Euroland update part 1:Spain in crisis

With all of the media focus on Greece, it seems to have escaped notice that Spain’s economy should probably now be considered to be in a depression. Industrial production in the Spanish economy is down 27% from its peak in 2006. In comparison, US industrial output is now only 4% below its peak and even Japan with its earthquake and currency-related challenges is ‘only’15% below its all time high production levels. Mirroring the production collapse, Spain’s unemployment is at close to record historical levels, construction activity is running at only 22% of its pre crisis highs and retail spending is down by 20% in real terms since 2007. However, despite these shocking numbers, import penetration is up in the economy and the gap between Spanish unit labour costs and those in Germany is continuing to rise and the budget deficit is beginning to look as intractable as elsewhere as tax revenues shrink. For Spain, austerity and the much vaunted ‘internal depreciation’ (=deflation) is simply not working or happening.

Portugal has made some progress but has been in a slump for a decade and in Italy, industrial production is now down 20% from its peak and real per capita household incomes are down by at least 10% since 2006. Real per capita GDP in Italy may fall back to 1997’s pre-Euro levels by the end of this year, thereby begging the question as to the Euro has done for Italy. Meanwhile, for Greece, the data are dreadful and austerity/deflation are not working. The costs experienced by the real sectors in pursuing the prescribed financial market-friendly policies are severe and a political backlash may result.

However, despite the intense pain in the periphery and the apparent ineffectiveness of the policy prescriptions (with all that this entails for the Euro’s long term sustainability), the ECB is continuing to focus not on its constituency within the wider real economies but rather on its narrower financial market constituency. The repeated response to any questions on the Euro’s problems is that there is required more austerity, more deflation and more fiscal discipline in the periphery to restore the Euro’s credibility. Thus far, particularly since the advent of the LTROs, markets are evidently prepared to welcome these answers.

It is the case that the LTROs have meant that Europe’s commercial banks should be able to avoid an illiquidity crisis. The weak banks in Europe now have an apparently ready supply of replacement funding/liabilities that will allow them not only to remain open but in some cases (including Spain) to start buying domestic government bonds, thereby notionally easing the sovereign debt crisis to the markets’ evident relief.

The LTROs have clearly pleased the ECB’s financial market constituency in the near term. However, by implicitly funding (or monetizing) the budget deficits of Spain and others, the LTROs are ultimately allowing the Spanish government to continue to offer high rates of unemployment benefit that in turn place a floor under wages and implicitly allow Spain’s unions to gain 3% wage hikes for their members.

At a social level clearly we would not want to see Spain’s population further impoverished by benefit cuts but, if the Europhiles really want Spain to deflate back to competitiveness, then the social security system must be pared back drastically so that Spanish wages can fall but the LTROs are in a way acting to sustain the level of benefits. The contradiction is obvious.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla