What's being cut in Spain?

You may have read about budget cuts in Spain. Where do they fall? Over at nada es gratis, a great econ blog (in Spanish), FLORENTINO FELGUEROSO has a great post on "Bread and Circus". R+D is going down; this matters for the hard sciences. In the humanities and social sciences? Not sure. Research grants from the Research/Education/add renaming exercise here Ministry were always so small you needed a microscope to see them... largely independent of the merit-points in the academic evaluation, or the amount one requested. Apparently, the time-honored distribution rule was "cafe para todos" (coffee for all). You see, discrimination based on quality is inappropriate. So, to be honest, this won't make much of a difference to the quality of research that I see going on here; funding was a joke long before. All the serious money comes from the ERC anyway these days, at least in economics. Job training is also being cut, clearly part of a cunning plan in a country where unemployment is pushing towards 25%. And what's going up by 13.6%? Payments to the state's sports agency. No joke. Apparently, they are taking on some new responsibilities, too, so this is not quite comparing like with like, but it is still... pretty depressing.

All of this reminds me of an old joke by American comedian Evan Esar, who said "America believes in education: the average professor earns more money in a year than a professional athlete earns in a whole week." Let's do the numbers for Spain. The country's soccer clubs dominate the international leagues largely by paying what it takes, and buying the best, like Cristiano Ronaldo (Brazil) - current pay $17.06 million -- and Lionel Messi ($ 16 million). Average pay at Barca and Real Madrid is now $ 7 million p.a. Most professors would be hard-pressed to earn €45,000 a year. So the equivalent calculation to Esar's quip is even worse: "Spain believes in education: It pays the average professor more money in a year than a soccer player earns in three days of hard work." 

The News From Spain

can drive you insane...via BBC:

Spain's jobless level hits record 4.75 millionContinue reading the main story

The number of Spanish jobseekers rose for the eighth month in a row in March to hit a record 4.75 million.The Labour Ministry said the number of people filing for unemployment benefits rose by 38,769 with the services sector seeing the most jobs lost.

The jobless rate in Spain stood at 23.6% in February, according to EU figures released on Monday.
Meanwhile, Spain has said its public debt will leap more than 10 percentage points this year to 79.8% of GDP.

Of course, if you are Eurocrat or a finance ministry official, you will think that austerity isn't failing, it just hasn't been tried long and hard enough.

Sex and the Banker - Aristophanes edition

In Aristophanes' Lystrata, the women end a war by withholding sexual favors. High-end Spanish hookers are now using the same idea, exploiting bankers' libido as a pressure point to get the economy moving again. According to news reports, the assocation of luxury sex workers has decided that its members should not offer services to bankers until the country's financial institutions start making loans to families and small- and medium-sized companies... let's see if it works better than quantitative easing.

Unrest and Bond Yields

via Euronews

Trouble is - if a country descends into anarchy, the best plans for reform don't help you much. The bond market today definitely got worried, with Spanish 10-year yields pushing towards 5.5%. Not everything the markets do is rational (remember those rallies in Greek bond prices after each summit?), but this reaction has some good analysis behind it. Woo (1983) for example showed that countries with greater frequencies of strikes and other forms of unrest have bigger public debts -- a clear sign of an inability to cut expenditure and raise revenue in societies at the verge of fracturing. You can see how this kind of reaction can lead to a self-reinforcing downward spiral, with uncertainty undermining growth (a la Bloom), lower growth causing lower taxes and bigger deficits, resulting in more austerity (reinforced by some extra finger-wagging from Brussels and Berlin), and then you get round again with some more unrest plus so much less growth that the deficit actually goes up (as per the new and instant classic Delong + Summers paper). The final result? Greece. I don't think the probability of Spain ending up there is high, but give us half a dozen incidents like today, and the chances will go from, say, 5% to 25%.

my Spanish elections review...

on Bavarian radio [in German].

decision time

In August, I gave an interview to Der Spiegel, saying that the Euro can't last another 5 years in its current form. At the time, many people thought I was nuts. Now, some 3 months later, it looks as if the beginning of the end is near. Yields on AAA-countries like Austria are moving up. Bloomberg reports that Spanish 10-year yields are now above 7%. That's not a catastrophe just yet - Spain can pay a bit more interest, and the debt profile isn't that short-term. But if it lasts any length of time, this is going to be very painful: Higher interest rates mean that the country will need more austerity measures to keep the future debt path under control; output will fall yet further; yields may increase even more. It's now abundantly clear that the last rescue package was a disaster on a monumental scale - forcing a 50% haircut on the private creditors felt good, but now everyone is asking who will be next. If all the promises over Greece were worthless, is the same true for Spain and Italy? Of course; they are too big to rescue outright. The only solution is to convince the markets to keep buying. It's a confidence trick that makes the markets work; once confidence goes, the spreads explode. The more people worry, the higher the yields, the higher the collateral requirements, the weaker the banks.

As the ECB tried to tell politicians for the last year - sovereign bonds are too important as a risk-free asset in the financial system to mess with them. The only solution now, to avoid defaults of Spain and Italy in the near future, is to offer a blanket guarantee of all existing EU debt, incl. Greece; undo the haircut on Greek bondholders; and introduce unlimited bond-buying by the ECB. I won't like it any more than the average German, but there is really no alternative short of a wholesale implosion of the weaker Eurozone economies.  

at last...

someone is thinking about the mountain of unrecognized losses in Spanish banks due to bad real estate deals, and the need to recapitalize. Bloomberg runs a story that the PP - poised to take power in Sunday's election - is preparing either a bad bank solution or will force capital injections. The latter (especially if done right - break up some of the bigger banks) would be a sensible step in the right direction... but my money is that there will be a half-botched bad bank instead, with taxpayer money dropped on the banks in exchange for some vague hope of starting lending again.

Europe's spectacular own-goal

The latest Euro summit was meant to build a firewall around Greece, and to isolate it from the other weaker members of the Eurozone. One week later, it is clear that this has failed spectacularly. Yields on Italian bonds are rising; the IMF has now been called in to monitor the budget. What is going on? Why does even the extended bailout fund not do more to stabilize investor confidence? The truth is actually very simple. The 50% "haircut" imposed on the private sector lenders to Greece is a gross violation of everything that European politicians promised until a few months ago. That's a bad way of reassuring investors.

Remember all the claims that no member of the Euro zone would ever default? That speculators betting on this would go bankrupt? That there would be no touching the creditors before 2013? All of this has gone out of the window, as a result of an ugly display of political strong-arming. Just as Germany's first post-war Chancellor Adenauer once said - "what do I care about the rubbish I talked yesterday". True, the politicians had the banks over a barrel; Ackermann could not say no to Mrs Merkel when she insisted on this voluntary write-down. But the obvious implication is that all other promises and declarations are equally empty - that bondholders of Spain and Italy might find themselves in exactly the same spot as the ones who hold Greek paper. Guess what? If you know you can lose up to 50% (up from 21% just 3 months ago -- latest update in November - Greece would now like to default/"voluntarily restructure" 75% of its debt in NPV terms), you don't feel that confident. About anything. How this was meant to solve the deeper crisis is anyone's guess.

With the benefit of hindsight, it's pretty clear that Europe should have just written an XXL-sized cheque for Greece a year ago. The Financial Times Germany is citing a few economists - Aghion, Alesina, me - saying precisely that. Austerity isn't working, and won't work. A single bad day on the exchanges destroys more value than all of Greece's external debt. Yes, Greece don't "deserve" another penny, but that's not the point. Europe has to do what is right for itself, without worrying about moral hazard (let's be honest - how many countries would want to follow the Greek route even if they get a big cheque?) It's time to switch from moralizing and punishing to actual crisis prevention.

The "transfer problem"

Larry Summers today wrote an interesting piece for Reuters. His first point - worth considering - is that the German obsession with wrapping the private sector's knuckles and enforcing discipline is overblown + dangerous. It is, indeed, what many thought before Lehman, and that one didn't end well. The second point he makes is about the chances of Greece actually paying up. Summers says "...no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors." Of course, if true, it also means that countries cannot credibly run up sizeable foreign debt positions. Pointing to Keynes' famous point in the Economic Consequences of the Peace, he argues that transferring so much money abroad is simply politically infeasible.

If I get my numbers right, Greece would have to produce primary surpluses of 5-10%, to be transferred to the rest of the EU (in the main) for the next 20 years or so. Of course, many regions in Europe transfer this much to other regions -- but not in exchange for past goods + services received, contrary to the Greek case. One example, close to home? Catalunya. One of the most productive regions in Spain, it is currently sending approximately 9% of its GDP to the rest of the country. Of course, Catalunya is not a separate country, but part of Spain, and all the taxes for which its citizens get precious little payback were not exactly embraced enthusiastically. But pay they do, regardless. This simply shows that open revolt need not follow on the heels of high transfers of a region's riches elsewhere; it depends on the way this is sold to the population. Catalans, while grumbling, are on the whole remarkably placid on the issue. What surprises me is that, in contrast to the rest of the Europe, where regions with their own culture + language are normally "bribed" to stay, Catalans end up paying for being part of a larger entity they do not much care about. Perhaps they should take some lessons from Southern Sudan, and sign up George Clooney to push their case internationally...

If you really want to know

what is going on in the Spanish economy, read Edward Hugh [long post].

tea leaves reading hour

How much economics can you get out of a single graph? Here's is my entry: The Economist has a chart for salary expectations of graduates. Not many surprises there - Swiss grads expect more than those in Poland. More surprising - women expect less than men, but hey, they do earn less. They are just realistic. Then my eye wandered to the entries for two countries close to my heart - Germany and Spain. First of all, the Spanish graduates all expected starting salaries LOWER than the national average salary. Pretty much everywhere else, that's not the case. Note that educational attainment has risen quite quickly in Spain in recent decades, from a low base. That means that the average university graduate is comparing himself with a salary paid to people whose educational attainment is really quite low -- and they still think (and probably will) earn much less. The college premium? None in Spain. Truth be told, much of the university education here has consisted in handing out pieces of paper to people who sat in overcrowded lecture theatres long enough to lower the reported unemployment rate. There they were often taught by people with a degree from the university where they are now teaching [no, that's not UPF economics - we never hire our own doctoral students, and class sizes here are small]. So education mostly doesn't pay. That mainly because it's lousy on average, and the selectivity of higher education is so low that there is no premium in Spain.

Then I looked at the national wage rates for Germany and Spain -- the difference is factor 2! Now, Germans are more productive per head (and much more productive per hour - working hours in Spain are pretty long). But the ratio is off. A quick check confirms what I remembered: Spain is about 3/4 as productive per head as Germany, and not 1/2. That's another way of saying that, per unit of output, Spaniards earn less. How come? Normally, you would think that having low wages relative to output would be great for growth - profits should be high, and growth should take off. But not so fast.

The reason why the pay difference is large probably reflects two things: First of all, there are lots of side payments in small-and-medium firms that are not reported ("the envelope" with black money). This is a major source of inefficiency. The big firms can't and won't engage in this practice, which means that their wage costs are higher -- to get workers, they have to fork out more. The uneven tax cheating is driving employment into the inefficient small firms. Second, if the ratio of wages to output is lower than in, say, Germany, then someone must be getting the rest. Normally, that would be profits. Part of it is, I am sure, just payments to fixed factors of production, like rent... those silly prices for land, again. Finally, returns to entrepreneurs and the self-employed may be higher, but possibly not for the reasons we might like. Entry regulation etc has something to do with it. Spain is not exactly home to a large number of small + medium, world-beating companies. Most produce for the home or regional market. The reason why they are in business at all is that they know how to navigate the local forest of regulation and connections - and not higher efficiency. The political cast conspires to keep competition out, from the national level down. The country has one of Europe's most uncompetitive phone- and internet-markets (all those well-connected board members at Telefonica); there is a blatant breaking of EU competition rules when it comes to takeovers (remember EON's attempt to buy a utility in Spain?), etc. All of this shows up as profits somewhere, but it isn't exactly good for the economic performance of the country. This also suggests that "pay restraint" isn't the first thing to think about when it comes to restoring the country's economic vigor.

Screw up now, enjoy later

Today, there are demonstrations in Barcelona and across Spain against "the political class, the crisis, and the fact that people who lose their house because they can't pay the mortgage still owe something to the banks..." or so my cabby explained. The last bit is interesting. Dación en pago, the idea that someone who borrows on mortgage can just hand back the keys, has become the fantasy of many Spanish house buyers who are faced with negative equity. In the US, this happens a lot; many states allow the practice. In almost all European countries, including Spain, it's a no-no.

So who is right? It's actually not very hard to think through the consequences. Allen and Gale have a beautiful paper that looks at exactly this kind of thing. It's called "Bubbles and Crises". The idea? If you have a "stupid" bank that, on average, loses money, its lending is likely to create bubbles galore. The reasons is risk-shifting. If you borrow to buy an asset, and it goes up in value - bingo, you are rich. If it goes down, you just hand it back to the bank. Since none of your money is at risk, you can't lose. How much of that asset do you want to buy? Me personally, a lot. Sign me up. Actually, double that. And so on. Of course, this creates price pressure upwards... The downside of the model was that it required a stupid bank that lost money on average. But if there is one thing we have learned in the last 10 years, it's that there is no shortage of stupid banks. So, while handing the keys back to the bank and cancelling all debts sounds nice ex post for those who got themselves mortgages that were too big relative to their incomes, it is really, really bad policy. The depressing thing, of course, is that given how loud vox populi is, it is not impossible that someone somewhere will want to garner some votes by changing the rules.

The bright side of the Irish crisis

These days, it is easy to remember why economics used to be known as the "dismal science". The EU finance ministers are meeting today, to put the fine print for the Irish rescue package together. One European bailout is following another; growth is mostly poor, and even where it isn't, output is not returning back to trend; and unemployment is stubbornly high. News that the last big private Irish bank was being nationalized last week seems like a small wrinkle. And yet, one can think of this detail as possibly a first ray of sunlight.

Whenever the future of the Euro is discussed, the practical difficulties of leaving are pointed out. In particular, as soon as there is a good chance that a country might leave, its banks will face a massive run on deposits; converting assets and liabilities into the new national currency will be tricky, as any mismatch will zap bank capital. But how do these problems look in a country whose banks have blown up already? Where the capital injections for the banks are so gigantic that they more or less double the national debt? And where banks mostly live on liquidity support from the rest of Europe? That place is Ireland, and somewhere, someone is hopefully thinking what I am thinking -- this is the time to get out.

The euro was a gigantic mistake in the first place, a vainglorious triumph of politics over sound economics. When the financial crisis broke out, the Queen famously asked during a visit to the LSE - why didn't anybody notice in advance? On this one, for once, many economists were actually acutely aware just how bad an idea the euro was. Barry Eichengreen wrote many articles and a book warning about foisting a new gold standard on advanced economies with massive nominal rigidities. Nobody listened.

Ireland will have to suffer massively in years to come as it is for the folly of its bankers and the stupidity of its housing bubble. It will have to live with IMF-EU imposed austerity. Why not try to get something in exchange for all that pain? A new Irish pound, introduced overnight, would quickly devalue and restore Irish competitiveness. An independent central bank could set appropriate interest rates while anchoring inflationary expectations. The banks would still have to struggle with potential asset-liability mismatches, but the problem cannot be large compared with the capital injections necessary already. And depositors have been taking their money out already. Once the new currency is in circulation, they can put it back in, as there is no uncertainty about the Irish future of the euro left.

What would this do to the rest of Europe? An Irish exit from the nightmare that the euro has become would surely see Greece, Spain, and Portugal leave, too. Depositors there would run on their banks to get euros out while they still can. Banks in some of these countries are healthier than in Ireland; an Irish exit would impose some real costs on the Club Med. And yet, much of the "health" of Spanish banks is illusory anyway, as it depends on fantasy valuations of all the brick and mortar on their balance sheets (something that the Bank of Spain is increasingly concerned and unforgiving about). A quick exit may still be better than a decade of slow, grinding deflation combined with Zombie banks and Zombie household balance sheets being kept on artificial life support before the inevitable rise in interest rates at some point pulls the plug.

When Britain left the gold standard in 1931, the governor of the Bank of England famously declared (having been aboard a ship and out of contact when the decision was made): "I didn't know we could do that." Leaving the euro may seem similarly unimaginable to many, but it may be just as feasible. In the 1930s, cutting the link quickly led to a recovery of demand, by reducing deflationary pressures. Far from the shattering blow to confidence feared by many, exiting the gold standard was actually great for business. Leaving the euro may be every bit as good.

A very accurate real estate idiot ranking...

goes live over at IDEALISTA. What is a flat or house worth? Whatever the value of having a roof over your head is... discounted to the present. Economists look at variables like the average rent to average house prices, and if the ratio is very low, you can normally be sure that the adjustment (back to its long-term average) comes through lower prices, not higher rents. The reason is that rents get paid out of current income, and house prices can be sustained by someone selling his house and buying a bit of extra house elsewhere... without ever being able to afford the price of the new one if he had to finance it all. In Spain, rental ratios were laughably low for some time, around the 2% mark. In the US, we are getting back to numbers around 3.5-4.5%, which seems about right; in Germany, the current ratio is 5-7.5%, meaning that rents are high relative to prices (mainly because prices are low).

All these comparisons are normally a bit doubtful because you have to believe that the average house for sale is like the average house for rent. That may or may not be true, and depends on rental law, etc. But sometimes, you can get it 100% right -- if the same house is available for renting or buying. That is what the good folks at Idealista have used to compile their list. Most of the owners listing their properties at these prices are clearly smoking something interesting -- a house in Asturias (listed without pictures) is for sale for 2.5 million €, or 2,500 p.m. Wow, that's a rental yield of 1.2%! Even the house ranked 80th (from low to high) only produces 2.66%. I would say two things. First of all, Robert Shiller must be right -- you have to believe in behavioral explanations to understand these owners. Second, the extra-slow-motion-deflation of Spain's housing bubble has a long way to go...

Spain keeps shrinking

Spain is much in the headlines these days. Markets worry about the PIGS (Portugal, Ireland, Greece, and Spain) not being able to meet their obligations. Paul Krugman has been pointing out that the cases are very different -- that Greece lied and cheated its way into EMU is well-known, as is the fact that its fiscal policies have been utterly irresponsible for as long as anyone can remember. Spain, on the other hand, had a surplus not that long ago, and its overall debt is still less than Germany's. The problem is not fiscal recklessness, but a massive real appreciation following EMU that left the economy largely uncompetitive on world markets. Institutions - labor market institutions in particular - are not up to dealing with this kind of problem, and the time-honored solution of the good old peseta days (devaluation) is no longer on the table. Now, news from the last quarter of 2009 shows that in contrast to almost all other OECD countries, Spain is still shrinking. I was particularly amused to see the folks over at Marketwatch reporting that

"Analysts at Capital Economics said Thursday's GDP data backs up the theory that a return to solid and unsustainable growth in Spain is unlikely anytime soon."

As typos go, this one is just wonderful. I am sure they meant sustainable, but... there is so much that was utterly unsustainable about the boom in the last 10 years that one doesn't even know where to start. Building houses that nobody wants to live in, at prices no-one is willing to pay, is my #1 on the list. It also sums up nicely the problem -- the old growth model post-1999 won't work, and there is not much of an alternative in sight. The government keeps saying R+D will pull Spain out of the crisis, but that is like Greece saying that a closer look at its national accounts show a massive surplus.
This relates to another of this week' highlights: Tim Kehoe was giving here on Tuesday, giving a talk at the Barcelona GSE about lessons from the Great Depressions of the 20th century for the Spanish financial crisis. He compared Chile to Mexico, and (not entirely surprisingly) blamed divergent fortunes on the ill tidings brought by wrong-footed government intervention in the latter. A case that is not in the book that he edited with Prescott, which I think could have provided a more appropriate analogy, is interwar Britain. Britain re-entered the gold standard in 1925 at an overvalued exchange rate, hoping that the currency regime would provide "discipline" for the last 10 percent of factor cost adjustment vis-a-vis the US. Instead, it got sub-par growth while everyone else enjoyed the roaring twenties... By Kehoe's reckoning, Spain's unit labor costs are now about 135% of their 2000 level, while Germany's are at 110%. While unions were powerful in interwar Britain, I am sure they are more powerful in Spain today. There is none of the grim determination to regain competitiveness that I saw in Germany over the last 20 years, after the reunification boom and debt orgy produced a sharp decline in competitiveness. My sense is that a lost decade or two for Spain are beginning to look more likely by the day. And who knows? When Tim Kehoe presents the Catalan edition of his book in a few years (he actually speaks Catalan), there may be a chapter in it on the Spanish depression of 2008-2018.