Monday 27 January 2020

David McWilliams: Germany cruises as Spain sits in a heap -- it can't last

David McWilliams

FEW indicators could have underscored the inconsistency at the heart of the eurozone than figures yesterday showing Germany's investor confidence at a 21-month high, while Spain, wracked by 22pc unemployment, gives the EU the two fingers on the fiscal compact.

Here we have Europe's biggest economy, Germany, cruising ahead and bathed in lots of free capital from the ECB; while Spain, the world's 12th richest country is in a heap. It is impossible to see how a currency union between such large countries going in such opposite directions can last.

The reason for the difference is that Germany and German investors have benefitted enormously from being a creditor nation over the past 10 years, while Spain -- a large version of Ireland -- has had a similar property slump and its banks are now bust and all the free money in the world from the ECB isn't going to make it any better soon. As the wonderfully prescient John Mauldin in his financial newsletter (www.johnmauldin.com) said this week, Spain's GDP of $1.4trn (€1.07trn), somewhat surprisingly perhaps, puts it just behind oil-rich Russia and Canada and people-rich India.

Spain is a big country. Spain matters. Spain does indeed matter and this is why the move by the Spanish government yesterday to tell the Merkozy where to go is an interesting development.

The new Spanish prime minster, Mariano Rajouy, signed the fiscal compact, flew back to Madrid and then promptly rejected the first obligation of the fiscal compact which compelled him to rapidly reduce his budget deficit. The Spaniard realised that with the country in difficulty, too much budget retrenchment would tip it over.

Like Ireland, the major issue is not just the public debt, but the private sector debt which stands at a staggering 227pc of GDP and, according to McKinsey (a report we quoted here in this column a few weeks back), Spanish corporations hold twice as much debt relative to their output as US companies and, in comparison to Germany, that number goes up to six times.

So Spain, much more than Greece, is a big Mediterranean version of Ireland with huge, private debt. We would be wise to watch what the Spaniards do next. It is clear that the Greek deal of last Friday will no more ring-fence Europe's debt crisis than the last bailouts. What it has done is bought a little time for the EU.

Spain is choosing to use that time to loosen the noose around its neck. It also realises that there is very little the EU can do and with two votes coming up -- a presidential one in France and the Irish referendum -- anything can happen.

The Germans on the other hand are hoping that they have done just enough to quarantine Greece and make Europe safe for German companies to export to without the trouble of yet more defaults on the periphery. What Germany fails to understand is its huge trade and current account surplus with the rest of Europe is as much a problem as Spanish or Irish debt.

To solve the problem, the ECB is now printing buckets of money to pump into the EU economy. The authorities seem to think that this will calm everything down and make the euro look like a sensible currency. Even yesterday, the former Portuguese communist Manuel Barroso was reported here in the Irish Independent as calling for "an end to the constant drama" about the single currency and he went on to say, wait for it, yes that the EU "may be turning a corner" towards "stability and growth".

Poor Mr Barroso still has an unwavering communist's grasp of economics and finance. Crises -- if they have a fundamental source in economic imbalances, debt or financial conundrums -- can't just be willed away.

IN fact as I listen to Mr Barroso and unfortunately to Michael Noonan's wide-ranging interview the other night when he kept alluding to "stability", I can't but think they are going through the four-stage cycle that many politicians go through after a crisis. This four-stage cycle was described this week by another of the best financial newsletters out of the US, www.thebigpicture.com

It contends that in Europe and America the political elite is going through the same four stages that were seen in Japan in the 1990s and into the early 2000s after its massive debt induced slump. The four stages are: response, improvement, complacency and repeat.

The first stage is the response stage. When any crisis reaches a panic stage, authorities will typically react (and overreact) creating an overwhelming response to the crisis. This usually includes lots of cash and some immediate legislative relief. This is what the ECB is doing by printing money.

The next stage is improvement. The response throws enough money at the problem so that symptoms are temporarily relieved. The improvement is not structural, but rather is driven by a trip of excess liquidity. It feels good but it is financially mind-altering. Witness the fall in bond yields of countries that have no money.

The temporary patchwork repair creates a false sense of accomplishment. This is the stability stage which Mr Noonan was speaking about the other night in that interview. The improvements feel good, the data improves, markets rally. This leads to a sense of complacency amongst all parties (government, private sector, banks, consumers and so on).

With few of the structural problems fixed, the excess liquidity eventually flows to the same sources of the original crisis to liquid assets such as government bonds, via the banks, setting the stage for the next crisis. Looking at the Spanish response yesterday and the fact that we have yet to deal with our massive debt overhang, it looks like these four stages are playing out here.

www.davidmcwilliams.ie

Irish Independent

Today's news headlines, directly to your inbox every morning.

Don't Miss