Has Spain’s economic contraction become self-perpetuating?

Spain’s political leaders are in cheerful mood at the moment. According to the country’s Economy Minister Luis de Guindos, the Spanish economy will return to growth in the second half of 2013. “The perception of the Spanish economy has improved and will continue to do so over the coming weeks and months,” he told his audience at the World Economic Forum in Davos. Earth-shattering it will not be, but grow it will, he insisted. Perhaps, he suggested, the economy will be stationary in the third quarter, with very slight growth in the fourth. And quite possibly he is right. The core of the problem is whether any faltering growth emerging in the last three months of the year will be sustained into 2014, and it is here that all the old doubts really emerge.

The brunt of the argument which says it will rests on the idea that Spain’s government have now enacted sufficient reforms to enable the economy to return to a strong growth path. Optimists claim it will, while the sceptics like myself are not convinced at all.

Certainly Mr De Guindos can point to occasions where he has carried the argument.  Back in October last year, when he told an audience at the London School of Economics that Spain didn’t need a bailout, they simply laughed. Four months later it is looking increasingly unlikely that the country will seek additional EU aid in the short term.  “Spain doesn’t need any sort of bailout,” he told Bloomberg TV only last week, and this time no one laughed.

Perhaps the key point here hangs on your interpretation of the word “need”. If paying around 5 percent on your 10-year bonds is considered to be an acceptable cost for financing your country’s debt – Germany, for example is paying around 1.7 percent – then there is no need to apply to the EU and trigger ECB bond buying via the Outright Monetary Transactions program. If, on the other hand, you think the country could well benefit from lower funding costs, and the kind of pressure for reform which would be exerted from the outside though a Memorandum of Understanding, then clearly a bailout is needed.

Personally I take the latter view, since I think the country has done far from enough in the way of reform and since it is clear that introducing more measures that bite would be massively unpopular, the shelter provided by a troika-driven program would make implementing them easier.

Pension reform is a case in point. With the country’s elderly dependency ratio rising rapidly, and the number of people paying contributions into the pension fund going down by the month,  the whole system is badly out of balance and urgently needs some deep structural reform. According to estimates provided by EU economics commissioner Olli Rehn at the last Euro Group finance ministers meeting, shortfalls in the pension system added more than 1 percent to the fiscal deficit in 2012. And without major changes in the system this problem will only get worse.  Yet Spain’s political leaders are apparently incapable of addressing this problem in public.

Another example is the urgent need to restore export competitiveness to the economy. Despite all the claims that the recent labour market reforms need time to work, it is already evident that what has been done is far too little far too late. Exports have undoubtedly improved considerably, and the current account balance is moving into surplus. Yet the economy contracted by 0.7 percent in the last three months of last year, and this during a period when the government was running at least a 7-percent annual fiscal deficit.

Exports: the only hope?

Private domestic demand is weak, and weakening. High unemployment and heavy household indebtedness mean that this will continue to be the case for years to come – no one seriously imagines an unemployment rate under 20 percent come 2020. On the other hand, whatever the deficit target relaxation the EU Commission gives Spain in 2013, fiscal accounts do eventually have to be brought into balance, so we can expect government spending to remain on a downward trend. The conclusion we are forced to draw is that all we have left are exports, if we want to see Mr De Guindos’s hopes fulfilled and the economy return to sustainable growth that is.

So to cut through the jargon, and the war of statistics and counter statistics, I want to propose a definition – a country suffering from a private debt overhang is sufficiently internationally competitive when its exports grow quickly enough to fuel headline GDP growth sufficient to generate new employment on a sustainable basis.

This is patently not Spain’s case, and it won’t be in the coming years, so more needs to be done. Much more.

The employment-generating caveat is important, since it is only by starting to generate new jobs again that the Spanish economy could enter a positive dynamic, bringing to an end the surge in non-performing loans in the banking system, initiating a recovery in the housing market, and giving some sort of stability to consumer demand.

What is beyond doubt is that conditions in the financial economy have improved greatly. The government has opened a market for its debt, the banks have a solid capital base for 2013 and are able to access European wholesale funding markets – even if this is still at a considerable price in terms of interest paid. This is why Mr De Guindos thinks the need for a bailout is receding.

But of course conditions in the real economy continue to deteriorate. Most estimates for 2013 are for a larger contraction than that estimated by the government (something which has become habitual), and many observers continue to expect the negative growth trend to continue in 2014. Unemployment was already hovering dangerously near the 27 percent mark (26.6 percent in November, Eurostat) as 2012 drew to a close, which makes 27.5 percent next December a virtual certainty and a number over 28 percent horrifyingly possible.

So despite all the positive “talking up” that Spain’s economy is receiving from well-wishers at the international level, the disconnect between the financial economy and the real one has now become markedly pronounced, and the clearest evidence for this is that what are now, at least for the time being, well-capitalized banks are still unable to provide systematic credit to the deteriorating private sector. And if the private sector doesn’t improve, then the banking system will surely need more capital further along down the line. Even the relaxation of deficit targets comes at a price – next year government debt will almost certainly slip through that psychological 100-percent-of-GDP level, and still be heading upwards. Meaning that at some point a sovereign debt restructuring in Spain certainly can’t be ruled out.

The ugly precedents

Perhaps the worst of all assumptions that policymakers seem to be making is the one that “economies always recover”, an assumption which seems to be based on some sort of quasi-religious version of the “hidden hand” theory. Indeed, all that is necessary to make this a less than universal generalization is one counter example, and unfortunately the real world is populated by several of them. Argentina in the 20th century would be one, the country started out among the richest globally, and look how it ended the century. Twentieth-century Japan would be another, and once you start to look you can surely find more (try Ukraine, or Hungary). So recovery isn’t automatic, and something has to happen for recovery to occur. That something isn’t present in Spain at the moment, and indeed the danger is that as conditions deteriorate the contraction becomes self-perpetuating.

One of the less commented features of Spain’s boom during the early years of this century is the way the arrival of economic migrants fuelled a significant part of GDP growth.  The country’s population grew by more than six million (from 40 to 46 million) in the first eight years of the century, raising employment levels in both the formal and the informal economies. Migrants are still arriving, but the balance has now turned negative. According to data from the National Statistics Office, as of last June the net outflow was 20,000 a month and accelerating. That is to say a quarter of a million a year, or a million every four years. And the final numbers will almost certainly be much larger.

So a country which already doesn’t have enough people working to pay for its pension system now faces having less and less as time goes by, while the number of pensioners looking to claim will only grow and grow. In part that is the end result of sitting back and watching a 1.3-child-per-woman fertility rate for over 30 years. But to this grave underlying problem is now being added a new and potentially more deadly one. Those leaving are not only migrants who came earlier. Increasingly, young, educated, Spanish people are upping and leaving, and unlike in earlier periods many who go now will never return. Not only is there a massive human capital loss involved here, trend GDP growth is evidently being reduced as the workforce steadily shrinks, while all those unsellable surplus-to-requirement houses become even less sellable.

So next time Luis de Guindos proudly proclaims that economic conditions are improving, he might care to consider stopping for a moment to reflect on the possibility, nay the almost certain reality, that Spain’s economic contraction now feeds on itself.