Now that Standard & Poor’s has downgraded, for the second time this year, Spain’s sovereign debt rating to AA with a further downgrade is possible, I think that there is serious trouble brewing everywhere among the “Club Med” countries and Ireland in the euro zone.
First of all, we must admit that the weak points of the euro zone have now come to surface.
One of them is that it has not seen among its member states the conversion of economic growth and performance it aimed for at the inception of the monetary union.
Instead, we now have a situation where, because of the lack of structural reforms, we are at a point where it becomes clear to the world there is no euro zone fiscal convergence and the euro zone countries’ lack of fiscal discipline and its rules only exists on paper.
This not only concerns Greece but essentially everybody because they all went beyond the euro zone’s 3 percent deficit target and the 60 percent upper limit on debt to GDP ratio.
Looking at the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain), they all face now a double problem of: public debt and deficits that are very large and potentially unsustainable and therefore they all will have to execute massive and painful fiscal adjustments, and secondly, they now also suffer from a persistent loss of external competitiveness and consequently of economical growth.
Since, and that now goes back for practically about a decade, all their unit labor costs have continuously risen more than their productivity, which in turn has caused them the loss of competitiveness to, of course, China and other countries in Asia and other emerging economies but also to countries like Greece’s neighbor Turkey.
This situation manifests itself in their large current account deficits that are in the 10 percent range and that now also have caused an accumulation of large amounts of foreign debt of the private sector alongside the well-commented mountains of public debt in Spain, Greece and so on.
Even if Spain and all its peers were able to execute a severe debt-fiscal adjustment, the multimillion dollar question becomes how they’re going to restore competitiveness.
That brings us to the dual problem of, from the one side, they need a “real depreciation” while they are boxed in with the euro, and, on the other side, simultaneously they need a “conditio sine qua non” implementation of fiscal austerity.
In simple words, this situation is a mess where they will have to raise taxes and cut spending that, at least in the short term, will also cut output whereby reducing debt will practically become “mission impossible.”
By the way, that “mission impossible” situation was the vicious circle that crippled Argentina between 1998 and 2001.
That said, for Spain and its peers, restoring competitiveness and having a real depreciation can only be done in two ways.
One choice is “deflation’ with prices and wages falling for something like five years or even more. Nevertheless, we should not forget that deflation is also associated with economic recession and, let’s be honest; there is no political body or any “homogeneous” society in the whole world that could or would accept five years of deflation and recession to achieve that necessary depreciation.
It’s important to keep in mind that the European Union and neither the euro zone represent a “homogeneous” society and certainly could not be called the United States of Europe.
So, coming back to Argentina, they tried to deflate themselves out of recession for 3 years and then, in 2001, they had to give up their undertaking and had to default and devalue their currency.
Now, in my opinion, Spain is for many reasons a bigger problem than Greece.
It’s true that Spain’s budget deficit and public debt is less than Greece, so, in that sense, they are better off than Greece. But it has formidable negatives.
As we all know, they had their housing boom, bubble and bust and now they face the severe collateral damage on their real economy that continues to cause huge financial losses to their financial system because of the still rising non-performing loans which result in a huge fiscal cost for bailing out the “Cajas” and the banks.
Besides that, all this is taking place at a moment when Spain has 20 percent unemployment (Greece has actually “only” 10 percent of unemployment).
Yes, and last but not least, the “real” appreciation of Spain and its consequential loss of competitiveness over the last decade were even bigger than the ones we have seen in Greece during Spain’s decadelong housing-boom years when wages in the housing and construction sectors were growing significantly faster than productivity.
Of course, we shouldn’t overlook the fact that Greece only represents 3 percent of the European economy (GDP) while Spain is the fourth largest economy of the European Union, after Germany, France and Italy.
If you ask me, Spain is therefore in many ways a bigger problem than Greece.
Looking at the international community and judging it by its acts, I would say today that, so far, it is “acting as” and “pretending that” Greece has only a problem of “liquidity” and not a problem of “solvency.”
The IMF, the European Commission (EC) and the European Central Bank (ECB) are getting ready to put money on the table for Greece whereby they in some way implicitly say: “We give you the money, you do your fiscal adjustment, you execute your austerity plan, you perform the necessary structural reforms and you dig yourself out of that hole where you’re in now.”
They know there is little chance this is going to work but, they also know that today, Greece is too interconnected to be allowed to fail (default) because that would probably occur in a disorderly way on top of all the problems that are already there and the losses for the international financial institutions that hold Greek debt would be huge and come on their books practically instantly.
The contagion for Spain, Portugal, etc., would be really big. Therefore the international community prefers to kick the can down the road without resolving anything while hoping that things in a year from now will be better.
The reality however is, if this a solvency problem instead of a liquidity problem, which in my opinion it is, kicking the can down the road is “only” and nothing more, going to be another waste of public resources.
As long as “competiveness” is not restored quickly and in an efficient way things cannot become better before they get worse. Where such a situation could end up is everybody’s guess but it certainly wouldn’t be constructive for maintaining the euro-zone as a whole in good health. Investors should this keep on their radar screen.
The only quick and efficient solution I can see, at least for now, is allowing a firmly lower euro that could even go to parity with the dollar. Why not? The euro has been there before. All European countries would profit from it, including Germany.
Now, as an investor I would use any knee jerk (upward) reaction of the euro as an opportunity to sell it.
Don’t worry, times will come back when you will have plenty of time to buy back the euro, as you should do as a long term investor, at much lower prices when the competitiveness of the euro member states will be in much better shape than it is today.
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