EconoMonitor

Europe’s Depressing Prospects: Two Reasons Why Spain Will Leave the Euro

Normally I don’t like to write about European prospects in the midst of a very rough patch in the market because in that case there isn’t much I can say that isn’t already being said.  I find it more useful to wait for those recurring periods in which the markets recover and optimism rises.  Still, given the conjunction of political uncertainty in Beijing, low Chinese growth numbers, and another round of deteriorating circumstances in Europe, I will spend most of this issue of the newsletter trying to outline the possible paths countries like Spain must face.

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 issues of this newsletter, 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.  One could assume for example that the rest of the non-European world – most importantly the US, China and Japan – take steps to stimulate their domestic economies sufficiently to force up consumption and run in the aggregate large and growing trade deficits.  These deficits, whose counterpart would be a very large European trade surplus, would then bail out the whole eurozone by generating GDP growth rates that exceed the debt refinancing rates.

I think most of my readers will however agree that this is pretty unlikely. The rest of the world is also struggling with growth and in no hurry to run large trade deficits.  Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels (or Berlin).  But that probably won’t happen either – the rise of nationalism throughout Europe has made this always-unlikely prospect even less likely.

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 amortize 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 skeptical 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 naïve 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 vigor.  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 recapitalize the German (and other European) banks to the point where they eventually are able to recognize 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 recapitalize themselves to the point where they could finally formally recognize 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 maneuvering 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 behavior” (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 wrote last year just after the election that this would happen, although I thought it would take a year or two before the population really turned on him and made it impossible for him to govern.  But Spaniards, from business leaders down to workers, are furious at the Rajoy government and this anger will continue until either the two major parties eject those of their leaders who continue to demand that Spain behave in a “responsible” way, or harder line extremist parties replace the two parties themselves.

I place the word “responsible” in quotation marks not because I am opposed to responsible behavior but rather because the attempt to tighten the budget and impose austerity in the name of remaining on the euro is being presented as the “responsible” thing to do.  It is, however, no more responsible than the policies France used in the 1920s to revalue the franc to pre-War parity, which were also sold to the French public as the “responsible” thing to do.

In both cases (and in many other deluded attempts to protect hopelessly overvalued currencies underpinned by rising eternal debt), policymakers did not understand that their policies were guaranteed to fail and were based on a misunderstanding of the causes of the underlying crisis.  The responsible thing to do is to acknowledge that the euro is indefensible and that Germany’s refusal to share the adjustment burden, after it absorbed most of the benefits of the mismanaged monetary position it imposed on the rest of Europe, means that Spain will be forced to take on far more than its share of the cost.

But whether or not everyone agrees with my analysis of what really is “responsible” behavior, I think it 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.

The death spiral

I said at the beginning of this newsletter that there were two reasons why I was certain Spain would leave the euro, the first of which has to do with the logic of Spain’s balance of payments position and the second with the internal dynamics that drive the process of financial crisis why I was certain that Spain would leave the euro.  To address the second, I think Spain will leave the euro because it seems to me that the country has already started on the self-reinforcing downward spiral that leads to a crisis, and there is no one big enough to reverse the spiral.

How does this process work?  It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history.  When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.

Of course as credibility is eroded, this further exacerbates the behavior of these stakeholders.  In that case bankruptcy comes, as Hemingway is reported to have said, at first slowly, and then all of a sudden, as the country moves slowly at first and then rapidly towards a breakdown in its debt capacity.

What is key to understanding the process is to see that stakeholders will behave for perfectly rational reasons in ways that politicians and moralists will decry as wholly irrational.  Rather however than respond to appeals that they stop behaving irrationally, stakeholders will continue making conditions worse by their behavior as they respond the distorted incentives created by the erosion of sovereign credibility.  To do otherwise would almost surely expose them to disaster.

To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:

  1. Private creditors.  As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities.  This has a double impact on making conditions worse.  First, higher interest rates mean that debt rises more quickly than it otherwise would.  Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
  2. Official lenders.  As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority.  This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
  3. Depositors.  As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system.  As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
  4. Workers.  Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
  5. Small and medium businesses.  One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector.  Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation.  They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
  6. Political leaders.  As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.

It is important to recognize the almost wholly mechanical nature of credit deterioration once a country is caught in this kind of spiral.  Deteriorating creditworthiness forces stakeholders to adjust.  Their adjustment causes debt to rise and/or growth to slow, thus eroding creditworthiness further.

The combination of these and other actions by stakeholders, in other words, can’t help but reduce GDP growth, increase debt, and increase the fragility of the balance sheet, all of which of course undermines credibility further, so reinforcing the suboptimal behavior of stakeholders.  All of the exhortations by politicians, the church, public intellectuals, bankers, etc. – and there will be many – that stakeholders put personal self-interest aside and act in the best interests of the nation will be useless.  Slowing this behavior is not enough.  It must be reversed.

But how can it be reversed?  No one is big enough credibly to guarantee the creditworthiness of all the afflicted countries, and without a credible guarantee the downward spiral will occur, more or less quickly, until it is clearly unstoppable.

Only connect…

It is pretty clear that all of this is already happening in Spain and it is also pretty clear that every few months when the government announces the latest batch of economic and debt data, these numbers always turn out to be worse than expected and much worse than originally projected, which is, ironically, exactly what we should expect under the circumstances.  Here is an article from Saturday’s Financial Times that shows just how bad it is:

Nearly one Spaniard in four is unemployed, according to data released on Friday, as the country’s economic and financial predicament prompted a government minister to talk of a “crisis of enormous proportions”.  The data from the National Statistics Institute showed 367,000 people lost their jobs in the first three months of the year. That means more than 5.6m Spaniards or 24.4 per cent of the workforce are unemployed, close to a record high set in 1994.

The data, which follow a sovereign credit rating downgrade, prompted José Manuel García-Margallo, foreign minister, to say that they were “terrible for everyone and terrible for the government”.  He compared the European Union to the doomed liner Titanic, saying that passengers would be saved only if all worked together to find a solution.

It is interesting that Garcia-Magallo is openly discussing the possibility of the “passengers” not being saved.  Usually in the beginning of a sovereign debt crisis we spend an unfortunately long time in which policymakers insist that the market is overreacting to bad news and that the problem – inevitably a short-term problem driven largely by illiquidity – can be resolved with patience and hard work.  There is no discussion of contingency plans because the contingency is unimaginable.

At some point however it becomes possible at least to acknowledge formally that policymakers might be forced into the contingency.  Once this happens, the debate becomes much more intelligent and the resolution of the crisis is speeded up.  I have no idea if we have reached that stage in Spain, but in that light I found an article last month, by Ambrose Evans-Pritchard of the Telegraph, both very worrying and, at the same time, comforting.  In the article he says:

Articles calling for Spain to withdraw from EMU – or at least exploring the idea – are no longer rare. They are appearing every day.

…What is striking is the response on the comment threads of such pieces. My impression over the last month is that a large bloc of informed Spanish opinion has reached the conclusion that EMU is dysfunctional, and increasingly destructive for Spain. Many posters seem extremely well-informed, using terminology such as “debt-traps”, “internal devaluations”, and “relative unit labour costs”.

Many point the finger directly at Germany, correctly stating that Berlin seems to think it can lock in a current account surplus with Club Med in perpetuity. Clearly, such as an arrangement is mathematically impossible within a currency union – unless Germany is willing to offset the surplus with flows of money for ever, either through fiscal transfers or loans or investment. These flows have been cut off.

Opinion is divided, of course. The pro-euro camp is still a majority. But the smothering conformity of past years has been obliterated.

As recently as six months ago one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt.  The prospect was unthinkable and like many unthinkable things it could not be discussed.

This made it very unlikely that anyone except the radical parties of the left or right would be able to control the discussion and of course this was likely to lead to a more disorderly resolution.  But now perhaps things have changed.  If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, I am pretty sure that a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.

And that is why the article is comforting.  The historical precedents suggest that typically policymakers postpone the decision to reverse the monetary straightjacket for as long as they can, and in the process they erect barriers towards such a reversal in the name of shoring up credibility.  These barriers work by increasing the cost of a policy reversal, and the point of this is to improve credibility in investors’ eyes by increasing the cost of “misbehavior” by policymakers.

Mexico did this for example in 1994 when, in order to convince an increasingly skeptical investor base that the central bank would not devalue the peso against the dollar, the Ministry of Finance shifted its domestic borrowing from peso-denominated funding to dollar-denominated funding, which of course would increase the debt-servicing cost of a devaluation for the government.  Unfortunately, when policy is reversed anyway, as was the case in Mexico in 1994, the cost indeed ends up being much higher, and it takes longer for the economy to recover.  In that sense the sooner Spain prepares for an abandonment of the euro the less painful it will be.

But of course it won’t be painless.  Whenever an analyst predicts that Spain will soon leave the euro he is almost always countered by someone who earnestly explains that Spain cannot leave the euro because the process will be too painful.  In 1993-94 of curse we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board. It would have been too painful to devalue.

But of course Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse.  And likewise while it is true that Spain cannot leave the euro without experiencing a very painful process, the point is not that anyone is arguing that Spain should willingly and irrationally choose to endure pain.  Spain will leave the euro because the alternative is worse.

55 Responses to “Europe’s Depressing Prospects: Two Reasons Why Spain Will Leave the Euro”

wyattMay 18th, 2012 at 12:44 pm

Thanks for telling the truth. We are all in life together and when a group of people take unfair advantage of their brothers because they can, or are more clever, or are stronger, or for any other reason they want, the fabric of civilization is destroyed. The underlying cause of this whole crisis is national and personal greed, a wanting more than a fair share for oneself at the expense of others. The euro was doomed from the start because of this unresolved issue.

CurtMay 18th, 2012 at 1:10 pm

There many organizations, people, companies, and countries which currently cannot pay for all they consume. Other organizations (banks) give loans to those who cannot currently pay.
Hopefully these organizations will not be stripped of their assets to repay their debts but will increase their income in the future perhaps by using the money they borrowed to increase their incomes.
This is the theory.

But it often turns out the people borrowing did not use the money for investment that paid off. Perhaps they were unwise from a technical point of view or just had "emotional" problems. (they can't control their desire for a high standard of living)

Now these organizations who can't pay for their consumption are called not competitive.
They are not competitive because they don't have the capital or the organization compared to their competitors. Germany is more competitive than Spain because at this point it has more capital and organization than Spain. If Germany gives Spain loans and ask them to pay them back there is no reason to believe that Germany will not increase its abilities faster than Spain does and so Spain will be in an even worse position. Germany could cancel its loans to Spain in which case Spain could use the money saved to be more competitive. But Germany has good organization and capital so in the future Germany will still be more competitive than Spain. In this case Spain could in the future respond to this by lowering its standard of living.

Or Germany could do the "right" thing and supply Spain with the resources and organization it needs to build plants that produce things that Germany needs.
In other words Germany could give Spain a gift to get Spain competitive. And could do this with all the non competitive states and hope that this in the future makes them competitive making all the states of Europe competitive which would stimulate progress in Europe. Competitveness what they say they want. But even though everyone knows this is the right thing to do and that this is sort of what they did when they absorbed east Germany, I don't think you are going to get Germany to do this. So this means Spain must become ever less competitive and will default as you pointed out.

princess1960May 18th, 2012 at 1:16 pm

WELL all the world in this moment ''metavivasi'' and this ofcours is painfull for midleclass specialy.. Spain have problem with small and midle bussinesis and this make highe unemployment. deFicite gv is not more hgier from Italy i have to explante EUz did not make good job and this is the consecuences ..but i know too inflation in EU is not higher IF EUZ have decide to saperate .. than Spain GR IT wil go out so i don't understand why this panic ..WRONG FROM BEGINING EUZ did not keep strong grade for countryes have inside not good controll balance sheet ..NOW IS to late for EUZ to saperat or thru out country because will be catastrofico for all the economy in world .
JUSY RITHMISSI political (structural) and follow economical .. with pain YES .. every restart from begining is difficult for 2-3 year ..after get power with new rules
thank you

techestateMay 18th, 2012 at 6:04 pm

India will soon see the downturn in next 1 or 2 years .
The politics are doing nothing either be India shining or dooming , they are fooling poor for petty votes and looting the public money so when the recession comes , they still can afford luxury.
The market cycle has been 1992-2000-2008-2016 ????

barfMay 18th, 2012 at 10:36 pm

the first thing that should be noted of course is that "the Socialists lost in Spain but won in France." And of course there was a common denominator: "both were not in power when the shit hit the fan." So before anything is to be said this simple fact needs to be pointed out. The same is true in England i might add. the only outlier so far is Ms. Merkel's Germany "and it would appear they are in big trouble" given what the media has said about local elections. In other words "incumbency is the kiss of death." The Folks are DEMANDING change. interestinlgy…."much of this change involves the enforcement of their basic rights"…all of which are of course being violated by this little tiny thing called a "personal computer" which has turned out to be anything but. THEN we can talk about "economics" of course…

VeronicaMay 19th, 2012 at 3:09 am

This analysis is so old school and so wrong. So Spain goes out of the Euro, becomes cheaper and more competitive? Really? There will always be someone cheaper, western cultures need to learn this, so going through this road is not making US or Europe competitive, no matter how much we try. A breakthrough is needed, western cultures have to come with something better than the formula cheap = competitive. I'm not an expert, but I can't believe that there are no more options out there!

StrangeMay 19th, 2012 at 9:30 am

Germany cannot cut its consumption or income tax. It has to pay for the debts of the financial aids for Greece and EU in general.

monetaryjusticeMay 19th, 2012 at 11:40 am

There is no mystery to projecting the pattern of failure engendered by any purported economy subject to interest.
As interest multiplies debt in proportion to a circulation, ever more of every existing dollar is dedicated to servicing multiplying debt, and ever less of every existing dollar can be dedicated to sustaining the commerce which is obligated to service the multiplying debt. Everything around you can be understood from the obvious consequences.

There is only one solution

Mathematically Perfected Economy (MPE)

Robert3May 19th, 2012 at 7:07 pm

Why not restructure debts to organisations outside a country into countries old currency, the Greek foreign debt would be restructured intodrachma, Italy's foreign debt into lira, Frances debt into the franc. The Euro would remain the common currency in the country, taxes etc, shop prices would be in Euro.

This would create the situation where the lenders could not depress the value of a local currency without damaging itself, the foreign debts would have a structure that would reflect the ability od a country to service its loans without involving the euro directly. The need for austerity to 'balance the books' would no longer be necessary

MarcusSedlmayrMay 20th, 2012 at 12:28 am

It is simply an insult to claim that the common currency is used by Germany to gain hegemony over the rest of Europe. The EUR was always seen by its founders as the tool for stronger integration. It was considered a means to an end: to achieve an integrated labor and economic union. A way to help people and businesses to realize opportunities not only within their home countries but in Europe at large.

I do not buy into the story that Germany is Übercompetitive and that Germans should consume more as one way to defuse the crisis. I am living in Germany and all I can consume from this country I do already consume. I am fully satisfied with what I can get. For me to consume more the PIGS would need to come up with new services or goods that I value and which I might buy.

Therefore also the second proposition is wrong, namely that the PIGS should devalue their new currencies to regain competitiveness. First, they would have to invent something which they could export to other EU countries. But what? With their new currencies they would directly compete with China which is absolutely impossible. China is partly donating its resources for free. So that would simply be a race to the bottom.

The most natural solution to the problem would be that workers from the PIGS migrate to Germany in order to produce the goods and services there which they later on consume at home. Not the Germans have the need to consume more but the people in the PIGS country. Therefore a tighter integration of the labour market is one ingredient to solve the crisis in the long term.

On the other hand also German companies could migrate to the PIGS in order to produce on-site what the people there would like to consume. Therefore a standardisation of production and labour costs in all EU countries would be another way to reduce the imbalances in the long run.

StephanMay 20th, 2012 at 5:32 am

In essence you are saying this:

1) Spain consumed more than would have been possible without the Euro

2) Germans produced what Spain consumed

3) The Euro is to the benefit of Germany rather than Spain

Funny. To me 1) and 2) sound like the real winner is Spain.

Truth is that the Euro damaged both countries by

1) distorting incentives for capital allocation and

2) hiding the need for reform in Spain

Stray__CatMay 20th, 2012 at 8:57 am

That's exactly what means being in a "union", helping each other and not depressing the weaker.

Nicholas WibberleyMay 20th, 2012 at 9:49 am

The author is right about a move towards recognition of a possible Spanish exit from the Euro. I live in Andalusia and have friends in both medicine and academia. Even a year ago they would not discuss the possibility of leaving the euro zone but that is now changed due in large part to the cuts in salary they have already endured combined with relentless rising costs, not least of fuel. I believe that most would still prefer to stay in the euro zone but see departure looming like an unavoidable thunderstorm.

Retreating from the author's three initial possibilities brings one to the more elementary choice between doing something and doing nothing, just muddling along, which is more or less what is happening. Throughout the world, I believe there to be an increasing disillusion with mechanistic solutions generally, and particularly, perhaps, mechanistic financial solutions. I see us moving into a post-mechanistic, even post-rational, age where unintended consequences are the norm. In its simplest form this means we no longer accept that if we do this then that will happen. But the process is more pervasive, it pervades much political debate which is becoming ever more evangelical, summoning emotions and demanding faith, promoting appearance over what we once thought of as reality. Concurrently I see the global capitalist system to be corrupt in the manner of the pre-Reformation Catholic church. If this perception has any validity then the current 'crisis' may morph into a Reformation so far-reaching that all these debts and liabilities will be swept aside like bundles papal dispensation.

BobitoMay 20th, 2012 at 11:27 am

There is a fourth alternative – Spain declines permanently and becomes a second world economy in permant crisis. This is where many Spaniards think we are headed.

It is not true that Rajoy is unpopular. The fools who voted him in still love him.

BobitoMay 20th, 2012 at 11:31 am

So basically it's a union when it's good for Germany, and then when the seas get rough, push all the livestock overboard.

buzzMay 20th, 2012 at 3:07 pm

Pettis is making the same mistake as Roubini on Greece. They both figure, perhaps correctly, that devaluation outside the Euro would be much easier than deflation within the Euro. They then assume, definitely wrongly, that Greeks and Spaniards must see things the same way.

Deal with the world as it is: the people of the European periphery don't want to leave the Euro. At least for now they would rather deflate withing the Euro, as ugly as that process might turn out to be. Arguably they don't know what they're getting into. Perhaps even they might eventually change their minds.

But is it really in the interests of the rest of the Eurozone to be threatening now to kick Greece out, and thus implying that even Spain could eventually be expelled? I don't think so. I think it's very destabilizing.

JaylatMay 20th, 2012 at 7:40 pm

Nice summary, but I don't get why people have to drag morality into this. It's pure economics; Germany took advantage of financial incentives to produce and export more, and Spain, etc. loaded up on cheap debt to develop real estate. To the extent that Germany has financed the PICS they've already "paid" for their benefits from the EU. Let Spain drop out and if its currency plummets its tourism will soar.

Nicholas WibberleyMay 21st, 2012 at 3:02 am

If in doubt, do nothing. Doing nothing doesn’t mean that nothing happens. It means that what happens develops inexorably from the circumstances and does so with an increasing degree of inevitability. As I wrote above, my perception is that middle-class Spaniards, I have no personal experience of Greek opinion, do not want to leave the euro zone. Thus imho they should stay in until either the current problems are resolved or they do prefer to leave.

Deva SagayamMay 21st, 2012 at 10:50 pm

“They can cut consumption and income taxes sharply in order to reduce domestic savings and increase domestic consumption.”!!

The fallacy in the argument is that Germany is not selling the major part of the surplus to Euro countries.

China , India, Brazil and US do not depend on German loans to buy German goods.

PhilBMay 22nd, 2012 at 10:23 am

Great post (or “newsletter”). The picture is rather ominous, but it’s difficult to find flaws in the analysis. However, a couple of important considerations may be missing. First, Spain’s predicament is in good part of its own making, owing to corrupt practices at the regional government level (somewhat reminiscent of 1997 Thailand or 2001 Argentina…), which should be fixed in all scenarios. Second, the euro construction is an appendage to the greater European project and letting the euro unravel is extrordinarily dangerous politically. The truth is that there is no good solution, and whatever course is chosen adjustment will be very painful indeed. This argues in favor of muddling through, if at all possible (rather than cutting the Gordian knot), which in turn implies that Germany will have to swallow the eurobonds and more – just as it did the unorthodox moves implemented by the ECB since November 2011.

K MorganMay 22nd, 2012 at 10:47 am

Thank you for so clearly laying out the economic arguments and stresses within the EZ. A beautiful piece of writing.

OsoVolandoMay 22nd, 2012 at 3:04 pm

This statement is loaded with moral indignation (about "pure economics"). Further, it is interesting to note the lack of interest in the sources of debt; it's "the Spanish," or whoever, who did this or that thing for which they ought to be held accountable. It is my understanding that, as in the U.S., the real estate debt overreach was on the part of the private banks, and the government accounts were not in all that bad a shape until the collapse. Yet as in the U.S., it is the public, through the government handmaidens of private finance, that ends up paying the piper.

WojMay 22nd, 2012 at 3:40 pm

This is is essential to understanding the situation in Europe because it focuses on actual responses and not abstract ideals. Many economists seem to overlook the simple fact that the individual dynamics of each party are a rational response to the troublesome predicament. Any resolution that keeps Spain in the monetary union therefore requires at least one of the parties to act irrationally, effectively placing the priorities of the other groups above their own (and accepting the risks if others don’t follow). It is often suggested that political leaders will ultimately recognize the massive costs of continuing to focus on the short-term and change course. Well, it has been 3 years since the crisis began and we are still waiting…
http://bubblesandbusts.blogspot.com/2012/05/self-…

John DugganMay 23rd, 2012 at 1:40 pm

Of course, you are absolutely right. The problem is that there is no other solution. The question is, does Germany want to solve the problem (as was done in comparable circumstances by the Marshall Plan, after WWII) or does it want to be the problem? That's all.

simpleMay 23rd, 2012 at 5:47 pm

Yes Germany can cut its consumption and income tax. They can sell bonds at zero coupon rate to allow for tax cuts. Germany get there debts back in the form of goods from Spain and vacations in Greece

simpleMay 23rd, 2012 at 5:51 pm

That means debt is restructured and devalued. Banks take huge looses and are insolvent.
Alot of pensions hold this debt also. Pain has to be spread around by all.

simpleMay 23rd, 2012 at 6:00 pm

Marcus? Who is Germany going to lend money to next so they can buy there products. Great stuff buy the way. Have several German machines in my shop to bad demand is to slow to run them at any more than 1/3 rd capacity. Germany subsidizes there manufacturing. They were smart until no one can afford to buy anything from them.

simpleMay 23rd, 2012 at 6:11 pm

It leads to more internal consumption, less imports into Spain. Not exporting your way out of debt. Debt is written off. Who was more irresponsible the ones that borrowed the money or the ones who lent it to them. I wont lend my brother money because I know I wont get it back. If I did lend it to him, It would be my own fault.

simpleMay 23rd, 2012 at 6:18 pm

Germany sold more goods than they could have without the euro. Without the Euro German currency would have been higher and exports would have been lower. Germany was big winner, there economy grew more than it would have without the euro.

simpleMay 23rd, 2012 at 6:22 pm

Without the weak countries in the euro the euro then soars, and down goes German exports.

simpleMay 23rd, 2012 at 6:25 pm

The talk of Euro bonds is ripe, the can seems like it will be kicked down the road some more.

Euroopa rahaliitu murendavast legitiimsuse defitsiidist « VABALOGMay 27th, 2012 at 2:46 pm

[...] Europe’s Depressing Prospects: Two Reasons Why Spain Will Leave the Euro – Michale Pettis ei kirjuta hirmuäratavalt minoorselt mitte Kreekast vaid juba Hispaaniast. Põhjuseks mehe isiklikumad ja vahetumad kokkupuuted riigi ja inimestega, mis annavad talle põhjuse enda spekulatsioone laiendada tervele Lõuna-Euroopale. Pettis on veendunud, et isegi Hispaaniat ootab ees devalveerimine ja seeläbi eurotsoonist lahkumine vaatamata sellele, et see on ebamugavalt kole protsess. Enda argumentides toetub ta ajaloolisele kogemusele, kus devalveerimine tundus tihti võimatu täpselt selle hetkeni kui devalveerimine lihtsalt toimus. [...]

Euromageddon « puntocerodosMay 29th, 2012 at 11:18 am

[...] Este otro artículo de Michael Pettis, aunque largo, deja muy claras cuáles son las opciones que en teoría tienen España y Alemania para resolver el problema.  Digo en teoría porque, tal como Pettis explica (y yo estoy de acuerdo), muchas de las decisiones y cruzadas políticas que son necesarias tienen una probabilidad casi nula de conseguir apoyo por parte de la población. [...]

KoRMay 31st, 2012 at 7:26 pm

Curt, this was wonderfully written. If the world were free of political ambitions and venality, corporate greed, and general human ignorance, your idea would have been surely adopted.

miwJune 2nd, 2012 at 3:12 am

Germany vs the Mediterranean Peripheral countries reminds me of the 1% vs the 99% rift in the US. The top 1% keeps gorging the surplus at ever increasing rate. And no escape hatch in sight for American masses. Does capitalism end like a monopoly game in the end? The world seems to need some economic paradigm shift.

ComparativadeBancosJune 5th, 2012 at 5:10 pm

Hi all,

what do you think about firing most of the politician that are working in Spain? Currently, we have around 450.000 people working in jobs related to public government while in Germany we can find around 100.000 having double population.

We have made a rough calculation of actually doing this, http://www.comparativadebancos.com/rescatemos-esp… and the NPV of the operation could be enough to cover spanish debt and also to modify some major fiscal problems we are affording and that are against growth.

What do you think?

cantuesoJune 8th, 2012 at 2:28 am

This is comic relief, ¿sabes? It helps to lower tensions. Did you learn English in Marbella?

cantuesoJune 8th, 2012 at 2:40 am

It also feels that way, i.e. that the real winner is Spain, and it still looks that way, maybe depending on where you live. Those highways! Bridges! Speed trains! Airports! (And those interminable lines of little houses: but those have already started to look a little sinister.)

I think Pettis' view has to be read more as a prognosis

diatoo1June 11th, 2012 at 8:33 am

Way no. 4 to increase the competitiveness of the states in the periphery against Germany would be, that Germany introduce export taxes varying from industry to industry and country to country. It would also help Germany fiscally to finance support for the Euro zone.

JulesJune 13th, 2012 at 10:34 am

The root problem of this crisis (and indeed the world crisis seen from 2008) is the “economy of growth”. It should not come as a surprise that the economies that grew the most during the boom years ar the worst hit. The fact is that economies should be steady state unless new resources (physical, predominantly energy) become available (say using extra terrestrial resources… solar energy from satellites, there is lots of it, but we have no infrastructure to harvest it now). Ultimately there is no activity without energy, and the oil production peaked and plateaued in 2005 leading the the growing crisis we’ve seen. Growth is not the answer. Growth (or the prosmise of growth) is why such debts were built, because of the promise that the future economy would be able to pay for the money borrowed now. The entire economic system needs to be overhauled. Germany is of course not immune to this. The weakest links in the chain were hit first, but eventually the absence of global growth will be felt by all who expect continued growth. The current growth in China and India is only possible because of the economic crisis of the west which has freed more resources than the size of their economies at the time were able to absorb, but as their growth continues we will hit again the ceiling of limited resources. This crisis will not be over soon. Cuba is in the best place right now to ride it out because they had to curtail their own growth a long time ago thanks to the loss of the soviet oil and the embargo (ironically enough).

Right now, the only direction availabe to growth is in space, but it will take decades to build the infrastructure to make it possible, and it’s likely that space activities are going to be the first victims of the crisis. Therefore, it is urgent to rethink the entire economic system. Growth is NOT the answer. Growth on a finite planet with finite resources is the root cause of the problem. Without new resources growth cannot go on.

JordiJuly 15th, 2012 at 11:36 am

Greetings from Barcelona. I can confirm that the capital flight is accelerating fast. Middle class families are starting to move funds out of the country. I work as an independent accountant and half of my clients (taxi drivers, consultants, doctors) are requesting information on how to open a bank account in Germany or France.

Many have transferred all their savings abroad (maybe not far enough), and the trend continues.

I expect long queues at the banks in Perpignan and a very hot summer!

Spanish lawyerJuly 16th, 2012 at 5:41 pm

We´re not leaving the eurozone. Spain is a great country. We were the kings of the world some centuries ago when the USA dind´t exist yet. We recieve each year millions and millions of tourists, we´ve a grat agriculture industry also fishing, we´re the link between various continents, so if you think spain is a weak country you really don´t know who spaniards are. There´re some people interested in eurozone collapse, but the truth is that the world cannot asume more dollars, and thats the real problem, if the euro survive the dollar is dead.

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