Spain in Pain: Why Leaving the Euro Is The Lesser of Two Evils: Michael Pettis

Spain in Pain: Why Leaving the Euro Is The Lesser of Two Evils: Michael Pettis

As recently as six months ago, one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt.  The prospect was unthinkable and like many unthinkable things it could not be discussed. But perhaps things have changed.  If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.

Normally I don’t like to write about European prospects in the midst of a very rough patch in the market because in that case there isn’t much I can say that isn’t already being said.  I find it more useful to wait for those recurring periods in which the markets recover and optimism rises.  Still, given the conjunction of political uncertainty in Beijing, low Chinese growth numbers, and another round of deteriorating circumstances in Europe, I will spend most of this issue of the article trying to outline the possible paths countries like Spain must face.

For several years I have been saying that Spain would leave the euro and restructure its external debt.  I should say that I specify Spain because it is the country in which I was born and grew up, and so it is also the country I know best.  When I say Spain, however, I really mean all the peripheral European countries that, like Spain, are uncompetitive, have high debt levels, and suffer from low savings rates that had been forced down in the past decade to dangerous levels.

Spain had a stronger fiscal position and healthier bank balance sheets than many of its peers when the crisis began, so any argument that applies to Spain is likely to apply more forcefully to its peers.  As an aside I will add that France is for me the dividing line between countries that will be forced into devaluation and restructuring and those that won’t – in my opinion France could go either way and we will get a much better sense of this in the first year of Hollande’s presidency.

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There are two reasons why I was and am fairly sure that Spain cannot stay in the euro (or, which amounts to the same thing, that Germany will leave the euro instead of Spain).  The first has to do with the logic of Spain’s balance of payments position, and the second has to do with the internal dynamics that drive the process of financial crisis.

To address the first, I would start by noting that thanks to excessively loose monetary policies driven primarily by German needs over the past decade, Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account deficits for nearly the entire past decade.  Its fundamental problem, in other words, has been the process by which its savings rate has collapsed, its cost structure forced up, its debt levels soared, and a great deal of investment directed into projects, mostly real estate, that were not economically viable.  As I have discussed often enough in previous issues of this article, I think all of these problems are related and are the automatic consequences of the same set of policy distortions implemented in Spain and in Germany.

Until Spain reverses its savings and consumption balance and drives down its current account deficit into surplus, which is what a reversal of these distortions would imply, it should be pretty clear that Spain will continue struggling with growth and will continue to see debt levels rise unsustainably.  But the balance of payments mechanism imposes pretty clear constraints on the process of adjustment.  In that sense there are really only three ways Spain can regain competitiveness sufficiently to raise savings and reverse the current account:

Germany and the other core countries can take steps to reverse the policies that led to the European crisis.  They can cut consumption and income taxes sharply in order to reduce domestic savings and increase domestic consumption.  These would lead to a reversal of the German trade surpluses and higher inflation in Germany, the combination of which would allow Spain to reverse its trade deficit and regain competitiveness via lower inflation relative to that of Germany and a weaker euro.

Spain can force austerity and tolerate high unemployment for many more years as wages are slowly pushed down and pricing excesses are ground away.  It can also take measures to reduce costs by making it easier to start businesses, reducing business taxes, and by improving infrastructure, but these latter provide too little relief except over a very long period, especially given the difficulty Spain will face in financing infrastructure and reducing taxes.

Spain can leave the euro and devalue.  This would leave it with a problem of euro-denominated debt, whose value would soar relative to GDP denominated in a weakening currency.  In that case Spain would almost certainly be forced to halt debt payments and restructure its debt.              

I want to stress that these are, practically speaking, the only three ways for Spain to regain competitiveness.  There are other ways that could in theory also work, but they are too unlikely to consider.  One could assume for example that the rest of the non-European world – most importantly the US, China and Japan – take steps to stimulate their domestic economies sufficiently to force up consumption and run in the aggregate large and growing trade deficits.  These deficits, whose counterpart would be a very large European trade surplus, would then bail out the whole eurozone by generating GDP growth rates that exceed the debt refinancing rates.

I think most of my readers will however agree that this is pretty unlikely. The rest of the world is also struggling with growth and in no hurry to run large trade deficits.  Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels (or Berlin).  But that probably won’t happen either – the rise of nationalism throughout Europe has made this always-unlikely prospect even less likely. 

So we are left largely with these three ways of allowing Spain to regain a cost structure that makes it competitive and allows it to amortize its debt while growing.  Anyone who rules out two of the three ways listed above must automatically imply that Spain will follow the third way.  So which will it be?

Humpty Dumpty Economics

The first way is for Germany to reverse its surplus and begin running large deficits.  This is by far the best way, but I think it is very unlikely.  Berlin has made no indication that it is prepared to do what would be necessary for it to run large deficits and, on the contrary, it is even talking about the need for more austerity. 

In part this is because Germany has a potentially huge debt problem on its balance sheet.  As a consequence of its consumption-repressing policies during the decade before the crisis, Germany’s domestic savings rate was forced up to much higher than it otherwise would have been and Germany has had to export the excess capital.  Not surprisingly, given European monetary dynamics, this capital has been exported largely to the rest of Europe in order to fund the current account deficits of peripheral Europe that corresponded to the surpluses Germany so badly needed to grow.

It did this not by accumulating euro reserves, which it could not do anyway, but rather by accumulating loans to peripheral Europe through the banking system.  As a result of all of these loans, Germany is rightly terrified that a wave of defaults in Europe will cause its own banking system to require a state bailout if it is not to collapse, and so it does not want to cut taxes and reduce savings because it believes (wrongly) that austerity will make it easier to protect its creditworthiness.

Related Story: Why Germany Has No Choice But To Save Europe: Mohamed El-Erian

But German’s anti-consumption policies are leading it towards a debt problem in the same way that similar US policies in the late 1920s created an American debt crisis during the next decade.  In that light I thought this very illuminating quote from then-presidential candidate Franklin Delano Roosevelt might be apposite:

   A puzzled, somewhat sceptical Alice asked the Republican leadership some simple questions:

   “Will not the printing and selling of more stocks and bonds the building of new plants and the increase of efficiency produce more goods than we can buy?”

   “No,” shouted Humpty Dumpty, “the more we produce the more we can buy.”

   “What if we produce a surplus?”

   “Oh, we can sell it to foreign consumers.”

   “How can the foreigners pay for it?”

   “Why, we will lend them the money.”

   “I see,” said little Alice, “they will buy our surplus with our money.  Of course these foreigners will pay us back by selling us their goods.”

   “Oh not at all, “said Humpty Dumpty.  “We set up a high wall called the tariff.”

   “And,” said Alice at last, “how will the foreigners pay off these loans?”

   “That is easy, said Humpty Dumpty. “Did you ever hear of a moratorium?”

   And so alas, my friends, we have reached the heart of the magic formula of 1928.

Humpty Dumpty’s grasp of the balance of payments, it turns out, is no more naïve than that of many European policymakers, and I suppose Germany will follow the historical precedent set by the US – and so many other countries that confuse trade surpluses with moral vigour.  By refusing to take steps that seem on the surface to undermine its creditworthiness, Berlin will only ensure the debt moratorium that will probably demolish its creditworthiness anyway. 

And of course without a major reversal of German’s current account position the balance of payments constraint absolutely prevents net repayments from peripheral Europe.  This game will go on as long as the core countries continue financing the periphery, but once they finally stop, the peripheral countries will almost certainly default or restructure their debt.

To take a brief detour before returning to discussing the three paths Spain can take, I think Berlin is betting that if they can prolong the crisis long enough, while pretending that the problem is one of liquidity, not solvency, they can recapitalize the German (and other European) banks to the point where they eventually are able to recognize the obvious and take the losses.  This was, after all, the strategy followed by the US during the LDC Crisis of the 1980s, when it waited until 1989, seven or eight years after the crisis began, to arrange the first formal debt forgiveness (the Mexican Brady Bond).  During that time a steep yield curve engineered by the Fed allowed the US banks to earn sufficient profits to recapitalize themselves to the point where they could finally formally recognize what had long been obvious.

Related Story: Spain’s Pain: Will The Spanish Banking System Collapse?

There are at least two reasons however why this strategy won’t work for the European banks.  First, the hole in the European banks’ balance sheets dwarves the equivalent hole in the balance sheets of the American banks during the LDC crisis.  It would take them much longer than seven or eight years to fix the problem.

Second, postponing resolution of the debt crisis is extremely painful for the debtor countries, who have to bear the full brunt of the adjustment that both debtor and creditor countries really need to make together.  This reduces manoeuvring space for Europe because the political system in Europe is less able than that of Latin America during the 1980s to accommodate this very painful process.  Well-functioning democracies, after all, make it harder for bankers and elites to force the cost of the adjustment onto the middle and working classes. 

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See also: Why Germany Has No Choice But To Save Europe: Mohamed El-Erian See also: Spain’s Pain: Will The Spanish Banking System Collapse?