in the heimat. But what use would it be to the receiving countries? That we won’t know till we see the proposals in detail, and discover how it is going to be financed. If such infrastructure would help exports, both within and outside Europe, then it could be a plus. If it is only to built high speed train networks that lead nowhere (or as is currently under discussion in Spain up to a frontier with Portugal across which there will be no connection waiting the other side) then we are simply falling into the Japan trap, and applying a simplistic 1930s version of Keynesianism that doesn’t work in the present context. But at the end of the day, the fact we are having this debate in the first place only serves to highlight the fact that we still don’t have a roadmap for coming out of the crisis in Europe, and we still don’t know what our future is going to look like.

And meanwhile, of course, there is Greece, and that blasted ongoing economic contraction to think about.

As Paul Smith, Senior Economist at Markit and author of the Greece Manufacturing PMI report commented:

“April proved to be another difficult month for Greek manufacturers, with latest data again showing steep contractions across a number of key variables measured by the survey. “In line with recent reports, the issues facing manufacturers – and the Greek economy as a whole – remain deep rooted. Panellists again noted problems in accessing working capital and a culture of cash payments, implying that credit lines remain either closed or that agreements will come with restrictive terms.

“At present, it remains hard to see how these issues can be solved suggesting that the manufacturing sector is set for continued struggle in the months ahead.”

Following his cue, and looking over at the latest election results in that unfortunate country, it remains hard to see how the issues arising can be solved, and it isn’t clear what gets to happen next.

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

It isn’t as obvious as you may think that FN voters are the lost sheep of the Right.

In so far as they’re protesting, they’re protesting against French conservative neoliberal euro-atlanticism. This ought to be obvious, because who’s been in charge all these years? Conservative neoliberal euro-atlanticists. The 5th Republic has mostly been governed by conservatives.

Typical FN voters aren’t, in fact, ex-communist voters, but rather, PCF voters’ kids. Studies of the FN electoral breakthrough found that it was actually quite rare for people to switch from the PCF or the PS to the FN. Instead, FN voters in the 1988 and 2002 breakthroughs were typically first-time voters in places that traditionally voted Communist.

As Bernard Girard explains, this time out the FN did well with exurban voters, especially first-time house buyers who did the French equivalent of “driving until you qualify” in the US housing bubble. This meant that places suffering from rural depopulation were partly converted into suburbs, not necessarily getting any more in the way of public services or economic development in the process, and leaving the new exurbanites vulnerable to property and petrol prices. Interestingly, this suggests that the Tea Party and the modern FN are parallel phenomena.

It strikes me that a lot of French politics in the last decade can be summed up as “France discovers that it has suburbs” and in fact I did a post on Fistful about this back in 2007. So, after this somewhat protracted radar vectoring around the Ile-de-France basin, we finally come back onto final approach. If you vote FN, you probably don’t have any socio-cultural ties to French conservatism or any intellectual conviction of its ideas, which in any case are radically opposed to those of the FN, and you’re protesting against French conservatives because they’re the ones in charge, and it makes no sense to assume that you’ll necessarily come back to vote for the conservatives, because you are an extreme-rightist and not a conservative.

FN thinking is far more sceptical of capitalism, more protectionist, more anti-European, and more anti-American than UMP thinking. FN style and tone are far more working-class than the UMP’s. The FN is mostly after a different demographic to the conservatives. The exurbanites sound more like the material of a conservative party…if it wasn’t for the fact they are furious with the conservative party, furious enough to vote for the sort-of fascists.

This has two key consequences. The first is that trying to merge the UMP and the FN might not work, because UMP people don’t want the same things as FN people. The second is that trying to make the FN the replacement for the UMP might not work, because FN people don’t want to be a boring conservative neoliberal Euroatlantic party. They want to vote something that hurts the boring conservative neoliberals.

Now, before the election, pollsters were working on the principle that about 20-30 per cent of FN voters would vote Sarkozy, between 15-25% would switch across to Hollande, and the rest would follow the party line and spoil their ballot or stay at home. We’ll need more data to know whether this happened, and no doubt it is coming. My gut impression is that the pandering had some effect and is partly responsible for the late tightening in the polls, but I don’t actually have any data that supports it. Turnout fell noticeably between the rounds – the difference could be Mélénchonistes who decided that the Left would win anyway and they didn’t need to compromise in round 2, for example.

Anyway, it didn’t have enough effect to win, and winning counts.

Everyone will have to find some sort of modus vivendi to get through the campaign, but after that it’s a free for all. There are perhaps three key groups in the UMP. Let’s work through them.

One group are the sarkozystes, the former president’s personal following. Despite many efforts to identify a shared ideology among them, the biggest common factor between them is that they are relatively comfortable with the extreme Right, and many of them (like Sarko’s advisor Patrick Buisson) have a background in it, whether the FN, the wider extreme-rightist student movement, or the network around Charles Pasqua and the dodgy fringe of Gaullism. Sarkozy’s personal court was always pretty febrile, and the experience of defeat is only going to make them more so.

As Marine Le Pen is talking about trying to re-organise the Right around her party, they are the ones who like the idea and will try to reach out, although of course they will see it as bringing the FN into the UMP rather than vice versa. But they will also have to decide who their leader is, and that will be a vicious experience.

Group two are the traditional Gaullists, who weren’t particularly happy with Sarkozy and fluctuated between putting up with him and outright sabotage. They are deeply suspicious of the FN, and one of their leaders, the former PM and current senator Raffarin, actually broke surface to criticise Sarko for pandering even before he lost. Look out for much talk about needing to rassembler, social peace, and the Republic. They will see Sarkozy as having lost a great conservative opportunity, and will be after revenge.

And then you have the overlap with the old droite classique, the heritage of Giscard, who don’t like the Gaullists much and don’t really want to be in a party with them. Neither do they like the far Right much, even if some people have been involved in both.

Actually, memberships and life histories tend to overlap all three, which is not surprising in a party whose original raison d’etre was just to support Jacques Chirac in the 2002 parliamentary.

The big short term decision is what strategy to adopt for the parliamentary elections, and how far to cooperate with the FN. Three-way marginal seats between the PS (or other left-wing candidate), UMP, and FN are common, and the question is whether to ally with the FN or fight it for every vote. It’s not hard to see how this fits with the factional divide, but it fits so well with it that it may end up being fudged in order to maintain some degree of unity. The fudge would be to say nothing and tacitly leave it to local initiatives, which has happened before.

The strategic question is whether to head for the centre or to keep going with the Sarkozy/Buisson strategy of “droitisation”. The sarkozystes will point to the fact that the polls pulled in some between the two rounds as evidence that the strategy was working. Everyone else will point to the fact that they still lost as evidence that pandering to the FN turns off moderates, and perhaps that FN voters aren’t sociologically very compatible with the UMP.

Meanwhile, of course, the Left has its own analogous question, which is whether and under what terms to cooperate. Ensuring a left-wing government is very important to the PS, and the degree of influence that the Front de Gauche will have as an awkward partner is vastly greater than what it would have yelling in opposition. Their incentives are to agree, and the cultural gap is less troublesome. Also, coalition between the parties of the Left is a feature of some of its proudest moments, and you can’t say the same about cooperation between French conservatism and the extreme Right.

But let’s get onto content. Hollande was very clear throughout the campaign that he intends to change European economic policy in the direction of more stimulus, and that he’s willing to pick a fight with the Germans about it. He referred to this in his press conference last night, and then again, hoarsely, to the crowds gathered at the Bastille. And the Germans have, as previously blogged, given the faintest suggestion that they might be willing to budge a little.

There is a detailed discussion of Hollande’s economic programme in two parts here and here. He is being notably careful not to promise a major fiscal expansion, and the balanced-budget multiplier is going to get quite a workout. On the other hand, any substantial budget consolidation is being firmly kicked down the road.

In general, it looks quite a bit like this post on the British TUC blog. On the European level, Hollande is arguing that if the Germans don’t want eurobonds, then they should accept quantitative easing, and vice versa.

There is a way out of the apparent impasse – the Germans are much warmer, or at least less icy, on expanding the European Investment Bank’s infrastructure projects than they are on eurobonds or QE, and Hollande explicitly mentions project bonds, i.e. linked to named projects. (It’s also rather like option 28 here.)

As far as the politics goes, Hollande’s working assumption seems to be that if the Germans want there to be an EU and a Euro, they’ll just have to shift somewhat, with the back-up plan of lining up the IMF and the Americans on this. As I mentioned in the last post, Hollande formally takes office on the 15th, and will be in Camp David on the 18th, which rather suggests that a call on the IMF (and its French director) and a bilateral with the Americans will be on his agenda, as at least one of the intervening days will be spent travelling. There’s also a trip to Berlin coming up, but Le Monde‘s sources left the date of that one open. Obama won the congratulations race by a country mile, getting in with an invite before Hollande got back to Paris. (As for the EU institutions, well, they want there to be an EU and a Euro.)

The market insta-response has been promising, although everyone’s attention is riveted by Greece, the Spanish industrial production numbers, and the banking sector. Speaking of which, does anyone else wonder whether the bail-in directive figures in his plans in that respect?

The exact details show that the polls narrowed at the last, to 51.6% vs 48.4%, not as decisive as you might have expected earlier in the campaign. However, as the winner said in an interview last week, the nature of the poll is that a win is a win, and the Left’s support, the peuple de gauche, put on a spectacular crowd at the Bastille for Hollande to struggle through with the sixty motorbike cops that were the security state’s own special tribute, today’s version of a bodyguard of lancers.

Transition of power in France is somewhere between the astonishingly swift process in Britain, where the old and new prime ministers’ official cars both park up outside Buckingham Palace while the first has their farewell audience and the second officially accepts the appointment, and the weeks long grind from a US presidential election to inauguration. The handover was fixed this morning for the 15th of May.

It couldn’t be much later, as the president will then have to zap off to the G-8 summit at Camp David on the 18th and then on to the NATO summit in Chicago on the 20th, as well as whatever happens on the European scene in the meantime.

The Russians are being constructive. The head of the Israeli military thinks that there has been no decision to build the Bomb, and that the talks are going the right way. David Ignatius sketches some details of a possible agreement, which would combine a halt to uranium enrichment with a promise of regular supplies of 20% enriched uranium and explicit recognition of the right to own the fuel cycle. And it’s been suggested that the Iranian government is trying to prepare public opinion for a deal.

In this context, Laura Rozen profiles the three women at the core of the Western negotiating team, Catherine Ashton from the EU, Helga Schmid from the German Foreign Ministry, and Wendy Sherman of the US State Department. Quote of note:

“She is totally working class,” the European diplomat said. “The criticism from the British press if anything is that she is from northern England, and speaks with a northern accent…

Yeah, well, if you think international understanding is difficult…

However, so far the response from the Sarkozy camp has just been to complain that it’s “undignified” and to point out that the legal maximum campaign spending is €22 million. Obviously you’d have to be naive to think that this somehow excludes finding something else to do with the spare money.

Obviously, the frantic last chance that the interval between the two rounds provides brings everyone with a grudge boiling up to the surface. Dominique Strauss-Kahn re-appeared, with what claims to be an interview with him appearing in the Guardian (rather-too-helpfully translated here) and causing Nicolas Sarkozy to start talking about him a lot. Weirdly, DSK then walked it back, denying that the piece was an interview. Perhaps it helped to move some books. The founder of Rue89 publishes an open letter calling on him to shut up.

Sarko, meanwhile, claims that he’s hoping for a unprecedented mobilisation of the electorate, although the 80% turnout in the first round didn’t seem to help his cause much. Both candidates finish their formal campaigns with a rally today, before the TV debate on Wednesday night.

In terms of actual content, the debate between the rounds has been marked by both candidates denying they were trying to suck up to the FN while also doing so. Rue89 takes a left-wing view of the FN electorate. Sarkozy announces he wants “a presumption of self defence” for the police, in a transparent sop to the FN, while also denying that he would ever form a coalition with them, although also basking in FN rhetoric. He also did a bit of culture war. There are limits to this: Sarko’s enemies in his own party, including two former prime ministers, are angry about the pandering.

Pandering is bipartisan, of course: Hollande has discovered a desire to have an annual parliamentary debate on an immigration quota, as well as doing a bit of security politics about policemen and cannabis. The PS has been measuring the dosage carefully, though – Ségoléne Royal was sent out to remind the public that the party wants foreigners to have the vote, at least in local elections, as a form of republican integration. However, this promise goes back as far as Mitterand’s 1981 campaign and has yet to be implemented.

Hollande is also trying to score off the European Union, or rather, off the ECB and Angela Merkel. In an interview this weekend, she suggested that she might be willing to support a “growth agenda”, perhaps making use of the EIB, but also said nobody was going to re-open the stability pact. Hollande took the credit and remarked that things had moved and were going to move further.

Le Pen and Mélénchon, meanwhile, are looking ahead to the parliamentary elections in June. Interestingly, the deal setting up the Front de Gauche gave the Communists the majority of parliamentary candidates in exchange for letting JLM run for president, but the man himself is bored with being an MEP and feels the need for a bigger megaphone in French politics. A big deal for both will be whether they can get an agreement with the bigger party on their side of politics to cooperate in three-way marginal seats. This is crucial for the smaller parties, as you need to get 12.5% of the vote in round one to be on the ballot in round two. The UMP and the PS are both playing hard to get.

Out with the PS in La Courneuve, where the local secretary reminds us that Barack Obama didn’t invent canvassing.

Apparently, Nigel Farage has been suggesting that Marine Le Pen dump the FN and create something like UKIP. All I can say to that is that perhaps he could give advice when he gets one in five Britons to vote for him as prime minister.

Restructuring of the banks as long as the guarantee was in effect was inhibited by the fact that any significant restructuring was likely to trigger an immediate entitlement for immediate payment in cash of all bondholders under the terms of the guarantee. This reason alone can explain why steps to deal definitively with even the two weakest banks were deferred to the end of the guarantee period.

In other words, the guarantee amounted to one giant cross-default clause in every single bank bond, with a default on one triggering default on all. Given the amount of fuss that went into Greece’s insertion of retroactive clauses into its sovereign debt, it’s strange to consider that Ireland took what Honohan now sees as radical step with such little thought.

Note incidentally the timeline implied by his interpretation. The guarantee went into effect at the end of September 2008. Because of the cascade problem, the banks couldn’t be restructured until after September 2010. Two months later, Ireland was in an IMF program. This is a very different sequence from one which holds wide sway in Ireland, that the country was doing OK during 2010 and was done in first by acceleration of the Greek crisis and then a threat from the ECB to pull the liquidity funding for Irish banks unless a program was in place. In short, it seems that even now, the history of Ireland’s descent into dependence on the aforementioned partners is not yet complete.

The rest of the speech is also worth a look, as the Governor explains how the country’s adjustment of residential mortgages and of the overall fiscal deficit could and should have been faster. It’s now at the point where the protracted nature of the process has become a problem in its own right.