Testing times for Spain's regions

by Antonio Garcia Pascual and Michaela Seimen

THE AAA HANDBOOK 2012 BENDING WITH THE WIND
Barclays Research June 2012


In this chapter we explain why the recent constitutional changes in Spain will have a positive medium-term impact on the fiscal position of the Spanish regions. We also discuss how the regions will manage to cope with their aggregate EUR140bn of debt and how new measures, such as the Fondo para la Financiación de Pago a Proveedores (FFPP), a government sponsored syndicated loan dedicated to pay suppliers, and Hispabonos, a joint funding platform, could help the regions to cope with the challenging economic and capital market environment.

The challenge continues

Spain has become (yet again) the focus of attention of financial markets. This has been the result of a large 2011 fiscal underperformance (mainly by the regions), a poorly managed upward revision to the 2012 deficit target, confirmation that the country re-entered recession in the first quarter, and a perception that the ECB’s recent injection of liquidity may have reached the limit of its effectiveness. More recently, market stress has escalated under the market perception that the clean-up of the banking sector is incomplete (despite intervention by the state in Bankia) and may result in larger fiscal costs than currently envisaged by the sovereign. However, since the new government took office in December 2011, and despite elevated market stress, it is also fair to say that the government has taken some bold steps to regain control of the fiscal performance of the regions.

To contain fiscal deficits, including the regions’, the parliament approved a new organic law on budgetary stability and financial sustainability of public administrations in May 2012. Of particular interest is that the law lays out the mechanisms of control for the central government in the event of fiscal deviations in the regions. Furthermore, the law also implements Article 135 of the Spanish Constitution (a new constitutional amendment approved by the parliament in September 2011), which legally enables the central government to intervene in a region that does not comply with the new fiscal stability framework. Among the various challenges confronting Spain, the ability to control the central government and regional deficits is one of the top priorities. The powers endowed to the central government under the new fiscal stability law are likely to be put to the test soon, in our view. Will those be enough to effectively limit future fiscal slippages and will the central government be able to control the regions?


Constitutional amendment of Article 135 & Fiscal Stability Law


In mid-September 2011, the Socialist government (now the opposition), with the support of the main opposition party (now in government), approved a “constitutional debt brake” consistent with the European new fiscal compact rules. The amendments are already enshrined in the Spanish constitution and include: 1) the principle of a structural balanced budget for the central government and the regions; local governments will also be required to run zero headline balances; 2) a ceiling for public debt of 60% of GDP; and 3) a change in the priority of government expenditures, whereby interest payments and amortisations of public debt will have the highest priority.

Technical details on the definition of the structural budget, including the “phase-in” period for the application of the rule and the specific mechanisms of adjustment in the event of deviations, are key features defined in the new, separate organic law (recently approved by the parliament) on budgetary stability and financial sustainability of public administrations. This new law has been drafted to be consistent with the agreements reached at the euro area level on the new “fiscal compact”. The law also automatically incorporates any future amendments to the European fiscal rules.

The new organic law defines the mechanisms available to the central government to rein in any fiscal slippages in the regions. Various mechanisms of ex-ante control, which are lacking so far, are now part of the new fiscal framework. These mechanisms include preapproval of regional budgets by the central government and the possibility for the central government to recommend or even impose fiscal consolidation measures on the regions. The regions also adopted new rules for the set-up of expenditure ceilings. These new elements of “ex-ante fiscal control” are now feasible legally for the central government (and certainly desirable) following the constitutional amendment approved in September.

Please see the Appendix in this section for details of the Fiscal Stability Law as well as new preventive and corrective mechanisms for central government control of the regions.


The 2012-13 fiscal targets are unnecessarily overambitious

Following a series of fiscal data revisions, the 2011 fiscal deficit currently stands at 8.9% of GDP, compared with a target of 6% of GDP. Of the overall 2.9pp slippage, the lion’s share corresponds largely to the regional budgets (about 70% of the slippage), with the rest of the deviation split between social security and central government. The regions with the largest slippages in terms of regional GDP were Castilla la Mancha, Valencia and Murcia, regions in which the boom-bust in real estate has been the most severe. However, in absolute terms, the largest contributors to the overall 2011 fiscal slippage were Valencia, followed by Catalunya and Andalucía (three of the largest four).

On 30 March, the Spanish government presented the 2012 budget for the central government, which includes measures worth EUR27.3bn (c.2.5% of GDP). When the government took office in December 2011, it announced a first round of fiscal consolidation measures totalling EUR15bn, including changes to personal income tax, capital gains, and property tax. The central government, social security, regions, and municipalities altogether will need to achieve a fiscal swing of 4.2% of GDP by reducing the public sector deficit to 5.3% of GDP in 2012.

Is the 2012 fiscal target achievable? The short answer is not under the existing measures. But we do not believe it is necessary to achieve fiscal solvency in the medium term. In our view a more moderate fiscal consolidation path, which ensures a fiscal swing of about 8% of GDP over the next 5-6 years would be sufficient to restore solvency. Specifically, for Spain, we think it is reasonable to assume that a 1% fiscal consolidation only produces an effective deficit reduction of 0.7% (see Spain: dealing with sudden reversals, 4 May 2012).

Using the government target, to achieve 4.2% of GDP consolidation in 2012 would require fiscal measures worth nearly 6% of GDP. Our more conservative estimate of a 3% of GDP consolidation in 2012 is based on adjustment measures worth slightly over 4% of GDP. There are three main differences between the more aggressive government adjustment path and ours. First, the government is probably using fiscal multipliers of smaller size than ours. We think this is because the government is considering that a large share of the expenditure cuts can be applied to activities (such as transfers) with a low fiscal multiplier. Second, we are assuming a larger GDP contraction than the government (Barclays -2.0%; Spanish government -1.7%). Third, we are also assuming slightly less fiscal adjustment in 2012 than the government. For example, we are excluding the EUR2.5bn expected revenues from a tax amnesty, which may or may not yield such revenues.

While the slippages are likely to occur across all the components of the general government, we still think that the largest fiscal risks remain in the regional fiscal consolidation targets. We estimate that, instead of the deficit target of 1.5% of GDP, a more likely outcome is in the range of 2.0% to 2.5% of GDP. The central government will have to help the regions by redefining the size of the welfare state that the Spanish economy can afford consistent with the targets of the regions. It will ultimately fall to the regions to implement the policies. Specifically, we believe significant cuts in health, education and social spending will be required. In fact, the government has proposed cuts on health and education spending cuts worth EUR10bn.


The social security fiscal target, which aims for a balanced budget, also seems quite challenging as the economic outlook has worsened relative to 2011. In 2011, social contributions fell c.3% and pension costs rose 4%; as a result, social security was -0.1% of GDP, versus the target of +0.4%. In 2012, a deficit larger than in 2011 seems likely (ie, a balanced budget strikes us as far-fetched) as pension spending continues to rise along with unemployment benefits, while social contributions are likely to continue falling.


Are there any safeguards against these risks?

First, the central government is backed by a brand new constitutional debt brake and a new organic law that sets expenditure-ceiling rules for all the sub-central government levels and allows the central government, if needed, to potentially “intervene in a region” and take away fiscal responsibilities. Also, the new draft law of “good governance” proposes that any local authority that fails to comply with the fiscal consolidation targets (ie, that fails to comply with the new constitutional amendment or the new organic law above mentioned) can be dismissed and be banned from running for public office for a period of up to 10 years. In practice, however, these brand new mechanisms of fiscal control have not yet been put to the test. We think that politically it would be very costly for the central government to revert the process of fiscal devolution by taking responsibilities away from any region, even if temporarily.

Second, the central government controls a large share of the regional taxes. Specifically, the central government controls the tax rates of the personal and corporate income tax (PIT and CIT), as well as the VAT. The fiscal revenues from these taxes are shared between the central government and the regions (50% each). Hence, any decision by the central government to increase the PIT, CIT and VAT rates has a direct impact on the fiscal revenue of the regions. In the approved 2012 budget and in the new 2012-15 stability and convergence programme, the government has approved (or proposed) changes to the corporate and personal income tax regime as well as an increase to indirect taxes, including a hike to the VAT rate in 2013 (the standard VAT rate is currently 18%, which is 3pp below the standard rate of Italy and 5pp below Ireland, Portugal and Greece).

Third, the government is taking stock of all state-owned real estate assets and planning more active management of these assets to reduce expenditures and privatise the more marketable assets to reduce public debt. It has set up a public sector entity to coordinate the disposal of these assets. While the government does have an inventory of its real estate assets, it has not yet indicated the assets it is planning to privatise or the possible valuation.

Finally, the government will target further structural reforms, in addition to the already approved labour market reform. New reforms will be aimed at enhancing competitiveness by reducing production costs and improving market flexibility, and will cover the energy sector, market integration, housing rental market, and innovation and R&D activities. With the presentation of 2012-14 regional budget plans on 17 May 2012, the first part of the fiscal planning is finally complete. We believe the targets set for the regions are overly ambitious.

Although we appreciate that there are segments that would need more comprehensive cuts, we nevertheless believe the restructuring of public economies is a rather longer-term project and market participants could be mislead by more limited short-term achievements. In the short term, the government will also need to focus on the funding of the regions. With strong risk aversion in the market and ongoing concerns regarding peripheral economies, we believe market access for Spanish regions will be rather limited in the near and medium term. As such, the government already tried to ease the burden by establishing a support fund to finance debt the regions had accumulated with its suppliers (Fondo para la Financiacion de Pago a Proveedores, more on this below).

Furthermore, we understand that the government is working on establishing so-called ‘Hispabonos’ to support the capital market funding of the regions. While the details of the Hispabonos have not been revealed, we think it is likely that the new instruments will: 1) carry a sovereign guarantee; 2) be responsible for (most of) the funding of the regions; 3) enhance liquidity relative to each region tapping the market separately; and 4) reduce the effective funding cost for most of the regions (albeit potentially at the expense of a higher funding cost for the central government).

Fondo para la Financiación de Pago a Proveedores


In 2011, we referred in our AAA Handbook overview of the Spanish sub-sovereign market to the problem of ‘hidden debts’, particularly for suppliers receiving delayed payments. Such payments are recorded in accounts payable and by the Bank of Spain; as such, an increase of these amounts was noted in recent years. Although such a development is not unexpected, as these accounts tend to behave pro-cyclically, delays in payments were partly used to bridge periods of a more difficult funding climate. However, the economy and SMEs in particular are constrained by such delays. To address this problem, the Spanish government has set up a fund – the Fondo para la Financiacion de Pago a Proveedores – to pay the mounting debt local and regional authorities (territorial administrations) have to their suppliers. The fund – effectively an intermediary between financers and territorial administrations – has been created through a subscribed syndicated loan totalling EUR30bn at the time of writing, and can be increased to EUR35bn, which is the current estimate of excess accounts payable to suppliers according to publications by the Ministry of Finance and Public Administration (Treasury) and the Ministry of Economy and Competitiveness. Repayments are set to commence on 31 May this year for local authorities, and 30 June for regional authorities, and will be made directly from the fund to the suppliers approved for repayment.

The fund, FFPP, will grant loans to territorial administrations for up to 10 years, with a 2- year grace period; in turn, these administrations will have to come up with a sustainable long-term adjustment plan guaranteeing the repayment of future loans. This adjustment plan will be supervised by the Ministry of Finance and Public Administrations (ie, Treasury).

The fund is set up through a syndicated loan, the biggest in Spanish history, made by 26 Spanish financial institutions, and will have a 5-year tenor (with a 2-year grace period). It will be guaranteed by the Treasury, which will assume the transition of the 5-year syndicated loan to the 10-year loan to the territorial authorities. The Treasury, in turn, will have a counter-guarantee against the local and regional revenues (Participación en los Ingresos del Estado). The loan will be made at 3-month Euribor plus a premium added for market conditions, which will make the loan cost about 5.9%.

Spain hopes this operation will inject liquidity equivalent to 3% GDP into the economy, which is respectively expected to increase by 0.4% between 2012 and 2013. The operation will mainly benefit small and medium-sized enterprises, and Spain is hoping to generate a further 100,000- 130,000 new jobs.

Funding outlook – a tricky business


In their recent 2012-14 Budget planning announcements, the regions also presented an overview of the quarterly maturity structures of their debt in 2012 (see Figure 3). However, due to short-term extensions, private placements and rolling bank loans, it is rather difficult to follow an exact debt profile for each region.

Furthermore, the newly established support fund to pay suppliers, plus additional ICO liquidity lines, shifted the funding needs of the regions slightly.

In the last 2 years retail bond issuance became an interesting alternative funding tool for some regions, as to being able to place larger bonds in the market. However, funding costs for this instrument are rather uneconomical; furthermore, it is our understanding that this funding source could come to a sudden stop, as more recently some regions have been downgraded to non-investment grade by some rating agencies, which would undermine the region’s ability to use the retail market segment.

As of year-end 2011, the Bank of Spain published the following overview on the short- and longer-term funding of Spanish regions (Figure 6).

We do not believe the funding pressure for the regions will decrease substantially in the near term, despite the efforts to meet the 1.5%-deficit agreement. In our view, this target is very ambitious and could lead to misjudgements regarding the progress regions will have to make to get their budgets and deficits under control. Instead, we tend to review the progress of the regions on a more gradual and broader view. In the meantime, we will focus on the implementation of the government’s control measures and systems and the respective triggers for penalties on regions that do not follow austerity measures on an ongoing basis.


However, in the long term, the success of the penalty/intervention structure is also dependent on central government political backing in the region. As long as the PP - People’s Party - holds a majority in the regions, changes and control mechanisms and penalty structures are more likely to be enforced. However, if this situation should change In the future, approvals for interventions could become more difficult.

Hispabonos

Hispabonos, although not in existence yet, will be bonds issued by the autonomous regions that the state intends to issue on a state-wide level to increase liquidity and lower the cost of debt. Basically, it is too costly for the autonomous regions to issue and service debt; as a result, the government might be obliged to intervene when the autonomous regions cannot pay.

The Spanish regions (some more than others) are struggling with large refinancing needs of c.EUR50bn this year. Given several Spanish regional authorities already have large amounts of debt outstanding (c.13% of GDP), it is more difficult for these to enter the market at reasonable levels. In addition, several regions have recently been downgraded to non-investment grade levels by Moody’s. For example, Catalunya alone has more then EUR41bn of debt outstanding, followed by Valencia with c.EUR20bn and Madrid with c.EUR15bn (see Figure 8). Valencia had to refinance a EUR500mn loan at a cost of 7% with a 6-month tenor in May this year, according to Bloomberg data, which is unsustainable even in the medium term.

For some regions, a recent source of funding has been larger retail bond issuance. Catalunya is one such region, issuing retail bonds, with severe additional costs attached. According to media reports, on top of paying 2.85% more in coupon than treasury securities with similar maturities, which were offering 1.94% at the time, the Generalitat of Catalunya also had to incur a further 3% in insurance costs and 2% as a commission to the individual banks selling the bonds, taking the total cost of the issue close to 10%. It is our understanding that this is not unusual as banks charge higher prices to insure and promote products that are difficult to commercialise.




Given the restrictions and risk aversion Spanish issuers face, we believe the plan to provide a joint issuance platform for the regions would be beneficial because there are several points the potential Hispabono could address:



- The issues would more likely be placed with institutional investors (and made repo-able at the ECB), which would be cheaper than trying to place them with private clients, as in the previously mentioned example of the retail bond issuance.

- Furthermore, the issues would also be larger in size, thus making them more liquid, as opposed to the individual, smaller sizes issued when needed by the regional authorities.

- According to a Reuters report, the financing costs incurred by regional authorities could be reduced more than EUR1bn per year by issuing Hispabonos. This represents an important 2% reduction in financing costs in 2012.

Nevertheless, the concept of Hispabonos also faces some opposition. Regional authorities that have smaller deficits, a comparatively small stock of outstanding debt and benefit from higher credit ratings are more reserved about pooling funding and thus facing a higher funding cost. Also, some market participants raised concerns that easier and more liquid market access could undermine current efforts to reduce spending.

The establishment of Hispabonos is being discussed at a government level, but no details regarding the format or structure of such bonds have been made public. From various media reports, we understand that different proposals are currently reviewed. In our view, an important feature would be a potential guarantee structure by the state, which is not necessarily envisaged however. Reuters, Cincodias and el Confidencial, among others reported on developments in regard to Hispabonos, with some articles mentioning that the state will guarantee the bond, while others merely say it will be backed by the state, which in our opinion is more akin to an implied guarantee as opposed to the full faith and credit of the Spanish government. In our view, since the regions have legal independence, we find it unlikely that Hispabonos would be backed by a full guarantee of the Spanish government. However, given the current sensitivity in the market, we believe correlation risk between Spain and any Spanish issuer is extremely high. As such, any failure in the sub-sovereign or agency or banking sector, for example, would have immediate implications for the state.

However, the government has passed a constitutional amendment and an organic law to have better control of the fiscal performance of the regions and repeatedly has stated in public that it will not let any region default – which is a very strong implicit guarantee in our view. For example, Treasury Minister Montoro was recently cited in el Confidencial, saying that the state would always be there when an autonomous region would require help, although we note this does not alleviate any region from its responsibility to control its budgets and reduce the deficit. The new government already proved its commitment to the regions, when it helped in December, according to Bloomberg, the region of Valencia to make a EUR123mn payment to Deutsche Bank. The Spanish treasury gave a verbal guarantee to an unidentified lender in order to advance the funds the regional government needed to make the payment.

From a timing perspective, we expect a decision on Hispabonos in the near future, as funding requirements for regions would need to be addressed at the latest in Q3 12. Bloomberg reported on 1 June 2012 that Spain is working on a mechanism to help its regions finance themselves in the financial markets and will publish details of the programme the following week. The mechanism will mean changes to Spanish law and impose stricter conditions on regions while leaving them responsible for their own debts, Budget Minister Cristobal Montoro said at a press conference in Madrid. Full implementation and legal foundation could be considerably lengthier though, as a financing mechanism must be set up and most likely reviewed by the rating agencies before any significant issuance takes place.

Either way, based on recent comments by government members cited in the media, we are confident that the establishment of Hispabonos will be addressed in the near future and that this new instrument will be implemented as an economical solution to finance the Spanish regions.

For an indication of pricing and investor acceptance in the market, we believe a comparison with other Spanish government-related debt is sensible. In the past, there has been a relatively widely diversified investor base in Spanish government guaranteed debt, such as ICO, FROB or FADE. However, with increased concerns regarding European peripheral issuers, international investor interest in these markets has become rather subdued and has been nearly completely replaced by a national investor base.

However, investors have focussed on the regions for a long time. Despite missing explicit guarantee structures, but more or less being based on the assumed large correlation risk with the Spanish sovereign, the higher spreads currently attract renewed investor interest in this segment. With the fractured market currently and a separate risk assessment necessary for each region due to complex and partially unclear data, some investors regard current spreads and the remaining insecurity about missing guarantee structures as insufficient to provide relative value in sub-sovereign investments.


In this respect, though, Hispabonos could add value by replacing a complex individual risk assessment for each region with a guarantee structure. Nevertheless, we expect investors to demand a pick up over Spanish sovereign bond issuance and given our expectation of a more implicit guarantee structure, the pick up also has to be considered to be currently slightly above government guaranteed debt.

With the introduction of a new issuance instrument, we expect maturity levels of new bonds to be skewed towards the shorter end of the maturity spectrum. As such, we expect bonds with a maturity of three years to most likely trade with an additional spread pick-up to fully guaranteed debt (eg, ICO currently is priced about 60bp over government debt). At first glance, this might appear to be an expensive option. However, with the limited liquidity and market access of Spanish regions, spreads of Spanish regional debt have been about 400bp over Spanish government debt.


Given the difference in credit quality of the regions based on the ratings and the indebtedness, we do not believe that the funds would be distributed at equal costs to the regions. As such, we would envisage a system, where funds raised via such an instrument would be distributed at a cost linked to the respective credit quality of the region.

Appendix

Institutional and political background

Spain is one of the most decentralized countries in the euro area (if not the most). In the 1980s, sub-national governments were responsible for c.15% of the public expenditure; in 2010, regions accounted for c.50% of the expenditures. The 1978 Constitution grants the regions competences in many areas including education, health, public works in their territory and the environment. As a result of the fiscal devolution process, the central government currently controls less than 30% of public expenditure (excluding social security and debt service).

Politically, the Kingdom of Spain is divided into 17 autonomous communities and two autonomous cities that are located in Northern Africa: Ceuta and Melilla. Geographically, with 18.6% of the total landmass, Castilla y León is the largest autonomous community, followed by Andalusia (17.2%) and Castilla La Mancha (15.7%). In terms of population, however, with c.17.8% (8.1mn) of the total 44.1mn inhabitants, Andalusia is clearly the largest autonomous community, followed by Catalonia (16.0%), Madrid (13.6%) and Valencia (10.9%).

“No bailout rule”


The Spanish budgetary stability law (Ley de Estabilidad Presupuestaria – LEP), which was implemented in 2007, specifically states there will not be any bailout procedures for the Spanish autonomous communities.

In the Real Decreto Legislativo 2/2007 of 31 December 2007, it is explicitly stated that “the Spanish central government will neither assume nor be responsible for the commitments of autonomous communities, local entities or those related or depending on these, without affecting mutual financial guarantees for the joint realisation of specific projects”5. As a result of this specific no-bailout clause, rating agencies understand the probability for timely sovereign support is relatively low6. Still, despite limiting federal support in the case of (financial) distress, in our view, the no-bailout clause does not exclude financial help in the form of specific transfers to autonomous communities before a bankruptcy emerges. In

fact, taking into consideration the legal barriers to provide (federal) help in the case of distress, we believe there is a high probability the central government (and other autonomous communities) would make the respective funds required to turn down an event of default available before any such situation arises.

Furthermore, we believe that in case of distress, the Financial and Fiscal Policy Council (FFPC) that represents Spain’s autonomous communities could arrange for emergency funding to weather any further adverse developments. Clearly, bearing in mind the potential spill-over effects, the default of a single autonomous community cannot be in the interest of the other autonomous communities.

Regulatory issues

In Circular 5/1993 from March 1993, Banco de España (BdE) provides a classification of the respective risk weightings (RW) applicable to debt issued by Spanish autonomous communities. Among other instruments, debt issued by the autonomous communities and local entities, provided the issues are authorised by the state (“Deuda pública emitida por las Comunidades Autónomas y las Entidades locales, cuando las emisiones estén autorizadas por el Estado”), benefit from an RW of zero. In principle, all debt (loans and bonds) issued on behalf of the autonomous communities are authorised by the state with RW of zero. Yet, in the case of municipalities, authorisation is usually only sought for bonds. All other debt issued thus falls outside the scope of the above clause and becomes subject to an RW of 20% (“Grupo con ponderacion del 20%: activos, […] que representen créditos frente a las Comunidades Autónomas y frente a las Entidades locales españolas”. Bonds issued by the Spanish autonomous communities generally fall into the ECB’s liquidity class category two. Depending on the remaining term to maturity, the applicable haircut applied by the ECB ranges between 1% and 7.5%.

Key elements of the draft Fiscal Stability Law

1. A debt brake rule: Public debt cannot exceed 60% of GDP, but there will be a transition period until 2020. During this period, a path to reducing the budgetary imbalances will be devised until the public debt ceiling of 60% of GDP is achieved. In particular, public debt will be reduced as long as the national economy is experiencing real positive growth. Furthermore, when a growth rate of 2% is reached, or if net employment is generated in annual terms, the debt ratio shall be reduced annually by a minimum of 2pp of GDP (the structural deficit of the overall public sector must be reduced by an annual average of 0.8% of national GDP).

2. Balanced structural budget rule: All public administrations (including the regions) will present a balanced or surplus budget. No administration may incur a structural deficit. A structural deficit may only occur in exceptional situations (natural disasters, economic recession or extraordinary emergency situations). The EU recommendations on the stability programme will be taken into account to set the stability and public debt targets.

3. An expenditure ceiling: All public administrations must approve an expenditure ceiling in keeping with the stability target and the expenditure rule. Public sector expenditures may not rise above the GDP growth rate, in accordance with European regulations.

4. Priority of debt service rule: Servicing the public debt will take absolute priority above all other expenses, as established in the constitution.

5. Control mechanisms and sanctions: Failure to comply with these objectives by the regions will result in the requirement to present an economic/financial plan that will correct the fiscal slippage within one year. This plan must explain the reasons for the deviation and the measures that will enable the administration to get back within the limits. Fulfilment of the objectives will be taken into account for authorising debt issuance, granting subsidies and signing agreements. In the event of non-compliance with the plan, the administration responsible will have to automatically approve the non-availability of credit that will ensure the established objective is met.

Any sanctions imposed on Spain in relation to stability will be assumed by the responsible administration. The law also transposes the EU corrective mechanisms. In the event that an economic/financial plan is not fulfilled, the administration (central or regional) that has failed to fulfil the plan must make a deposit of 0.2% of its nominal GDP, which after six months may become a penalty if the failure is repeated. Moreover, after nine months, the central government may send a delegation to assess the economic and budgetary situation of the administration in question.

More importantly, the government has clearly indicated that, according with the new constitutional amendment and the new organic law, failure to comply with the fiscal stability law could trigger intervention in a region. The central government would take control of the budget of the region until fiscal stability is restored.

Japan: What went wrong?

By Paul Krugman

Note, this article was originally published in June 1998. I (Edward Hugh) am simple republishing it here to make it directly accessible online, as I think it has considerable importance for the whole debate we are having at this time.

SYNOPSIS: Scary story of how wonderful country collapsed through no fault of its own

       In an early-'90s Dilbert, an excessively trendy manager exhorted his team to "search for excellence in the total quality chaos, or whatever the Japanese are doing this month." Only a few years ago, the business sections of airport bookstores were largely given over to tracts revealing the supposed secrets of Japanese management and the menace Japan posed to the United States. Then it turned out the Japanese were human, after all, and everyone lost interest. Western pundits, having once placed Japan on a pedestal, now either prefer not to discuss the subject or see Japan's failures mainly as an occasion for smug self-congratulation. 

       But the new story is much more interesting than the old one. How could a wealthy, productive, sophisticated country have gone from enviable growth in the 1980s to stagnation in the '90s, and now be slipping into a downward spiral of recession and deflation? True, Japan is not a country on the edge of chaos--as Indonesia or Russia is--but that only adds to the mystery. Japan isn't a place where the state is weak, unable to collect taxes or convince investors that their property rights are secure. Nor is it a country at the mercy of skittish foreign investors who must be persuaded to roll over its debt: Japan is still the world's largest creditor. So what's the explanation?

Japan has many inefficiencies that limit its productive capacity--too many mom-and-pop stores, not enough computerization in the office, and so on--but inefficiency per se is not the immediate problem. What Japan lacks right now is not supply but demand: Japan's consumers and investors just aren't spending enough to keep the country's shops and factories busy. 

       And the usual remedies for inadequate demand aren't working. Interest rates have been pushed down almost as far as they can go. Like the Fed, the Bank of Japan normally targets the interest rate on overnight loans that banks make to each other. The difference is that this rate is more than 5 percent here, but basically zero there. The big public spending projects the Japanese government launches every now and then do create some jobs, but they never seem to yield enough bang for the yen: The economy keeps relapsing, while government debt keeps mounting. here are three common explanations for Japan's plight. 

       Explanation 1 is that it is mainly a financial problem. Japan's corporations are too burdened with debt, its banks too burdened with bad loans that have never been acknowledged. On this view, what Japan needs is a long, painful financial housecleaning. 

       Explanation 2 is that the problem is mainly psychological. When the "bubble economy" of the 1980s (remember when the square mile under the Imperial Palace was supposedly worth more than all California?) burst, goes the story, consumers and investors went into a funk that has depressed the economy, and the depressed economy has perpetuated the funk. On this view, what Japan needs is a jump-start--say, a massive but temporary round of tax cuts and public spending programs that will restore confidence and get people spending again. (Although it is tactless to say this, the model everyone privately has in mind is the way wartime spending jolted the United States out of the Great Depression. Thank you, Adm. Yamamoto!)

Explanation 1 doesn't make sense to me. If Japan's problem is demand, not supply, how do corporate debt and bad loans cause that problem? You might say that the answer is obvious: Overindebted companies can't borrow more, and the banks are in no position to lend anyway. But Japan's investment as a percentage of gross domestic product is the highest among major advanced economies. And banks have been lending, too--after all, where do you think those excessive debts and bad loans came from? The problem is that even these high rates of investment aren't enough to absorb the huge sums that consumers apparently want to save. 

       Until recently I was more sympathetic to Explanation 2. But lately I have started to wonder whether the stubborn unwillingness of Japan's economic engine to catch is, as many foreigners seem to think, merely because the jump-start hasn't been big enough or sustained enough. 

And so (like a small but growing number of people, including at least one influential Japanese economist and I have started paying attention to Explanation 3--that Japan's troubles really stem from a subtle but deadly interaction between demography and ideology.

Here's the story: Japan, like the United States only much more so, is an aging society. Thanks to a declining birth rate and negligible immigration, it faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the countryshould save heavily to make provision for the future--and lacking the kind of pay-as-you-go Social Security system that allows Americans to ignore such realities, it does. But investment opportunities in Japan are limited, so that businesses will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession.

       If this is the problem, there is in principle a simple, if unsettling, solution: What Japan needs to do is promise borrowers that there will be inflation in the future! If it can do that, then the effective "real" interest rate on borrowing will be negative: Borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs. In short, this explanation suggests that inflation--or more precisely the promise of future inflation--is the medicine that will cure Japan's ills. The trouble--the other half of the Japanese trap--is that while the conclusion that Japan needs inflation emerges from what looks like impeccable economic logic, we live in an era in which central bankers believe (and are believed to believe) in price stability as an overriding goal. The peculiar result of the credibility of modern central bankers as inflation hawks is that no matter how much money the Bank of Japan prints now, it doesn't matter: It can't lower the nominal interest rate, because that rate is already zero, and because people don't believe that it will allow inflation to break out any time in the future, it can't lower the realinterest rate either.

This theory is offensive to many people. Deep economic problems are supposed to be a punishment for deep economic sins, not an accidental byproduct of swings in the birth rate. Inflation is supposed to be a deadly poison, not a useful medicine. Above all, it seems implausible that the proposed solution to such severe difficulties could involve so little pain. And while I think logic and evidence are on my side--that demography, not crony capitalism, is the villain, and inflation is the answer--it is certainly possible that I am wrong.

       But Japan worries me. It's not just that we are talking about a huge economy here, an economy whose woes can drag down a lot of smaller countries with it. What really disturbs me is this: If we don't really understand what has gone wrong in Japan, who's to say the same thing can't happen to us?

What Wolfson Did Next

At around 9:00am London time this morning Lord Wolfson held a press conference to announce the five finalists in his economics prize contest.

The first thing that needs to be said about the initiative Wolfson has taken, in offering a 250,000 pounds stirling of his own money to anyone who was able to offer practical solutions to the current Euro crisis, is bravo. Someone willing to put their money where their mouth is, to try to find policies which should be in the common good has to be lauded.

Naturally Lord Wolfson is not looking for just any solutions, as the initial question makes clear, he is looking for a solution in which at least one member country leaves the Euro and a procedure (or template) whereby other countries who find themselves in a similar situation might leave. The question he has asked is the following one.

“If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?”

 Unfortunately this questions begs many other questions, some of which have no easy answer. In particular the question assumes that someone at some point will be seeking to voluntarily leave the currency union, and that this process can be managed in an orderly fashion. I doubt that either of these assumptions are realistic, on grounds which I will explain in what follows. But first, I have to declare an interest, I submitted an essay (which you can find downloadable here), although in all honesty I have to say I never expected to be shortlisted or win. I never expected this outcome since I basically wrote trying to explain some of the theoretical background to the Euro crisis which I feel is poorly understood, and suggest that they had asked the wrong question. As I wrote in the letter accompanying my submission.

Hello there,

Please find attached a Word version of the essay I would like to present to your prize. I'm sure its not exactly what you are looking for, but it is what I have to say on the subject. I fear the question is looking for a technical answer to what is inevitably a political and economic/theoretical problem. On the other hand I did not feel I could let such an important event go by without submitting something.

Anyhow, I am sure I will fare rather better than Arthur Schopenhauer did with his essay “On the Foundations of Morality” (“Über die Grundlage der Moral”) which was not honored with an award by The Royal Danish Society of the Sciences in Copenhagen, even though it was the sole submission in their essay competition. On this occasion I am confident you will recieve a wide selection of excellent and appropriate responses. With my best wishes for every success in your endeavour,

Edward Hugh

So Where's The Snag?

Basically the intellectual world surrounding the Euro is divided into two (more or less fortified) camps - those who believe it can work, and those who don't. Many things could be said about the assumptions being made by those who think the project can still be rescued, but I have commented on this endlessly, and here is not the place to repeat already well known arguments. The problem and the frustration is, and this is what I imagine is getting through to Wolfson, virtually no argument presented by those who fear it can work seems to cut any ice with those who are convinced it can. Either you think the Earth goes round the Sun, or you think the Sun goes round the Earth, and that's it, there is no single empirical argument which can lead people to change their opinion. The truly worrying thing is that most participants in the debate seem unable to even identify an argument or a fact in the world which would lead them to a rethink.

But leaving aside the "Euro Too Big To Fail" camp, there is far from uniformity amonth those who feel the project is flawed. Certainly there is consensus on some basic core questions, such as:

a) Currency unions - like marriages - can be done and undone
b) Greece has a special problem
c) Many periphery economies need to devalue

But beyond this things get more complicated. In particular, I think the debate about why the Euro could be a problem which was held in the 1990s and the one we are having today  are very different animals. In part this is because currency unions when they divorce, just like marriages, leave offspring (in this case shared legacy debts) and what exactly to do with this offspring can occasion dispute between the parties. The kind of dispute which gives endless work to lawyers and makes amicable settlements very difficult.

In addition there are a number of key theoretical issues which need to be addressed, and in many ways this is why I sent in the piece I did, to try and call attention to just these issues.

a) the impact of financial globalisation and what Carsten Valgreen calls the global financial accelerator on currency values. Virtually no one - not the USD or the UK pound sterling, or the Swedish Krona - can manage their currency valuation as they see fit, or devalue as they want. Currency parities are determined by complex interactive process which are by their very nature non linear in character.

Just look at the current valuation of the Japanese Yen and its impact on Japanese exports. It is impossible to understand much about current German policy thinking if you don't get the fact that a principle constraint for Germany is not ending up being another Japan. The world of the 1990's was not like this, and the simple wrote argument (which I myself use) of devaluation as the answer is not as straightforward as it seems, or as it once was. Hence the resistance in Brussels, Berlin and Paris to this panacea.

b) European societies are ageing and this has implications. You will strain hard to find any reference to this phenomenon in the  majority of commentaries offered on what to do about the Euro crisis, yet arguably the pehomenon of population ageing lies at the heart of the current debt crisis in developed economies. Impending health and pension liabilities are what makes so much sovereign debt unsustainable, and this is an issue which goes beyond the boundaries of the Euro Area, affecting countries like the US, the UK and Japan. Again, "the Euro is the root of all evil" argument fails to address this issue.

This approach is typified by Nomura economist Richard Koo, who argues  “Japan had a Great Recession, and a Great Stagnation, but it never had a Great Depression,” he says. “But recession in some eurozone countries could become a depression, just like the 1930s. This is a view which spectacularly seems to miss the point that people in Spain are not envious of where Japan finds itself now, with sovereign debt somewhere over 225% of GDP and in danger of spiralling upwards out of control. It is evident that Japan has simply bought time, and not resolved its problem. Having your own currency and the ability to print money is a simplistic solution to what is a very complex problem. Fools gold.

c) Finally we have now a decade's experience of labour mobility from one European country to another, and in particular from periphery countries to the core. Among young qualified workers there is more mobility than many seem to imagine. I was in Latvia recently, which is a country not in the Euro which is suffering population loss in such a way as to make it unsustainable in the longer run. What I became convinced of during my visit there is that the fiscal union question is not only a Euro currency one. Simply having a single labour market in the context of population ageing means that even non Euro countries will eventually need to participate in a common treasury due to health and pension liabilities they are going to face.


Having said all this, let me return to my initial argument. For reasons I explain in the essay (or in this post here) it seems unlikely anyone would willingly want to leave the common currency.

a) Greece might like to leave if its debts to the IMF, the EU and the ECB could be restructured in an orderly and amicable way, but this seems unlikely, especially since others would rapidly seek similar treatment. On the other hand, if Greece left without agreement on official sector restructuring their debts to the official sector would become unpayable, so Greece is unlikely to want to leave.

b) So let's look at another possibility - a German exit. Germany, as I argue in my essay  has been a great beneficiary of the Euro since it has effectively had the advantage  of having an extremely undervalued currency.  Germany will not easily surrender this competitive advantage.

So what is likely to happen? Well, the LTROs have temporarily stabilised things, and made deposit movements from one country to another more containable. But this only offers some short term relief. Credit is still gridlocked all along the periphery, countries are essentially entering long term depressions, with very high levels of unemployment, low economic growth and rising non performing loans in the financial sector. This is all unsustainable, but what could be the trigger for disorderly break up?

Well, in the short term  Greece could find itself unable to comply with the terms of its Troika programme, and as a consequence not receive its ongoing funding. This could happen at the time of the first review (roughly three months from now) or at the time of the second one (towards the end of the year). Given that the Greeks themselves are likely to be unwilling to leave, they could decide to print their own Euros using a facility known as Emergency Liquidity Assistance (ELA) whereby the local central bank effectively monetises government debt and enables civil servants to be paid (or even recieve a pay rise). Up to now use of ELA (in Ireland, in Greece) has only been possible with the agreement of the ECB, but desparate circumstances can produce desparate solutions. Certainly this issue is being discussed in Greece. In article entitled "Is ELA the key to keeping the Drachma at bay?" journalist Nick Malkoutzis argued:

"Greek banks have turned to ELA several times over the past couple of years. It’s not clear exactly how much they’ve borrowed in this way but some estimates put it in excess of 30 billion euros. The difference with the past few days is that Greece has essentially been in default and, despite that, the roof did not cave in on its financial system and the need for it to exit the eurozone did not come up once in the European debate. Could it be that the last few days have given us undeniable proof that Greece can default and remain in the euro?"

 "Athens University economics professor Yiannis Varoufakis is one of the experts who argue that it is up to the ECB whether Greece can default on its debt but not need to return to the drachma. “All that it would take to allow Greece to stay in the eurozone, in a better state than it is today (and less austerity for that matter), is the continuation of the present ECB policy toward Greek banks,” he wrote in a blog post last month. “As for those who argue that the ECB will take an aggressive stance, think again: The ECB will not knowingly take steps which will destroy the eurozone.”"

If Greece did make this move it would effectively be initiating what Buiter has termed the "Euro as the new rouble zone". The Euro Group (or even the entire EU) would then be faced with the much more general problem of whether or not to expel the country, risking initiating a cascade effect of contagion of totally unknown dimesions.

In the longer term, given the growing economic depression, we will almost certainly see growing political destabilisation along the periphery, leading to a steady process of weakening in democratic institutions. The Euro was created as means of drawing Europe together political, it would be a tremendous tragedy if it ended up tearing the continent apart and effectively destroying democracy in one country after another all along Europe's periphery. I repeat what I said in my letter of submission the problems with the Euro are not by-and-large legal and technical, they are inevitably political and economic/theoretical. Lord Wolfson is a practical man, I am sure he will know how to appreciate this.

My Wolfson Essay

Wolfson Essay - Revised

Metabolic

Metabolic Pathways and the Demographic Dividend

Is There Really

America, we know, has a currency union that works, and we know why it works: because it coincides with a nation — a nation with a big central government, a common language and a shared culture. Europe has none of these things, which from the beginning made the prospects of a single currency dubious.
Paul Krugman - Can Europe Be Saved?

All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth, 1956

One of the key premises underpinning the establishment of the Euro as a common currency to be shared by a number of individual national states rather than one single nation was the central idea that the several economies of the participating countries would eventually converge to one common typology. That is to say, even if the individual nations would not be dissolved into one single superstate, then the idea was that the difficulty this could obviously create would be overcome by the generation of a number of different, but to all-important-economic-effects identical economies, each one a replica (in minature or "a lo grande") of the other. Absent this, it is hard to see how people could have convinced themselves that having a single currency and a single monetary policy could possibly work in the longer term.

Convergence Towards a Common "Steady State"

This critical idea of convergence was based on a simple (and possibly rather simplistic) application of the kind of neo-classical economics widely taught in the modern university. Every economy, it is postulated, is capable of generating some sort of relatively constant "steady state" growth rate , and given the application of sound common monetary policy and an appropriate mix of relevant structural reforms these relatively constant growth rates should not diverge too much one from the other, since if they did, and continued to do so on a sustained basis, then a fiscal mechanism would need to be created to serve as a stabiliser able to redress the consequences of such steadily diverging rates of growth with the associated large differences in living standards. Political consensus could never realistically be maintained behind a process which was manifestly generating inequality between participating countries.

Naturally, if there was no eventual convergence then any fiscal mechanism which was created would need to be something more than an ad hoc fund for handling the impact of a one-off asymmetric shock (like the bursting of a property bubble), since it would need to be permanent and systematic and operate in a way which is broadly similar to the internal redistribution mechanisms which operate between north and south in countries like Spain and Italy, or between rich and poor states in the USA. Naturally, in the course of the current crisis, no one with any degree of institutional authority even in the most desperate of moments has been prepared to publicly contemplate the possibility that the creation of such a territorial equalisation mechanism might eventually be need, even though, as will be argued here, successfully saving the Eurozone will almost inevitably mean putting just such a fiscal compensator in place. Just think about it: the Greeks never had a fiscal deficit problem at all, since what was lacking was adequate compensation for their growth imbalances! You can just see the anxious (or enraged) look on all those German faces. Yet just this is the conclusion that I think can be drawn about the creation of a common currency area among a group of countries where convergence is not operative, since the consequence of not doing so, as is now becoming clear enough, is that the countries with lower underlying growth profiles become steadily weighed down by the burden of their indebtedness to the higher growth economies - that is to say debt obligations are created where fiscal transfers are lacking.

Now, as we all have come to know only too well, this kind of fiscal mechanism was neither contemplated by the founding fathers of the Euro, nor has anything even remotely resembling it been envisioned as part of the collective response to the present crisis. Indeed the need for its creation remains one of the most highly controversial topics in the current debate (rivalling in the emotional charge it engenders only the suggestion that some sort of internal devaluation might be needed for the zone's struggling peripheral economies). Advocacy of this move has been restricted to commentators outside the mainstream, most notably among them Wolfgang Munchau (see here, and here), and for his pains he has acquired the honorary title of "Enemy of Spain" from the Spanish newspaper El Mundo, who presumably found his suggestion that Spain might need to be a beneficiary of such a mechanism an insult to their national honour.

Diverging Not Converging Economies?

Meanwhile back in the world of the real economy, nothing could be more evident from all the signs we are seeing during the present recovery than that the Euro Area economies are not converging - indeed they are visibly diverging in all manner of different ways. Some economies are now called "peripheral", and others are called "core". Yet neither the core, nor the peripheral economies resemble the other members of their sets in a way which standard theory might lead you to expect that they should.

France is a domestic consumption driven economy, running a goods trade deficit, where manufacturing industry seems to be losing competitiveness, while Germany has weak domestic consumption, is completely export driven, runs a large external surplus, and German manufacturing industry seems to get more (rather than less) competitive by the day.

Among the peripheral economies Greece would seem to distinguish itself for its extreme fiscal profligacy, while Italy and Portugal have just passed through a decade of slow growth, which contrasts with the case of Spain and Ireland where fiscal deficits and government debt were not a large issue during the first decade of the Euro's existence, but where a growing mountain of private sector debt (fuelled by negative interest rates and a growing housing bubble evidently was) evidently was.

The consequences of needing to accommodate policy to this diversity of economic "types" have, however, still to be recognised, yet the lessons of why convergence hasn't occurred do need to be assimilated, otherwise effectively staying in denial will only raise the chances of an eventual disorderly disintegration of the zone itself. Interestingly, Poul Thomsen, IMF Mission Chief for Portugal recently emphasised in the context of the bailout there that as far as the IMF is concerned, "Every country is different and there is no one-size-fits-all for the programs we support". How long will it be before this message reaches Frankfurt?



As an anecdotal aside, I cannot help having the feeling that the practitioners of academic neo-classical economics spend far too much of their time building models based on premises which remain far from self-evident in order to tell the world how it ought to be, leaving the pathways through which empirical facts-on-the-ground could work their way back to influence or modify the initial assumptions rather obscure, to say the least.

To give one example, on a recent visit to the monetary policy department of one of Europe's smaller central banks I found myself engaged in a rather frustrating debate about the relative merits of competitive devaluation and structural reform as ways of getting heavily-indebted export-dependent economies back to economic growth and job-creation in sufficient volume to be able to start paying down the debt. Unfortunately the discussion became a rather unrewarding "dialogue of the deaf" of the kind to which I have by now become so accustomed. In fact the whole think so evidently became so tiresome that one of the ever courteous central bank particpants took me aside on my way out to reassure me that "there was of course nothing personal in our exchange". Well, of course not! But that being said, the debate did seem to me to be rather asymmetric and one-sided, because while I am absolutely convinced you need structural reform alongside any (hypothetical) competitive devaluation (otherwise all the old ills simply return), the other side of the argument obviously does not accept the need for competitive devaluations to accompany structural reform. Au contraire, the one is seen as the complete and much more desirable alternative to the other.

During our discussions, in my frustration at the fact we were obviously getting absolutely nowhere, I asked the central bank representatives what it would take to convince them they were wrong. Surely, I asked, if the economies in question did not return to a reasonable and sustainable growth rate within the next 3 to 5 years, then they would need to ask themselves whether or not they had been doing something wrong. I for my part clearly recognise that if those economies I consider to be in need of competitive devaluations to underpin structural reforms do achieve significant and sustainable economic growth over the next five years without them then I have been missing something, somewhere (in fact I consider such recognitions of reality to be in my own best interest, to be taken on board on a "sooner the better" basis). Yet,“no”, came the answer, loud and clear, “that would simply mean that the structural reforms had not been deep enough or sufficiently energetically implemented”.

I am now put in mind of a recent (and rather infamous) press conference given by the Real Madrid football club coach José Mourinho. When asked by one of the journalists what responsibility he felt his players and he had in the recent series of defeats by their rival Barcelona FC, "zero" was the answer he gave to the astonished journalist. Well, there you go, learning by doing in action!

Am I the only one to find something strange (and even frustrating) about this kind of answer? What is the connection between the fundamental assumptions of the kind of economics that is being applied in this crisis on Europe's periphery (which in many ways means prioritizing micro and ignoring the core theorems of applied macro) and reality? And how do we test these assumptions? Surely anyone with any kind of scientific frame of mind should look for facts that can confirm (or better, following in the footsteps of Sir Karl Popper refute) the hypotheses they advance. Which brings us back to the lack of symmetry in the argument we are having at the moment. I personally do consider the lessons learnt from our attempts to handle the crisis to form a vital part of the knowledge acquisition process. As I say, I for my part am clear that if these economies do return to reasonable and sustainable growth within a 3 to 5 year time horizon, then there will be something wrong with the way I have been going about things. On the other hand, since several hundred million Europeans are currently being subjected to a massive social and economic experiment, it would be a pity if economic theory were to prove itself unable to learn anything substantial from the eventual outcomes.

In the meantime I find myself gasping for air, trying to pin down threads in the argument that can be examined and tested, which is why I think the convergence issue is important, since either convergence is taking place or it isn't. Put another way, is convergence taking place across a meaningful, in the here and now, time horizon, or is it simply one of those things which is only destined to happen in the longest of long runs by which time, as Keynes so tactfully put it, we will all be well and truly dead? Evidently the future of the Euro depends on the kind of answer you give to this question, and the conclusions you draw from that answer.

The Eurozone Credit Cycle

Now one of the areas in which mainstream economic theory surfaces in search of some real world air is in the context of what many analysts call the “credit cycle”. This concept is interesting, since it allows for the introduction of some data, and enables us to take a look and see if the real world is as theory (and all those models they work with) imagines it should be.

In fact, the idea of a credit cycle is a natural offshoot of the idea of a business cycle, insofar as central banks pass though an interest rate cycle which maps to some extent movements in the business cycle (that is to say as the economy slows rates come down, and as it accelerates they go up), while demand for credit in the private sector of the economy tracks movements in both of the aforementioned cycles. That is to say, private demand for credit declines during recessions (despite the fact that interest rates fall, and public sector demand for credit rises to offset this drop and cushion real economy impacts), while the subsequent recovery in the demand for private sector credit can be seen as one of the key indicators influencing central bank decision taking when it comes to interest rate policy, since an over-rapid expansion in credit can produce excess demand which can lead to inflation, and in a “normal” world central banks tend to want to fend off any unwarranted surge in inflation or in inflation expectations.

The problem with all this is that business cycles are not such straightforward beasts as they are often assumed to be, nor is it really clear how useful conventional business cycle theory really is during a structural (as opposed to cyclical) crisis like the one we are presently living through. Evidently in every economic expansion (or contraction) there is a structural and a cyclical component, and normally the former is less important than the latter in explaining short term movements in output, but during the present crisis this situation has been reversed in both the developed and the developing economies. Take the following charts illustrating recent growth patterns in the Spanish and Chinese economies, can anyone really spot the cyclical components, since I sure as hell can’t.





Spain didn't have a single quarter of contraction following the ending of the 1992/93 contraction until the great global economic crisis broke out, and China hasn't had one during this century at least. Obviously in each case there are reasons for these phenomena (catch up growth, inappropriate expansionary monetary policy lifting you through the roof), but the only point I want to make is that they are clear examples of where structural elements far outweighed cyclical ones, and I would argue that this situation is much more common than is often admitted.

So, we need to be very careful, and in the context of the current global recovery we need to be be at great pains in trying to distinguish between cyclical and structural components in growth, whether this is in the context of growth in GDP or in private sector credit.

Now one of the points of core dogma which is institutionally enshrined at the heart of the ECB is that aggregate Eurozone data has some sort of useful, or valid, or interesting interpretation. So strongly is this belief held that the central bank representatives seldom examine interpretations of the data that drill down and try to identify what is happening (and more importantly why it is happening) at the individual country level. This is hardly surprising since as suggested above, the very existence and survival of the Euro is seen as hanging on the idea that (given the appropriate country level structural reforms) all the individual economies will converge, and any recognition that tailor-made monetary policies are needed for individual countries would be tantamount to accepting that the founding assumptions of the monetary union had sprung a leak.


However, as we will see, credit conditions do in fact vary widely across member countries, and this uneven availability-of and demand-for credit across the Eurozone has become just one more headache to add to the far from small number policy-makers at the ECB currently have, since the growing economic recovery in some countries is being facilitated by the relatively easy availability of credit, while in others problems resulting from a debt overhang and a lack of competitiveness are only reinforced by the difficulties their banking systems face when trying to provide new credit to viable enterprises and solvent households.

In any event, starting with the aggregate data released by the ECB such as it is, we find that Eurozone-wide bank lending - which has (truth be told) remained far from strong since the official ending of the recession - lost some of its limited momentum in March, suggesting any real recovery in aggregate Eurozone domestic demand is still a long way off. Private-sector lending increased during the month by 2.5% over March 2010, after rising by 2.6% year on year in February. In fact, the recovery from the economic and financial crisis has been characterised across the Eurozone by weak bank lending, particularly to businesses, and although the annual growth rate of loans to non-financial corporations rose in March, it continued to expand at the relatively modest rate of 0.8% following a 0.6% rise in February. Loans to households have been doing slightly better, and grew at a 3.4% rate compared with the 3.0% registered during the previous month. The annual growth rate of lending for house purchases grew to 4.4% in March from 3.8% in February.



At the same time broad money, or M3, rose by an annual 2.3% (M3 comprises currency in circulation, overnight, short-term deposits and debt securities of up to two years, repurchase agreements, and money market fund shares), and the three-month moving average of the annual rate of change of M3 was +2.0%. Thus monetary growth still remains well below the ECB's reference value of +4.5% for the three-month average, a monetary growth rate it considers to be broadly in line with an inflation rate of just under 2% over the medium term, implying there is little risk that broad money growth will push up inflation in the eurozone, although it is unlikely that this particular detail will cut much ice with policymakers at the ECB in relation to their interest rate decisions, since it is not monetary fuelled demand-side pull that worries them, but rather commodity induced supply-side push, and in particular the impact this could have on inflation expectations.

The latest ECB quarterly bank lending survey suggested only a moderate tightening of credit standards for both enterprises and households in the current quarter. But as I am saying, this appreciation of the aggregate sitution conceals significant differences at the individual country level. In Italy, France, Finland and Germany (for example) credit seems to be widely available, while in Spain, Portugal and Greece credit conditions remain very tight. The Bundesbank noted only last week that in Germany there had been a "marked easing of credit standards in lending to both enterprises and households" in the first quarter of this year and that surveyed banks expect little change in credit standards in the current quarter. This view was reinforced by the Ifo Institute who reported that the percentage of German firms which have difficulty accessing credit fell by 1.1 percentage points in April to a record low of 22.6%.

Meanwhile in Spain, the central bank state in their latest quarterly report on the economy that notwithstanding the reduced tension in capital market attitudes towards the country, "accessibility by the resident private sector to funding became somewhat tighter".

The peculiar thing here though, is that if you look at the comparative inter-annual rates of change the two countries don't seem to be that different.














What is apparent is that in each case (Germany or Spain) and regardless of whether or not we are talking about total private sector lending, corporate lending or mortgage lending, the rate of increase in borrowing is extremely low, with the only significant difference between the two countries being that in the German case such extremely low rates of credit growth date back to the turn of the century, while in the Spanish case they area recent phenomenon following the bursting of the housing bubble. (I have dealt with this comparison between Spain and German at greater length in this post here).

The big difference between these two countries is, of course, the level of international competitiveness of their economies, since Germany is well able to live with such low levels of domestic credit growth due to its strong export capacity, which enables the country to generate significant GDP growth (currently over 3% annually). Spain's economy, on the other hand, has been unable to expand export capacity fast enough to compensate for the sharp loss in domestic consumption, and hence what little growth there is has been supported by a substantial government fiscal deficit and even this has still left the economy continually flirting with recession.



Further, in the German case credit conditions are comparatively loose even though there is no great demand for additional credit, while in the Spanish one credit conditions are tight (for a variety of reasons) so potential home-buyers and companies have difficulty getting as much credit as they would like to have, and this despite the fact that prevalent interest rates in both countries are broadly similar, and result from one common monetary policy.


In fact Spain is not unique in this sense, even if the country does offer a somewhat dramatic example of a larger problem. Credit conditions in Portugal are also now tightening, and demand for loans is falling.







And we find a similar picture in Greece.








What is most remarkable about these charts for Spain, Portugal and Greece is how they so resemble each other in the sharp decline in credit to the private sector. Nor should any up-tick be expected since all these countries are already heavily in debt, and the only serious way for them to attain sustainable growth is to de-leverage via export-induced saving. That being said, this transition is likely to prove, as we all know, pretty painful. Even during the German transition from 1999 to 2005 things weren't entirely easy, yet these three countries now face a far more difficult and far more demanding challenge, given the scale of their external debt and the current market conditions.

To help them move through that challenging process what they arguably need, in the same way as the UK and the US do, is some form of quantitative easing. Unfortunately excessive reliance on aggregate data leads ECB policy-makers to miss this relatively self-evident fact. So these countries are being asked to make a structural transition of almost monumental proportions without carrying out a competitive devaluation, with accompanying monetary and fiscal tightening. It is hard to see a successful outcome, and indeed I imagine we won't see one.


But the monetary union's problems don't end here, since there are another group of countries where monetary easing from the ECB does appear to have been having an impact, and where credit growth has, to some extent taken off. The first of these would be Italy.







Now there is little to alarm us here, since Italy's private sector is not especially indebted, but it is interesting to see how the pattern varies, and how credit conditions in Italy are very different from those elsewhere in Southern Europe. On the other hand, if we move across the continent to Finland, once more we find little sign of difficult credit conditions:







Indeed, the low interest rate policy of the ECB during the crisis really does seem to have worked in the Finnish case, in that housing demand and private consumption never really collapsed (see this earlier post on the property boom in Finland). Finally, in this brief survey, there is France, where even though corporate borrowing remains restrained, demand for consumer and housing credit seems to be really kicking back to life.






Evidently France is becoming a very special case, since France's private sector is not heavily indebted, although looking at its comparatively young population profile it could easily become so. If there is one country where a property bubble could be produced, that country is France - for both demographic and low-indebtedness reasons (just look at the line of take-off for household mortgages in the above chart). So evidently, at least in the French case ECB tightening makes perfect sense, as it does when we look at the inflation expectations chart.



So Just How Many Sizes Do We Need To Fit All?

The purpose of this brief survey of credit conditions in a number of individual Eurozone countries has been to draw attention to one rather neglected area of policy difficulty. It is common knowledge that having a "one size fits all monetary policy" can prove problematic, in that the application of negative interest rates to an economy that is essentially booming can lead to significant structural distortions, and even produce asset bubbles of one class or another.



But the issue of credit conditions and credit availability is normally given far less attention, even though it is an equally important one. It is clear that it is hard to identify one common "credit cycle" among the zone's diverse economies, and indeed the need for credit is always going to be very different in an economy which runs a large and continuing external surplus when compared with an economy (like France's) where domestic consumption remains strong and the country continues to run an external deficit.

It is clear that some of the difficulties which were likely to be faced by countries attempting to handle the rigidities associated with participating in a common currency were well anticipated in advance, even if few of those involved in setting it up were able to listen at the time of its creation. Other problems which were not so clearly foreseen have emerged with time. The difficulty presented by surrendering powers from your own central bank with respect to monetising government debt is only now becoming clear, as is the problem created by acquiescence in the kinds of structural distortions which permit the accumulation of high levels of external debt, debt which fickle markets may suddenly decide they are no longer willing to support. The fact that cheaper interest rates might lead to larger fiscal deficits and growing government debt was foreseen, but the danger presented by ever larger private indebtedness funded by external borrowing surely was not.

However, the problems entailed by the absence of any meaningful common credit pattern and the consequent difficulty of maintaining the core idea of ongoing convergence raises perhaps one of the most serious obstacles to Euro credibility and continuity, since, as I try to argue at the start of this study, even the issuing of Eurobonds and the creation of a common fiscal treasury can only represent a stopgap measure in such a situation given that what this then produces is a constant and ongoing transfer of resources from one set of countries to another. This outcome is neither sustainable nor is it desirable, since voters in the funding countries will eventually grow tired of it (even under the rather dubious hypothesis that they were willing to entertain it in the first place) while those who are funded would find themselves in the unpleasant situation of having their long term dependency institutionally re-inforced, even as they find themselves watching a steady trickle of their educated youth moving towards the funding countries in search of better remunerated work.

Basically it is not clear at this point whether this growing mountain of associated system-management problems really is capable of being resolved, but one thing is surely very evident, and that is that not talking about them won't make them go away. It really is high time the ECB stopped boxing itself into a corner by examining monetary policy impacts only at the aggregated data level, and started to analyse and identify policy implementation impacts at the individual country level. Simply throwing the issue back to the various national governments by saying "this is your problem, what you need are more structural reforms" is no response at all. This will be especially true if the proposed structural reforms prove not be sufficient to handle the scale of the problem, since this will only produce an even greater loss of confidence in the Euro than that which has been sustained to date, precisely the outcome that ECB governing council members must be anxious to avoid. Or will we be told that the structural reforms implemented simply were not deep enough. What has been argued here is that the idea of a common Eurozone-wide credit cycle and ongoing convergence between member state economies are "simplifying assumptions" in the sense used by Robert Solow in the quote at the start of this study, assumptions which underpin the whole theoretical apparatus on which the common currency is based. The question is, after ten years of operation, do they still remain plausible and reasonably realistic assumptions.