Another empire crumbles

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Please find below former Reserve Bank of New Zealand advisor and multiple CEO, Terry “Macca” McFadgen’s, latest ‘Maccanomics’ article, which tackles the looming Spanish disaster and what might be in stall for the European Union. Enjoy!

Macca writes to you from a little village near Avignon where spring has been late this year. Most grape varieties have still not set their fruit and roses remain in full flush.

Not much has happened in the village over the past 500 years nor is it likely to any time soon. It was mostly built in the 1300’s and the Medieval style church consecrated in about 1450. However we now have four new houses under construction-which is more than normal-and everyone seems happy and well.

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The village lies in a fertile plain that was occupied by the Roman Empire in its heyday. Their fingerprints are still visible in the form of magnificent ruins in nearby towns like Orange, Arles, Nimes, Glanum (near St Remy) and Vaison.

It’s a truism of course that all Empires fade and die. Historians still argue about the precise reasons for Rome’s collapse but they would agree I think that in the 1500 or so years since the Roman Empire collapsed the European Union has been the boldest political initiative to emerge in that time.

Certainly it has been the experiment that offered the most hope to the people of Europe in terms of peace and prosperity. But sadly it too now faces collapse. South west of here lie the Pyrenees and beyond them Spain which is currently destroying itself in the pursuit of a mad German experiment in “fiscal austerity”.

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The Looming Spanish Disaster

Spain is not remotely like Greece. Its government is neither corrupt nor incompetent and its people are not systematic tax evaders. Nor did the Spanish Government over-borrow in the boom years. If Spain is guilty of anything it is ignoring labor market rigidities and turning a blind eye to its rising manufacturing costs. Spain’s dilatoriness in these areas saw its competitiveness fall behind the North by 20-30% on a unit cost basis.

Like Japan in the 1990s and Ireland in the 2000s, Spain’s problems derive from a private sector which borrowed very heavily over the past decade to fund a construction boom that ultimately collapsed under its own weight.

By the end of the boom (2008/9) Spain had close to 1million unsold and unwanted houses and apartments. A substantial portion of its labor force was thrown out of work. The banks which had funded the construction work were broke and most remain so today, at least when assets are realistically valued.

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The Government’s accounts were hit with an explosive growth in benefits for the unemployed and collapsing tax revenues. Unemployment is close to 25% across the board and is nearly 50% for Spain’s youth.

It is widely accepted –by everyone except the Spanish Government which publicly remains in denial-that the banking system is insolvent. Real estate assets are being held at unrealistic book values and there is much confusion about where market clearing prices might lie. Most outside estimates see a need for prices to fall another 20-40%, and the consensus is that the banking system needs an equity injection of at least EUR50b and maybe up to EUR200b to restore solvency.

This will have to be funded by external agencies-mainly the European emergency fund.

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In the meantime Spain is being blighted by zombie banks which are cutting credit aggressively and making a bad situation worse.

Those of you of a certain age will recognize many disturbing similarities between this picture and the situation in Japan in the early 1990’s following the Japanese real estate bust. Those readers who are too young to recall the Japanese collapse are urged to read Richard Koo’s book “The Holy Grail of Macroeconomics” (Koo is currently chief economist for Nomura).

As Koo recounts, the Japanese recession lasted for 15 years. Policy mistakes were made along the way but in fighting their recession Japan had both a better starting position than Spain and a much more formidable armory of weapons. Consider the following dichotomies:

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  • Japanese unemployment in 1990 was a little over 2%, not 25% as in Spain today;
  • Japan was in total control of its own monetary policy and quickly moved policy rates to zero. It also was able to implement some quantitative easing. In contrast, Spain has no control of the monetary policy ,and the combination of relatively persistent inflation in the north of the Euro-zone plus a one-size- fits all approach to rates means it is stuck with policy rates well above zero and entirely inappropriate for its economy;
  • Ø Very importantly-this is really the focus of Koo’s book-Japan was able to recycle excess private sector savings into the economy via the Government running large fiscal deficits for many years(the absolute reverse of “fiscal austerity”). As a result, Japan built a lot of bridges to nowhere but the economy did not contract.[1] In contrast, Spain has signed a fiscal compact committing it to shrinking its government sector at the same time as the private sector is in deep distress (We will take a look at some numbers is a minute);
  • Japan’s corporate sector was awash with debt but its major companies were technological leaders on a world scale and remained profitable thanks to their strong market positions and a reasonably healthy world economy. And as noted above, business sector savings were able to be recycled back into the economy through large Government sector debt raisings and deficit spending programs;
  • Japan also had the benefit of a floating currency which was able to devalue about 8% over the period for 1992 -2002 and provide an added boost to export returns. Spain of course is stuck with Euro.

With that armory it took Japan 15 years to clamber out of recession. With no such armory-and indeed with its hands tied firmly behind its back in relation to interest rates, the currency and deficit spending- how exactly does Spain escape?

The answer I suggest is simple-it cannot. It is likely doomed to a death spiral of declining GDP, an eroding tax base, growing unemployment and widening deficits which will ultimately engulf it unless Europe changes course in ways which are hard to imagine.

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The numbers tell you why. To meet the requirements of its feudal overlords in the north Spain has pledged to contract its fiscal deficit from 8.9% to 5.3% of GDP in one year. Let’s call that 3.5%. To put that in context, Australia is contracting its Government deficit by about 2% this year but all that contraction should be offset by an expansion in mining investment of roughly the same amount. Prominent economists have criticized this “neutral” position as being too aggressive.

Or consider the UK where a fiscal contraction of about 1% is planned for a number of years until the accounts are back in balance in 2017. That economy is already walking a narrow tightrope between growth and recession and respected economists are calling for more Government spending until a growth path is better established.

But back to Spain. If the government sector is contracting by 3.5% then the overall economy must contract-and unemployment must grow-unless the other sectors provide compensating expansion. The potential sources of offsetting growth are household spending, business investment and growth in net exports.

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  • Unsurprisingly, no one expects households, suffering from raging unemployment and hard to access credit, to start a spending spree. In fact in April retail sales in Spain fell 9.8% (year on year). This was the biggest fall since records began to be kept so the strong likelihood is that households will subtract from GDP not add to it;
  • With a domestic customer base which is living in fear of job losses and bank failures no business will be lifting its level of investment and Spain will be lucky to see business investment remain stable. Those businesses with an export focus face the added hurdle of slowing world growth and Spain’s awful cost position. Spanish businesses wishing to expand can do so in Eastern Europe, exploiting a 20% plus cost advantage and total labor flexibility.
  • And as for net exports-well, flat or slowing world growth will cruel the prospects there.

There is nothing original in the above analysis. It is entirely conventional in the Anglo Saxon economic universe and as you will observe, it leaves little or no room for hope.

Spain will be destroyed unless it revolts or the German Zone [2]changes direction.

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 Can Spain be Saved?

On paper, yes it can and any half competent observer can provide the prescription:

  1. Spain needs to fully recapitalize its banks. To do so foreign capital will be required from the European emergency facilities. That will involve foreign control of the banks-hurtful to Spanish pride but unavoidable.
  2. Concurrently the fiscal austerity pact needs to be shredded and Spain needs to increase its debt load in order to maintain GDP whilst it completes a re-engineering of its labor market and its regional constitutional arrangements.
  3. Realistically it will take up to five years for the reform program to deliver results-so someone has to fund Spain through that transition period. It will probably not be the IMF and it certainly will not be private investors. So only the German Zone can do so-either by Eurobonds secured over the entire Euro-Zone, or by direct fiscal transfers.
  4. To assist the Spanish export sector to transition to a cost competitive position(that is, to achieve a relative cost reduction of about 20%) inflation will need to be allowed to run at say 4% in the German Zone relative to under 1% in Spain. In five years the adjustment would be complete.

One quick glance through that list should provoke a shudder because this paper solution is light years from political practicality. Yes, Spain’s banks will be recapitalized because that suits everyone including the bank’s creditors in the North. But the German Zone cannot shred the austerity pact without an intellectual and political revolution and its populations have not been prepared for prolonged fiscal transfers to the South. Nor do they remotely seem likely to agree to them.

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In result, Spain’s economy will collapse or its people will revolt and force an exit from the Euro-zone.

What Next?

That is one of the few questions to which there is an easy answer because in the short term procrastination suits everyone. Spain’s banks will have to be recapitalized. There will be prolonged wrangling about the terms of rescue and how hard the axe falls on various classes of creditor-but it will happen.

In the meantime Spain’s economy will drift downward and fiscal targets will be missed and the extended because no one will want to bear the blame for “pulling Spain down”.

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Over this painful period the German Zone and France will strengthen their own banks to the point where they can hopefully withstand a Euro-Zone breakup-or at least Spanish exit-without a severe impact.

But beyond the temporizing, realities will need to be faced. Either the German Zone will have to agree to make transfers to the South for many years, or the Euro-Zone will suffer a break up.

Much ink is being spilt by people much more familiar with German politics than Macca on the subject of Germany’s intent. There is no consensus other than a recognition of deep grass roots opposition to German Zone funds (or support via euro bonds) going south.

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Macca is going to posit an outcome based on the common sense observation that the Euro-Zone as currently structured simply does not make economic sense. For a nation to surrender control of both its monetary policy and its fiscal policy-all for the vague benefits of a common currency-is an act of madness. And madness does not have a long half life.

So it will fail. Maybe failure will come with a rush and with the horrors of political extremism from the Left or the Right. Maybe the monetary union will just stagger on, like drunks staying upright by leaning against each other as one commentator put it, and Europe will enter an era of slow but inexorable decline.

In fact it is easy to imagine much worse outcomes as the people of Europe come to comprehend the disastrous deal that has been done on their behalf without their understanding or mandate. The transfer of economic sovereignty to a beast in Brussels which has none of the tools required to manage the Euro-zone economy effectively was not just mad but a perversion of Europe’s proud tradition of democracy. For that there may be Hell to pay.

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But maybe we can take solace in the fact that not much is permanent in human affairs. In 473, right here in my current neighborhood, the Visigoths reclaimed Arles and Nimes from the Romans and three years later Rome itself fell. That spelled the end of the Western Roman Empire. But the Eastern Empire, centered on Constantinople, battled on for centuries as a diminished but not irrelevant force in world affairs.

Is that the paradigm for the Euro-zone? A North /South split mirroring the old Roman split along the east West axis?

I fear that is the best case. And in the short term things must get worse before they can get any better.

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[1] Koo argues convincingly that this avoided any permanent loss of output due to hysteresis effects and of course supported households.

[2] Primarily Germany, Austria, the old Benelux countries and Scandinavia.


About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.