04/23/2012 03:26 PM

The Spanish Dilemma

Euro's Fate Hinges on Austerity in Madrid
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Spain in recent days has taken center stage in the euro crisis. The country's banks are threatened with collapse and the government in Madrid has not been successful in efforts to get the national budget under control. Will the country be forced to request aid from the euro bailout fund?

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Everything is going according to plan, no reason to worry, the threat has been contained. When Europe's monetary watchdogs resort to such catch phrases, investors and politicians alike know that the situation is serious.



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Last week, it was apparently very serious as top-ranking Brussels officials practically lined up to disseminate their reassuring phrases to the people of Europe. "I don't think Spain will need any kind of external support," said Euro Group chief Jean-Claude Juncker, who is also the prime minister of Luxembourg. And European Commission President José Manuel Barroso insisted: "I am absolutely confident that Spain can meet its economic challenges."



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But the fact of the matter is that the crisis fighters in Brussels are highly alarmed. It was less than two months ago that economists and financial experts were sounding the all-clear signal after the European Central Bank (ECB) had flooded the markets with €1 trillion ($1.32 trillion) in cheap money for banks. German columnists even announced "the end of the crisis."



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In reality, though, the fuse is still burning, and financial experts at the European Commission, the EU's executive, the ECB and the national finance ministries are more concerned than ever.



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Time Bombs


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Spain's banks are widely regarded as time bombs, with portfolios of volatile loans on their balance sheets that could explode at any time. The country is sliding deeper into recession and international financial investors are slowly but surely withdrawing.
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Last week, the government in Madrid succeeded in selling new bonds on the markets. But the yields for these 10-year sovereign bonds are currently running at a crisis level of roughly 6 percent.


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The fate of the monetary union currently depends on Spain's austerity policies. The experts in Brussels are convinced that if the country seeks aid from the rescue package, the crisis will reach the next escalation stage.



The danger is real. Indeed, since the current Spanish government took office four months ago, it's proven more adept at upsetting its European partners than at solving its financial problems. Many observers say that the latest escalation in the crisis was sparked when Spanish Prime Minister Mariano Rajoy announced that he did not intend to adhere to EU austerity rules. "That's the perfect way to scare off investors," said an official in the German Finance Ministry in Berlin.


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Since then, officials in Brussels have been saying that Spain isn't expressing enough serious interest in cutting costs. According to the plans put forward by the government in Madrid, public expenditures will rise by 2 percent this year alone, taxes will only be moderately increased and Rajoy doesn't even intend to reduce the public sector workforce. There's quite a lot of "fat" in Spain's public sector, as European Commission President Barroso often complains in small circles.


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Next Setback Unavoidable


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For example, Spain has some 4,000 state-owned companies whose privatization could fill government coffers with billions of euros. But these stakes are primarily held by regional governments, and Rajoy can't simply issue instructions to regional political leaders. Last year, the central government in Madrid got a taste of what this entails. Madrid had largely adhered to the belt-tightening regulations. Spain's autonomous regions, though, such as Catalonia and Andalusia, ruined the results with their debt policies.



The next setback is unavoidable. The prime minister recently announced that he wants to reduce expenditures in the country's education and health system by €10 billion. But Spain's regions are doing everything they can to resist the threatened cuts in their budgets. Andalusia, for example, is slated to receive €2.7 billion less, but it's demanding €1.5 billion from the central government for investments that were approved over the previous years.



The conflict threatens to escalate. To meet the demands of the central government, the regions would have to slash 80,000 out of 500,000 teaching positions, the teachers' trade union claims. Not surprisingly, this has met with staunch resistance from local politicians and it remains unclear whether Madrid can meet its budget commitments.



There are equally large concerns about Spain's financial sector. Just a few years ago, the banks financed an unprecedented real estate boom. This was fueled by the low interest rates that Spain enjoyed after the introduction of the euro, along with the avid interest of foreign investors. Between 1997 and 2007, real estate prices rose by approximately 120 percent.



Since then, prices have fallen by roughly one-fifth. Now, Spain's banking sector is caught in a downward spiral of falling prices and bad loans. Citigroup estimates that the country's financial industry has over €1 trillion in loans on its books that are linked to the real estate market. In late 2011, nearly one-tenth of these loans were junk.


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Fears Grow that Crisis Will Spread


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Consequently, there's a growing fear that the crisis will spread. The Spanish central bank has just announced that the country's financial institutions are putting an additional €50 billion aside to cover impending loan defaults. But if the downturn continues, the economists from Citigroup say that the losses could be as high as €200 billion.



And there is another reason for pessimism: Due to the recession, an increasing number of companies and private households can no longer service their debts. As a result, when the ECB pumped money into the European banking sector this winter, Spanish banks soaked it up like a sponge. By late March, they owed the ECB €228 billion.


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The so-called "Big Bertha," which is also the nickname commonly used to describe a big howitzer used by the German army in World War I, deployed by ECB President Mario Draghi not only eased the acute woes of Spanish financial institutions, it also helped the government in Madrid. Indeed, just as Draghi had hoped, the banks invested a large share of this money in Spanish sovereign bonds.


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This seemed to be a sound investment, at least as long as the trading value of these bonds increased. But now more and more foreign investors are dumping their Spanish bonds, which means that the country's banks could face new losses. "The Spanish banks won't be able to keep purchasing sovereign bonds if the prices of these bonds continue to drop," says Uwe Burkert, head of credit analysis at the Landesbank Baden-Württemberg, a bank owned by the government of that southern German state.



Draghi's aid to the banks hasn't helped the Spanish economy anyway. Spain's financial institutions continue to scale back their loans to companies and private households. Instead, they are financing the cash-strapped government. In Spain, of all places, where the economy is more dependent on bank loans than in virtually any other country in the euro zone, people are complaining about the credit crunch.



European leaders battling to rescue the euro are faced with a dilemma. Spain's banks urgently need capital, but no one knows where it should come from. Using Europe's euro rescue funds would contravene the regulations, which stipulate that only states may borrow money under the bailout scheme. If the government in Madrid were to support the banks directly, it would have to take on new debt -- and, in the process, add considerably more momentum to the spiraling crisis.


.A Dilemma for Europe

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Leaders in Brussels, Berlin and Paris have decided to cross their fingers and hope for the best. They are hoping that the Spanish austerity program will take hold at some point in time, that the recession will ease and a gradual upswing will pull the banks out of the crisis. At the same time, Brussels has set its sights on boosting growth across Europe. There are plans to introduce new infrastructure projects, promote greater competition in the service sector and open up labor markets.


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However, these initiatives are not allowed to cost money, because nothing should jeopardize the balancing of national budgets. "Trust" is the new magic word that the euro's rescuers intend to use to woo international financial investors. This is the message that Spanish Economics Minister Luis de Guindos broadcast to all and sundry last week as he toured European capitals and stock exchanges in an effort to calm politicians and investors.



It's questionable whether this intensive public relations campaign can head off the threat of the country asking for money from the Luxembourg-based euro rescue fund. In confidential discussions, representatives of the European Commission, the ECB and national governments are urging the Spanish to do everything possible to put their banking sector in order -- if necessary, with the help of the bailout fund.

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Government representatives from Madrid have responded by ruling out this possibility. But experienced financial experts remain skeptical. "I've already heard similar tones from Greece, Portugal and Ireland," says one source who has been involved in efforts to rescue the common currency since the beginning of the crisis. "But sooner or later they come asking for money."




Translated from the German by Paul Cohen


A World Adrift
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Jeffrey D. Sachs
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22 April 2012




NEW YORKThe annual spring meetings of the International Monetary Fund and the World Bank have provided a window onto two fundamental trends driving global politics and the world economy. Geopolitics is moving decisively away from a world dominated by Europe and the United States to one with many regional powers but no global leader. And a new era of economic instability is at hand, owing as much to physical limits to growth as to financial turmoil.



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Europe’s economic crisis dominated this year’s IMF/World Bank meetings. The Fund is seeking to create an emergency rescue mechanism in case the weak European economies need another financial bailout, and has turned to major emerging economiesBrazil, China, India, the Gulf oil exporters, and others – to help provide the necessary resources. Their answer is clear: yes, but only in exchange for more power and votes at the IMF. As Europe wants an international financial backstop, it will have to agree.


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Of course, the emerging economies’ demand for more power is a well-known story. In 2010, when the IMF last increased its financial resources, the emerging economies agreed to the deal only if their voting share within the IMF was increased by around 6%, with Europe losing around 4%. Now emerging markets are demanding an even greater share of power.



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The underlying reason is not difficult to see. According to the IMF’s own data, the European Union’s current members accounted for 31% of the world economy in 1980 (measured by each country’s GDP, adjusted for purchasing power). By 2011, the EU share slid to 20%, and the Fund projects that it will decline further, to 17%, by 2017.



This decline reflects Europe’s slow growth in terms of both population and output per person. On the other side of the ledger, the global GDP share of the Asian developing countries, including China and India, has soared, from around 8% in 1980 to 25% in 2011, and is expected to reach 31% by 2017.


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The US, characteristically these days, insists that it will not join any new IMF bailout fund. The US Congress has increasingly embraced isolationist economic policies, especially regarding financial help for others. This, too, reflects the long-term wane of US power. The US share of global GDP, around 25% in 1980, declined to 19% in 2011, and is expected to slip to 18% in 2017, by which point the IMF expects that China will have overtaken the US economy in absolute size (adjusted for purchasing power).



But the shift of global power is more complicated than the decline of the North Atlantic (EU and US) and the rise of the emerging economies, especially the BRICS (Brazil, Russia, India, China, and South Africa). We are also shifting from a unipolar world, led mainly by the US, to a truly multipolar world, in which the US, the EU, the BRICS, and smaller powers (such as Nigeria and Turkey) carry regional weight but are reticent to assume global leadership, especially its financial burdens. The issue is not just that there are five or six major powers now; it is also that all of them want a free ride at the others’ expense.



The shift to such a multipolar world has the advantage that no single country or small bloc can dominate the others. Each region can end up with room for maneuver and some space to find its own path. Yet a multipolar world also carries great risks, notably that major global challenges will go unmet, because no single country or region is able or willing to coordinate a global response, or even to participate in one.



The US has shifted rapidly from global leadership to that kind of free riding, seeming to bypass the stage of global cooperation. Thus, the US currently excuses itself from global cooperation on climate change, IMF financial-bailout packages, global development-assistance targets, and other aspects of international collaboration in the provision of global public goods.



The weaknesses of global policy cooperation are especially worrisome in view of the gravity of the challenges that must be met. Of course, the ongoing global financial turmoil comes to mind immediately, but other challenges are even more significant.



Indeed, the IMF/World Bank meetings also grappled with a second fundamental change in the world economy: high and volatile primary commodity prices are now a major threat to global economic stability and growth.



Since around 2005, the prices of most major commodities have soared. Prices for oil, coal, copper, gold, wheat, maize, iron ore, and many other commodities have doubled, tripled, or risen even more. Fuels, food grains, and minerals have all been affected. Some have attributed the rise to bubbles in commodities prices, owing to low interest rates and easy access to credit for commodity speculation. Yet the most compelling explanation is almost certainly more fundamental.



Growing world demand for primary commodities, especially in China, is pushing hard against the physical supplies of global resources. Yes, more oil or copper can be produced, but only at much higher marginal production costs.



But the problem goes beyond supply constraints. Global economic growth is also causing a burgeoning environmental crisis. Food prices are high today partly because food-growing regions around the world are experiencing the adverse effects of human-induced climate change (such as more droughts and extreme storms), and of water scarcity caused by excessive use of freshwater from rivers and aquifers.



In short, the global economy is experiencing a sustainability crisis, in which resource constraints and environmental pressures are causing large price shocks and ecological instability. Economic development rapidly needs to become sustainable development, by adopting technologies and lifestyles that reduce the dangerous pressures on the Earth’s ecosystems. This, too, will require a level of global cooperation that remains nowhere to be seen.



The IMF/World Bank meetings remind us of an overarching truth: our highly interconnected and crowded world has become a highly complicated vessel. If we are to move forward, we must start pulling in the same direction, even without a single captain at the helm.


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Jeffrey D. Sachs is a professor at Columbia University, Director of its Earth Institute, and a special adviser to United Nations Secretary-General Ban Ki-Moon. His work focuses on economic development and international aid, was he was Director of the UN Millennium Project from 2002 to 2006. His books include The End of Poverty and Common Wealth

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Copyright Project Syndicate - www.project-syndicate.org


April 23, 2012 4:44 pm
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A euro parable: the young couple with a joint account
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By Kenneth Rogoff


Perhaps the following parable is not entirely fair to the euro, but nevertheless the parallels seem striking.




Consider a young couple who is contemplating marriage, but unsure whether to take the big step. So instead they decide to test things out by opening a joint bank account. At first things go remarkably smoothly. Heady with success, they get the inspiration of extending the arrangement to her brother and his sister. Not only do they hope to show their siblings how well they can cooperate, but with four people, the total size of the account reaches the critical threshold needed to receive exorbitant privileges normally accorded to the bank’s larger customers.

 

 

Thanks to a cleverly designed constraint to limit imbalances between each sibling’s contributions and withdrawals, the innovative experiment continues to flourish. There is no real enforcement mechanism, but the two sets of siblings are determined to make the arrangement succeed. Forced to interact routinely, the couple and their siblings start becoming closer. They even start having dinners together on a routine basis.




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Eventually, the quartet decides that dinners will be even more fun, and the bank will give them an even better deal, if they expand the arrangement. So the siblings persuade a few cousins to join. Pretty soon, their phones are ringing off the hook with family members they have not seen in years. Cousin Kendra, a marginally employed chef with precarious finances, is nevertheless welcomed in hopes she will employ her culinary skills to enrich group meals.



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Life is not without its problems. Everyone is irritated at first cousin Nigel, who lives just across the river yet insists on managing his own finances. He is still invited to meals, though his cooking skills are hardly up to Cousin Kendra’s. She, in turn, exhibits little enthusiasm for balancing her chequebook, and the bank sends ever more frequent warnings that her overdrafts would have to be covered by the others. Shortly after joining, a couple other cousins have taken advantage of their new prime customer bank status to buy extravagant apartments with jumbo loans at far lower interest rates than they were ever afforded in the past.



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The whole complex scheme seems to survive against all odds until one day things suddenly start to collapse. Despite informal personal imbalance limits, several cousins significantly overdraw their accounts. Others fall behind on mortgage repayments. Panicked, the founding siblings ask themselves whether it might be best simply to kick out the group’s worst behaving members. Unfortunately, the bank informs them this will be very difficult to do without first closing the entire account, wreaking havoc with everone’s finances.


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Desperate, the family brings in a well-regarded outside financial advisor. She comes up with the seemingly brilliant idea of a joint credit card, with payments guaranteed unconditionally by all, including the wealthiest cousins. 


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This would allow the impecunious members to pay off bad cheques and mortgages, effectively borrowing against the resources of the others. And it wouldn’t be a gift, the advisor promised. Borrowers would pledge to skip meals. Any savings on ingredients would be used to make loan repayments. This works for a while until cousin Kendra starts to look pale from her diet.



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She begins missing work and the imbalance between her occasional deposits and frequent withdrawals gets worse. The richest cousins soon find they have to mortgage their houses in order to pledge enough cash to the bank to prevent an immediate collapse.



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Of course, this grand experiment ends catastrophically. I will have to leave the reader in suspense as to whether the couple gets married. No doubt, in the film version of this parable, the studio would tape alternate endings and test which one sample audiences liked best.



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Perhaps the parable overstates the risks fully independent countries face when sharing the same currency, but then again, maybe not by so much.



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Economists have long understood that significant labour mobility is not nearly enough. A sustainable currency union requires other country-like features including a centralised fiscal authority that has as at least as much power to collect taxes as the constituent states. A central financial regulator is also essential, at least absent an adequate global regulator. And the centre cannot be endowed with so much power without the legitimacy that can only come from political union. Currency union without political union is an unstable halfway house.






This is not to say that a future United States of Europe, or part of Europe, needs to take any particular narrowly defined form. There is no one-size-fits-all formula for marriages or currency unions, although a loose bond that is easily broken is obviously not enough.


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The real lesson of the euro’s grand experiment is that, given the weak state of global governance, the optimal single currency area is probably still a country, at least when two or more large countries are involved. A pre-nuptial joint bank account is a very unstable route to marriage.



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The writer is professsor of economics at Harvard University and co-author of “This Time is Different”


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Copyright The Financial Times Limited 2012.


REVIEW & OUTLOOK

Updated April 23, 2012, 7:22 p.m. ET

The End of Borderless Europe?

Another potential casualty of the French presidential election.




France's presidential campaign has been a parade of policy lowlights—from attacks on the independence of the European Central Bank to calls for 75% tax rates—and that's only in the first round. Now there's evidence that one of the campaign's worst ideas may be getting traction elsewhere in Europe.

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The Süddeutsche Zeitung reported Friday that German Interior Minister Hans-Peter Friedrich and his French counterpart Claude Guéant have asked the European Union to allow 30-day internal border controls whenever the EU's external borders are deemed to be insufficiently controlled. The 1985 Schengen Treaty currently allows controls only when "public policy or national security" demands it, such as during major sporting events or after London's 2005 bomb attacks.



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The Schengen Treaty is one of the best features of modern-day Europe. It eliminates border hassles, facilitates trade and tourism, and creates the tangible sense that Europe is greater than the sum of its parts. But what's a good thing if some politician doesn't want to ruin it?

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2schengen
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German Interior Minister Hans-Peter Friedrich.


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That politician is Nicolas Sarkozy. In a bid to win the anti-immigrant vote, the French President threatened last month to withdraw France from Schengen if the treaty isn't renegotiated to better prevent illegal immigration. That followed France's decision last April to turn back trains from Italy after some 25,000 refugees crossed the sea to escape the turmoil in North Africa.



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What's new is that Germany seems to be coming aboard. Last year, Mr. Friedrich denounced the French proposal and later opposed Denmark's decision to reinstate spot checks at its borders. Now he says that "we need interior border controls not just during large events, such as football matches or large conventions, but also when member states don't fulfill their duties."


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In Europe, as everywhere in the developed world, immigration poses important questions for governments that host and support migrants, and for societies that work to integrate them. Few border or immigration regimes are foolproof, and those that "work"—think of the Korean DMZaren't always worthy of emulation.



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But it's hard to see how temporary controls will do much to stem the flow of illegal immigration. They will simply redirect that flow to underground channels, putting migrants at greater risk and creating opportunities for crime. As for the argument that border controls can stop terrorism, it's worth noting that Europe's most notorious recent terrorist acts were perpetrated by people who entered the Continent legally, if they weren't citizens to begin with.



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It should come as no surprise that politicians who have neither the courage nor the ideas to fix their economic problems should take to scapegoating foreigners, even when they are neighbors.


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