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ECB, Behold The Wonders You Have Wrought!

Published: May 3, 2012 | 8:28 am
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In the middle of a high-profile security operation which has even involved the temporary suspension of the European Union’s Schengen Treaty on freedom of movement as it refers to Spain, the European Central Bank Governing Council are this month holding their annual “moveable feast” meeting in Barcelona.

The timing couldn’t be better, since this year’s “get out and meet the people” excursion will offer Council members the direct opportunity to take a close-up look at the effects of their handiwork.

The Spanish economy is now back in its second recession since the start of the global financial crisis.

Estimates for the scale of the contraction expected this year range from 1.5 percent to 2 percent, while forecasts for 2013 vary from a tepid 0.3 percent growth on the upside to a further contraction of 1 percent according to more pessimistic scenarios. In any event, on one thing there is consensus: the next couple of years are not going to be easy for Spain.

Naturally, with this kind of economic outlook, job creation will hardly be on the agenda, and the real question is just how much farther unemployment has to rise before it peaks?

Arguably it could well continue to rise all through 2013, although there is a more pessimistic scenario involving a ceiling being hit as the number of people giving up hope and leaving the country starts to rise even more rapidly than jobs are actually lost.

Familiar With Job Loss

And job loss is a topic Spaniards are now well familiar with. As of the end of March, the unemployment rate hit a level just below the 25 percent mark, while the number of unemployed hit 5.6 million, an all-time high.

Spain’s once mighty job creation machine – at one point during the boom years over half the new jobs in the euro area were being created in Spain – has been recycled during the crisis, and is now working flat out as a job destruction one.

Nearly 4 million jobs have now disappeared during the crisis, almost 375,000 of them in the last three months alone. And this is precisely what is worrying Spain’s leaders most: as the country’s recession deepens, the rate of job loss has been accelerating. Hardly the conditions in which you should be applying a sharp fiscal tourniquet, at least according to the classic manual.

Yet austerity is what Spain is in for over the next two years, and buckets of it. And yet, despite all the talk of a fiscal crisis, and the need to bring down excessive government spending, in its origins the crisis in Spain has little to do with the sort of issues we have seen in Greece or Italy.

Spain’s crisis is one of private, not public debt, and arguably has its roots far more in the inappropriate monetary policy applied from Frankfurt during the key 2002 to 2006 period than in any failure in the application of the EU Stability and Growth Pact.

Spain Unlike Greece

Unlike Greece, where the economy is collapsing because government spending was allowed to get out of control, in Spain government spending has gone spiraling out of control as a result of the economy collapsing.

It is the collapse in revenue produced by the ending of the housing boom that has made Spain’s social and welfare system too expensive for the country to afford, in particular as the cost of supporting the growing economically inactive population (whether unemployed or retired) has been rising steadily. So Spain has to make a social, not just an economic, adjustment.

Naturally a return to sustainable economic growth would help, but this is far easier to say than to accomplish. The institutional obstacles to the sort of correction Spain needs are obvious.

Euro membership means that the country has no currency of its own to devalue, and while there is a remarkable similarity between the country and Florida in terms of the background to the problem, unlike the U.S. state the country has no central European Treasury to turn to for support.

Naturally, as the ECB will be quick to point out, since last August they have been selectively buying Spain sovereign bonds, and the two recent 3-year LTROs have done a lot to ease the bank financing problems and to enable Spain’s commercial banks to offer support to their government in the national sovereign bond market.

Yet credit is still not flowing to the private sector, and international investors are far from convinced that enough has been done in provisioning for potential bad loans as economic conditions deteriorate.

Only last week the IMF warned that Spanish banks needed to do more to strengthen their balance sheets, and singled out a group of 10 banks which were considered to be at particular risk.

Although it wasn’t mentioned by name, Bankia – the recently-floated offshoot of a consortium of problematic savings banks headed by ex-IMF Director General Rodrigo Rato – was the word which almost immediately came to the forefront of everyone’s mind.

Definitive Solution?

After various “false start” attempts to address the problem, Madrid is now alive with rumors that the EU and the IMF are pushing for a definitive, game-changing, solution involving the creation of an institution similar to Ireland’s NAMA to “ring-fence” the problematic property assets, probably involving the use of funding from the two European bailout funds, the EFSF and the ESM.

Yet all the dilly-dallying in terms of recognizing the need for a decisive resolution to the country’s banking and economic problems does not come without a price. In the meantime the problem has grown, and with it the cost of a solution.

Many observers now worry that what was originally perceived as an issue in some problematic savings banks involving a limited number of developer loans may now have become much more serious. In particular, analysts at JPMorgan last week drew attention to the likely impact of continuing high unemployment and falling house prices on the residential mortgage book.

The response from Banco Santander CEO Alfredo Saenz was depressingly predictable. “Mortgages get paid in good times and in bad. Anyone raising this (the mortgage default) problem as one of the issues for the Spanish financial system is saying something stupid,” he told a press conference in Madrid last week.

Unfortunately, as bankers in Ireland will tell you, fewer mortgages get paid in bad times than in good. The issue is just how much fewer.

Rather than engaging in flat denial, which now convinces no one, Spain’s banking community would be far better off doing what the rumors suggest the Bank of Spain (under pressure from the IMF) is now about to do, and bring in some outside experts to make an independent assessment of the situation.

Otherwise the danger is that this will become Spain’s metastasis moment, the point where what had been contained as a construction slump tied in with a set of bad developer loans, after years of neglect as the patient refused to accept the diagnosis and pass through the operating theater, now spreads out and infects the whole bank loan book.

As for the ECB, I have one simple piece of advice for Council members as they visit the marvelous city of Barcelona: “look on in wonder and behold”!


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