Monday, December 28, 2009

A Zero Too Far

Paul Krugman in the NYT

Maybe we knew, at some unconscious, instinctive level, that it would be an era best forgotten. Whatever the reason, we got through the first decade of the new millennium without ever agreeing on what to call it. The aughts? The naughties? Whatever. (Yes, I know that strictly speaking the millennium didn’t begin until 2001. Do we really care?)

But from an economic point of view, I’d suggest that we call the decade past the Big Zero. It was a decade in which nothing good happened, and none of the optimistic things we were supposed to believe turned out to be true.

It was a decade with basically zero job creation. O.K., the headline employment number for December 2009 will be slightly higher than that for December 1999, but only slightly. And private-sector employment has actually declined — the first decade on record in which that happened.

It was a decade with zero economic gains for the typical family. Actually, even at the height of the alleged “Bush boom,” in 2007, median household income adjusted for inflation was lower than it had been in 1999. And you know what happened next.

It was a decade of zero gains for homeowners, even if they bought early: right now housing prices, adjusted for inflation, are roughly back to where they were at the beginning of the decade. And for those who bought in the decade’s middle years — when all the serious people ridiculed warnings that housing prices made no sense, that we were in the middle of a gigantic bubble — well, I feel your pain. Almost a quarter of all mortgages in America, and 45 percent of mortgages in Florida, are underwater, with owners owing more than their houses are worth.

Last and least for most Americans — but a big deal for retirement accounts, not to mention the talking heads on financial TV — it was a decade of zero gains for stocks, even without taking inflation into account. Remember the excitement when the Dow first topped 10,000, and best-selling books like “Dow 36,000” predicted that the good times would just keep rolling? Well, that was back in 1999. Last week the market closed at 10,520.

So there was a whole lot of nothing going on in measures of economic progress or success. Funny how that happened.

For as the decade began, there was an overwhelming sense of economic triumphalism in America’s business and political establishments, a belief that we — more than anyone else in the world — knew what we were doing.

Let me quote from a speech that Lawrence Summers, then deputy Treasury secretary (and now the Obama administration’s top economist), gave in 1999. “If you ask why the American financial system succeeds,” he said, “at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities.” And he went on to declare that there is “an ongoing process that really is what makes our capital market work and work as stably as it does.”

So here’s what Mr. Summers — and, to be fair, just about everyone in a policy-making position at the time — believed in 1999: America has honest corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.

What percentage of all this turned out to be true? Zero.

What was truly impressive about the decade past, however, was our unwillingness, as a nation, to learn from our mistakes.

Even as the dot-com bubble deflated, credulous bankers and investors began inflating a new bubble in housing. Even after famous, admired companies like Enron and WorldCom were revealed to have been Potemkin corporations with facades built out of creative accounting, analysts and investors believed banks’ claims about their own financial strength and bought into the hype about investments they didn’t understand. Even after triggering a global economic collapse, and having to be rescued at taxpayers’ expense, bankers wasted no time going right back to the culture of giant bonuses and excessive leverage.

Then there are the politicians. Even now, it’s hard to get Democrats, President Obama included, to deliver a full-throated critique of the practices that got us into the mess we’re in. And as for the Republicans: now that their policies of tax cuts and deregulation have led us into an economic quagmire, their prescription for recovery is — tax cuts and deregulation.

So let’s bid a not at all fond farewell to the Big Zero — the decade in which we achieved nothing and learned nothing. Will the next decade be better? Stay tuned. Oh, and happy New Year.

Tuesday, December 22, 2009

ECB Tender Hints At Weak Spots In Improving Market

By Geoffrey T. Smith


FRANKFURT (Dow Jones)--The European Central Bank on Wednesday wrapped up its anti-crisis program of extraordinarily long-term lending to banks with a funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months.

Analysts said the results of the tender suggested that much of the banking system can now live without the ECB's life-support mechanism, but that a small number of banks are still highly dependent on it, and the European banking system still has plenty of weak points that could cause trouble in the future.

The ECB said it injected EUR96.937 billion at a 12-month lending operation, the last of three that it announced in the spring in order to guarantee that banks in the 16-country currency bloc have access to longer-term funding to weather the credit crisis.

Market conditions have eased substantially since then. The interest rates at which solid banks lend to each other for short periods--even without the safety of collateral--are now below the ECB's reference rate of 1%.

Analysts said that the money allotted Wednesday--which will increase the total amount of ECB money in the market by around 14%--will keep the Euro Overnight Index Average, or EONIA, which is the key rate for interbank overnight money, around its recent level of 0.30%-0.35%. It was little changed after the operation, as was the euro, which ticked only fractionally higher against the dollar Wednesday.

Actual overnight rates have barely moved from this level since the ECB's first 12-month tender--a mammoth EUR442.24 billion in June--created a structural surplus of money in the market and reduced the cost of borrowing accordingly.

Silvio Perruzzo, an economist with Royal Bank of Scotland in London, said he doesn't expect EONIA to move until the funds from this first 12-month tender mature next June, taking away much of the excess liquidity currently in circulation.

As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to those tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.

This move was generally interpreted as an effort to stop banks from indulging in risk-free carry trades--using money borrowed at low, fixed rates to finance bets on government bonds or foreign-currency deposits offering higher rates. The indexation means that banks won't know the final cost of the funds until a year from now.

Banks have deployed the cheap ECB billions mainly in two ways this year: either hoarding them to insure themselves against possible defaults by other banks, or throwing them at perceived low-risk instruments, particularly government bonds. The latter has generated handsome paper profits for the banks but raised concerns about a possible bubble in those markets.

"Indexation has halted the speculative demand," said Lena Komileva, an analyst with Tullet Prebon in London. She estimated that the market had needed only EUR70 billion from the bank, and that the remaining EUR27 billion was "precautionary."

The number of banks bidding, at 224, was down by more than 60% from 589 at the previous 12-month operation in September, indicating that many more banks now have access to the market instead of relying on the ECB, Komileva said.

However, the banks that remain dependent on the ECB appear to be even more dependent than they were three months ago, the average bid rising from EUR128 million to EUR433 million.

"Those banks which went to the ECB this time are clearly those which are having difficulty funding themselves in the market," RBS's Perruzzo said.

Tullet Prebon's Komileva said the tender suggests an increasing polarization in the euro-zone money market, between those banks that are successfully overcoming the crisis and those that aren't. Greek and Austrian banks in particular have been in the spotlight in the last week amid a fresh wave of fears over their exposure, respectively, to domestic fiscal problems and continuing pressures from bad loans in central and eastern Europe.

"Structurally, the tender shows more normal conditions in the core [European market], but the periphery is still struggling," Komileva said.

The ECB, as ever, declined to comment on which banks participated in the tender. Last month, the Greek central bank had urged Greek commercial banks to show restraint at the tender, rather than increase their dependence on ECB funding.

The ECB plans one final six-month tender in March to smooth its exit from longer-term refinancing operations. After March, none of its operations will be longer than the three-month tenders the ECB had offered since its inception in 1999. The central bank plans to end most of its other non-standard policy measures over the course of 2010, as the banking sector completes its return to health after the financial crisis.

Sunday, December 20, 2009

Why Standard and Poor's Are Right To Worry About Spanish Finances

"Spain's weaknesses over the developing crisis reflect mainly the reversal of the continuous domestic demand expansion of over a decade, which was associated with high indebtedness of the private sector, large external deficits and debt, an oversized housing sector compared with the euro area average and fast rising asset prices, notably of real estate assets."
European Commission assessment of Spain's Response to the Excess Deficit Procedure, Brussels 11 November 2009.

“The latest services PMI data suggests that the Spanish economy remains on a downward trajectory. The fact that variables such as activity, new orders and employment all fell at sharper rates during November is real cause for concern, with the prospects for 2010 becoming increasingly gloomy. Businesses report that consumers remain cautious of making any major purchases, particularly those requiring credit. It appears that any economic recovery over the next twelve months will be gradual and drawn-out.”
Andrew Harker, economist at Markit commenting on the November Spanish Services PMI survey.
According to Spanish Prime Minister José Luis Rodriguez Zapatero Spain's government is firmly committed to reducing its fiscal deficit, and is intent on lowering it as requested by the EU Commission by 1.5% of GDP annually, until it finally brings it within the EU 3 per cent of gross domestic product limit by 2013 at the latest. What's more he is quite explicit about how this is going to be possible: Spain is right now, and even as I write, on the verge of emerging from the long night of recession in whose grip it has now been for several quarters. As such it will soon resume its old and normal path onwards down the highway of high speed growth. There is only one snag here: few external observers are prepared to share Mr Zapatero's optimist.

“The return to growth and the expected fiscal consolidation will allow us to reach the stability pact objectives by 2013,” Mr Zapatero said in a speech last week, using a rhetoric by which few outside Spain are now convinced, and indeed only the day before the credit rating agency Standard & Poor’s had revised its outlook for Kingdom of Spain sovereign debt to negative from stable. The decision followed their earlier move last January to downgrade Spanish debt by revising their long term rating from AAA to AA+. S&Ps justified their latest decision by stating that they now believe Spain will experience a more pronounced and persistent deterioration in its public finances and a more prolonged period of economic weakness versus its peers than looked probable at the start of the year. So things have been getting worse and not better, and indeed, the EU Commission themsleves seem to take a similar view, since while they have lifted their immediate excess deficit procedure in the short term (see below) their longer term worries have only grown.

Standard and Poor's feel that reducing Spain’s sizable fiscal and economic imbalances requires strong policy actions, actions which have yet to materialize, and the EU Commission and just about everyone else agree, and the only people who seem to take the view that the current policy mix is "just fine" are José Luis Zapatero, and the political party that maintains him in office.

Effectively S&P's are concerned about two things: i) growing fiscal deficits; and ii) growth prospects:

The change in the outlook stems from our expectation of significantly lower GDP growth and persistently high fiscal deficits relative to peers over the medium term, in the absence of more aggressive fiscal consolidation efforts and a stronger policy focus on enhancing medium-term growth prospects.

Compared to its rated peers, we believe that Spain faces a prolonged period of below-par economic performance, with trend GDP growth below 1% annually, due to high private sector indebtedness (177% of GDP in 2009) and an inflexible labor market. These factors, in turn, suggest to us that deflationary pressures could be more persistent in Spain than in most other Eurozone sovereigns, which we expect would further slow the pace of fiscal consolidation in the medium term.
Even some insie Spain are now openly questioning the viability of the government's strategy. The downward revisision in Spain's credit outlook, was "hard to deny," according to Spanish representative on the European Central Bank Governing Council, Jose Manuel Gonzalez-Paramo - "The ECB is not taking issue with whether Standard & Poor's should cut Spain's rating, but the report that accompanies this warning is hard to deny" he told the Spanish Press agancy EFE, adding that he was "convinced that the Spanish authorities share this analysis and will do whatever is needed to avoid S&P's negative outlook resulting in a change in rating". However Standard and Poor's explicitly justified the negative outlook by referring to the fact that Spain was not showing signs of taking adequate action to cut its longer term fiscal deficit as required by the EU Commission, and Spanish Prime Minister Jose Luis Rodriguez Zapatero himself stated he could see no no reason why ratings agency Standard & Poor's should downgrade the long-term sovereign debt rating of Spain. So it is hard to share Gomez-Paramo's (rather diplomatic) optimism at this point.

The World Turned Inside Out

Just how realistic is the view being taking by the Spanish administration at this point, and just what are the prospects of that imminent and sutainable return to growth in the Spanish economy on which everything seems to depend? That is the question we will try to ask ourselves in that follows. Certainly the situation we are looking at is a rather peculiar one, since Mr Zapatero's recovery hope seems to be a widely shared one inside Spain. Certainly, if the ICO Consumer Confidence reading is anything to go by, Spaniards are feeling pretty hopeful at this point that the worst of the economic crisis is now behind them. Evidently confidence is still not back to its old pre-crisis level, but it is now well up from its July 2008 lows.

What is even more interesting is to look at the breakdown of some of the ICO consumer confidence index components. According to the ICO data series I looked at, the expectations index has only been above the present level three times since the series started in January 2004 (in September 2004, in January 2005, and in August 2009). That is, the Spanish people currently have the third highest level of expectations about the future registered at any point over the last five years. I find that pretty incredible. Evidently Mr Zapatero is not alone in assuming that S&P's have it wrong.

But is such a viewpoint rationally founded, and even more to the point, is there any economic justification which lies behind it? What could explain such dyed-in-the-wool optimism? It is hard to understand, unless, perhaps, the alternative - that Spain is in for a long and difficult economic correction, after many years of relatively "painless" economic growth - is very hard to contemplate for a population who are severely unaccustomed to such pressures.

Possibly the Financial Times' Victor Mallet puts his finger on another important ingredient - after two years of being told that they have been living though the worst crisis in recent memory, many Spaniards have quite simply never had it so good, so how could anything horrible possibly happen now?
The pre-Christmas mood in Madrid is a curious mixture of pessimism and cheeriness.On the one hand, anxious Spaniards are told they are suffering the worst economic crisis in 50 years and fear for their jobs. On the other, those still in employment have rarely had more money to spend. It is not surprising that the city’s restaurants are packed with noisy but neurotic diners as the holiday season approaches.

The reasons for this odd combination of economic gloom and robust personal consumption are no secret. Unemployment has risen sharply – to 18 per cent of the workforce in Spain – but emergency measures around the world to avert another depression have kept economies flush with liquidity and cut interest rates (and monthly mortgage payments) to historically low levels. Inflation is low or negative.

Low interest rates, safe jobs (or pensions) and salaries rising faster than the rate of inflation all combine to make "the worst" not that bad at all, especially if the government are shelling out 12% percent of GDP per annum to pay for it all. But as Javier Díaz-Giménez, economy professor at IESE business school says (and S&P's well know) “It is easy to raise the deficit to 10 per cent of GDP....But we really don’t know how to get back down to a deficit of 3 per cent of GDP.” This then is the problem, especially as a reducing deficit, rising taxes and utility charges, and eventually rising interest rates all make the task of restoring economic growth seem a rather daunting one.

Think about it this way: Spain's construction industry amounted to around 12 percent of GDP, now government borrowing of around the same size has stepped in to fill the gap, but once this poly-filla solution no longer holds, where is the employment creating activity to come from? As Michael Hennigan, Founder and Editor of Finfacts Ireland says in the (similar) Irish context:

"The scale of the task of creating sustainable jobs in the international tradable goods and services sectors, is illustrated... by stark statistics from State agency, Forfás, which show that in the ten years to 2008, less than 4,000 net new jobs were added by foreign and Irish-owned firms, while overall employment in construction, the public sector, retail and distribution, expanded by over half a million......Total Irish employment in December 1998 was 1.54 million and was 2.05 million in December 2008 - a surge of 33 per cent. In the peak boom year of 2006, 83,000 new jobs were added in the economy while direct job creation in the export sectors was less than 6,000."
I don't have the comparable Spanish figures to hand, but the situation is surely not that different.

Meanwhile Spanish Industry and Services Show No Real Signs Of Recovery

There was no let up in the contraction in the Spanish manufacturing sector in November, and PMI data pointed to a further deterioration of operating conditions. Moreover, the rates of decline of key variables such as output, new orders and employment all accelerated during the month, with the seasonally adjusted Markit Purchasing Managers’ Index falling to 45.3, from 46.3 in October. The Spanish manufacturing PMI has now been below the neutral 50.0 mark for two years, with the latest reading being the lowest since last June.

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker,
economist at Markit, said:

“The Spanish manufacturing sector looks set to endure a bleak winter period, characterised by falling new business, job cuts and heavy price discounting. The glimpse of a possible recovery seen during the summer appears to have been only a temporary reprieve, with even the stabilisation of demand now seeming some way off again.”

The impression gained from the PMI data is broadly confirmed by the monthly output statistics supplied by the Spanish statistics office (INE) to Eurostat. True, in October the output index was up fractionally over September (a preliminary 0.29% on a seasonal and calendar adjusted basis), but there is no sign of any sort of recovery and the drift is still downwards.

Output has now fallen around 32% from its July 2007 peak.

Nor is the situation in the Spanish services sector much better, and November PMI data indicated that operating conditions among Spanish service providers worsened again during the month, and at a sharper pace than in the previous survey period. Business activity, new business and employment all fell more quickly than in October. The headline seasonally adjusted Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared to one month ago – dropped to 46.1 in November, from 47.7 in the previous month. The latest reading pointed to the fastest rate of decline since August.

The situation is also confirmed by the Spanish INE Services Activity Index, which shows that activity was down 7.9% in October over October 2008, following a 9.8% drop in October 2008 over October 2007.

Which means that activity was own a total of 17.4% from the July 2007 peak, or an average of 23% over the three months August - October, just better than the 25% average drop registered in January to March. Which means that while there is plenty of evidence that the contraction has stabilised during the last six months, this seems to be stability with a negative (and not a positive) outlook, given that things have now started to deteriorate again, and we must never forget that this stability has been achieved via a massive fiscal injection from the government, an injection which cannot be sustained indefinitely.

Construction Activity Continues to Fall

Activity fell around one percent in October over September.

While total output is now down nearly 35 percent from the July 2006 peak. That is to say, this Christmas Spanish construction output will have been falling for nearly three and a half years, and this decline is going to be permanent, the only outsanding issue is what activity is going to replace it.

Spain's Employment Minister Celestino Corbacho was widely quoted in the Spanish press last week as saying that he could see clear signs that the housing market had "bottomed". I would really badly like to know where he is finding such signs.

In the first place Spain’s residential construction sector continues to shrink at an unprecedented rate. Housing starts fell by 47% (to 33,140) in Q3 compared to the same period in 2008, according to the latest figure from the Ministry of Housing. If we exclude social housing the fall was much greater - 61% less homes started in the period, and evn 20% down compared to the second quarter. Taken over a 12 month period total housing starts were down 35% to 444,544.

At the other end of the production line the Housing Ministry reported 83,500 construction completions in the third quarter (excluding social housing), 41% down year on the same time last year and 13% down on the previous quarter. Over a 12 month period construction completions were down 35% to 444,544, and this in a market where sales of new properties are running at a rate of something like 200,000 properties a year. That is to say, the stock of unsold houses continues to swell.

And prices continue to fall, since even though the Tinsa property price index for November showed that average prices fell by only 6.6% over the previous 12 months (down from 7.4% last month - the smallest annual fall in a year) this piece of data is not that illuminating in a market where prices have now been falling for more than twelve months. So while TINSA's own graphs makes for a very encouraging looking trend line, you need to remember that they've plotted the percentage change in house prices on an annual basis. If we look at the overall index (below) we see pretty much the same picture as with everything else, slower decline, but decline nonetheless. No bottom hit yet.

And, of course, if we look at the peak to present chart, then the percentage fall simply continues, and house prices are now down 14.75% on the December 2007 peak.

And it isn't only sceptics like me who think there is still a long, long way to go with Spain's house price adjustment. According to the latest report on the housing market by BBVA, Spanish property prices were 30% over-valued at the end of 2007, since they only fell by something like 10% in 2008, they have another 20% or so to drop before the correction is over. BBVA thus expect prices to fall by 7% in 2009, 8% next year, and 5% in 2011 Prices won’t stabilise until 2012, and the price correction is likely to be a protracted and long drawn out affair. What the likely impact of this on the real economy, and on their balance sheet, is likely to be they don't say.

BBVA mentions another key reason why the fall in Spanish house prices is far from over - the high ratio of house prices to annual disposable income. This ratio (house prices / annual disposable income) rose to 7.7 years at the height of the boom, and has now fallen back to 6.6 years. But that is a long way off the historical average of 4, not to mention the 3.5 it has fallen to in the US.

Meanwhile, a new report from BNP Paribas Real Estate, the real estate arm of French bank BNP Paribas, argues that banks in Spain (currently the largest holders of unwanted real estate) will need to start offering bigger discounts (of up to 50% in 2010 they suggest) if they are to really start to move their stock of property. Spain's banks claim to be offering discounts to buyers, but as BNP Paribas Real Estate argue, judging by the growing inventory they hold, these are not big enough to attract the volume of sales they really need.

In fact, after several months of dithering towards a recovery the Spanish housing market fnally relapsed again in October, with the number of houses falling by 24% compared to the same month last year, according to the latest figures from the National Institute of Statistics (INE).

In fact sales in October fell below the 30,000 transactions per month rate for the first time since last April. Sales were down by 10% over September. According to Mark Stucklin of Spanish Property Insight the explanation for this relapse is to be found in the breakdown between new build and resales. During the first half of 2009 sales of newly built homes were significantly higher than resales, whereas in normal years it’s the other way around. Indeed, if new build sales hadn’t been higher this year the market crash would have been significantly worse. But many of the new build sales recorded this year were actually sold off plan during the boom, and many others were banks buying properties from developers to keep them afloat, so not they were not really sales at all. Naturally, as those sources of sales start to dry up (either as the stock of sold off plan evaporates, or banks cannot accept too many more), then new build sales begin to head south.

As you can see from the above chart which Mark produced for his post, new build sales dropped sharply in October, almost to the level of resales. And if we look at the rate of monthly house sales in the P2P chart below, you will see that monthly sales have now dropped by neary 60% from their peak. That is to say, we are still having something over 400,000 new houses coming off the production line, and only a maximum of 200,000 new home purchases. Even as output drops towards an annual 100,000, this level of sales would only clear off the backlog at a rate of something like 100,000 a year, which mean we would be well over a decade clearing off that massive backlog, and meantime who foots the bill for maintaining such a large stock?

The chart above tells the story eloquently. It shows cumulative sales over 12 months to the end of every quarter, and you can see how the market has shrunk from just above 1 million sales over the 12 months to the end of Q1 2006, to just above 400,000 sales at the end of Q3 this year. In terms of transactions, the market has shrunk by around 60% over that period.

And we get a similar picture on the mortgages front, with the volume of new residential mortgages signed in September being 62,411, down 4.2% compared to the same month last year. In value terms the fall was more pronounced, with new residential mortgages dropping 16% to 7.3 billion Euros. The good news is the annual decline in new mortgage lending has been bottoming out in the last few months. It fell 31% in June, 19% in July, 7% in August, and 4.% in September.

And looking towards the future again, the number of new homes started in the third quarter was down 54% compared to the same period in 2008, according to the latest figures from Spain’s College of Architects. Excluding social housing, there were just 17,500 planning approvals in the third quarter, compared to 28,400 last year. To put this into perspective, planning approvals were down by 94% from the 287,000 granted in the third quarter of 2006, at the height of Spain’s construction boom. The chart (below, and which comes again from Mark Stucklin) shows just how dramatically Spain’s residential construction production chain has collapsed in the last few years. This year there are likely to be a total of just over 100,000 planning approvals, the lowest level in more than 20 years.

Unemployment Rising Towards the 20 Percent Mark and Beyond

Spain's registered jobless total rose for the fourth consecutive month in November according to data from the employment office INEM, and is obviously bound to rise further as the recession drags on and the multi-billion euro stimulus package gradually loses steam. Seasonally unadjusted data showed Spanish jobless claims rose by 60,593 in November from October to reach a total of almost 3.9 million people, almost a million more than a year ago.

The rise was milder than the almost 100,000 layoffs in October and leap of around 170,000 seen in November 2008, but this should not be taken as a sign the economy will begin to create jobs any time soon. Data showed the jobless rate in the service industry rose 1.7 percent month-on-month and by 1.3 percent in construction. Joblessness also increased by 0.6 percent in the industrial sector and by 2.6 percent in agriculture.

The Spanish government has injected some 8 billion euros (nearly one percent of GDP) into the economy this year in order to create more than 400,000 mostly low-skilled jobs in order to put a temporary patch on the hole left by the paralysed housing sector. The 30,000 or so infrastructure contracts created under what is know as plan E will be completed by the end of the year, and with little sign of a general return to growth, or a revival in job creating activity the majority of those employed on these projects will surely soon be finding their way back onto the dole queues. The government has announced plans for a new 5 billion euro stimulus plan for 2010, but this, in theory, will be aimed at sustainable long-term growth sectors like renewable energy, environmental tourism and new technologies.

November's 1.5% rise in jobless claims is nonetheless weaker than the 2.6 percent rise in October, the 2.2 percent in September and the 2.4 percent in August. And the annual rate of increase fell sharply, from 42.7% in October to 29.43% in November. But does the month mark a new trend, or will we see renewed deterioration as the winter advances? The Spanish administration officially provides only quarterly (unadjusted) data on the unemployment rate but does forward a monthly (and seasonally adjusted) rate to according to the European Union statistics agency Eurostat, based on the Labour Force Survey (which is generally regarded as a more accurate (and internationally comparable) assessment of the true level of unemployment than simple Labour Office signings. This stood at 19.3 percent in October, the second highest rate in the entire EU, and behind only Latvia.

Of course, as ever with this administration, hope springs eternal. The Spanish economy will likely return to growth early next year and start creating new jobs toward the end of next year, according to Finance Minister Elena Salgado: "I think there is a high probability we will start to grow in early 2010," she told the Cadena Ser radio station, although she did admit that the trend of rising unemployment will not likely be broken until late 2010 or early 2011. "We think we will start to see net job creation in some sectors at the end of 2010, and more clearly in 2011," she said. This realism about job creation is, of course, a by-product of the very low 2010 growth rate envisaged by even the optimistic forecast of the Spanish government (less than one percent), which given the need for drastic productivity improvement in Spain would evidently not be enough to create new employment. And, of course, others are less optimistic, with both the EU Commission and the IMF foreseeing negative growth in 2010. Indeed the EU Commission still anticipates unemployment to be over 20 percent in 2011.

Basically the outlook is bleak, and unemployment is far more likely to continue rising than it is to fall. My own current estimate (which in part depends on how much consumer prices fall, on how seriously the government follows the agreed 1.5% reduction in the fiscal debt, and on how rapidly interest rate expectations rise at the ECB) is that we should be moving towards the 25% range around next summer.

Domestic Consumption Continues To Decline

Despite the best efforts of the Spanish government stimulus programme household consumption continues to decline, at a slower rate in the third quarter, but still decline. The quarter on quarter drop was 0.1% as compared with a 1.5% drop in the second quarter, and a 2.4% fall in the first one. On an annual basic household consumption was down 4.2% in the third quarter following a 7.5% drop in the second one (see chart).

And retail sales simply keep falling, more slowly than before, but down and down they go.

In October they fell back again over September, and were down a total of 10.3% from their November 2007 peak.

So Why Should We Expect Recovery In 2010?

Or better put, why should we suspect that we might not see a Spanish economic recovery in 2010? Well, let's take a quick look at some of the structural features of Spanish GDP. As the Spanish administration never lose an opportunity to point out, Spain's economic contraction to date has been significantly less extreme than both the Eurozone 16 and the EU 27 averages. GDP never actually declined as dramatically as it did in some other countries.

But looking at the situation in this way is rather misleading, since in fact, as can be seen in the chart below (which comes from the Spanish statistical office - the INE - as does the chart above) in fact domestic demand in the Spanish economy fell every bit as rapidly as in other European countries, but external demand in fact moved in such a way as to add percentage points to the final GDP reading.

In fact, on analysing the two main components of Spanish GDP from the expenditure side in in the third quarter, the INE found, on the one hand, that national demand reduced its negative contribution to annual GDP movements by nine tenths as compared with the previous quarter, from minus 7.4 to minus 6.5 points, whereas conversely, external demand reduced its positive contribution to aggregate growth seven points, from 3.2 to 2.5 points.

Now all of this is, as I say, rather strange to those unaccustomed to the niceities of GDP analysis, since the positive contribution from external trade to GDP growth has got nothing to do with extra imports, but rather it is a product of the fact that Spain was running a whopping trade deficit, and simply reducing this trade deficit gave the positive impetus to GDP, whereas the third quarter negative impact of external trade was the product of, guess what, a further deterioration in the trade balance (see chart below).

The thing is, behind the whole situation lies the problem of debt, and indebtedness. Basically, despite the fact that many, many Spaniards have never had it so good as they did in 2009, Spanish living standards have actually been falling since the amount of money available for spending has been falling, since what we need to take into account here is the sum of actual earned income PLUS what Spanish citizens are able to borrow in any given time period. Essentially when you borrow you shift disposable income from one time period to another. This is why Franco Mogigliani advanced what has come to be called the life cycle theory of saving and borrowing, since patterns change across the age groups, and naturally as whole populations age the pattern of any particular country changes. A younger country - Ireland, the US - is much more likely to be a net borrower, while an older country - Japan, Sweden, Germany - is much more likely to be a net saver.

So why is all this important. Well, during the years you borrow, you spend more. I think this is obvious, and also why when there are less capital inflows there are less imports. Capital flows are to finance borrowing, and borrowing improves living standards in the short term, until it has to be paid back. Remember the saying, I am a rich man till the day I have to pay my debts.

The impact of the capital flows is that in the short term your disposable income goes up (someone gives you money to spend), while later on it goes down (as you have to subtract from earned income to pay back). This latter situation is where Spain is now. The capital flows have been sustained via the ECB liquidity process, which has fuelled domestic demand via government borrowing and spending, but at some point all of this needs to be reversed and the debts need to be paid down, and that will mean lower disposable income (in terms of money to spend) for the internal population as a whole, which is why without sales abroad domestic consumption will only continue to fall and unemployment will continue to rise. The only way to compensate for this is to export and run a trade surplus, since in this way the debt payments can be made without subtracting from current income.

Of course, borrowing is not income neutral in the longer term either, since it all depends what the borrowed funds are spent on. If you spend the borrowed money on infrastructure, education and new productive capacity (ie useful investment) then evidently you can raise the trajectory of GDP in the longer term, while if you only use it to finance short term consumption - or invest in a lot of houses no one really needs - then you simply get a destruction of internal productive capacity, massive price distortions and long term GDP on a lower trajectory. This is where Spain, Greece and much of Eastern Europe are now.

Basically, for those countries who lack their own currencies there is now real alternative to a rather painful “internal devaluation” to restore export competitiveness and the trade surplus. And this of course is why everyone from Standard and Poor's to the EU Commission and the ECB are now insisting not only on a return to fiscal order, but deep structural reforms to restore competitiveness.

EU Excessive Deficit Procedure Now The Key

On 27 April 2009 the European Council (Ecofin, the Finance Ministers of member states basically) decided, in accordance with Article 104(6) of the Treaty establishing the European Community, that an excessive deficit existed in Spain and issued recommendations to correct the excessive deficit by 2012 at the latest. At the time this appeared to imply an average annual fiscal effort of 1.25 % of GDP over the period 2010-2013. The Council also established a deadline of 27 October 2009 for effective action to be taken.

On 20 October 2009 the Council agreed that, provided that the Commission forecasts continue to indicate that the recovery in the EU economies is strengthening and becoming self-sustaining, fiscal consolidation in all EU Member States should start in 2011 at the latest, that specificities of country situations should be taken into account, and that a number of countries need to consolidate before then.

According to the Commission January 2009 interim forecast, Spain's GDP was projected to decline in by 2 % in 2009 and by a further 0.2 % in 2010. Spain's economic outlook deteriorated rapidly during the course of 2009 and the Commission autumn forecast projected a GDP decline of 3.7 % in 2009 and 0.8 % in 2010 (basically the same as the IMF October outlook). As the commission stress, the downward revision in nominal (current price terms) is even stronger, since prices (and the GDP deflator) have been falling over the period, and this is a strong negative factor for both revenue and outstanding debt to GDP levels.

Spain’s fiscal outlook also worsened in the course of 2009 reflecting this sharper-than-expected fall in economic activity. Notably, the Commission autumn forecast project the 2009 general government deficit to come in at 11.2 % of GDP, compared with the 6.2 % deficit envisioned in the January forecast. In particular, revenue has fallen sharply more than expected, as the result of the stronger-than-assumed fall in activity and of the fact that tax proceeds are reflecting falling activity much more strongly than the normal long-term tax elasticity considerations would have suggested.

Thus in the Commission review of the Spanish Excess Deficit Procedure carried out at the end of October, they found that the plans for government expenditure foreseen in the January 2009 update of the Spanish stability programme had been broadly observed (and this is the big difference with the Greek case) although the expenditure-to-GDP ratio increased on account of the lower-than-expected nominal GDP level.

The Commission now expect the 2009 deterioration in the fiscal outlook to continue into 2010, although the discretionary fiscal measures adopted by the Spanish government post January 2009 were considered to have played no role in the intervening deterioration in the fiscal outlook. They thus took the view that "unexpected adverse economic events with major unfavourable consequences for government finances" had occurred and thus recommended a provisional lifting of the Excess Deficit Procedure, conditional on substantial further progress in bringing the deficit within the 3% of GDP limit by 2013.

Looking ahead to 2010, the Commission took the view that the draft 2010 Budget Law published in late September 2009, which targeted a general government deficit of 8.1 % of GDP in 2010. was credible, given that the combined impact of the withdrawal of the temporary stimulus measures, on the one hand, and of the new discretionary measures presented in the draft 2010 Budget Law, on the other, could yield a significant improvement of the fiscal balance by some 1.75 % of GDP in 2010. Further in the light of the unanticipated deterioration in Spanish government finances an average annual fiscal effort in excess of that originally recommended - at least 1.25 % of GDP - is needed between 2010 and 2013 in order to bring the headline government deficit below the 3 % of GDP reference value by 2013. The Commission aregue that this correction would represent an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013.

The Commission autumn forecast, projects a government deficit of 11.2 % of GDP in 2009 and 10.1 % of GDP in 2010. Assuming unchanged policies, and GDP growth of 1 % in 2011, the deficit would then be 9.8 % of GDP. A credible and sustained adjustment path thus requires the Spanish authorities to implement the budgetary plans outlined in the draft 2010 Budget Law; ensure an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013; and, most importantly, to specify the measures that are necessary to achieve the correction of the excessive deficit by 2013.

As the Spanish administration constantly point out, Spain's accumulated national debt is a lot lower as a percentage of GDP than that of many other EU member states, and even after 2011 will remain below the EU average. However, as given the difficult situation likely to be faced by Spanish banks and the heavier than average weight of ageing in Spain, the burden of Spain's finances in the context of an economy which may struggle to find growth over the next decade should not be underestimated.

According to the Commission autumn forecast, general government debt is projected to reach 54.3 % of GDP in 2009, up from 39.7 % in 2008. Although it is currently still below the 60 % of GDP EU reference value, debt is expected to increase further in 2010 and 2011 to 66 % and 74 % of GDP respectively. And evidently there is strong downside risk here should growth be lower than anticipated, and/or prices fall, this number could rise significantly, and it could should Spain's banks need a substantial bailout at some point.

As the Commission point out, the long-term budgetary impact of ageing in Spain is well above the EU average - mainly as the result of a projected high increase in pension expenditure as a share of GDP over the coming decades. The budgetary position in 2009 compounds the budgetary impact of population ageing on the sustainability gap. The Commission thus stresses the importance of improving the primary balance over the medium term and of further reforms to Spain's old-age pension and health-care systems in order to reduce the risk to the long-term sustainability of public finances.

Indeed, the Council of Finance Ministers (Ecofin) specifically "invited" the Spanish authorities to improve the long-term sustainability of public finances by implementing further old-age pension and health care reform measures when they lifted the Excess Deficit Procedure at the start of December. The Council also invited the Spanish authorities to implement reforms with a view to raising potential GDP growth.

As Standard and Poor's stressed, their decision to revise the Spanish sovereign outlook to negative reflected the perceived risk of a further downgrade within the next two years in the absence of more aggressive actions by the authorities to tackle fiscal and external imbalances. It is the continuing silence which surrounds this absence which is so ominous, and makes the concerns of the EU Commission and the various ratings agencies at this point more than understandable.