ECB Guarantee Did Not Save Spain

By now, everyone around the world has probably heard that Spain is de facto in fiscal default – i.e., bankrupt. The IMF, whose report Fiscal Monitor number 1301 presented the numbers showing that Spain is practically in default, does not offer an explicit analysis of the default scenario itself, but it gives a very illuminating background to the proliferating economic tragedy in Europe.

I will do an analysis of the Fiscal Monitor report later; for now, let’s return to Spain and the notable fact that the country has gone into effective bankruptcy despite the commitment by the European Central Bank to buy up every euro’s worth of Spanish treasury bonds. This commitment meant two things:

  1. owners of Spanish bonds would always be able to sell them, thus putting a mild downward pressure on the interest rate; and
  2. the Spanish government would be able to finance its own debt in perpetuity – all it would have to do would be to issue more debt, i.e., to ask the ECB to print more money.

This is a slight simplification, as the Spanish government would still have to meet certain fiscal criteria, such as continued austerity. But at the same time, if a central bank issues a guarantee to buy all bonds that its government issues in order to bring down the interest rate on those bonds, you cannot condition your promise on fiscal austerity. As soon as the government must take fiscal steps to maintain the central bank’s purchasing guarantee, the guarantee loses its inherent value. It is no longer worth any more than the bonds it is supposed to guarantee.

In other words, meaningless.

Assuming that the ECB does not make meaningless promises, the Spanish de facto default is all the more remarkable – and comes with serious warnings to everyone with money in Spain: get out or face a Cypriot Bank Heist seizure of your assets.

Here is what Jeremy Warner said in the Daily Telegraph a couple of days ago:

Next year, the [Spanish] deficit is expected to be 6.9 per cent [of GDP], the year after 6.6 per cent, and so on with very little further progress thereafter. Remember, all these projections are made on the basis of everything we know about policy so far, so they take account of the latest package of austerity measures announced by the Spanish Government.

Which means that we can expect an increase in the deficit ratio in the future, as forecasters often forget to incorporate the negative effects of austerity on GDP.

The situation looks even worse on a cyclically adjusted basis. What is sometimes called the “structural deficit”, or the bit of government borrowing that doesn’t go away even after the economy returns to growth (if indeed it ever does), actually deteriorates from an expected 4.2 per cent of GDP this year to 5.7 per cent in 2018.

This is important, because it shows that there is a structural change going on in the Spanish economy. People are paying permanently higher taxes and get permanently less back from government for that money. The private sector has been permanently diminished and an entire generation of young Spaniards has been sentenced to a life on welfare.

By 2018, Spain has far and away the worst structural deficit of any advanced economy, including other such well known fiscal basket cases as the UK and the US. So what happens when you carry on borrowing at that sort of rate, year in, year out? Your overall indebtedness rockets, of course, and that’s what’s going to happen to Spain, where general government gross debt is forecast to rise from 84.1 per cent of GDP last year to 110.6 per cent in 2018. No other advanced economy has such a dramatically worsening outlook.

But Greece did, and they ended up losing one quarter of the GDP.

Unfortunately, Jeremy Warner does not see the damage done by austerity:

And the tragedy of it all is that Spain is actually making relatively good progress in addressing the “primary balance”, that’s the deficit before debt servicing costs.

The “progress” consists of increasing taxes and reducing spending in an entirely static fashion. There is no analysis behind the austerity efforts of the long-term effects they will have on the economy. For example, the increase in the value-added tax that was enacted last year reduced the ability of consumers to spend on other items. This reduced private consumption and forced lay-offs in retail and other consumer-oriented industries. The laid off workers went from being taxpayers to being full-time entitlement consumers. As they did they reduced the tax base and cut tax revenues for the government in the future.

This point aside, Warner explains well the bankruptcy side of the issue:

What’s projected to occur is essentially what happens in all bankruptcies. Eventually you have to borrow more just to pay the interest on your existing debt. The fiscal compact requires eurozone countries to reduce their deficits to 3 per cent by the end of this year, though Spain among others was recently granted an extension. But on these numbers, there is no chance ever of achieving this target without further austerity measures … it seems doubtful an economy where unemployment is already above 25 per cent could take any more. … All this leads to the conclusion that a big Spanish debt restructuring is inevitable.

Debt restructuring, of course, being the same as bankruptcy. In a matter of speaking, Greece did a “bankruptcy light” when they unilaterally wrote down their debt. In the case of Spain it would probably mean a much bigger debt writedown than in Greece.

Back to Warner:

Spanish sovereign bond yields have fallen sharply since announcement of the European Central Bank’s “outright monetary transactions” programme. … But in the end, no amount of liquidity can cover up for an underlying problem with solvency. Europe said that Greece was the first and last such restructuring, but then there was Cyprus.

And toward the end Warner issues a fair warning about a repetition of the Cyprus Bank Heist:

Confiscation of deposits looks all too possible. I don’t advise getting your money out lightly. Indeed, such advise is generally thought grossly irresponsible, for it risks inducing a self reinforcing panic. Yet looking at the IMF projections, it’s the only rational thing to do.

Spain is the fourth largest euro-area economy, with ten percent of the euro zone GDP. If we add Greece, Cyprus and an all-but-certain Portuguese de facto bankruptcy, we would now have 14 percent of the euro area economy declared practically insolvent.  As Jeremy Warner so well explains, the point where this bankruptcy becomes a fact is one where the macroeconomy in a country is permanently unable to bear the burden of government.

This means that 14 percent of the euro-zone economy will be at a point where it is acutely unable to fund the welfare state.

What conclusions will Europe’s elected officials draw from that? It remains to be seen, though it is not far fetched to assume that no one will be ready, willing or courageous enough to remove the welfare state.

That is too bad, because it means – again – that Europe is stuck in a permanent state of industrial poverty. Hopefully, America’s elected officials will watch, learn and do the right thing.

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