Wednesday, June 22, 2011

Spain and Italy

In yesterday's post, I tentatively expressed some scepticism about the idea that the credit situation in Greece, Ireland, and Portugal represents a major threat to economies outside of these three countries (I don't dispute that they themselves are in a lot of trouble).  The best rejoinder came from commenter "James", who argued:
I think the danger of contagion comes from bank runs.

Lets say that Greece goes the way of Argentina, finally capitulates, and decides to withdraw from the EMU. The first thing they have to do is impose a Corralito.
A corralito was the name give to Argentina's practice in its 2001 financial crisis of preventing withdrawals from bank accounts. James goes on:
This is devastating for a society. Imagine waking up one morning and finding that you have 1/3rd the savings that you had when you went to bed the night before.

So the Irish and the Portuguese will see this and rush to their banks to withdraw their savings so they can put them someplace safe. That will leave the governments of Ireland and Portugal no option but to impose Corralitos of their own. Then Spain will undoubtedly be the next domino. (I believe Spain is in worse shape then is generally recognized - Spain had a housing bubble every bit as big as the US but has the Spanish banks have been essentially hiding the problem by not foreclosing on delinquent borrowers.)

After Spain has imposed its Corralito, then the banks runs will begin in earnest in Italy.
I'm sceptical, but let's take a look at these countries (all data in this post from Eurostat).  Firstly, if you are willing to add Spain and Italy to your list of serious concerns, then you are now up to about a third of the Eurozone, so there's definitely potential for a big economic impact:

Here's the recent trend of GDP in those countries:

Both have started to experience some recovery, but weaker in Spain than Italy.  In terms of unemployment (from this post), Spain looks terrible in the wake of its housing bubble and crash:

However, I'm not persuaded that government finances are bad enough in either of these countries for there to be any imminent risk of sovereign default.  James bank-run contagion theory relies on the idea of weak sovereign finance.  A state in reasonable shape does not face serious risk of runs on its banks because it has options like that in Sweden in the nineties (nationalize the banks, recapitalize as needed, and then sell them off again when things improve), or the US in 2008 (loan the banks enough money to tide them over and then structure interest rates so that they can earn their way out of trouble).  In neither case were bank depositors seriously hurt, and in neither case were there serious bank runs by those depositers.  It's only if the state itself is financially weak that it has few options to deal with weak banks.

This next chart shows the trajectory of government deficit and total debt for five countries.  In each case the data start in 1999 and end in 2010, and the 2010 end is the one down and to the right.

Look first at Germany (purple), which has been running moderate deficits of a few percentage points most of the time, and its debt has gradually drifted up over 80% of GDP.  This is not a seriously scary level and Germany is generally regarded as an excellent risk and pays low interest rates.  On the other end of the scale, look at Greece (red) which, in addition to having a seriously depressed economy has accumulated debt of 140% of GDP and is running deficits of 10-15% of GDP each year.  Or Ireland (turquoise), which was doing fine until it decided to take on the liabilities of all its banks when the bubble burst, and since then has been accumulating truly awe-inspiring deficits that have undermined confidence in the Irish state.

By contrast, Spain was paying down its debt to a low level through much of the 1990s, and although it has run biggish deficits since the great recession, public debt is still only up to 60% of GDP, increasing at about ten percentage points per year.  Thus, while Spain is very likely in for a period of extended economic pain and high unemployment, it would seem that the Spanish government is not going to run out of room to maneuver for quite a number of years.  Likewise Italy, which has fairly high debt, but quite moderate deficits and where the economy is beginning to recover with unemployment not that high.

This is reflected in the interest on 10 year bonds (data for May 2011), where Spain and Italy have to pay a percentage point or two more than France or Germany, but nowhere near the levels of Greece or Italy Ireland:

So I find it implausible that serious bank runs would spread into Spain and Italy any time soon, and therefore implausible that the crisis would become a continent-wide economic disaster.


Joachim said...

Just a tiny typo correction:

"Spain and Italy have to pay a percentage point or two more than France or Germany, but nowhere near the levels of Greece or Italy"

I believe the last word there is supposed to be Ireland.

Stuart Staniford said...

Joachim - thank you. That was my intent, and it's been fixed.

Anonymous said...

It seems to me the issue is credit risk. What happened with Lehman wasn't about the default of that one company. It was about the fact that nobody really knew who had exposure and how much. As a result, nobody wanted to lend money to anybody and the credit markets froze up completely. This was the fundamental issue.

The same is true of Greece, et. al. The problem is that nobody is really sure how much exposure people have beyond the limited information available publicly. Many financial institutions have hedged their credit exposure, but there is little public information about the extent or source of that hedging. If some major counter-party or insurer goes south (a la AIG), then all the exposures have to be recalculated. These are the fears that drive people to stop lending to anybody and a lock up credit.

No credit. No money. No economy.

Burk said...

The difference is that Sweden and the US have their own currencies, so dealing with a banking crisis is an internal matter, with infinite monetary resources. The euro countries are in a euro straitjacket, with their ECB and German overloads highly unwilling to put out the money required to deal with large monetary emergencies.

James said...

I agree with Burk that Sweden and the US having their own currencies make for a fundamentally different situation than the PiiG countries which have to deal with a situation that is functionally equivalent to having a currency peg.

Or to put it another way - there are two different types of bank runs: (i) runs on individual banks and (ii) currency speculation driven runs on all of the banks of a given country. What Sweden did in the nineties was extremely effective at dealing with bank runs of type (i), but would have been useless at dealing with bank runs of type (ii).

Type (ii) runs are not analogous to the situation in Sweden in the nineties, they are analagous to George Soros breaking the bank of England. Having large number of depositors in in a given country withdraw their funds and move them outside of the country basically constitutes a speculative attack on that country's currency.

Thus I would humbly submit that my "bank run contagion theory" does not rely on the idea of weak sovereign finance, it relies on the idea that countries with unsound currency pegs are very vulnerable to speculative attacks on their currencies. Of course the PiiG countries have been able to weather the storm so far because (as the links in my original comment discuss), they have been advanced liquidity by the ECB and the Bundesbank. But just as the Bank of England eventually said uncle to George Soros, there is a good chance that the ECB and the Bundesbank will eventually say uncle to those betting against continued Greek membership of the EMU.

Krugman talks a bit about the slow motion bank run that is already happening, here:

Coincidentally, the FT published a story yesterday afternoon about Greek depositors "rushing" to move their deposits out of the country or into gold:

The Rational Pessimist said...


I think a problem with this post, and a previous one by you discussing Japan’s experience with deflation, is that you are missing the wood for the trees. What Greece, Portugal, Ireland and Spain all have in common is a problem with economic growth (and for that matter the US, UK and Japan). Bad things happen when your nominal GDP growth rate falls below the average interest rate you are paying on your debt; ie the debt just gets bigger (if government outlays and the tax take stays the same). Just look at Italy’s growth record: it is truly awful.

The contagion danger rests with the possibility that markets begin to realize that a whole swathe of economies have lost their ability to grow out of their debt difficulties and will ultimately default.

The most immediate cause of growth sclerosis is bad demographics, closely followed by negative productivity trends. Unfortunately, neither factor is amenable to a short-term policy prescription. For a good analysis of productivity trends see here:

Unfortunately, I think it gets a lot worse as we have yet to feel the full force of two further massive potential drags on growth that are only just getting started: peak resources and climate change.

You did a good post a while back on how the IMF recently recognized the threat of peak oil, and the IMF report you mentioned references in the footnotes the work of Ayres and Warr, showing how high oil prices stymie growth on a whole variety of levels beyond the share of energy in GDP. For climate change and growth, we are just entering the foothills, but the Fed’s hat tip to extreme weather dampening US GDP growth year to date is just a taste of things to come.

Going back to your original analysis, what Greece, Portugal, Spain and Italy all have in common is bad demographics and a spotty productivity growth record (Ireland is somewhat different). They also incidentally have high import energy dependency and will be on the front line of climate change through drought and water resource vulnerability.

These are problems that are nothing to do with fiscal policy, monetary policy, exchange rate regimes and so on. I call such things ‘second order’ problems, while demographics, productivity/technology, peak resources and climate change are ‘first order’ problems. The threat of contagion stems from the markets waking up to the threat posed by those ‘first order’ problems structurally changing the nature of growth, and thus the value of the credit that rests on such growth. Yes, they all these countries start from a slightly different place in terms of primary balance, GDP debt ratios and so on, but the threat to credit is ultimately a paucity of growth.

Whether Greece and Portugal will be the triggers for a structural change in the market’s thinking on credit and growth I am less sure. Japan may be the better candidate for this.

HalFiore said...

According to "Ilargi" on the Automatic Earth, it's all about the derivatives. Hard figures are scarce, but they indicate some possible major exposure by England and France.

the manual oracle said...

I can only concur with Justin's comment above.
On Italy see here
If you are not familiar with him,
I recommend you read Edward Hugh on demographic risks to the EU and elsewhere (he has a dozen of blogs) I think you are familiar with Michael Pettis work on China and he suggests a serious slowdown there. Both are original thinkers and incredibly well informed.

Seani said...

The 2 main concerns from my point of view is that the euro bond market will seize up and the european banks will be bankrupt (causing bank runs). If the bond market seizes up, all European countries will default on their debt. Why?

Because of the amount of debt that each country needs to roll over and the amount of debt needed to run their deficit. For example, Italy needs to roll over almost 30% of GDP in debt this year. When bond markets are running smoothly, this isn't a concern. However, when a bond investor just lost all of their money on their Greek debt, they probably will not be quick to reinvest their maturing bonds. Once that happens on a macro scale all bets are off.

As for the banks, their main problem is leverage. When a banks buys Greek bonds, they normally use them as collateral to get additional funding from the European Central Bank. If Greece has defauted, those bonds are no longer suitable for collateral so the ECB will be forced to call the loans of those banks that posted greek bonds. Those banks will then have to call the loans they made with that money, or if it was another bond, they will have to sell that bond into the market. Once a number of banks are major sellers of bonds and calling in their loans, the banking system and bond market will seize up. (This is basically what happened in 2008, but the US printed enough money to keep everything going).
Once the banking system seizes up, people will realize their savings are in danger- for deposit guarantees are worthless when the government backing them are most likely bankrupt too. Besides, why count on a deposit guarantee that may or may not be there when you can have the cash in your pocket!

This is already going on, just in a slow speed manner. People are electronically transferring their money into banks that they trust, mainly swiss banks. Since 2007, the EUR/CHF rate has gone from 1.7 to 1.187 today. The swiss central bank for a while tried to stop this trend but utterly failed.

I haven't even gotten into the question of how many of the European banks sold Credit default swaps that bought Greek Debt. If Greece were to default on their debt, these banks need to pony up the billions to pay off these CDS loses.

Once you look at the leverage of the European banks, you realize that it doesn't take much to topple them. The German banks are levered 30:1.(Lehman was at 30 when they went down) 30:1 means for every dollar of their own money, they borrowed 30 to buy an asset. This also means for every 1% of loses they have on said asset (Greek bond) they have a 30% loss on their equity. The average European banks is levered at 26:1 and US banks are at 13:1..Starting to see why European governments don't want to have banks take any losses on Greek bonds?

The Rational Pessimist said...


The Manual Oracle in a comment above refers to analysis by Edward Hugh, and by chance Hugh has just put out a superb post on his Spain Economy Watch blog refuting those arguing that Spain is different from Greece and Portugal.

It is a long post, but well worth reading the whole thing; I will just pull out two points. 

First, Hugh points out that the public debt numbers you see do not reflect the bigger picture. In particular, the threat that a forced bank bailout in Spain could cause public debt to ratchet up. He raises the example of Ireland, whose public debt exploded from 25% of GDP to 114% in a mere four years when it was forced to back stop its banks.

Second, Spain has a chronic productivity problem that is not amenable to short-term fixes. Critically, he notes that Spain’s export sector is just too small to produce an export-led growth renaissance.

But without decent GDP growth, they will not be able to fix their banking sector, and ultimately will not be able to restrain public debt.

A lack of growth is the common denominator for all the PIGS. It is also a massive problem for Japan, the US and the UK too. Personally, I think the long-term potential growth rate of these Big Three economies has also come right down, which is why credit contagion in the PIGS may not be contained within the PIGS going forward.