Spanish economy: What is to blame for its problems?
- 18 May 2012
- From the section Business
Once again, markets are becoming nervous about lending to a eurozone government. This time it's Spain's turn.
The interest rate demanded by markets from the Spanish government to lend it money for 10 years has risen well above 6% - not far short of the 7%-8% level that prompted Greece, the Irish Republic and Portugal to go cap in hand to Brussels for a bailout.
In comparison, the German government only has to pay an interest rate of 1.42% - which, by the way, is the cheapest cost of borrowing that Berlin has ever faced.
What the markets are saying is that they are afraid Spain may ultimately go the same way as Greece, and prove unable to repay its debts, so they are moving their money to the safety of German bonds.
Meanwhile, Spain's banks are also in trouble. A rumour - denied by the Spanish finance ministry - circulated on Thursday that nervous depositors had withdrawn a billion euros of cash from their accounts at Bankia, a bank that was created out of the merger-cum-rescue of seven small regional savings banks in 2010.
Fears are rife of a vicious circle. If more cash leaves the Spanish banking system, the banks may not have the money needed to keep lending to the government.
Spaniards might be all the more minded to transfer their money to the safety of a German bank account if they witness a traumatic exit of Greece from the eurozone - something likely to involve the freezing and forced conversion of ordinary Greeks' savings into severely devalued drachmas.
On the other hand, if the Spanish banks get into trouble then the government in Madrid may not have enough money to bail them all out.
But the problems faced by Spain's government and its banks are just symptoms. The real issue is the mess that is Spain's economy.
Believe it or not, before 2008 Spain's government was one of the least spendthrift in the eurozone - unlike Greece. Or Germany.
The Spanish government's debts were a mere 36% of its gross domestic product (GDP) (the output of its economy) in 2007, while the German government's were 65%.
What's more, Madrid was in the process of paying its debts off - it earned more in tax revenues than its total spending . In contrast, Berlin regularly broke the maximum annual borrowing level laid down in the Maastricht Treaty of 3% of GDP.
Evidently, this crisis has nothing to do with the recklessness of Spain's government.
Instead, it was other people in Spain who behaved recklessly.
Interest rates fell to historic lows when the euro was launched in 1999. So Spain's banks, property developers and ordinary home-buyers collectively borrowed and fuelled an enormous property bubble.
Between 1996 and 2007, Spanish property prices tripled - comparable to the price rises seen in the UK.
Now the bubble has popped. Those prices are steadily falling - and they look like they have a lot further to go.
The construction industry has collapsed, leaving hundreds of thousands out of work. Overindebted home-owners face financial misery and have cut back on spending. And the banks are staring at a mounting pile of bad mortgage debts.
All of which means that now - just like the UK - Spain's government finds itself borrowing and spending like crazy to stop its economy from collapsing altogether.
In Spain, unemployment has risen to 24% of the workforce - which means fewer people paying income taxes and more people demanding benefits from the government.
Unfortunately for Spain, a burst housing bubble isn't the biggest problem the country faces.
That's because Spain also experienced another bubble - in its labour markets.
Wages rose far too quickly during the boom years of the last decade. Labour unit costs - a measure of how internationally competitive a country's labour force is - rose 40% relative to levels in Germany during the past decade .
That loss of competitiveness has left Spain - not just the government, but the entire country - with a big overspending problem.
With imports so cheap, and Spanish exports so expensive, the country's economy as a whole found itself spending 10% more than it was earning from the rest of the world in 2007 and 2008.
Unfortunately for Spain, it shares a currency with Germany. That means Spain can no longer simply devalue the peseta - something that would automatically make its workers cheaper and more competitive in the world. There is no peseta to devalue.
It means that Spain will remain stuck in an overvalued currency - while Germany will continue to enjoy an undervalued currency - for many more years, until that gap in the relative competitiveness of their workers slowly closes again.
And this is where it gets really nasty. Because so long as Spanish workers remain uncompetitive in the world economy, it is inevitable that Spain as a whole - government and private sector - will continue to have to borrow from the rest of the world.
Despite having entered its second recession since 2008, even as of 2011 Spain's economy was still overspending at a rate of 5% of its GDP. To eliminate this overspending altogether may require a far deeper recession.
Which brings us to the big question: Who will lend Spain the money it needs to pay for this continuing overspending, and thereby avoid a total collapse of its economy?
In the boom years, it was Germany's (and France's) banks that did the lending.
But since last summer that has changed. These banks have started to ask for their money back.
That's because, since last summer, a doubt has crept into the minds of Spain's lenders.
It is not merely that Spaniards - be it the government, the banks, property developers or home-buyers - have borrowed more than they can repay.
There is now a tangible risk, albeit small, that a country like Spain might go for the nuclear option and leave the euro altogether, because this might eventually prove to be the only way that Spain can regain its competitiveness and end its economic misery.
In that case it does not matter whether or not your Spanish borrower can repay their debts or not. The money you have lent could be frozen, forcibly converted into new pesetas, and then devalued against the rest of the remaining eurozone by perhaps 50% or more.
So, more and more people - not just French and German banks, but also many big investors and companies - have started pulling their money out of Spain and moving it to the safety of Germany.
All of which means that since last summer, Spain has not only needed to borrow to pay for its nasty overspending habit. Now it also needs to borrow to replace all of the money that is fleeing the country.
What is the scale of this problem?
According to the Spanish central bank - which is subordinate to the European Central Bank (ECB) - by March its total lending to Spain's banks had increased to 264bn euros (£210bn; $335bn). That has risen from less than 50bn euros in June 2011.
Spain's central bank in turn borrows most of this money from the ECB. It now owes the ECB 285bn euros, or 27% of Spain's GDP, and rising.
And it isn't just Spain's central bank. For similar reasons, the central bank of Italy has now borrowed about 279bn euros from the ECB , or 18% of Italian GDP, while those of France, Greece and the Irish Republic have taken about 100bn each.
And where has the ECB been getting all this money from? The answer is mainly from Germany's central bank, the Bundesbank.
The total lending provided by the Bundesbank via the ECB to its peers within the eurozone has risen and risen since the eurozone crisis began, reaching 644bn euros in April . That's 24% of Germany's GDP, and rising.
All of this is a convoluted way of saying that, as Germany's banks have steadily demanded the return of the money they lent to Spain, Italy and the rest over the past 10 years, Germany's central bank has had to step into the breach.
And these are not small figures. Compare them with the mere 130bn-euro second bailout package for Greece that caused so much hand-wringing by European politicians late last year.
But if the Bundesbank has come to the rescue, then why are markets getting in a tizz all over again?
Well, there are three reasons.
First of all, Spain's (and Italy's, Portugal's, Greece's and Ireland's) rescue lenders - namely the ECB, the IMF and the other eurozone governments - have all made clear that they expect to be repaid not only in full, but ahead of anyone else that these countries might happen to owe money to.
And that makes Spain's other lenders very uncomfortable, because it means that if Spain one day has to write off some of her debts, then they are the ones who will take all the losses.
Secondly, the supply of rescue loans is at risk of running out.
The Spanish central bank can only prop up Spain's banks if they provide security to back the emergency loans they receive (like when you offer your house as security for your mortgage).
That security - which is mainly Spanish government debt - is in short supply.
What's more, as the crisis has worsened again, the value of this security has gone down, reducing the amount that Spain's banks can borrow from their central bank.
Meanwhile, the political will of the eurozone's governments - the other main source of rescue loans - has been tested and found wanting.
The existing bailout facility - the European Financial Stability Facility - may still be too small to rescue Spain (especially if Italy also needs to be rescued).
But so far Germany and the few other stronger eurozone governments have been unwilling to put in more money.
But the third, and most worrying, reason for the current market jitters are the economic policies being signed up to by the eurozone, which seem set to make the economic pain in Spain even worse.
Spain's government has agreed to one of the biggest programme of spending cuts and tax rises in its history .
That wouldn't be so bad if Spain could devalue her currency. Although the cost of imports like oil would soar, the pain of spending cuts would fall disproportionately on the incomes of foreigners who export goods to Spain.
But inside the eurozone, that is not an option.
What's more, it isn't just Spain. Every other member of the European Union including Germany - in other words Spain's main export markets - has also signed up to huge rounds of austerity over the coming years .
In the UK, we are also experiencing the pain of austerity. But the Bank of England has alleviated the pain of our austerity by cutting borrowing costs and printing money.
In the eurozone, the ECB has proved less willing to provide these painkillers. Indeed, twice - in 2008 and again last year - it has even shown itself willing to actually raise interest rates just months before a major financial crisis broke out.
The fear is that Spain could face horrendous economic pain over the coming months and years, comparable to Greece, that will sorely test its willingness to stay inside the eurozone.
The Nobel-winning economist Paul Krugman has called this combined policy prescription of austerity and hard money "Europe's economic suicide" .
Europe's leaders will hope he is wrong.