Spanish Prime Minister Mariano Rajoy’s economic policy is in tatters. Spain’s economic descent is now accelerating, with output shrinking 0.7% in just the last quarter alone – the worst since crisis began in 2009. For the full year, output has fallen 1.8%, retail sales have plunged a remarkable 10.7%, and vehicle ales have fallen 17%. This is diastrous. This is Greek-style debt deflation.
The Spanish cannot say they weren’t forewarned. Those who understand how an economy in a credit crisis works knew his plan was going to be disastrous. And so it has been.When Rajoy was campaigning for office, he was quite clear about what he planned to do. And he was elected anyway – with a sizeable majority to boot. Clearly, the Spanish have no one to blame but themselves.
But, we’re here now. The question is how this moves forward. First, I want to posit a thesis about the European crisis countries. On the one hand, there are smaller, export oriented countries like Ireland and Latvia, which are highly dependent on external trade and money flows. Then, there are larger economies like Spain’s which have a more sizeable domestic economy relative to their external trade and money flows. Because all of these economies have fixed exchange rate policies as part of the euro system or desire to join the euro system, external devaluation vis-a-vis trade partners is a route to growth that is not available. Instead, all of these countries have had to implement internal devaluation strategies via harsh wage and spending cuts in order to regain external competitiveness.
Ireland and Latvia, because of their small size and dependence on external flows are much more able to pull this off. Internal devaluation is a bigger boost due to the importance of the external sector and their small size makes the changes and the emigration abroad easily absorbed by their much larger trade partners. Spain, on the other hand, cannot benefit as readily from these factors. And so internal devaluation is even more destructive economically in Spain than it has been in Ireland and Latvia. That’s my thesis. And what it means for Spain is that it was never going to become the next Ireland. Instead, it has always been at risk of becoming the next Greece.
The latest numbers out of Spain suggest that the pace of economic decline accelerated somewhat toward the end of 2012. And this should put downward pressure on house prices. You have to remember that, at least according to the Economist, house prices in Spain are still modestly overvalued. So the fall in economic output, income, and in residential rents should cause Spanish house prices to continue falling. We could see another 20% down from here given these factors.
If you recall, the stress associated with the housing market was one of two principal reasons I believe crisis will return to Spain in 2013:
“My view is that the combination of house prices declines and austerity will be too much for the Spanish private sector to bear. I believe the contraction in consumption and GDP to support balance sheets will be larger than is commonly assumed. And this will mean Spain misses its fiscal targets. Moreover, I also believe that the still accelerating house price declines will mean that Spain’s government will have to contribute more to recapitalise its banks than is now assumed. And so this combination will make Spain vulnerable to a spike in interest rates, causing the country to seek protection under the OMT umbrella by formally requesting a bailout from the Troika with ECB monetisation support:
Now the second reason I see problems has to do with the local governments. We see governments like Galicia’s funding itself. But we also see much more important governments like Catalonia’s needing yet more bailout money from the Spanish central government. Yields are low as risk seeks return in a world of low rates. And that makes it easier for borrowers. Nonetheless, we do have to mindful of Spain’s need to support local governments as the recent Catalonia aid request makes clear. Spain is by no means in the clear on the municipal and state debt problem.
Euro watchers need to watch Spain closely. The government has already pulled off the largest deficit reduction in the last 25 years. But it still wasn’t able to hit targets. I expect the same for this year, given the negative feedback that deficit reduction has on private demand and tax receipts. GDP is falling an accelerated pace. Housing is still falling. And more bank and municipal bailouts are likely. The macro fundamentals in Spain are weak. Spain needs to apply for OMT support and it needs to do so before another flare of the sovereign debt crisis kicks in. If Spain delays and crisis re-emerges, we should expect Portugal, Italy, and France to all be critically affected by contagion. Greece will remain in the dumps and Ireland may be able to decouple.