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.
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 articles, 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:
1. 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.
2. 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.
3. 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. …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 amortise 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.
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 naive 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 recapitalise the German (and other European) banks to the point where they eventually are able to recognise 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 recapitalise themselves to the point where they could finally formally recognise what had long been obvious.
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 then 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.
Can Spain adjust by itself?
This is also the reason why Spain cannot follow the second of the three paths described above. The second path requires that Spain bear the full brunt of the economic adjustment, which in reality Spain and Germany should bear together. Spanish voters, however, will not permit (and rightly so) that Madrid force such economic pain on its citizens in the name of an ideal of "responsible behaviour” (i.e. remaining within the euro) that is both mistaken and extremely painful.
The adjustment will require that Spanish wages and prices are forced down substantially until Spain can reverse the higher price differential relative to Germany from which it suffers. Figuring out how to do this is not very hard – we have plenty of historical precedents upon which to draw. To simplify substantially, there are basically two things that have to happen in order to force a relative decline in prices. First, unemployment must remain very high for many years so that wages either decline, or rise by less than inflation and relative productivity growth. This is pretty straightforward.
Second, there must be some way to deal with the real increase in the domestic debt burden. Why? Because there are two ways relative prices can be forced down, and both of these result in a real increase in the debt burden. First, high inflation in Germany can exceed lower Spanish inflation, and second, Spain can deflate. In both cases the real cost of debt must increase substantially – in the former case because high German inflation will force up euro interest rates so that Spain’s refinancing cost will exceed its domestic growth rate, and in the latter case because deflation automatically increases the real debt burden.
How will we deal with the rising debt burden? Typically we do so by confiscating the wealth of small and medium enterprises or by confiscating the savings of the middle classes, and usually we do both.
So for Spain to adjust we need both very high unemployment for many years and we need to undermine the middle classes. Any policy that requires an enormous and unfair burden on both the workers and the middle classes is unlikely to be rewarded at the polling booths. The huge unpopularity of the newly elected Prime Minister Mariano Rajoy, in that context, should not be a surprise.
…I think most people will agree that, rightly or wrongly, Spanish voters are unlikely to accept high unemployment and an assault of middle class savings for many years without rebelling at the polls. Spain simply cannot accept the full burden of adjustment.
This means that the first two of the three paths I listed above cannot be followed. If I am right, we are automatically left with the third. Spain (and by extension many other countries) must leave the euro. It will be very painful and chaotic for them to abandon the euro, but the sooner they do it the less painful it will be.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets, where a longer version of this article first appeared.