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Monday, May 18, 2015

Are The IMF and the EU at Loggerheads Over Greece?

Everything has a cost, or so the story goes, especially time. In the Greek case we now know an additional item on the mounting bill: the country is back in recession. The issue is who - apart of course from the long-suffering Greeks themselves - will pay the extra costs of  the latest imbroglio.

The Cost Of Not Finding A Solution


It is now clear that Greece's economy has been going backwards over the last 6 months, and that it has once more fallen back into recession. Greek GDP fell by 0.4% in the last three month of 2014, and by a further 0.2% in the Jan - March 2015 period. As a result at the end of March Greek GDP was only 0.3% above the year-earlier level. This is a lot lower than expected in IMF forecasts, and - perhaps more importantly - well out of line with what is needed to maintain the 2022 debt sustainability targets on which continuing Fund support for Greek programmes depends.

Indeed "Greece is so far off course on its €172bn bailout programme that it faces losing vital International Monetary Fund support unless European lenders write off significant amounts of its sovereign debt", Peter Spiegel wrote in the Financial Times on 4 May 2015. The reason for this is obvious: IMF regulations prevent the Fund continuing to make tranche payments to countries where there is a foreseeable financing shortfall during in the coming twelve months. The worsening in the Greek economic outlook and the consequent reduction in the revenue outlook effectively guarantee this shortfall.

But the sort of debt write-off the IMF is demanding of its European partners goes much deeper than that. Future IMF participation in any new Greek programme after June is also in doubt because without additional pardoning the debt will not be on a sustainable trajectory in terms of the objectives set down and  agreed upon in November 2012.  So you reach a point where extend and pretend hits the proverbial fan. You can, of course, do more extend and pretend till the next time it happens, but at this point the IMF seems reluctant to do so. On the other hand austerity-type spending cuts which only make the economy smaller and the growth path lower simply don't help in this context, since what they give with one hand (debt reduction) they take away with the other (in the form of lower GDP).

The background to the current stand-off is to be found in the debt targets the Eurogroup agreed with the IMF in November 2012 and which effectively made the current programme possible. Given the latest recession these targets are clearly now not attainable. On the other hand Greece is totally bust, so the only way the negative effects of the negotiating gridlock can be paid for is by someone else "coughing up" (or rather "pardoning" debt). This someone will need to be the Euro partners (who else is there), and the longer the stand-off goes on the higher the cost. Naturally the other alternative would be allowing Grexit, but arguably the cost of Grexit would be much higher to the Euro partners, and by a large multiple.

The issue of the growing IMF/Eurogroup divergence came to general public attention over the weekend when an IMF internal memo was leaked to Channel 4 News (UK). The key point in the memo, which is hardly news, is that Greece is running out of money. “There will be no possibility for the Greek authorities to repay the whole amount unless an agreement is reached with international partners," referring to a series of June repayments to the IMF  amounting to roughly  1.5 billion euros.

This impression is also confirmed by details of  the letter that the Greek Prime Minister Alexis Tsipras wrote to International Monetary Fund Managing Director Christine Lagarde at the start of May (see details in this Kathimerini article) to inform her that Athens would not be able to pay the 750 million euros due to the Fund on May 12 unless the European Central Bank allowed Greece to issue more T-bills. It appears that at the time of writing the letter (which also went to EU Commission President Jean-Claude Junker and ECB President Mario Draghi) Mr Tsipras was not aware he could temporarily use the 650 million euros held on reserve at the Fund to make the payment, which he subsequently did. It's not unreasonable to assume that it was the IMF itself who advised him on this.

The inter-institutional tensions are evidently reaching a critical stage, although in fact the issue has now been knocking around for some weeks, as Simon Nixon reported in the WSJ on April 22.The IMF, he said, "appears to have blinked".

The general impression being given is that the IMF is contemplating a much lower bar for agreement, and then possibly disengagement from any post June programme. The Euro partners are evidently anxious to avoid this outcome, but they are caught between a rock and a hard place.

On Or Off The Hook? 


In order to understand what is going on between the Eurogroup and the IMF it is necessary to go back to a 2013 document entitled: The Third Review Under the Extended Arrangement Under the Extended Fund Facility (what a mouthful that is, henceforth the Third Review). In particular the following paragraph in that document off a key:
The macroeconomic outlook, debt service to the Fund, and peak access remain broadly unchanged and euro area member states remain committed to an official support package that will help keep debt on the programmed path as long as Greece adheres to program policies. Capacity to repay the Fund thus depends on the authorities’ ability to fully implement an ambitious program. It continues to be the case that if the program went irretrievably off-track and euro area member states did not continue to support Greece, capacity to repay the Fund would likely be insufficient.
Now all of this may sound - at least to the uninitiated - like a load of old bureaucratic mumbo-jumbo, but actually there are a number of key statements here which may help to put the current internal Troika tiff in some sort of broader and more intelligible perspective.

The cited paragraph talks about three issues: the macroeconomic outlook, the commitment of euro area member states to support Greece and keep the debt on the programmed path as long as Greece adheres to the programme's requirements. It also warns of the danger that should the programme go "irretrievably off track", and euro area member states not give the necessary support then the country's capacity to repay the Fund would clearly be insufficient - ie the IMF would be left holding the can, and Fund employees would be faced with the complicated task of explaining to its non-European members why losses had been incurred.

Crudely put the position is this - as long as the IMF continue to write reviews stating the Greek programme is on track then the euro area member states are on the hook to cover any shortfall in Greek debt performance in order to make the 2020 and 2022 targets (see above) achievable. This is a commitment they undertook during negotiations on the second bailout agreement.

On the other hand, if the IMF were to start producing reports stating that the programme was off-track because of Greek non-compliance, rather than for example arguing that the numbers were out of whack due to faulty macroeconomic forecasts (and of course the recent economic relapse makes those forecasts even less realistic), then the euro area member states would be off the hook from additional stepping up to the plate with the result that the IMF would end-up taking a loss.

Well the present recession makes it evident that those targets are even less achievable than they were previously, and that future debt sustainability analyses will have to reflect this. Bottom line: the IMF has a clear interest in enabling Greece to sign successfully off the current programme (due to end in 2016) and they thus have more interest in giving the country a "pass" note than the Eurogroup ministers do.This is why, in Simon Nixon's words, they are blinking, to the great discomfort of the Eurogroup partners.

Bottom Line: When You're Bust, You're Bust


A lot of attention is being paid at the moment to the idea that Greece is running out of money, and indeed there is a lot of chuckling about just how much grasp Yannis Varoufakis actually has of game theory. But at the end of the day it is also true that when you have lost everything (in the bankruptcy sense) you have relatively little still to lose. To some extent the idea that the Greek government might be deploying this strategy - known technically as coercive deficiency - was explored by Jacques Sapir back in February.  In my humble opinion far too much energy may have been wasted on laughing at Mr Varoufakis (which might precisely have been his intention) and far too little invested in trying to think through what he might have been up to.
If delays in negotiations mean a large bill is run up on your credit card (figuratively speaking) at the end of the day you can't pay it, so someone else will have to. This is the situation Greece is now in. If non performing loans start to rise with the new recession eventually these will have to be written off, and the bank recapitalization costs will go on someone else's account.

 The IMF memo in fact draws attention to this issue, and states that “non-performing loans are at very high levels and – going forward – the system might suffer from important stress." Indeed they go further and point out how "staff also noted a dramatic deterioration in the payment culture in the country”. This is what you would expect to find in a country steadily, and day by day, going bankrupt.

It's no longer clear that even if progress was made in the next two weeks towards some sort of fudged compromise deal - the so called "quick and dirty outcome" that the IMF oppose - that this would be able to get the necessary agreement from all EU parties and the IMF before the June payment. That is not necessarily an insurmountable issue, but it does highlight just how near to a potential brink (or "accident") we are, and it also serves to draw attention to the point that the longer all this goes on the greater the cost for Eurogroup members. Reforms will bring a bit more growth, but only in the longer run. Whatever the package of structural reforms the Greeks sign on to it won't do that much to mitigate the effects of the hit the Greek debt sustainability profile just took.

But then there is the other alternative - just allow the momentum of the present impasse to carry Greece straight out of the Euro Area. That would solve the problem of getting a deal, but the cost, when you come to think of EFSF and IMF loans plus ELA would hardly be negligible, not to mention the as yet unquantified geopolitical and contagion effects.

Whatever way you look at it, the next few weeks are certainly likely to be interesting.


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Tuesday, May 5, 2015

If Greece Had Not Existed, Europe’s Leaders Would Have Had to Invent It

δεῖ δ’ αὐτὸν ἐς φάρμακον ἐκποιήσασθαι - He must be chosen from among you as a scapegoat. Hipponax

One of the more intriguing aspects of the whole modern Greek drama is the tragicomic way the country seems to be constantly condemned to live out well known themes which come from its own mythology. The latest example is the way what was once the cradle of European civilization has allowed itself to be converted into the role model for everything its fellow Europeans are not. Or at least, this is the story we are supposed to believe.

Greek culture and historiography is replete with references to a figure - the pharmakos, or scapegoat – who needed to die that others might live. In fact, the pharmakos ritual is probably as old as human experience itself. In classical Greece it was the custom in times of crisis for some poor unfortunate to be singled out to serve as a whipping boy, the one whose chastisement served to make the wounded demos whole.

The unlucky victim, according to the texts, was first beaten with fig branches, and then ceremonially led through the assembled community to receive a bout of verbal abuse prior to the execution of sentence, which invariably meant being either sacrificially killed or permanently banished. The whole process has normally been interpreted by anthropologists as the means of purifying the group of some kind of perceived pollution, some sort of plague or great misfortune which has inexplicably befallen them. The source of the evil is first accumulated in the victim - the scapegoat - who is then sacrificed in order that it may in this way be extirpated and the city cleansed.

According to the nineteenth century British classicist Jane Harrison the pharmakos was viewed as an “infected horror”, even to the extent that the kindest thing might be “to put an end to a life which was worse than death”. The resonance of all this with the recent history of the Euro Area should not be hard to discern. For many Greece has come to incarnate all that is bad within the monetary union. Due to its own laxness it has been transformed into the rotten apple that endangers the rest of the barrel. It needs to be set apart, if need be even expelled. Hypocritically or otherwise some even go so far as to suggest it would be in the country’s best interest to meet this fate, to have Grexit forced on it as an act of kindness, in a way which is all too reminiscent of the arguments used to justify terminating the scapegoat’s suffering . Such a life was, after all, "worse than death".

The line in the sand that has been drawn around the country is slowly but surely becoming an impermeable frontier. The logical step for the country to take now is "capital controls", or so we often hear, as if such a measure were to help the country remain inside the currency whereas in reality it is the obvious stepping stone on the road to exit.

Extraordinarily those who are most praised for being "not like Greece" often turn out, on inspection, to be only milder versions of the same. They have debts which are almost as unsustainable as the Greek one (Italy or Portugal), they run far higher fiscal deficits (Spain), they need more labour and pension reforms just like Greece, and without doing more are surely stuck in similar kinds of “growth traps”. Yet far from the others being subjected to harsh austerity and pressure for “tough love” reforms, they are big beneficiaries – without any kind of conditionality – of central bank bond purchases, a backstop for guaranteeing ultra-low interest rates and the kind of market access from which the transgressor country remains frustratingly cut off from. Given that Greece is so obviously the weakest member of the group, what kind of bizarre logic leads the EU’s leaders to impose the most difficult of conditions, especially given how much is at stake for all of us?

Looked at from a suitable distance it isn’t that hard to argue that if Greece hadn’t existed it would probably have been necessary to invent it. Amongst so many squabbling parties Greece’s presence has served to unite, to let the others know who they are by enabling them to say who they are not. Whatever his shortcomings, the fact that Finance Minister Varoufakis found himself in an 18 to 1 minority in Riga speaks volumes: Greece is the tie that binds.

So Greece has suffered greatly so that Europe might save itself. And this has now happened twice.

The first occasion was when the country’s debt was consciously not restructured in 2010, provoking an impossible fiscal adjustment which was inevitably followed by an ultra-deep recession. This decision, as is often noted, allowed Europe’s banks to be saved, while at the same all the other struggling countries had their economies talked up, simply on the basis of their not being "Greece". Indeed the much vaunted European Banking Union is very much a by-product of the Greek travails, as was Draghi’s currency-saving promise. Without the threat of contagion from Greece to support the case for it would this have ever been made? And now, before our eyes, history is being repeated. The second time is just as much a tragedy as the first one was. Greece is being starved of cash, while everyone else is receiving substantial debt support and enjoying seeing their interest payments reduced to extraordinarily low levels by ECB QE bond buying. Fiscal deficits targets in countries like France, Spain, Italy and Portugal have been relaxed, and in any event no longer attract the investor attention they once did. Everyone wants to ride the Draghi wave, not push back against him. And how exactly was QE pushed so easily through an otherwise deeply divided ECB governing council? It couldn't possibly be because those who were most opposed to it were also those most in favour of forcing Grexit, could it?

Could there have been some kind of "unholy alliance" between hawks and doves at the central bank since QE put in place the essential "cordon sanitaire" firewall, even while many were busy denying there was any real deflation risk. Naturally it is the presence of this QE firewall which would be absolutely essential to the existential well-being of the common currency should the worst come to pass in negotiations with the new Greek government. How can it be, at the end of the day, that those who are deemed strongest get most support, while those who are weakest are left exposed – like frail babies in a world long past – to wolves and inclement weather, just to test if they are strong enough to survive before being fed?

The First Bailout Enabled a Firewall to Be Built

Greece undoubtedly suffered as a result of the delay in accepting that the country’s original debt dynamic was unsustainable. In fact technical staff at the Fund were convinced of this from the outset, but EU leaders were opposed and from the Greek vantage point critical time was lost. As the IMF explain in their review of the first bailout programme; “An upfront debt restructuring would have been better for Greece, although this was not acceptable for the Euro partners.”

It would have been better for Greece since it would have enabled the IMF to lend over a longer period, which would have meant that the rate of reduction in the fiscal deficit could have been slower. In plain language the austerity applied would have been less severe, and the economic adjustment more manageable. This is the philosophy being pursued at the present time with the Spanish and French deficits. These two countries are being given longer to bring the overspend down below the critical 3% of GDP stipulated in the Maastricht Treaty, and there is a consensus that this is a good thing.

An earlier recognition that Greece was insolvent would certainly have helped the Greeks, but it would not have been welcomed by other EU governments who would have had to help their banks – the ones who had been financing the excesses in the first place. "Contagion from Greece was a major concern for euro area members,” the IMF explain, “given the considerable exposure of their banks to the sovereign debt of the euro area periphery.”

So a programme where there were serious doubts about long term debt sustainability was adopted due to the risk of contagion elsewhere in the Eurozone. The result was that Greece's correction had to be carried out more quickly (or an attempt had to be made to do so) resulting in a much steeper than absolutely essential recession. This way of doing things is not desirable, but even less desirable is to do it, and then fail to accept responsibility for having done so.

The objective of the line of argument being laid out here is not to support the world view of Syriza or the current Greek government, rather it is to suggest that mistakes made earlier are what has produced a climate in which Syriza-type arguments prosper. Simply to blame the Greeks for this is a travesty. Europe's leaders need to look beyond the current Greek government, and think about the long term interests of the Greeks themselves. Starving the Greek government of cash and crashing the economic recovery - which will only foment more radicalism later - is not the way to do things.

How Serious Is Recession Risk Now In Greece?

Getting hard data on Greek economic performance since February is still difficult, since all the important developments are far too recent. However, what information we do have all points in the direction of serious weakening in the economy. Economic sentiment has been falling in recent months, and April's drop was particularly pronounced. The economy contracted in the last three months of last year, and it has surely contracted again in the first three months of this one, making a new recession well nigh a certainty.

The Greek Parliament Budget Office declared at the end of April that in its opinion Greece was at risk of a new recession. “An agreement with creditors is urgent because the country is in danger of falling into deep recession and the government’s lack of strategy harms the economy”, they say in their latest quarterly report. In fact the economy is almost certainly relapsing and has been in a recessionary trajectory since the last quarter of 2014. Bank deposits have dropped by 26 billion euros since then and outstanding debts to the state have risen by almost 3.5 billion euros in the first quarter of 2015.

Most businesses are having serious financial problems and huge difficulties with foreign suppliers and clients. Non-performing loans are increasing and the retail sector is suffering, while new investments are almost non-existent. The economy has reached a point where even healthy businesses are in danger, the report says. Some evidence to back this view has also come from the Greek Commercial Register which reported a 21.8% annual drop in new business creation in the first three months of the year. As the Parliament budget office notes, the economy is starting to suffer from a shortage of cash and liquidity. The banks have suffered a severe deposit loss, and although much of this is covered by emergency liquidity assistance (ELA) obtained via the ECB the fact of the matter is people will be holding on to their hard currency Euros just in case Grexit occurs. This in itself slows activity down.

But in addition the Greek government itself is short of cash, which means it is not paying suppliers punctually, if at all. Those suppliers then need short term working capital loans from banks who themselves are short on capital, and so on. Basically the economy is suffering a severe cash and credit crunch and it is hard to see how this won't have a severe negative effect on economic activity. The lasts EU Greece forecasts recognizes this state of affairs, and lowers the 2015 GDP growth forecast from 2.5% to 0.5%. More ominously it also raised the debt outlook for this year from 170.2% of GDP to 180.2%. Since Greece is effectively bankrupt this inevitably means more debt pardoning from the country’s Euro Area partners if it is to remain in monetary union. A point which is picked up by the IMF in signs of growing tensions within the Troika itself over how things are being handled.

Under existing bailout targets, Athens was supposed to run a primary surplus — government receipts net of spending, excluding interest payments on sovereign debt — of 3 per cent of GDP in 2015. But according to the Financial Times, the IMF Greek representatives Poul Thomsen told EU Finance Ministers in Riga that initial data showed Athens was on track to run a primary budget deficit of as much as 1.5 per cent of gross domestic product this year.

As the FT’s Peter Spiegel puts it: “With the large surplus now turning into a sizable deficit, Greece’s debt levels would begin to spike again. This would force either Athens to take drastic austerity measures or Eurozone bailout lenders to agree to debt write-offs to get Athens’ debt back on a sustainable path. Officials said Mr Thomsen specifically mentioned the need for debt relief during the three-hour meeting.”

The Politics of Fear

The question is, what will be the longer term political consequence of crashing the economy again? The sharp growth in support for Syriza over the last couple of years can be seen as the one of the side effects of an overly deep recession/depression. Sending the Greek economy down further is only going to complicate the political scene even more, and make finding consensus even more difficult.

Too much EU policy emphasis has been placed on "defeating" Syriza, rather than securing the long term stability of Greece, and its people. Too many EU politicians have even been playing games, using the specter of Syriza to fight domestic populism at home. Naturally the cases of Spain and Portugal come immediately to mind. But does this lack of flexibility serve the long term interest of Europe? Greece's problems are still long term, and can't all be resolved in negotiations between now and June. Releasing bailout money to pay the IMF and the ECB - or rather paying it direct - would have made sense, using these payments as a way of pressuring Syriza by strangling the Greek economy doesn't.

While growth returned in 2014, it was very modest growth in relation to the fall which preceded it. In addition the country's economy is still suffering from deflation, with consumer prices falling by 1.9% in March over a year earlier, the 24th consecutive month of negative inflation. What the country needs from the EU and the IMF is not a bed of nails, but rather support in moving the economy back onto the path of stronger growth momentum. Rather than treating the country as a scapegoat, as an example of what not to do, Greece badly needs the kind of positive support Portugal, Italy and Spain have been receiving in order to start to attract some constructive investment. All have to serve, but not all are being forced to serve as an example.

What is needed is not a lesson in morality - from either side - but some plain old fashioned pragmatism. If Greek GDP really does constitute a negligible part of Euro Area GDP where's the big deal? Do US politicians make such a fuss about states like Alabama, or similar? It's in everyone's best interest, and you know it makes sense.

Greece has already made a very substantial adjustment to its fiscal and external balances. On the fiscal side Paul Krugman estimates it amounts to around 20% of GDP between spending cuts and tax hikes. What a pity if for want of the final nail the whole kingdom were to fall. Greece's has now lost less competitiveness than Finland since the year 2000. This doesn't mean that the one is more competitive than the other, Finland was a lot more competitive at the turn of the century, but it does suggest that the country has made a lot more progress than the anti-Syriza bias in statements on Greece is giving its citizens credit for at the moment.

 Naturally the country "cheated" on its partners, and sacrifices were inevitable but surely a more pragmatic and equitable solution could have been found. Simply punishing a country for what is perceived to have been "wrong doing" on the part of its elected representatives accomplishes little and may put a great deal at risk, including amongst those not directly involved.  


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Friday, April 17, 2015

ECB Taper News

What Business Insider's Mike Bird somewhat ironically calls #euroboom2015 seems to be well and truly with us.

The WSJ's Simon Nixon spelled  it out for us in his "QE is Working Better than the ECB Dared Hope" article:  "one month into the ECB’s €1 trillion ($1.06 trillion) quantitative-easing program, and ECB President Mario Draghi was only too happy to take credit for a remarkable turnaround in the economy’s fortunes at Wednesday’s news conference." And he goes on to give examples:
"Growth forecasts have been continually revised up since January when the program was announced: the International Monetary Fund said this week it now expects the eurozone to grow by 1.5% in 2015. Business and consumer confidence are the highest since 2007. Bank lending is finally picking up."

"The strongest growth is coming from former crisis countries: Spain is forecast to grow by up to 3% and Ireland up to 4% this year. Meanwhile German policy makers fret that with growth likely to hit 2.5%, the economy may overheat."
 Naturally, as he also says, "not all of this can be traced to quantitative easing." But then, here comes the point: "Indeed, if the ECB had delayed its decision on quantitative easing until March, as the Bundesbank had urged, it may have concluded it didn’t need to buy any bonds at all."

This is just the issue. There is such a phenomenon as getting too much of a good thing. If you talk up the successes of QE to the nth degree then suddenly it seems its continuation is hardly going to be necessary, since all the good work has already been done. Naturally Mr Draghi is anxious to avoid this conclusion, even if some of his opponents on the ECB's Governing Council are not.

For the moment the critics are silent, since the possible Grexit eventuality means that tolerating QE is for the time being expedient to protect the rest of the periphery from possible contagion. In fact most of Mr Draghi's critics are also among those who are most favorable to a Grexit outcome.

Markets are evidently growing increasingly nervous at the lack of a resolution in the EU Institutions/Greece stand-off, but eventually - match point style - the ball will come down on one side of the other of the net. Then we will see that the situation we are in now - which appeared to be so peaceful and full of joy - is actually a very unstable, and very temporary, equilibrium. The initial ECB QE trade is nearly done, and markets are looking for another narrative. Either one of two things can happen: Greece can leave, or it can stay. In the first case QE becomes permanent, since countries like Portugal and Italy also have unsustainable debt burdens, and taking QE off would simply lead to market testing of one or other.

In the second case, Greece stays in, we will go straight into a taper debate, since the opponents will become more vocal, and the data - as I will explain below - will support them. In this case market reaction is going to be very hard to anticipate.

Careful With That Monetary Policy Divergence

Commenting on the outcome of the news conference Anatoli Annenkov, an economist at Société Générale, said it was clear Mr. Draghi’s main goal was to “tone down expectations of an early tapering just because things are going well. He wanted to send a strong signal that QE would continue for some time, and that’s very reassuring for investors:” But this is exactly Mario Draghi's problem at this point, he wants to "tone down" tapering expectations without killing them off completely.

The main reason the ECB President doesn't want to rule out tapering entirely concerns what is called monetary policy divergence. This relates to the gap between an "easing" stance and a "tightening" one. At the moment, with their extensive QE programs both the ECB and the Bank of Japan are seen as having a strong easing bias, while the US Federal Reserve has a discourse which points to the likelihood of interest rate rises (ot tightening) in a non too distant future. The more Messrs Draghi and Kuroda stress the long term nature of their programs the more they effectively re-inforce this easing bias. The nearer Janet Yellen gets to putting a date on the first rate hike, the more she generates a "tightening" perception.

All of this is important given that the main channel for inflation/deflation at the moment is the relative currency value one. So Draghi being more doveish tends to weaken the Euro, and conversly "taper talk" tends to strengthen it. This is important since the ECB's medium term inflation expectations are based on a currency level: $1:04 in 2017. Any overshooting on this and the forecast moves up, bringing tapering nearer. Mr Draghi wants to keep the purchases going, all the way through to September 2016, but ironically in order to do this it is important he doesn't appear too doveish: suggesting a tapering debate may take place may be the one - even the only - way of ensuring it doesn't.


Does The Euro Area Have a Deflation Problem, Or Doesn't It?

As described in my previous post on this topic, the ECB is committed to a 60 billion Euro a month bond purchasing proposal, which is conditional on achieving a sustained increase in the inflation outlook towards a 2% inflation rate, in the medium term. Period. There is no other objective - not growth, nor unemployment - since these are not in the ECB mandate.

Naturally, the fact that many people - including several country representatives on the ECB governing council - have never really accepted there was a deflation risk, rather than just a short term dip in headline inflation provoked by a drop in energy prices, is bound to  lead to increasing speculation about the immovability of the September 2016 end-date as inflation and inflation expectations start to rebound.

Perhaps its worth pointing out that examining the potential for short term "taper tantrums" in no way precludes the possibility that whatever happens to the predictable attempts to stop QE early the ECB may in fact eventually find itself caught in the jaws of QE for many years to come. The reason for this is simple: the Euro Area may be suffering from secular stagnation, a possibility the vast majority of ECB watchers and Governing Council members still exclude.

In the short term, however, the legal basis of the current programme is more tenuous than many imagine, since, as will be explained below, it exclusively hangs on attempting to comply with the price stability mandate. It is also important to understand that the ECB is not the Bank of Japan, not only because it rests on a different institutional base, but because it hasn't been fighting deflation for over 15 years.

If we look back at the history of the BoJ there had been numerous false starts before Governor Kuroda was actually given the authority to go as far as it took, and damn the consequences.

Mario Draghi - despite his "whatever it takes" promise - still does not have this kind of political backing, as was evident during the long running debate about whether he would be able to do QE at all. So it is the opinion of this author that the likelihood of a Governing Council which is only half convinced that it is necessary to do what it is actually doing, and which has an inflation- and not a deflation-bias mindset is more than likely to err on the side of a false start at some point in time. The question, really, is when.

Naturally, and before going any further, it is worth making one more thing clear: if Grexit were to happen, all QE taper bets would be off, since in the aftermath QE would surely be maintained more or less indefinitely, but in that case Mario Draghi which be able to refer to a Euro existential survival argument which he can't use otherwise.

So Just Who Has Been Provoking the Tapering Debate?

Evidence of a lack of conviction among members of the ECB governing council about the absolute necessity for the current programme given the context of what is seen as the Euro Area economy's strong rebound is widespread. Spain's representative, Luis Maria Linde, for example, told Bloomberg news recently “I think that perhaps to say now that there is no deflation risk is easier to say than two months ago." "Two or three months ago there wasn’t this feeling. There was a feeling that there was a risk of deflation, he said.”

ECB Executive Board member Yves Mersch was also out before the last meeting informing Germany's Boersen-Zeitung newspaper that, in his opinion,  the bank would be free to adjust its programme if prices moved faster than expected towards its inflation goal. "If we were to see that this process brings us to our goal earlier, then we are naturally not so tied to our decisions that we could not adjust things," he said. This flexibility would apply either way: "In neither direction are we resistant to reality," he told the paper.

Such remarks were preceded in February by Slovenian central bank governor, and ECB Governing Council member Governor Bostjan Jazbec - always good to be in first -  who told The Wall Street Journal even before purchases started that they might end early. “I understand it this way," he said, "Once the price mandate is fulfilled, we can end it earlier.”

So when Mario Draghi told journalists last Wednesday that he was "quite surprised...by the attention that a possible early exit of the programme is receiving, when we’ve been in this programme only a month," it's not clear who he was referring to, bloggers like me, or members of his own board who have been busying themselves encouraging speculation in the press.

Marathon Example

A lot of attention has been diverted away from the (possibly tiresome for many) details of what actually went on at the board meeting by the confetti incident, but the ECB President did have to face numerous questions during the presser related to the tapering issue. An outcome hich really, at least on grounds of clarity, is not that surprising. Many of those present were curious to learn, not whether or not tapering was coming at the June meeting - which obviously it isn't - but about what exactly the criteria are for assessing when such a scenario might arise. For those investors currently buying bonds quoted at interest rates below zero you could consider that the issue is one of some importance.

Curiously, in answering one of these questions Mr Draghi referred to a discussion that, he explained, had taken place during the board meeting (now we await minutes to see more of the substance). One of his colleagues apparently is given to running marathons, and had suggested the current tapering concerns were "like asking yourself, after 1 km, am I going to finish this marathon." He did not, however, report on how Messrs Mersch, Jazbec, Linde et al responded to the comparison.

What he did inform the journalists was that an extra, clarificatory, sentence had been added to the introductory statement as a response to such concerns. The original wording is first repeated:  "Purchases are intended to run until the end of September 2016 and, in any case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term."

But then wording - "When carrying out its assessment, the Governing Council will follow its monetary policy strategy and concentrate on trends in inflation, looking through unexpected outcomes in measured inflation in either direction if judged to be transient and to have no implication for the medium-term outlook for price stability" - has been added. So we are dealing with trends, not transient fluctuations. Fine. Did anyone ever think otherwise?

On the use and significance of the word "intended" - which has been the centre of much attention -  the ECB President said the following:  "Some of you, when I first used the word intended, rather than expected, rightly pointed out the difference between the two concepts" - actually they are words, lexemes or whatever, not concepts, but still Mr Draghi is a banker not a linguistic philosopher - "This was at the beginning of December last year, in an introductory statement where we changed the word, and that was meant, and was accepted by markets, as being a powerful signal of changing the monetary policy."

So you see, it isn't all boring, at every meeting we learn something. On this occasion we learnt that the change from "expected" to "intended" was a powerful signal about monetary policy. But what does "intended" (as used by the ECB, we will soon need a glossary of terms) mean. Well, let's go back to December: "yes indeed, intended is different from expected. It’s not simply an expectation; it’s an intention, but it’s not yet a target. So it’s something in between."

At this point we really do need the linguistic philosophers. Maybe we do have a better idea what the ECB president means by a "powerful signal", but I personally have to admit to not being very clear about how exactly "intended" is meant to from "target", Target is something you can aim for but miss. You can intend to achieve a target but still miss it, and you can intend to arrive on time but in fact turn up late. If there was no tapering possibility surely the auxiliary verb will would have been enough, "the programme will continue till at least September 2012." That way there would have been no doubt, or room for speculation. That's the form of words the Bank of Japan Governor Haruhiko Kuroda used, so if the ECB President isn't using it there must be a reason.

What we are left with, then, is the idea that it is the intention of the ECB to continue purchases until September 2016, but in fact that intention may be modified, in either direction, depending on something else. It's not the same, for example, as promising to continue the purchases till September 2016.

Cutting through all the long grass here, I think we can safely assume that what Mr Draghi was trying to tell us was that it is the ECB's intention to carry out bond purchases for as long as, but only for as long as, sustained medium term expectations for inflation are not "below, but close to, 2%", and that the September 2016 date is for orientation purposes only.  I really don't think there is any room for doubt here: once medium term expectations are perceived to sustainably reach this level, bond purchases will start to be wound down, whether that date be before of after September 2012.

And what does "medium term" mean? Well, basically this is easier, it means 2 years forward. So currently we are talking about expectations for 2017. Obviously in September 2016 we will be talking about mid 2018, and so on.

And as I discussed in my last post on this topic, the main mechanism for inducing inflation  here is the exchange rate drop, and even though Mario Draghi wouldn't dream of mentioning an exchange rate target, fulfilling the inflation objective (not target) in 2017 implies a fall in Euro/Dollar to $1.04. Once the Euro starts to fall below that level the risk rises that inflation may go above target over the forecast horizon, and I'm sure Jens Weidemann will be there reminding him of that, all the way through.

So Why All the Fuss About Such a Byzantine Issue?

Well one reason it is worthwhile paying some attention to all this linguistic juggling might be the one suggested by Mario Draghi himself, since he did point out that no matter how premature the topic "it’s always good to ask difficult questions. It just forces one to think."

Looking beyond that, there may in fact be one or two more immediate reasons.  Just as a starter Spain's first negative bond yield arrived last week. Now I know the country's economy has made great strides in recent months, but is it really so much improved that investors should be willing to pay money to have the privilege of lending to the government, which just by-the-by had the EU's highest fiscal deficit in 2014, and the second highest unemployment rate?

And Italian bond yields aren't far behind.

The real question we should be asking ourselves is if QE were to end, what would happen to these - and Portuguese - yields? They are all ridiculously low in relation to the level of country-specific risk in each case. At the moment they are being held at these levels by the ECB purchases programme. But if the termination of those purchases comes in sight, how will financial markets react? Eventual QE possibilities have been being built in steadily since the "whatever it takes" speech. As a result in the enthusiasm which preceded QE markets have been paying very little attention to "details" like deficit levels, etc. But what happens when you take that QE support away? When the consensus trade becomes a different one?

So the issue of how long the programme will last is far from being an academic one.

Impact on Policy-making at the Federal Reserve


Mario Draghi would never admit it, but his policy - as well as that of the Bank of Japan - is having an increasing impact on the freedom of movement of the US Federal Reserve. Monetary policy divergence is the main driver of lower Euro/USD and increasingly negative bund yields. This is effectively crimping  Janet Yellen's discourse space. An early end to ECB QE would surely make the Fed's job a lot easier.

The Fed is perceived by markets as being forced to postpone its first interest rate rise in this cycle. One reason for his is the weaker economic growth in the US, which is partly affected by the trade performance, but the higher dollar also makes US inflation weaker, thus undermining one of the principal justifications for raising.

If Janet Yellen does move towards a rate rise, and Draghi maintains a strongly "doveish" stance about insisting on September 2016, then that combination looks guaranteed to send the Euro right down to parity and below. But this, in the process, will raise the medium term inflation outlook, while probably at the same time sending German bunds ever deeper into negative territory. This could effectively force the ECB into tapering, even if the effect might well turn out to be muted in the longer run. As Mr Draghi said, it is illegal for him not to comply with his mandate. In introducing QE this argument worked in his favor, but the point could come where it works against him. Continuing with QE could become illegal, and I don't doubt there will be no shortage of people in Germany only waiting to point this out, in court if need be.

The Possible Shortage of German Bunds.

The run in to ECB QE saw a massive reduction in bond yields across the Euro Area as investors steadily "priced in" the effect of a long anticipated policy move. That is one of the reasons why most of the impact of QE is seen before its actual implementation (as also happened in Japan) and is what leads to the "semi euphoria" surrounding the initial surge in economic activity. It is also part of the explanation about why the tapering debate takes off so quickly. The main thing - except Grexit - that could counter this would be signs the policy wasn't working which produced speculation the central bank would do more (again as seen in Japan). But in 2015 that looks unlikely.

Portuguese securities have seen the biggest fall, dropping from a 10 year yield of around 7% in mid 2013 to around  2% currently. Portugal’s 10-year bond yield dropped nine basis points on March 5 (the day the purchases started), to 1.79 percent, while Germany’s fell four basis points to 0.35 percent. By the start of April twenty-eight percent of German bonds within the two- to thirty-year range had yields below the ECB’s minus 0.2 percent deposit rate, according to Moody’s Investors Service, making them ineligible for the QE program. This share was 5 percent when the ECB announced the buying programme in January.

As a result Moody’s have warned that the ECB could run out of eligible bonds for some governments by the end of the year. Asked about this problem Mr Draghi said such speculation was premature. "To ask about scarcity in the bond market is really premature. We really don’t see any such phenomenon. It’s also impossible to answer what would one do in case something that’s not evident at all were to materialise, and it would be very difficult to answer this question now."


Yet even while saying this, as the WSJ's Emese Barthra points out, the bank actually increased the number of European institutions eligible for bond purchases (you can find the list here, newly added institutions in bold). The ECB programme includes 12% of purchases of non sovereign bonds issued by a variety of European institutions, and as an ECB official official was quick to point out expansion of the initial list was always planned, but still, the timing is curious. Mr Draghi said the bank would not be lowering its deposit rate (which would have made possible the purchase of bunds with a less than minus 0.2% yield), but the bank could change the structure of purchases to increase the percentage of  institutional purchases if things eventually got difficult.

Risk Of Bubbles?


Finally, one of the issues which arises in the context of QE programmes is that there is a  risk of fueling bubbles elsewhere, outside the government bond sector, and outside the program countries. One of the main mechanisms through which such programs work is via the so-called "portfolio effect". Essentially the central bank forces down interest rates on the long (10yr+) end of government bonds to encourage existing holders to sell (thus realizing capital gains) and move into other, riskier, assets. The composition of the investment portfolios of banks, insurance companies, pension funds etc starts to change making credit more available either across the domestic economy, or abroad. In the latter case the move helps the bank achieve its objectives by weakening the currency (promoting exports) and generating inflation via more expensive imports.

This is what is steadily happening in one market after another, as bond yields gradually fall below zero. Germany is obviously becoming an acute case with all debt out to nine years now negative, and even the ten year bond looks all set to join the rest.

Mario Draghi was asked about this issue at the last presser. "We are certainly aware," he told his audience, "that a protracted period of time with very low interest rates is potentially conducive to financial stability imbalances."  "So far," he went on to say, "we have not seen evidence of any bubble."

Not everyone would agree with that. Pension funds in Germany are especially sensitive on the question. One popular asset class being used as an alternative, according to Investment Week, is property. "European property has become a popular asset class as people move up the risk curve," Alban Lhonneur, manager at F and C Real Estate Securities, told them in a recent interview. Christopher Iggo, senior manager at Axa Investment Managers put the problem more forcefully.  “It is a tax on pension funds because they cannot get the required return,”he told the Financial Times. So everyone becomes more risk prone, and starts to buy more problematic assets.

At the bottom of these concerns are worries about whether or not QE does have any lasting impact on real economy dynamics. The UK and US cases appear to suggest that it might. But this depends on what the problem you are addressing is. QE certainly seems to work in cases of financial instability following a global crisis, ie it can protect against the effects of shocks, but it seems to work less well in longer term, deeper problems like the one from which the Euro Area and Japan are suffering. Thus the balance sheet of pluses and minuses will be different, especially if the underlying issue really is secular stagnation.

At the end of the day you can understand Reserve Bank of India governor Raghuram Rajan's frustration when he went to Frankfurt and complained to his audience: "We seem to be in a situation where we are doomed to inflate bubbles elsewhere." As Larry Summers notes in a Financial Times article on secular stagnation: "In the past decade, before the crisis, bubbles and loose credit were only sufficient to drive moderate growth". What, one might ask, will be needed to achieve that "moderate growth" outcome this time round? Perhaps in Europe and Japan we are about to find out.  


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Tuesday, April 14, 2015

Is The Crisis Now History In Spain?

Mariano Rajoy is a man who is not shy when it comes to being controversial, as the storm surrounding his stance over the recent Greek bailout negotiations clearly illustrates (and here). So it is perhaps not surprising that he did not notably blush when he informed a Madrid audience recently that "In many ways, the crisis is history." Such was the storm that followed that he was forced to at least partially retract the offending phrase after a meeting with union officials some four days later. "In many ways the crisis is history, but its consequences are not," he clarified.

Of course all of this is mainly political rhetoric at the start of what is set to be an election year, but still, it does raise interesting questions. Where exactly is Spain? What is the outlook for the future? Is the country still in crisis, or is it, as Rajoy 2.0 suggests simply suffering from the legacy of an earlier one? These questions are not as easy to answer as they seem at first sight, nonetheless in what follows I will take a shot at it.

 Questions to be discussed below are:
  •  has enough been done in terms of international competitiveness to be able to guarantee a "complete" labour market recovery?
  • to what extent is Spain's housing market really going to recover?
  • is the external correction complete, or is there more to do?
  • Spain's population (and especially it's working age population) is in decline, what are the economic implications of this? And what is the long run growth outlook for Spain?
  • the cost of paying pensioners continues to grow more rapidly than income from contributors - does Spain need another pension reform.
  • Spain's economy will grow comparatively quickly in 2015, but the ECB is buying Spain government bonds, ECB interest rates are near zero, and the country is running the largest fiscal deficit in the EU. What would Spanish growth look like without the deficit and with a "normalisation" of interest rates?
  • Spain's sovereign debt is about to pass the 100% of GDP level, will the next government be able to stabilise the debt, or will it continue to grow?
  • Spain's recovery at present is largely a services and domestic consumption based one. Industry and capital expenditure continue to lag behind. Is this profile sustainable in the longer term?
  The sections on deflation, population ageing and the pensions crisis are summaries of the following earlier posts.

Spain's "Good" Deflation?

Why Is Spain's Population Loss An Economic Problem? 

Spain - Fuelling Today's Retail Sales By Spending Tomorrow's Pensions?

 Spain's Recovery Is Real

The most striking and obvious thing about the Spanish recovery is the way in which real (inflation adjusted) GDP growth rates have steadily accelerated. The country's economy - with a quarterly increase of 0.8% -had one of the fastest growing Euro Area economies in the first three months of 2015. The annual rate accelerated to 2.5%, while full year 2014 growth rate (as compared to 2013, when it shrank by 1.2%) was 1.4%.
These are good results, but it is worth bearing in mind that everything is relative and that there is still a long hard road to travel. GDP levels still remain around 4.5% below the pre-crisis level. And while the (possibly optimistic) Bank of Spain forecasts are for robust growth in the near future - 2.8% in 2015 and 2.7% in 2016 - even their achievement will mean the pre-crisis level will not be attained before 2017, which gives a very concrete and precise meaning to the term "lost decade". The real debate is about the following decade, whether or not that one will be lost too, as deflation and secular stagnation steadily take hold in the context of an ageing and declining population (see the latest IMF report on this, and Larry Summers on Secular Stagnation here) . Is Spain not at risk of becoming Japan 2.0?

Certainly there are many in Spain who would deny that possibility, among them Economy Minister Luis De Guindos, who recently told the Wall Street Journal that he expected growth of between 2.5% and 3% for the next two to three years with the trend simply continuing thereafter. Bank of Spain governor Luis Maria Linde would be another. He recently told Bloomberg reporters that negative interest rates would be a temporary phenomenon which would disappear as the "recovery tales hold" and that it was much easier to "assert there was no deflation risk" in Spain than it had been some months earlier (when he was also saying there was no risk). Such assertions are hard to either agree with or dispute, since no one really knows the future. Words are easy while economic models simply mindlessly churn out predictions based on past performance. The only thing we can be sure at this point is that the future will look less like the past than it ever did, so forecasts based on old data have less validity than ever. At the same time simple economic theory suggests that as work forces decline economic growth rates will do too.

Still, were the most optimistic forecasts to be confirmed the resulting growth rates over a sustained period would clearly turn the country into the Euro Area's most efficient and fastest growing economy, and it is hard to see where the basis for such confidence comes from. When Spain's economy grew at rates of 3% or more a decade or so ago it was on the back of excessive and unsustainable debt increases, and that isn't going to happen again, even were it desirable. Spain's economy may well grow by more than 2.5% this year (although with deflation nominal GDP will grow by less), but - failing something unexpected like Grexit - it is hard to imagine a more positive growth environment. As for when we get to 2016, as they say, it depends.........

Employment Growth Is Strong As Unemployment Falls

The second area where it is possible to see a strong positive side to Spain's recent performance is on the employment front.According to the latest labour force survey Spain created 434,000 jobs in 2014.
To put some flesh on these numbers it should be said that many of the new jobs are part time (40% of new indefinite contracts are p-t), while many others are temporary and not well paid (the economy is increasingly becoming a low value added services one, lead by tourism), but still, Spain's economy is once more creating employment, and that is good news.

A similar picture emerges when it comes to unemployment which is now steadily falling back, with the seasonally adjusted rate falling to 23.2% in February.

And the positive news continued in March: registered signings fell by 7.17% year on year.

A similar picture emerges from the data for affiliations to the country's national insurance system, which were up 416,000 (or 2.3%) in 2014.

In fact - as can be seen in the following chart showing numbers of social insurance affiliates - the rate of job creation continues to accelerate.

And this better employment situation is also confirmed by the fact that the economically active population rose in the last three months of 2014, although it was down over the previous December by 44,000. The participation rate rose from 58.03% in Q3 to 58.24% during the last quarter.
Naturally, putting all this in perspective, the number of unemployed - almost 5.5 million - remains unacceptably high, and the increase in employment needs to be seen in the context of more than 3 million jobs having been lost since the start of the crisis, but still, things are manifestly improving.

Consumer Confidence Hits A Record High in March

Household Consumption Driving Recovery

As employment has risen and real (inflation adjusted) wages and pensions have increased (since consumer prices have fallen) spending has naturally rebounded: indeed we seem to be in the midst of a mini consumption boom driven by what is perceived as a short term reduction in prices (which look to many shoppers like very welcome discount offers).

According to the National Statisics Office retail sales rose (in price adjusted terms) by 1% in 2014 as compared with 2013. I stress price adjusted since with consumer falling an annual 1.1% in December and 0.2% across the year the actually increase in cash in the till was less. Perhaps such an increase is not a game-changer, but after a 30% drop any improvement is welcome.However 2015 sales did not start on such a strong footing, with retail sales falling for a second month in Feb. They were down 0.7% vs Jan (when down 0.4% vs Dec). Still due to the strong autumn surge they were still up 2.6% y-o-y.

Household consumption - which includes a broader range of spending than retail sales, including the government subsidized car sales - had a very strong 2014, and was up 3.9%. It is not clear that this pace can be repeated in 2015, especially if inflation starts to rebound following the Euro devaluation.

Construction Activity Growing Again

Construction activity has also been rising. Output was up 14.4% year on year in January. Quite what is driving this isn't clear, since with a large stock of unsold houses the demand for more at this point (see below) must be limited, but surely there is activity involved in completing unfinished buildings, of which there are more than a few. Again, this is (in theory) election year so infrastructure spending is probably increasing.Well again, peak to trough was something like 60%, so the rebound could have been anticipated.

IBEX on a Roll?

The financial sector has been one of the principal beneficiaries of the Spanish recovery, thanks largely to the hard work of Mario Draghi at the ECB. Many will remember the immortal words of the late Emilio Botín: "Es un momento fantástico para España, llega dinero de todas partes." ("This is a fantastic moment for Spain, it is literally raining money from all corners of the globe" October 2013). As a result the IBEX had a very good 12 months from July 2013 to July 2014 (up maybe 35%) but in the second half of last year struggled to stay over the 10,000 level. QE from the ECB will likely be a positive for the index in 2015.

 Negative Bond Yields Arrive

 The Draghi QE effect has long been making itself felt right across the Euro periphery, and Spain's bond yields are now constantly breaking historic lows. The 10 year yield has more than halved over the the last 12 months and is now at 1.39% (and falling). Naturally these lower yields will make government interest payments lower (and indeed due to seigniorage repayment will even become zero on those bonds purchased as part of the ECB programme). This benefits everyone, but beyond this the IBEX boom and the increase in bond values which accompanies the drop in yields has made a lot of money for some people, even though these people are a small minority of the Spanish population (indeed they have often been external investors). This means on the one hand that the Spanish net external debt has risen, while on the other those who have suffered most during the crisis feel even more aggrieved that they have been left out of this particular party (the Podemos effect).

It's possible every time Mariano Rajoy opens his mouth to declare "victory" he probably only ends up alienating yet another group of people who feel they are missing out on the "good times". Certainly this is what the government opinion surveys suggest. In March 41.8% of those asked thought the economic situation was "bad", and 33.8% thought it "very bad", while only 1.8% replied it was "good", and 21.6% "passable". So I think it is reasonable to say that ordinary Spanish citizens do not buy the very bullish arguments being offered by the government at this point, and this is also being reflected in the opinion polls. As most political observers note, economic recovery should help the PP, but first the PP have to convince a skeptical populous that this recovery is real, and that talk about it is not simply another attempt to lead them up the garden path.

Now For The Glass Half Empty Part

How "Good" is Spain's Deflation?

In my opinion deflation is one of the serious problems potentially clouding the economic outlook in Spain, as I explain in my Spain's "Good" Deflation post. Since I have gone through all the arguments in great detail there I won't repeat myself here.

I would just note that the argument that Spain is simply suffering the impact of a negative oil price shock doesn't hold up, since as the chart below suggests, once you strip out tax impacts and energy, Spain has been flirting with deflation since the start of 2012.

It is also clear that there is no short term purchase postponement effect, in fact we can see evidence across countries that as prices fall people buy more. This is largely because they do not expect deflation, and simply take advantage of what they see as "temporary" sales offers and discounts to buy. As very low to negative inflation extends across time the risk is that people come to expect constant and renewed discounts, forcing prices even further down. This is the short term self-reinforcing component.

It is also the case that up to now prices have fallen, but wages and pensions have not been reduced proportionally. If and when this starts happening the impact on consumer confidence may be the opposite of the one we are now seeing.

In general, as long as incomes don't fall the growing debt burden problem isn't operative, since debt to income levels don't change, it's only as incomes fall, and over extended periods of time, that this impact starts to make its presence felt.

Is There a Recovery In The Housing Market?

Spanish housing offers us a clear example of something whose price has fallen considerably, around 40% since the 2007 peak, and whose price continues to fall (in the 3% to 5% per annum range).

Yet far from this fall in prices having stimulated demand we are witnessing the opposite effect: demand has collapsed, and is not recovering significantly (see my piece from April 2014, "Firmly Anchored Expectations, No Postponement of Purchases?"). The number of new house purchased in December was just over 7,000. That was the lowest monthly level in more than a decade.

True, the number of second hand houses is rising, but even the combined total is far from showing a sharp rebound.

Perhaps the most worrying thing about the fact that second hand purchases are improving while new ones aren't is that part of the explanation for this is that properties become reclassified as "used" 2 years after completion (so some of the second hand houses are in fact new), but this makes the situation with new houses deeply preoccupying since there are nearly half a million unsold housing units still classified as "new" (see this article on the Spanish property website Idealista) which means they have - by and large - been built within the last two years. According to the construction manufacturers association Cepco the number of new housing units which had been neither sold nor let at the end of 2014 stood at 439,617.

The housing market is obviously stabilizing but that is not the same thing as returning to real growth, especially as far as house prices are concerned. There are two reasons for thinking that the recovery will be very weak. The first of these is the growing custom among young people to rent rather than buy. But the second is even more important: Spain's population, especially in the 25-40 age group is falling and each generation is now smaller than the previous one.

From an Export Lead to an Imports Driven Recovery?

Exports went through a "soft spot" in the middle of 2014, but recovered towards the end of the year. Price deflated goods exports were up 4.7% in the year to December in comparison with the same period in the previous year. Deflation in Spain (export prices were down an annual 1.1% over the same period) and the weakening Euro are obviously helping. Tourism is also doing well, and income from this activity rose by about 3.4% in the year to January (when compared with the previous 12 months).

Nonetheless, it is no longer true to speak of Spain's recovery as "export driven" since the growth in domestic consumption has lead to a surge in imports, and the goods trade balance has weakened accordingly, meaning that when it comes to GDP levels net trade is now a negative factor (see below). This issue will come back to haunt us, since with the population falling, the government reducing the fiscal deficit and the private sector not increasing its appetite for credit domestic demand cannot continue to drive the economy indefinitely.

External Balances Worsening?

While external demand had been making a positive contribution to Spanish economic growth from early 2010, the second quarter of 2013 saw a major shift, with net trade becoming negative, at the same time as domestic demand became a positive factor. Thus the recent recovery is almost entirely due to growth in domestic demand (and growing imports) despite the fact that exports have held up well, and continue to grow to new highs.
The level of Spanish exports is constantly higher, but exports only contribute to GDP growth insofar as they grow, and this rate has been falling steadily since the post crisis peak. As such the contribution of exports to growth becomes less and less.

On the other hand the current account balance, after deteriorating in 2013/14 has been improving since mid 2014 thanks largely to the drop in oil price and the impact of the falling Euro on income Spanish residents (including corporates) derive from their non-Euro overseas holdings (USD investments are worth more in Euros after the devaluation).

However the fund inflow that has accompanied the boom in Spanish bonds and stocks has meant that the net external debt balance has again deteriorated. In fact the Net International Investment Position now stands at nearly 100% of GDP negative. This is not a good development, or sustainable. Spain cannot both deleverage and have positive net fund inflows. The long term numbers don't add up. In the short run the inflows are financing the government's fiscal deficit.

But since interest rates are lower in Europe than in many other parts of the world, the net income stream has actually improved since foreign investors earn relatively little on their Spanish asset holdings, and mainly are benefiting from capital gains. Nonetheless Spain has clearly made a massive improvement in its current account balance which is a big positive for the economy.

Industrial Output Lags Behind GDP

Spain's economic recovery is no longer export lead, and it isn't industry based either. Industrial output, as can be seen from the chart, has hardly budged since the return to growth began, and was only up 0.6% compared with a year earlier in February. To get a sustainable recovery Spain needs industrial (and not just services) growth.

And Let's Not Forget the Fiscal Deficit

 Spain's leaders are very proud of the country's recent growth performance, they also like to claim that it is largely due to their ongoing austerity policy. What they don't mention so often is that the country ran the largest fiscal deficit in the EU in 2014 (5.7% of GDP) and will do the same in 2015 (around 4.5% of GDP). In fact Spain's deficit objectives have been relaxed a number of times in recent years, so far from the outcome being a victory for austerity it is more like a victory for leaving extra stimulus.

Between falling prices, high fiscal deficit, ultra low interest rates and strong external fund inflows it would be surprising if Spain weren't doing well at the moment. A bigger test will come as all these positive tailwinds start to change direction. Spain probably be running a primary (before interest payments) budget surplus before 2017 - Greece, it will be remembered, is being asked to run one of between 3% and 4% of GDP. If Spain does eventually manage to run a primary surplus it will indeed be interesting to see what the growth rate is. In the meantime the sovereign debt level will pass 100% of GDP this year, and will continue to increase.

Economic Consequences of Demographic Decline

The Price Of Doing Nothing

The social and political risks associated with Spain having conducted a far from complete economic adjustment are now becoming apparent, but there are also long term economic consequences, ones which may not be very evident at this point. People are often too busy celebrating a short term return to growth to ask themselves the tricky question of where all this is leading.

The most obvious result of having such a high level of unemployment over such a long period of time - Spain's overall rate won't be below 20% before 2017 at the earliest - is that people are steadily leaving the country in search of better opportunities elsewhere. Initially this new development was officially denied, and since there is little policy interest in the topic we still don't have any adequate measure of just how many young educated Spaniards are now working outside their home country. Anecdotal evidence, however, backs the idea that the number is large and the phenomenon widespread. All too often articles in the popular press are misleading simply because journalists have no better data to work from than anyone else. On the other hand work like this from researchers at the Bank of Spain (Spain: From (massive) immigration to (vast) emigration? - 2013) only serves to illustrate how little we know, especially about movement among Spanish nationals.

On the other hand, when it comes to migration flows among non Spanish nationals we do have a lot better quality information due to the existence of the the municipal register electronic database. Everyone who wishes to be included in the health system needs to register with it (whether they are a regular or an irregular immigrant), and non Spanish nationals need to re-register with a certain frequency (so the authorities know if they leave). For a fuller discussion of the economic issues raised by Spain's population decline see my post "Why Is Spain's Population Loss An Economic Problem".

Current Level of Pensions Not Sustainable

The average pension paid is also rising. In February 2015 the total amount paid out by the system in pensions was up 3.1% year on year. But the number of pensioners was only up 1.3%, so the average pension went up by 2.1% due to the fact that the most recent retirees have been earning more than earlier cohorts and are thus entitled to higher pensions. We don't have data on this year's pension system income yet, but at the end of last year it was rising at about 1.5% a year, leaving a growing shortfall for the system to cover.

As I said, under the former PSOE the shortfall was funded out of the general government budget, and possibly 1.5 percentage points of the 9.6% 2011 fiscal deficit were the result of this financing. With the arrival of the PP in government this policy changed, and pension financing moved over to the Reserve Fund.

The attrition has been constant and the Fund is now starting to dwindle. In 2012 7 billion euros were withdrawn, in 2013 it was 11.6 billion euros and in 2014 15.3 billion euros (or 1.5% of GDP). If you want to compare apples with apples and pears with pears, you would need to add this 1.5% of GDP to the 5.6% fiscal deficit, giving a 7.1% deficit using the same accounting criteria as 2011. Put another way the deficit has really been reduced from 9.6% to 7.1% in 3 years, hardly dramatic austerity. Instead of paying the pensions gap out of current income the government are using a credit card issued by "future pensions" to keep payments up even though the situation is obviously getting worse, meaning it will be even more difficult to pay current pension levels in the future than it is As a result of all these withdrawals the size of the Reserve Fund has fallen from its 66.8 billion euro peak in 2011 to the current level of 41.6 billion euros. At the moment the government have budgeted for another 8.4 billion euro withdrawal this year, but this number could easily turn out to be larger. So 2015 should close with around 30 billion euros outstanding - about 3 years more money at the current rate. It is clear that soon after the election changes will have to be made. Even though the number of contributors to the system is growing as the employment situation improves the rate of spending is rising faster.

Financial Sector Deleveraging or Less Solvent Demand for Credit?

Mario Draghi understands that falling inflation expectations raise real interest rates by influencing the perceived cost of credit into the future. If consumers anticipate inflation, then that makes borrowing cheaper and people tend to advance purchases. Conversely expected price falls make the cost of borrowing greater, make the desirability of advancing purchases via credit less, and in this sense constitute monetary tightening. I am aware of an ongoing debate about whether interest rates really are a key factor influencing investment decisions, but I have never seen an argument suggesting that the cost of credit does not influence consumption. And so it is in Spain, since the demand for household borrowing is not surging, even though the country's banks keep telling us they are now "ready to lend".

I am aware of an ongoing debate about whether interest rates really are a key factor influencing investment decisions, but I have never seen an argument suggesting that the cost of credit does not influence consumption. And so it is in Spain, since the demand for household borrowing is not surging, even though the country's banks keep telling us they are now "ready to lend".

In fact lending is still falling, and was down an annual 3.2% to the private sector in February. There may be many reasons beyond the strength of bank balance sheets which may explain why we are not seeing an increase in private sector credit in Spain. Some may simply not be able to get loans because they already can't pay their existing debt. The 4 million Spaniards currently on the credit blacklist run by credit consulting firm ASNEF will have a hard time joining in the current consumer "boom" even if they have a job. Spain's Economy minister Luis De Guindos put quite graphically when he said: "It’s hard not to defer purchases when you’ve got no money for them in the first place. In the case of Spanish unemployed I think they’ve got more worries than waiting for a new sofa suite to drop by €50."

So part of the reason for the "no credit expansion" is the high level of existing debt and the large number of unemployed or people working in low pay short-term contract jobs. Many corporates are also still heavily indebted, and those that aren't are still facing comparatively low levels of demand for their products, which means they will not be engaging in large scale investment projects, which anyway they would probably finance via the bond markets.

Political Uncertainty Ahead

When the IMF said last year that Spain's unemployment level was unacceptably high, I was pretty critical of the fact that they didn't spell out the consequences of this, or offer any substantial policy alternative. The most obvious impact of this failure to find an alternative is being seen right now, with the emergence of political movements which could well turn the country's two party system completely upside down, and the steady flow of talented young people out of the country in search of work.

According to the latest Metroscopia opinion poll carried out for the newspaper El País ( April 12 2015), four parties (Podemos 22.1%, PSOE 21.9%, PP 20.8%, and Ciudadanos 19.4%) are in close competition for first place in the forthcoming election. The lastest arrival on the national political scene is Citizens (Ciudadanos), a movement which despite being difficult to pin down in terms of specific policy, seems to lie somewhere to the centre right, between PP and PSOE in terms of its political ideology. It is very hard to predict what the outcome of the coming general election (due at the end of this year) will be, but it seems clear that no one party will have a majority. So governmental arithmentic is about to get complicated.

The first indication of what the political landscape might start to look like should come in Andalusia, which has regional elections on March 22. Then in May there will be regional elections in Madrid and Valencia, and municipal ones in large cities like Madrid, Valencia and Barcelona. Such elections will, however, only give a vague impression, since personality factors and local loyalties will also be important.

As for the concerns which are driving this earthquake, these are clear enough from the opinion surveys: unemployment, corruption and the issues related to their current economic situation are by a long way the most important issues in voters minds, indeed despite all the talk of recovery the vast majority of them continue to think the current economic situation is either bad (41.8%), or very bad (33.8%).

Forthcoming alliances are hard to predict. Ideologically Podemos and Citizens may seem far apart, but the voter concerns which are driving their rise are often surprisingly similar, even if the solutions they offer are quite different. Over the corruption issue, for example, the possibility must exist of a de facto alliance between the two movements to force major reform on the two "traditional" parties.

Another issue which will probably unite them is that of debt. Many of Spain's citizens are badly indebted, and many still have difficulty paying their mortgages despite very low interest rates. In addition there is the notorious "full recourse" rule, which means people who can't pay can't simply return their home and liquidate their debt. There is a wide feeling of injustice associated with the fact that property developers received limited liability mortgages (many of which have now ended up with bad bank Sareb, with losses being met by taxpayers) while ordinary citizens were given no such "escape clause". "Rescue the citizens not just the banks," is a slogan you often hear these days.

It is unclear what Citizens propose to do about the issue, but Podemos's opinion is clear enough, and on this stance they enjoy widespread popular support, going well beyond those who will actually vote for them: they will revoke full recourse. It's not a mere detail that the point Pablo Isglesias stressed in his interview with CNBC's Michelle Caruso-Cabrera was, "we can have governments that work for people and not for the banks," As the interviewer commented, "One thing he's really got going for him is ... that in Spain they can kick you out of the house and you still keep paying the mortgage. It's a recourse loan".

The other big issue is austerity. Spain still runs a large fiscal deficit - 5.6% of GDP in 2014 - the largest in the Euro Area. At first glance, with so many elections taking place it doesn't seem likely this will come down that much this year, and in 2016 it is hard to imagine there won't be a parliamentary majority in favour of prioritizing bringing down unemployment over reducing the deficit, making some sort of clash with the EU commission not improbable. Nevertheless, as long as ECB QE stays in place investors are hardly going to worry too much so yields wouldn't necessarily be affected. But what if the ECB wanted to taper at some point?  


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.