Will The Spanish Economy Ever Recover?

Of the four largest Eurozone economies, Spain is enjoying the strongest recovery with real growth rates topping 4% in the year leading up to Q2 2015 yet output remains substantially below pre-crisis levels and GNI/capita at PPP is only $32,860[1]. This figure is 15% below the UK’s levels, about $2,000 less than Italy and a third less than the average German’s income. Thus the obvious question is whether Spain will continue to cut this gap or will she confront serious economic challenges in the foreseeable future?

The unemployment rate of 22.4%[2] is the most concerning challenge that the economy faces since it has been a long running issue: the pre-crisis trough was still above 8%. Considering consumer confidence is at a 15-year record high[3], private consumption is expected to continue to grow close to 3%/annum and exports are 10%[4] higher than the 2007 peak, it is fair to conclude that supply-side issues are to blame for the high unemployment. Despite reforms in 2012, labour regulations remain too rigid, especially over permanent contract severance packages. Recent figures released by the Spanish Ministry of Employment reflect these concerns since out of the 4m contracts signed in Q1 2015, 91.7%[5] were temporary, a quarter of which lasted for less than a week. This, in turn, may hamper longer term growth prospects as consumption may stagnate owing to reduced job security and the low-paid nature of temporary jobs. According to a European Commission report from February 2015,  fixed-term employees typically earn 16%[6] less than their permanent counterparts even though, according to the “bonding argument”, employers hand out lower wages for permanent contracts owing to the expected dismissal costs. In addition, excessive temporary employment also damages earning potential via another mechanism; there is a lack of investment since there is little incentive to pour resources on temporary employees.

The recent depreciation of the euro is set to continue owing to the removal of the Swiss central bank’s franc ceiling against the euro, the ECB’s €60bn monthly asset purchases and divergent monetary policies with the UK and US. Moreover, the €400bn current account surplus in the Eurozone may weaken the currency further since it is a result of high savings not high demand for European exports and thus the implied capital outflows play a larger role in the exchange rate process. The depreciation may reduce the need for further investment as it masks a lack of competitiveness; Spain is 35^th in the international competitiveness rankings published by the World Economic Forum, not even in the European top ten. To make matters worse, there is also a strong risk of hysteresis, despite figures showing increases of over 12%[7] in productivity, since 53%[8] of those without a job have been in that situation for over a year, 18% above the OECD average, damaging potential growth severely.

Over-indebtedness is also a pressing issue for Spain in both the private and public spheres. Household indebtedness is over 130%[9] of gross disposable income and 4m Spaniards find themselves on a credit blacklist run by ASNEF. The full recourse rule has exacerbated the problem by prolonging the effects of the sub-prime mortgage crisis since the remainder of loans must be repaid despite homes being repossessed. This alongside low-paid short term contracts and high unemployment has disrupted the flow of credit towards consumers. Lending has continued to disappoint falling 2.7% in the year leading up to June 2015 despite Spanish banks sailing through the ECB’s stress tests in October 2014 with only one bank failing initially to meet the capital requirements. Lending volumes to consumers have not only been weak but business lending has also fallen 5.7%[10] in 2014. Again this has to do with over-indebtedness since the Spanish non-financial corporate debt pile, as a percentage of GDP, is 10%[11] higher than the Eurozone average. Thus the deleveraging process, that sprang into action after the 2008 crisis, has not yet been completed explaining why investment has been so sluggish in Spain with gross fixed capital formation still 35% below the 2008 peak.

The government debt pile is as large as the economy, 15%[12] above the OECD average and 35% above the world average. To make matters worse, half of it is foreign owned increasing the cost and volatility of the debt pile. The Eurozone has been confronted with deflationary pressures and in the year leading up to Q1 2015 experienced a 1.1%[13] fall in the price level. This will act to increase the debt burden which is particularly concerning since it is unlikely firms and unions wield significant price or wage setting powers owing to the high unemployment; as a consequence inflationary pressures are set to remain weak. Moreover, anti-austerity parties are starting to gain a foothold in Spanish politics demonstrated by  Podemos forming coalition governments in key regions such as Madrid and Andalucía. This combined with the victory of pro-independence parties in Catalonia has not gone unnoticed by the bond markets, with 5 year government bond yields doubling over the past 6 months, increasing the cost of servicing debt which represents a substantial opportunity cost. With Spain still running the largest fiscal deficit in the EU at 5.8% of GDP, she can hardly afford such an increase in expenditure especially when nominal GDP growth has been so disappointing over the past 7 years, with total output still 1.8%[14] below 2008 levels, meaning government receipts have risen only modestly.

Another troubling issue facing Spain is the nature of her demographics with her population declining since 2011 and expected to fall by a further 10%[15] by 2052, according to the INE. One reason for this is that Spain only has 1.32[16] births/woman with 2.1 needed just to sustain the population. The over-65’s share of the population is set to rise from 17% to 30%[17] by 2030 which , in turn, will put added pressure on the already fragile government finances. To make matters worse, recent retirees have earned more than previous generations and thus pension obligations will rise quicker than the rise in pensioners as shown by the fact pension costs rose by 3.1% last year despite only a 1.3% increase in retirees. Furthermore, the terrible job prospects in Spain, especially for the young, as half of under-25s are unemployed, has led to a ‘brain drain’ with the INE forecasting 500,000[18] are set to leave the nation every year until 2023. Not only will these demographic changes severely impair potential growth prospects but they pose another conundrum for the already decimated construction industry. Construction output fell from almost 22% of GDP to less than 10%[19] and the expected population declines suggests demand for new homes will remain weak. Significant slack already exists in the housing market, since there are over 0.5m[20] unsold housing units classified as new, compounding the woes for the construction industry. This is particularly concerning since the areas in Spain that experienced the construction boom have unemployment rates far higher than the national average suggesting occupational labour immobility. For example, Extremadura was one of the hubs of the housing bubbles but has since failed to recover with the jobless rate 10% higher than the rest of Spain.

Thus, overall, Spain is growing but precariously as high  unemployment remains a stark reminder of the structural issues that still need to be addressed whilst the debt mountain continues to obstruct consumption and investment. Finally, the danger of a declining population poses a serious threat to long term growth prospects but also living standards as pension obligations may become unmanageable and the most productive workers are leaving in search of employment opportunities elsewhere.

---

[1] World Development Indicators database, World Bank, 18 September 2015, p1

[2] Country Report: Spain, Economist Intelligence Unit, 11 September 2015, p2

[3] Ibid, p7

[4] World Bank

[5] Ministry of Employment (Spain)

[6] ‘Precarious and less well-paid? Wage differences between permanent and fixed-term contracts across the EU’ by Silva, Turrini (http://ec.europa.eu/economy_finance/publications/economic_paper/2015/pdf/ecp544_en.pdf )

[7] FT (http://ftalphaville.ft.com/2015/03/16/2121741/explaining-the-pain-in-spain/ )

[8] OECD: Employment Outlook Spain 2015

[9] OECD National Accounts Statistics (http://www.oecd.org/eco/surveys/Spain-Overview-2014.pdf), p13

[10] FT (http://www.ft.com/cms/s/0/f05e8cac-796d-11e4-a57d-00144feabdc0.html#axzz3n27KxXUT )

[11] http://ec.europa.eu/europe2020/pdf/csr2015/cr2015_spain_en.pdf (p31)

[12] EIU, p13

[13] Ibid, p7

[14] Ibid, p23

[15] INE

[16] World Bank

[17] Ibid

[18] FT (http://www.ft.com/cms/s/0/f7bdd5ce-995e-11e3-91cd-00144feab7de.html#axzz3n27KxXUT )

[19] FT (http://ftalphaville.ft.com/2015/03/16/2121741/explaining-the-pain-in-spain/ )

[20] Spanish Ministry of Public Works

Are the advanced economies in for a prolonged period of economic growth?

Real economic growth was spectacular for Japan in 1960s averaging over 10% and later 4.5% over the next two decades. Living standards in Japan rocketed as unemployment fell and disposable income rose culminating in increased consumption. By the late 1970s 99.4% of Japanese households owned refrigerators, more than in West Germany and France for example.

However growth slowed in 1990s, hovering above just 1% and falling multiple times into recession in the 2000s. Deflation has led to a large increase in people saving, since their money will be worth more in the future, which has caused consumption to fall reducing business opportunities. In addition, the Government has accumulated a massive debt of 220% of its GDP, its population is aging with almost 40% of the population over 55 and real wages are falling as well. Japan’s economy has definitely stagnated with investment, consumption and its population all declining. Is Japan an exception or a foretaste of what is to come?

In Greece, the economy has shrunk by 23% since 2007. Germany, the best-performing European nation, has had miserly growth of 0.7% over the last 6 years. Median real income in the US is below its level a quarter-century ago and median income for male American workers is lower than in 1970s. However, we should go back to before the banking system collapse in 2007-8 to see the full extent of the problems confronting these developed nations.

The graph above shows the growth rates in the UK and US compared to the global average.  Even though annual growth rates were relatively healthy in 2004, above 3%, the figures are below the global average and mask underlying problems. During the period up to the crisis, expansionary fiscal policy was adopted with the US and UK governments increasing their spending to boost aggregate demand. However, aggregate demand still remained sluggish even before the economic recession of 2008, where technology and housing bubbles were widespread. The ‘recovery’ has been long and stuttering with the UK, for instance, still failing to reach its peak output level of early 2008. There have been hugely aggressive attempts at stimulating the economy. In the UK, the Bank of England has kept record low interest rates of 0.5% and used non-conventional monetary policy in the form of forward guidance and quantitative easing. Yet growth and the recovery have been reasonably weak hinting at problems relating to consumption and investment since they account for 70% of aggregate demand in the UK.

            Firstly, to understand what is happening with consumption, we must look at real income, which in the United States has remained at around the same level since 1970 (graph below), which has a direct and large impact on consumption. Stagnant wages mean there is a ceiling on consumption, as most Americans simply cannot afford to consume more goods and services. Of course, there is always the option of borrowing and that is precisely what millions of Americans did resulting in household debt-to-income ratios reaching 150% by 2007 rising from about 100% in the year 2000. This means households owe more money than they earn therefore they will have to curtail spending in the future and hence consumption should fall. The period leading up to the crisis of 2008 where loans were easily acquired artificially boosted the US economy and its consumption. This hid the problems of stagnated real wages as people could still increase their spending relatively easily by getting a loan from a bank.

Borrowing may have boosted consumption in the short run but in the long run consumption would decline since debts needed to be repaid.  This problem of a lower average propensity to consume was exacerbated by the crisis of 2007-2008 denting consumer confidence hence making them more reluctant to go out and spend. Households were now intent on repairing their balance sheets.

            However, there is also another reason behind this sluggish consumption. This is income inequality, which is particularly of concern in the US where the top 5% of wage earners have taken 30% more of the total income since 1967. A growing gap is developing leaving a huge disparity in income as shown by the graph beside, impacting consumption since the lower income groups, who on average have a high marginal propensity to consume, now don’t have as much money so they spend less in total. Meanwhile the higher income groups with a relatively low average propensity to consume now have more money saving most of it. Overall, growing inequality stunts growth since effectively more people are spending less.

            Domestic investment in human or physical capital from firms has been on the slide with 67% of companies admitting that they are ‘underinvesting’.  This is a particular problem in the technology industry where Apple, Microsoft and Google alone have corporate cash reserves of $258 billion with almost no debt. This problem doesn’t only affect the USA, as capital investment is at a 15 year low in the UK. Moreover, according to Deloitte (professional services firm), a third of the world’s largest non-financial transnational corporations are hoarding $2.8 trillion in cash. This could be again explained by the lack of confidence in the economy, hence creating a fear to make long-term investments, as there is more perceived risk for the firm. There is no point building a factory to manufacture your goods if nobody is able or willing to buy them.

However, the graph above does demonstrate that firms started to hoard cash well before the financial crash of 2008. US non-financial companies’ cash and liquid assets rose in real terms from $700 billion in 1990 to over $1,600bn by 2004. This surely means that short-term confidence concerns cannot be entirely to blame and there must be some other issues within the economy.

Tax regulations disincentivize companies to bring back the profits earned abroad. They will be taxed (up to 35%) on it therefore they stick it in a bank abroad (60% of American corporate cash piles are offshore). Moreover, technology companies in particular don’t offer dividends on their shares. They believe it would appear like they were failing to grow as a business having to appease shareholders by giving them dividends. This in turn again results in less money flowing back into the economy with corporations just deciding to sit on the cash. These factors mean that investment will continue to fall and stagnate until the Government brings about some sort of regulatory change.

In addition, banks will not lend to businesses owing to the banks’ large debts, this means that there are fewer fundable investment projects. Moreover, firms that can afford to invest through retained profit, want to see banks taking the lead through lending, thus stimulating the economy reducing the risk of investing.

Consumption and investment in the advanced economies of the UK and US have been in decline even before the crash in the late 2000s. The crash merely put the issues into stark relief and highlighted the underlying problems that had started to brew in the previous century. This means growth will be limited in the future and therefore the economy will continue stagnate especially since government spending cannot make up constantly for the shortcomings of both consumption and investment.

Government spending, both as a part of GDP and as a total, is rising quickly. In the UK, government spending as a percentage of GDP has more than doubled since 2007. In the US, government spending has risen by 100% as a total from 2007. However, the governments recognise they cannot continue in this fashion with David Cameron, for example, deciding to adopt austerity measures to combat the growing debt and budget deficit. Many governments tried to save the banking sector; the Irish government guaranteed it entirely putting itself on the verge of bankruptcy, so now it cannot possibly adopt expansionary fiscal policy to manipulate aggregate demand.

            This means that government spending cannot prop up aggregate demand and the worst effects of stagnant consumption and investment may yet be felt. There is definitely a huge amount of evidence indicating that nations like the UK and the US are in for a prolonged period of economic stagnation. But is it all doom and gloom? Is there anything that could stave off economic torpor?

According to a classical economic view, the economy should sort itself out without intervention. A deprecation in the currency would make the countries exports more price competitive and imports more expensive. In the long run, the current account would improve by building surpluses thus boosting aggregate demand, increasing confidence as firms are selling more of their goods. They therefore believe there is more demand in the economy, so are more likely to invest. This then impacts AD again and causes a multiplier effect as firms start to increase their output, they hire more workers paying them wages, who then can afford to consume more goods, in turn leading to more output.

            Moreover, an economic downturn should lead to nominal wages falling as there is less demand for goods and services and therefore less derived demand for labour. Prices would fall restoring the demand within the economy. The fall in wages and currency deprecation should restore the economy to its original position…in theory.

            However, Britain for example is still running current account deficits year on year despite a depreciated pound, most recently at 3.8% of its GDP in late 2013. The USA is not exempt either with a deficit of above 2.5% of GDP. This can be explained by the types of goods the UK and the USA imported and exported. As the economies develop, their products become more sophisticated. Therefore their main trading partners are also advanced economies, since they are the ones that can afford and require them. The USA exports almost 20% of its goods to Canada and the UK’s top 5 trading partners are all advanced economies. If the consumers of the exports are in a bad economic situation, it would require a massive depreciation in the currency to stimulate any sizeable increase in exports.

            To make matters worse the imports are price inelastic, since they are often related to energy requirements. Crude oil alone accounts for 8.8% of American’s total imports. This is such an important product nowadays, needed for fuel, energy and chemicals, that it is a necessity and even if crude oil does become slightly more expensive, it will continue to be bought. This exacerbates the current account deficit by increasing the cost of imports whilst exportation remains stable. In addition, the Eurozone, comprising of 18 countries, cannot have this natural depreciation since they share the same currency.

            Moreover, as Keynes pointed out, wages are sticky downwards especially in the advanced economies as workers are not willing to receive lower wages. Therefore the self-stabilising mechanisms do not work in the advanced economies adding strength to the idea of stagnation.

From the information above, it appears the balance of payments won’t lead the advanced economies out of stagnation and into a new era of reinvigorated growth. However, there is a revolution on the horizon brewing in America where ‘fracking’ is tacking centre stage in the energy market. Hydraulic fracturing or ‘fracking’ has made oil and gas reserves, previously not viable to extract, obtainable. The US Energy Information Administration has forecast record levels of oil output of 9.6 million barrels per day. This has driven the trade deficit to a 4 year low and is expected to continue to fall, as imports are to meet only 24% of the US fuels demands by 2015 down from 60%.

            Now, major banks like JPMorgan are expecting higher growth than forecast, 3.3% rather than 2.4%. In addition, ‘fracking’ has kept the price of oil, gas and therefore energy in the US low compared to the rest of the World. For example, propane (product of refining crude oil) is only $620 a tonne in the US compared with over $1,000 a tonne in China. This has an effect on both households and firms.

            Households have benefitted from ‘fracking’ as their energy bills have stayed constant and even fallen. Households in some states, Ohio for example, would have paid up to 129% more on their gas bills if it wasn’t for this drilling boom. More disposable income combined with a new sense of confidence due to higher growth forecasts may stimulate consumption. Increased demand may provide companies with encouragement to invest in capital to meet the increased demand, starting a cycle of growth that would definitely help to solve the stagnation issue.

            Moreover, lower energy prices help firms in a more direct manner reducing their costs of production and therefore the price. If the quantity demanded rises for their goods or services, this may give companies the confidence to invest as they have seen that there is actually demand within the economy. Firms may start to employ more people, increasing the number of people with disposable income, which could cause consumption to rise as well.

            The American economy may still recover and escape from the jaws of stagnation through an energy revolution. However, it begs the question whether the other advanced economies will also return to plentiful growth?

A resurgent USA will probably lead the advanced economies out of stagnation, since America is so vital to the World economy. They are hugely important in the context of trade because they are large trade partners with many of the developed nations. The US accounts for over 10% of British exports, 8% of German exports and 18% of Japanese exports highlighting that the US is the cog that turns the machine of international trade. If America starts to import more, the effects may be monumental on other developed countries, both in terms of business but also it stimulates confidence within the other economies, which has been so lacking over the last 6 years.

In conclusion, the private sector, firms and households, have built up a lot of debt during the last decade and according to the economist Hyman Minsky, a debt crisis takes a long time to get resolved. People and firms are not willing to spend until their debt is removed completely. Of course, there are other issues such as motionless real wages and trade, that doesn’t follow classical economic thinking, making stagnation more likely. The seismic event in the American energy market of ‘fracking’ may spark a period of prosperous growth. Moreover, the parallels with Japan are tenuous, as they have very little immigration and an aging population compared to the younger, multi-cultural areas of Europe and America. However, stagnation does seem to be engulfing the advanced economies and no Government is at the moment successfully combating it. There is no real evidence that suggests an economic recovery is on the cards and most of arguments against stagnation are speculative. An economic resurgence hinges on America, but most of the evidence does point to the depressing prospect of stagnation.

Bibliography

• ·       CIA Factbook
• ·       World Bank
• ·       ‘Japanese Industrialisation and its Social Consequences’, Hugh. T. Patrick and Larry Meissner
• ·       Organisation for Economic Co-Operation and Development
• ·       US Bureau of Labor Statistics
• ·       US Bureau of Economic Analysis
• ·       rwer.wordpress.com
• ·       Financial Times: ‘How to spend $2.8tn of corporate cash’ by John Plender, 2014
• ·       Financial Times: ‘US Oil Boom drives trade deficit to four-year-low’ by James Politi and Ed Crooks, 2014
• ·       Eurostat
• ·       ‘The Road to Recovery: How and Why Economic Policy must change’ by Andrew Smithers, 2013
• ·       Office of National Statistics
• ·       GOV.UK
• ·       The Economist: ‘The Fed discovers Hyman Minsky’, 2010