The Blame in Spain

As you are no doubt aware, the Eurozone is going through a bit of a tough time at the moment. While the economy in Germany has remained resilient throughout the crisis, many other Euro members have not been as lucky. Take Spain for example. Here’s how Spanish unemployment compares with German unemployment during the crisis:

Spanish and German Unemployment Rates (Source IMF)

Spanish and German Unemployment Rates (Source IMF)

Yes, it’s awful but we all know how this happened, right? The Spanish government borrowed far beyond its means during the good years, running up huge debts and when the economic crisis hit they couldn’t afford to pay it off. How do we know this? Well, Angela Merkel told us. Anyway, it’s easy enough to prove – the IMF database has everything we need. So let’s grab the data and see how terribly irresponsible Spanish government borrowing was during the good years of the Euro:

Spanish and German Debt:GDP Ratio (Source IMF)

Spanish and German Debt:GDP Ratio (Source IMF)

Oh. So if Spain was doing the precise opposite of plunging itself deeper into debt, what exactly is going on?

At the moment Spain is a deeply ill patient and Germany is her self-appointed doctor. Not only has Germany (as we’ve just seen) misdiagnosed the cause of the problem but they have also prescribed austerity as the cure.

I’ve talked before about the fallacy of attempting to solve a depression with austerity and we need not go through those details again to know why it is a fallacy. What I do want to think about though, is why Germany has been so quick to misdiagnose the cause of Spain’s problems and for four years has chosen not to look at the numbers in the graph above.

There is a theory about this but to understand it we first need to travel back in time to the 28th of June 1919.

On that day in history, Germany and The Allies marked the end of war by signing The Treaty of Versailles. The treaty, amongst other things, laid out the reparations that Germany would have to pay The Allies in compensation.

At the time that the treaty was signed the British economist John Maynard Keynes described the reparations not as a compensation but as a “deliberate impoverishment”, and went on to predict (rather chillingly) that they would lead initially to mass poverty and then on to vengeance and another war.

When the reparations began, Germany soon didn’t have enough Marks to buy the foreign currency needed to make the repayments so they printed more Marks. Each time they did this the value of the Mark decreased, so that the next time they went to the printing press, they had to print more Marks than last time. Inflation turned into hyperinflation and the value of the Mark fell off a cliff and then kept going in spectacular fashion.

At the end of The First World War, one US dollar was worth about nine Marks. By the end of 1923, one US dollar was worth 4.2 trillion Marks. Inflation was so high that prices were doubling every two days. Saving money was a pointless exercise, so people spent it as soon as it was in their hands. Workers were paid hourly so they could hand the money to their families to go out and spend immediately while they could still get something for it. If someone went to the pub intending on having a couple of beers, they would buy their two beers on entry for fear that otherwise the second would be more expensive by the time that they came to order it. To help to put this into perspective, here’s a fifty billion mark postage stamp.

A 50 Billion Mark Postage Stamp (Milliarden means Billion)

A 50 Billion Mark Postage Stamp (Milliarden means Billion)

Living through such a period is almost unimaginable for us and it is little wonder that the current generation in Germany have such an inherent fear of inflation. A leader who would even give a hint of allowing some of it would immediately become deeply unpopular.

So how, you may ask, does this have any bearing at all on the current crisis in the Eurozone? Sadly, the solution that is needed, inconvenient as it may be, is German inflation.

During the good years of the Euro, Spain’s economy did well. Adoption of the single currency led to huge capital inflows from German banks to Spanish banks. The German banks’ perceived risk of lending lots to Spanish banks (and the Spanish banks’ perceived risk of borrowing lots from German banks) reduced significantly (and erroneously) once they were all using the same currency. The German banks thought that since they were both on the same currency now, lending to Spain was like lending to Germany. The Spanish banks eagerly accepted the German loans and invested them in the Spanish housing bubble (they didn’t call it a bubble at the time). As more and more money passed from Germany to Spain the bubble grew, Spanish wages increased and Spanish prices increased.

This is how relative Spanish and German prices changed throughout this period:

German and Spanish Price Inflation (Source IMF)

German and Spanish Price Inflation (Source IMF)

And this is how relative Spanish and German labour costs changed throughout this period:

German and Spanish Unit Labour Costs (Source OECD)

German and Spanish Unit Labour Costs (Source OECD)

As you can see, during this time the cost of Spanish workers became much higher relative to their trading partners in the north. When the financial crisis hit and demand dropped off, this left Spain with a deeply uncompetitive economy. Production of goods and services for export to Germany, France and other economies in the north is simply too expensive now.

This is the primary problem that needs to be solved in order for Spain to recover and you might note, it has nothing to do with government spending.

So now we understand the problem, what’s the solution? Well, one solution would be Spanish deflation but deflating your way to competitiveness is extremely difficult because it means everyone taking pay cuts and people don’t really like taking pay cuts. The Spanish government could start by cutting the wages of all public sector employees (and deal with the riots) but how do you convince the private sector to do the same? Also, Spanish deflation effectively increases their debt burden*, which means it’s pretty unworkable in any case.

There is another option – inflation in Spain (and Italy, Portugal, Ireland**) that is low relative to the Eurozone as a whole. The Eurozone economy is dominated by Germany so essentially this means German inflation. We’re not in any way talking hyperinflation but something like inflation of 1% in Spain and say 5% or 6% in Germany would start moving things back toward competitiveness.

With the horrors of 1920s hyperinflation still ingrained in German minds, Angela Merkel will have no easy task in pushing such a policy through and her current policy of blaming the problem on Spanish government spending in the good years and prescribing austerity as the cure has certainly helped to maintain her popularity with German voters.

Sadly though, Angela Merkel being popular won’t be enough to save the Euro.


*Although Spain’s debt wasn’t high during the good years it is high now due to their economy collapsing. It’s important to understand the the high debt was caused by the crisis rather than the other way around.

** You might have noticed I didn’t mention Greece. They actually did borrow beyond their means for a sustained period and relative deflation is not sufficient to save them. From what I can see they are pretty much done for.


The French Disconnection

Today, Christian Noyer, the chairman of the French Central Bank called for the credit rating agencies to focus on downgrading the UK before looking at France. His comments came in response to S&P placing France on “CreditWatch” – essentially monitoring it closely and considering an imminent downgrade.

The UK, Noyer argued, should be ahead of France in the queue for downgrades because it has:

  • a higher deficit
  • higher inflation
  • lower growth

Now, I have no love for rating agencies but he has missed the point a bit. If the factors he mentioned were the only factors then fine but he forgot to mention anything to do with the reasons S&P gave for putting France on CreditWatch, namely that the countries using the Euro are in a massive pickle and their politicians have proved unable to decide upon a way to depickle themselves.

I understand why he’s upset with the UK. David Cameron’s performance last week of refusing any attempt of negotiation in favour of showing his backbenchers that he is tough on Europe and tough on the causes of Europe was probably not our proudest moment.

Even so, Noyer should have a bit more compassion. He might have to deal with Cameron every now and then but in the UK we have to deal with the guy every day, and it’s hard enough without foreign central banks petitioning the rating agencies for a UK downgrade.

Yes, our finances are in bad shape but we are a long way from risking default. How he could compare the UK’s credit worthiness with France’s without mentioning the Euro-shaped elephant in the room shows he is either clouding his judgment because he is in a big huff with David Cameron or he is simply disconnected with reality.

We might have equally incompetent politicians running our country but while we are not using the same currency as Greece or Italy and while we have the ability to determine our own monetary policy, it should be no surprise to Noyer or anyone else that when it comes to worries about debt repayments, all eyes are on Europe.


We need to talk about Europe

In the run-up to the last election, much was made of the UK’s poor financial situation. We were told repeatedly  by the Conservatives that after years of irresponsible borrowing, our finances were the worst in the developed world, that we were on the point of bankruptcy and that if we didn’t immediately reduce the deficit then no one would lend to us.

18 months on, we’ve achieved nigh on no economic growth and despite the government’s cuts have continued to increase our debt at more or less the same rate.

This leads me to wonder – if our finances were so bad then and have got worse since, why is it that we can continue to borrow money so cheaply when no one will lend two Drachmas to all of those struggling economies in the Eurozone? Something doesn’t add up.

First, let’s look at whether our finances were really the worst in the developed world. This is a graph of government debt as a percentage of GDP for each country in the G7. The data is taken from the IMF website.

Government Debt as a Percentage of GDP (source IMF)

Government Debt as a Percentage of GDP (source IMF)

You see that orange line at the bottom? That’s the UK. Were we really borrowing so irresponsibly for all of those years under Labour? That’s a matter of opinion but if we’re on the naughty step then it’s pretty crowded.

On a side-note, Japan’s is quite impressive, isn’t it? They seem to be in a Ponzi scheme with their own public but Japan could be a million blog posts on its own so I’m not going down that avenue.

Turning our attention to the Eurozone, you will have noticed in recent weeks that Angela Merkel has blamed the current crisis on the irresponsible fiscal policy of certain member nations – i.e. that they have screwed the Euro by living beyond their means.

Here’s some more data from the IMF website showing some Eurozone economies’ borrowing as a proportion of GDP from the adoption of the Euro up until 2007, the year before the financial crisis.

Government debt as a percentage of GDP (Source IMF)

Government debt as a percentage of GDP (Source IMF)

Ireland and Spain reduced their debt significantly in this period. Italy reduced theirs a bit and although it was pretty awful in 2007, it was even worse when they joined the Euro so I don’t understand the sudden surprise now.

Anyway, it’s fairly clear that while Italy and Greece maintained high levels of borrowing throughout this period, Ireland and Spain did not. Merkel’s claim that each of these nations brought it on themselves purely through their government borrowing is not backed up by the figures. Ireland arrived on the eve of the financial crisis with much lower borrowing rates than they’d had historically but their economy imploded spectacularly nonetheless. Saying that the problems are purely down to fiscal policy is quite bizarre.

Another factor, which Merkel hasn’t wanted to mention, is monetary policy. In the UK when our economy got into difficulty the Bank of England cut interest rates and they have been sitting at a tiny 0.5% for the last two and a half years. Conversely, in April, egged on by Germany, the European Central Bank started to increase interest rates in the Eurozone and perhaps it should not come as a surprise that this coincided with the start of the current crisis.

The fragile Eurozone economies didn’t want higher interest rates but they could do nothing about it. Germany wanted higher interest rates because they were worried about inflation and so the weaker economies had to pay for this through lower growth and higher unemployment.

When the fragile Eurozone economies want to borrow money, lenders look at them and see that they are powerless to control this basic facet of monetary policy and therefore have lower confidence in their ability to respond to changes in their economies. If I want to invest some money shall I do it with a country who can respond to economic problems or one who can’t? Not a difficult decision.

There is though, another branch of monetary policy that is perhaps even more concerning. There is a reason that no one in the market really worries about the UK or the US being able to repay its debt but do worry about the economies in the Eurozone.

If the UK ever gets into a real pickle and needs some more Pounds to repay a loan they always have the option of going to the printer and just printing it. The UK controls its own currency. Ireland doesn’t. Italy doesn’t. Spain doesn’t. If they run out of money they go bust.

In the first recession they have faced, the Eurozone members’ lack of control over their own monetary policy has been a key factor in the crippling of several economies. Angela Merkel now wants to take things further and take away their control over their fiscal policy. Forcing the weak economies into crazy austerity measures will simply lead to many more years of high unemployment and no economic growth.

If it’s that simple though, why would Merkel be advocating a clearly bad policy? The problem Merkel has is that if she did the sensible thing and told the ECB to cut interest rates and buy up lots of government bonds from the weak economies, the German people would get cross and she would not be re-elected. Sadly, these are the things that matter most to politicians.

So what will actually happen? This is my prediction:

  • Germany will implement some rules to restrict fiscal policy of the Euro member states which will keep German voters happy but screw up the weak economies for years to come
  • Having done this Germany will then, finally, allow the ECB to buy up some government bonds, allowing the fragile economies breathing space to avoid short term default
  • The underlying problems will remain

Do you remember when William Hague fought his 2001 election campaign with pretty much one policy? “Keep the Pound,” he bleated incessantly for several months before losing in a landslide against a government who, err, kept the Pound.

He was right to want to keep the Pound though. Ok, he was right for the wrong reasons – nationalism and xenophobia have little place in macroeconomics but in hindsight, I shudder at the thought of where we would be now if we’d adopted the Euro too.

There is a certain romance in the single currency. It feels like it brings us all closer together, working with our neighbours in one financial union and it’s a marvellous two-fingered salute to the sickening xenophobia peddled by Nigel Farage and The Daily Mail.

Sadly, romance and economics don’t mix either and whatever transpires, one thing is abundantly clear – in an era of many bad ideas, the worst one of all was the Euro itself.