Nothing can save Spain

Published in Business Spectator (Melbourne), 17 June 2010

Before the 2010 FIFA World Cup, Spain was the clear favourite to win the tournament. At Betdaq, the betting exchange, the odds for a Spanish victory were 4/1. In another field, the bets are also on Spain, albeit in a less flattering way.

There are growing concerns that the Iberians will be the next casualties of the economic crisis.The widening spread between Spanish securities and German bunds as well as the increasing costs of credit default swaps on Spain’s savings banks both point in the same direction. Markets are betting against Spain and its financial institutions.

In comparison, and to stay with the soccer analogy, the troubles in Greece were just a warm-up friendly for Europe. The next challenge is far more daunting: to avoid financial meltdown in Spain.

“Greece is not Spain”, has been how European politicians have been trying to reassure the markets. Once analysts had a closer look at the Spanish figures they concluded that this was indeed true – Spain’s troubles are much worse.

It is not that the Spanish had committed the same mistakes as their Greek companions in misfortune. They had not cooked their books to report manipulated data to the European authorities. They had not created a bloated public sector. They had not failed to enforce their tax laws.

In fact, before the crisis struck the Spanish were seen as Europe’s model citizens. Public debt was low, the economy grew rapidly, and in 2007 the government could still report a healthy budget surplus of 1.9 per cent of GDP. There was no sign of grave economic mismanagement, let alone on a scale comparable to the Greek basket case.

So what turned the Spanish miracle into an economy on the abyss? How can a country be regarded as a role model one day and almost a failed state the next?

The answer to both questions lies in Spain’s membership of the European monetary union. Just like Greece, Spain enjoyed much lower interest rates under the euro than under its old national currency. But whereas in Greece the lower interest rates were taken as an opportunity to incur greater public deficits, in Spain it was the private sector which accepted the invitation to go deeper into debt.

One sector in particular benefited from this injection of cheap cash thanks to the euro: real estate. For many years, Spanish house prices only knew one way, and that was up. Between 1998 and 2007, property prices increased by about 10 per cent per year on average.

When the global financial crisis struck, the bubble burst. Since 2008, Spanish house prices have declined 15 per cent and there is no end in sight to the correction. Some real estate experts are predicting further falls of up to 35 per cent.

Suddenly, the weak foundations of Spain’s economy are exposed, especially its over-reliance on debt coupled with low productivity. The slump in construction has contributed to a jump in unemployment with one in five Spaniards out of work. Spain’s public finances have turned deep into the red. Even more worryingly, Spain’s financial system now faces massive write-downs.

It is estimated that the building sector alone owes Spanish banks some €300 billion. The banks also had to buy more than 1.5 million dwellings, although it is very unlikely they are ever going to recover the purchasing costs. Earlier this year, the Bank of Spain told lenders to write down the value of their property related assets by 20 percent.

It was only a question of time until the first Spanish bank would collapse under the mountain of bad loans. That happened when Cajasur, a small savings bank, had to be taken over by Spain’s central bank. Given the amount of debt, it is likely that others will follow. Besides, a government subsidised a wave of mergers is working its way through Spain’s financial sector.

The situation is only going to get worse. According to Standard & Poor’s, Spain’s total private debt stands at 178 per cent of GDP. Morgan Stanley believes that the country’s savings banks could have to write down between €87 billion and €131 billion.

For policymakers in Europe, Spain presents a dilemma. The austerity measures they are forcing on the country could help restore fiscal balance. However, they could also undermine Spain’s economic recovery and destabilise it both economically and politically. In any case, these policies are unable to deal with the real challenge, the deflation of the debt-fuelled bubble. “There is no means of avoiding the final collapse of a boom brought about by credit expansion”, Austrian economist Ludwig von Mises warned more than 60 years ago.It sounds as if he had written about Spain today.

In all likelihood, Spain’s banks will need to be recapitalised out of the trillion dollar fund the EU agreed on in May. This would only confirm what many observers had suspected from the beginning – the EU measure is first and foremost a bank bailout, not a vehicle to save the euro.

Whether this enormous amount of capital will be sufficient is questionable. Last week, EU president Herman van Rompuy indicated that the initial stabilisation package may need to be extended – before the first euros out of this package have actually been paid.

In this dire situation, the best option for Spain is not even on the table. Outside the eurozone, Spain could have devalued its currency. Just as the Bank of England responded to Britain’s very similar woes by debasing sterling, this would have been a viable path to support Spain’s painful recalibration, too. Instead Spain – like Greece – remains trapped in a monetary union with countries it can no longer compete with.

There is one vital difference to Greece, though – Spain is too big to be saved.

And there is, of course, another difference as well. Unlike Greece, Spain still has a working chance to win the soccer world cup. That’s better than nothing.

%d bloggers like this: