Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

One step forward and two steps backwards?

Economics can often provide solutions to problems while the study of politics can be about why the solutions are not always easy to implement.  This could be seen as a bias interpretation but the changes in the fate of Spain over the past month could possibility be an example.

The interest rates on Spanish government debt tumbled at the beginning of September following the announcement of plans by the European Central Bank (ECB) to buy an unlimited amount of bonds of indebted countries in Europe (refer to “Whatever it takes”).  This should have been the beginning of the end of the debt crisis in Europe.  But the mood turned sour as Spain once again hit the front pages of the papers as politicians in Madrid and in the region of Catalonia positioned themselves amidst the changing political landscape.  As a result, the Spanish government is having to fight to stay in the Eurozone as well as trying to hold the country together. 

The ECB made a bold stand in its willingness to stand behind countries like Spain who suffer from excessively high interest rates as a result of concerns over a possible breakup of the Eurozone.  If the ECB makes good on its pledge to do “whatever it takes” to save the euro, investors have less to worry about and renewed buying of Spanish bonds should help bring down the interest rates on the government debt.  But in practice, the best laid plans do not always work out.

The backing of the ECB required countries to submit to supervision from the EU and the IMF which makes the help offered by the ECB less attractive.  Losing control of their own affairs is a fate that those in power do not welcome and the Spanish government is holding off on asking for help from the ECB.  But the daunting nature of the economic problems in Spain suggests that help from outside is inevitable.  Real GDP in Spain is expected to shrink by 1.5% in 2012 and 0.7% in 2013 according to the IMF while the government debt continues to increase.  The Spanish government is expecting to borrow 207.2 billion euros in 2013 which is more than its plans for 186 billion euros in new debt in 2012.  An examination of Spanish banks this week suggests that a further 60 billion euros are needed to stabilize the banking sector and some of these funds may have to come from the government.

However, help from the ECB may be on the way as the Spanish government is making moves in the right direction and is in the process of implementing many of the policies that would be required of it if the country needed assistance from the ECB.  This may be crucial as the Spanish prime minister Mariano Rajoy has remained firm in his stance that he will not accept conditions being imposed from outside.  Yet, if the prescribed policies had already been put in place, the outside help need not require any further harsh measures.  But the policies of austerity have resulted in protests in Spain so the government is treading a fine line and the possibility of turmoil is never far away but at least efforts towards a solution are in the process of being made. 

The political difficulties of cutting government spending and raising taxes would be more than enough to deal with.  But the tough measures taken by the government have triggered another crisis – the perennial issue of secession in Spain.  Catalonia which is centred on Barcelona is both the wealthiest region in Spain as well as the region which has the most debt.  Its prosperity means that Catalonia provides more tax revenue to the central government in Madrid than it receives in government spending.  But, at the same time, the regional government in Catalonia has had to ask Madrid for just over 5 billion euros as investors will no longer lend the region any money.  This contraction has been jumped on by politicians in Catalonia who want to push for independence for the region and a snap election for the regional government in Catalonia has been called for November which is being seen as a proxy referendum on the possibility of secession.   A crisis is always a good opportunity for politicians to push for change even if it adds to the mayhem.

But such is politics.  Politicians must keep voters happy to stay in their jobs while others will take their opportunity to grab for power.  But this is not always conducive to action.  It is no coincidence that the ECB has been able to make bold policy shifts while governments in the various countries in Europe (including Germany) have been squabbling on the sidelines.  The messy politics in democracies can get in the way of doing what is required.  If only economists ruled the world!

Bracing for Impact!

The ongoing sagas in Europe can seem at times like a multi-car pile-up.  It begins with just a car or two spinning in circles after having been swiped but soon escalates as drivers are surprised by what they encounter.  Onlookers try to warn the oncoming traffic but the drivers are distracted and everything seems to happen in slow motion.  Just as people wince as they wait for what seems to be a major collision (fresh elections in Greece on July 17^th), eyes are averted to the potential for even more carnage – a banking crisis in Spain.

The turmoil in Greece and Spain appear similar but stem from different causes.  The government in Greece had too much debt before the global financial crisis came crashing into our living rooms.  The Greek government had borrowings of more than 100% of GDP in 2007 and this quickly rose to over 160% of GDP in the four years as tax revenues plummeted and government spending proved difficult to trim.  The government in Spain, on the other hand, was comparatively a model of virtue with debt of than less 40% of GDP in 2007.  Even as worries mounted, the level of government debt in Spain was still less than 70% in 2011. 

Yet Spain has been shunned by investors due to concerns over its banking sector.  Spain has fallen victim to a property bubble and it is typically in banks where the first symptoms show.  People or companies take out a mortgage using their new real estate purchase as collateral, and when prices are rising, everyone is happy.  However, when the market turns sour, property prices drop and prospective sales are not enough for the banks to recover the value of the debt. 

Dealing with a banking crisis like this is tough enough as it is.  The government needs to shovel money into the banks to stop them from collapsing under the weight of all the bad debts.  Write-offs are required for money that won’t be recovered and considerable time and effort is necessary before banks can get back to operating as per normal.  Typically, the government would just step in and put up the money to bolster the banks.  Bankia, Spain’s four largest bank, was recently bailed out by the government at a cost of 19 billion euros with the rest of the banking section expected to need around another 45 billion euros.  Compared to the level of government debt in 2011 of over 700 billion euros, putting up the cash is manageable and the debt to GDP ratio would still be less than 100%. 

Yet, Spain has more obstacles in the road in front of it than just a banking crisis.  The high interest rates on Spanish government debt (around 7%) means that the government doesn’t have the access to the funds it would normally have.  And the government is short on cash as it cuts spending to lower the government deficit.  To add to this, the economy is in recession with real GDP expected to fall by 1.5% in 2012 and 0.1% in 2013 with the austerity measures and banking crisis likely to make things worse.  The deteriorating economy also hits property prices, exacerbating the problems at the banks.  And on top of all this, the possibility of Greece dumping the euro means that Spaniards are taking their savings out of the banks and putting it under their mattresses due to worries about a return to the peseta.

As well as being short on funds, the Spanish government has lacked the creditability in dealing with its banks after having underestimated that cash that would be needed to bolster Bankia.  Help is on offer via a bailout for its banks from Europe and the IMF but Spain is wary.  While the money would be welcome, the conditions would not be and the saga in Greece are a reminder of this.  There have been some positive moves such as deliberation over whether Spain should be given an extra year to reduce its deficit to 3% which would help (as suggested previously – Spain and the Long Hard Slog).  But with both Spain and Greece now playing chicken with the leaders of Europe to try and ease their share of the burden, expect the carnage to mount.

Spain and the Long Hard Slog

Despite all the brouha over the bail out for Greece, the most pain from the Eurozone crisis is going to be felt elsewhere in the Mediterranean.  Spain doesn’t have the debt of Greece but it does have the highest unemployment and is set for the biggest cuts in government spending in the Eurozone.  And it is not going to be quick or easy with a weak economy made worse by fiscal cuts and trouble likely from its feckless regional government and agitation from a generation of youth out of work.

In terms of government debt, Spain looks like a model of virtue compared to many other countries in Europe.  Its government debt as a percentage of GDP was a mere 39.9% in 2008 before the Eurozone crisis and had only climbed up to 68.3% by 2011 which is lower than the supposedly virtuous Germans who have a government debt to GDP ratio of 82.6%. 

However, the budget deficit of the Spanish government has ballooned due to the effects of the global recession.  The initial effects on the Spanish economy was not as bad as elsewhere with a 3.7% decline in GDP in 2009 compared to the Eurozone average of a 4.3% drop.  But while 2010 saw a recovery in most European countries, the economy in Spain remained weak and GDP edged down by a further 0.1%.  Growth returned in 2011 but was limited to a 0.7% rise in GDP and all eyes had turned to Europe in the midst of its sovereign debt crisis.

What attracted the concern of investors to Spain was the combination of the sluggish economy and a rapidly expanding budget deficit.  The budget deficit hit 11.2% of GDP in 2009 and remained stubbornly high in the following years at 9.2% in 2010 and 8.5% in 2011.  Along with extra government spending for unemployment benefits and the like, government revenues dried up as two sectors which had benefitted from the boom before the crisis, construction and banking, fell into trouble. 

Now, the government has announced plans to implement savage austerity measures to lower the deficit to a target of 5.3% in 2012 and 3.0% in 2013.  While saving the country from a rise in the interest rates on government debt and the possibility of similar debt restructuring to Greece, the cuts to government spending will further weaken the economy and this may get Spain in even more trouble by creating a perverse spiral of government cutbacks and economic fallout.  Considering the lower level of government debt, a slower pace of budget cutting could be seen to be more appropriate but this is not something that the bond markets or Angela Merkel (among others) seem likely to allow.

Plans to cut the budget are also expected to run in trouble with protests already a common sight on Spanish streets.  Also, regional government controls a large part of government spending and won’t be happy to see spending cuts hit home on their turf.  So the stories in the papers have been whether the unprecedented 27 billion euros worth of budget cutting measures announced last month will be enough.  With a further 1.7% decline in GDP forecast for 2012, it is unclear whether the economy or the Spanish people can take much more.