…comes from Part One:
How will all this end in Spain?
Spain’s problem is linked to that of the entire European periphery. The boom years following the adoption of the euro brought about: 1) easy money via negative real interest rates; and 2) price overvaluation relative to real exchange rates.
Spain, and the rest of Europe’s periphery, could emerge from this crisis either with a massive increase in productivity – which is highly unlikely – or by reducing wages and prices by around 20–30%, which is what will happen very gradually, at the cost of great suffering. This reduction in prices and wages could also be described as an «internal» devaluation.
A devaluation of this kind will result in heavy losses for local banks and foreign creditors. In the case of Eastern European countries, the damage will be substantial but not excessive. In the case of Spain, the write-off of mortgage debt will be massive. We estimate that property losses in Spain will exceed €250,000 million when all is said and done. Obviously, Spanish and foreign banks are not going to admit the scale of the problem, which is why the losses are being covered up.
The widening of the trade deficit is a form of «negative saving». The strong growth in consumption in Spain has had to be financed by the rest of Europe. Spain’s trade deficit was among the largest in the world in both absolute and relative terms, standing at 10% of GDP at the end of 2007.
There is no doubt that Spain’s current account deficit was the largest in the world, alongside that of the US, in absolute terms. The Spanish economy acted like a consumer giant, draining the savings of the rest of Europe.
The high level of consumption in Spain was mainly fuelled by external borrowing and was not financed by existing domestic savings.
How bad is the situation compared with other countries? Spain’s external debt is extremely high in both absolute and relative terms. It ranks among the top five in the world, and is rising at an alarming rate:
Real interest rates: Deflation is the devil
Eastern Europe, Spain and Ireland are experiencing the onset of deflation. We believe we will see much more deflation in these countries in the future, which will have repercussions for the entire European banking sector. The peripheral countries are net debtors, whilst the rest of Europe is a net creditor. When a debtor is unable to pay, the creditor suffers. Germany, France and others will need to bear the cost of recapitalising the peripheral countries and Spain. In the words of Plautus: «I am rich if I do not pay those to whom I owe money.» A deflationary spiral means that most of the debt will need to be written off by creditors, who will have to absorb the losses.
In a deflationary environment, being in debt becomes much harder. Even when interest rates fall to zero, prices and wages may fall further, and the real amount owed may increase even more. That is why deflation is such a terrible thing.
Spain now has a negative CPI (Consumer Price Index) and a negative WPI (Wholesale Price Index).
Inflation in Spain has been negative in recent quarters, and has not seen a similar fall for almost 50 years. However, the Bank of Spain and the Government are burying their heads in the sand like ostriches.
The problem with deflation is that, even though the rates set by the European Central Bank are very low, they still represent an extremely high real interest rate for Spain, due to its negative CPI and MIP.
Spain is not the only country facing deflation. The problem is also affecting the entire European periphery. Ireland, for example, is experiencing a rate of -5.9%, well above that of other countries worldwide (only Thailand comes close, at -4.4%).
We believe that what is happening in Ireland is what lies in store for Spain in the coming months, as the economy slowly adjusts to reality. Almost all of Ireland’s banks have been bailed out by the Irish government, which is trying to offload its toxic assets as best it can. We believe that Spain’s situation will bear much closer resemblance to Ireland’s than to that of its other European neighbours.
Despite negative inflation and high unemployment, wage negotiations between trade unions and the government are still leading to higher pay. Most wage agreements in Spain are reached through negotiations and haggling with the industrial sector. In fact, wage increases are exceeding the ECB’s inflation target of 2%.
Given the extent of wage rises and production costs, and the deflationary situation in Spain, we believe that unemployment could rise to levels of 25%. With unemployment at 25% and a dynamic deflationary debt burden, how do the banks expect people to be able to pay them back? Who is going to earn enough money to keep up with their mortgage payments? How will people be able to buy a house when their wages have been eroded by inflation? To think that the worst is already over in Spain is to lack common sense.
We believe that Spanish politicians and international investors have taken a very lenient view of the situation in Spain, but events will force them to change their minds. Looking back, Spain is like the subprime crisis, where all the banks’ results were good – until they weren’t. This is typical of bubbles, and Spain will be no different this time.
I am rich indeed, if I do not repay those to whom I am indebted.
I’m rich, even if I don’t pay the people I owe money to.
Titus Maccius Plautus (c. 254–184 BCE), «Curculio»