Daily Archives: May 9, 2012

No one can pretend to know whether Spain is illiquid or insolvent without gauging the size of the black hole that is the country’s banking sector. The Spanish government is finally starting to do this: Bankia and other banks are reportedly set to receive a capital injection from Madrid. With the Spanish economy contracting sharply and with unemployment soaring, it was inevitable that the government had to bail out the banks. But this only deals with one piece of the puzzle. Without growth, the Spanish sovereign will need a bailout as well.

Spain’s credit boom peaked in 2008 when the supply of cheap, external finance began to fall sharply. Four years later, Spanish banks’ asset quality continues to plummet. The sector will require €100-250bn in recapitalisation later this year to maintain a 9 per cent core tier one capital ratio, the minimum stipulated by the European Banking Authority. In the meantime, there are concerns about the capacity and appetite of Spanish banks to support the sovereign, particularly amid rating downgrades and deposit withdrawals.

Ideally, a bailout for Spanish banks should come immediately and in the form of direct capital injections from the EU bailout funds. Germany remains staunchly opposed to this, as it would mean giving up the stick of conditionality and feeding Spain the funding carrot. Such an option is also resisted by the Spanish authorities as the EU taxpayer will effectively take over their banks.

Instead it looks like a bailout for Spanish banks has been postponed until the very last minute. The cost of a bank bailout would then be foisted on to the Spanish sovereign’s balance sheet.

Bank bailouts on this scale may well bring the Spanish state to its knees. If they don’t, Spain’s public and external debt positions will.

In order to stabilise its public debt levels after a bank recapitalisation, Spain would have to generate a swing in its public finances that is not only unrealistic, but also self-defeating. The tax hikes and spending cuts required would make the recession deeper and cause the primary balance to deteriorate.

In order to put itself on a path towards external debt sustainability, Spain would need to see a huge adjustment in its trade balance. In the short-run, a fall in domestic demand could quickly improve the trade balance. However, in the medium-term, Spain can only service its foreign debt if it finds balanced and sustainable growth, which requires a real-terms depreciation that will not occur unless the value of the euro falls sharply.

Anyone who has closely followed developments in the eurozone will be struck by déjà vu looking at Spain’s current predicament. The corrosiveness of banking sector uncertainty for investor confidence in Spain is reminiscent of Ireland in 2009 and 2010. Spain’s austerity-recession feedback loop is similar to the process that fed the economic contraction in Greece and Portugal.

And yet despite the clear signs of failure in the existing bailout countries, the EU looks set to pursue an unchanged plan in Spain. But the crucial difference between Spain and the bailout countries is size. If things go wrong in Greece, Portugal and Ireland, a second bailout is affordable. But there can only be one roll of the dice for a country as large as Spain.

A bailout package would buy some time for Spain, but time will only help if it is used to generate economic growth. By making private claims on the sovereign junior to the claims of the troika (European Commission, European Central Bank and International Monetary Fund) even a bailout risks reducing the chances of it regaining market access. Moreover, with economic indicators showing Spain sinking further into recession, a turnround in the country’s economic performance would require a significant shift in policy: monetary easing by the ECB, a weaker euro, fiscal stimulus in the core, less front-loaded austerity in the periphery, more international firewalls and debt mutualisation.

The only way for there to be a happy ending in Spain is if action is taken swiftly in Brussels, Frankfurt and other European capitals. But that is not likely to happen. The eurozone periphery and Spanish crisis look like a slow motion train wreck.

The writer is chairman of Roubini Global Economics and a professor at the Stern School of Business, New York University. He co-authored this piece with Megan Greene, director of European economics, Roubini Global Economics.

Neither the pomp and ceremony of the Queen’s Speech nor its accompanying bills can hide the fact the UK requires urgent action to restart economic growth.

So too does Europe as a whole.  A European recovery would help the UK greatly. But Europe will take time to agree a strategy: the UK can and must get on with it. There is a clear way forward – kick-start investment now through strong, clear and credible measures that reduce so-called ‘policy risk’ and mobilise private savings and liquidity.

Tax cuts to generate consumption-led growth will not be fiscally credible. Structural reform of the UK economy to increase productivity is essential, but takes time. The recovery must be investment-led and place only modest demands on the public finances. But without the recovery any attempt to achieve fiscal balance, however defined, any time soon will be unacceptably destructive, both economically and politically, a lesson which the last few weeks and days in the UK and Europe have surely demonstrated dramatically.

Investment has slumped mainly because households, businesses and banks are nervous about future demand, and have responded by forgoing more risky investment in physical capital. Instead, companies and households are squirrelling away private saving into ‘risk-free’ assets such as solvent sovereign bonds. As a result, annual private sector surpluses over the past few years have been at record levels, and amounted to £99bn last year, equivalent to 6 per cent of UK gross domestic product. When everyone cuts spending simultaneously, fear of recession becomes self-fulfilling.

Desired saving has exceeded desired investment in many advanced economies to such a degree that real ‘risk-free’ interest rates for the next 20 years have been pushed to zero and below. Savings are losing value by the day as pension funds and financial institutions pay real interest to (rather than receive interest from) governments; a truly perverse state of affairs given the need for productive investment. These low rates do not reflect a collapse in the underlying returns to capital, but instead reflect desperately depleted confidence.

With short-term interest rates close to zero, the effectiveness of monetary policy to stimulate growth is reaching its limits. Fiscal policy is tightly constrained. What is needed to restore confidence is a strategic vision, the rationale for which businesses clearly understand, with supporting policies to guide investors.

In the past, we have seen Roosevelt’s New Deal or rearmament. In this case, recognising the inevitable transition to a low-carbon economy, and helping drive forward investment in resource-efficient, innovative sectors, could restore growth and leave a lasting legacy. As well as bringing energy security, tackling climate change, and saving consumers and businesses costs in the long run, these sectors offer long-term returns for investors.

Standard macroeconomics tells us that the best time to promote investment is during a protracted economic slowdown. Resource costs are low and the potential to crowd out alternative investment and employment is small. In addition, while public budgets are stretched, there is no shortage either of private capital available for investment, or of investment opportunities with potential profitable returns. There is, however, a shortage of perceived opportunities. The longer that recovery is delayed, the more skills will be lost and potentially valuable capital is scrapped.

This is about more than correcting market failures, such as those associated with greenhouse gas emissions; it is about restoring confidence through creating new markets which spur innovation. Policies to encourage low-carbon investment would provide new business opportunities, would generate income for investors, and would have credibility in the long term both because they address growing global resource challenges, while tapping into a fast-growing global market for resource-efficient activities, and there is a recognition that actions cannot be delayed indefinitely.

The most recent figures published by the Department for Business, Innovation and Skills show that the UK low-carbon and environmental goods and services sector had sales of £116.8bn in 2009-10, growing 4.3 per cent from the previous year and placing us sixth in the global league table for such sales.

But the private sector is not investing as heavily as it could in green innovation and infrastructure because of a lack of confidence in future returns in this policy-driven sector. Only the government can reduce this policy risk. Thus, by backing its own low-carbon policies, the Government can stimulate additional net private sector investment, and make a significant contribution to economic growth and employment.

The government can do this, for instance, by introducing in the next Parliamentary session a bill to reform the electricity market, and by allowing the Green Investment Bank to operate as a lending institution, offering loans to private companies so that it shares some of the risk of private investments in green infrastructure. The UK should also work with other member countries to increase the European Union’s target for emissions reductions for 2020 to 30 per cent from 20 per cent, providing a boost for the carbon price within the Emissions Trading System. And it should support additional investment from the European Investment Bank, and encourage the development of a European supergrid.

But the prime minister and his cabinet colleagues also need to be strong advocates for the green economy. If they convey the false impression that we have to make a choice between environmental responsibility and economic growth, they will undermine the confidence of private sector investors in the direction and consistency of future policy.

Nicholas Stern (an independent cross-bench peer) and his co-author Dimitri Zenghelis are respectively chair and senior visiting fellow at the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science. A recent lecture on green investment by Mr Zenghelis, who is also a senior advisor to Cisco, can be read  here.

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