Revisiting the pain in Spain

Paul De Grauwe

There has been a stark contrast between the experiences of Spain and the UK since the Global Crisis. This column argues that although the ECB’s Outright Monetary Transactions policy has been instrumental in reducing Spanish government bond yields, it has not made the Spanish fiscal position sustainable. Although the UK has implemented less austerity than Spain since the start of the crisis, a large currency depreciation has helped to reduce its debt-to-GDP ratio

The different macroeconomic adjustment dynamics in Spain – a member of a monetary union – and the UK – a stand-alone country – is stark. Paul Krugman popularised this contrast in his New York Times blog with the title “The Pain in Spain” (Krugman 2009, 2011), and commented on my own analysis in De Grauwe (2011).

Following the Greek sovereign debt crisis in 2010, Spain – together with other countries of the periphery – was hit by panic in the government bond market, leading to massive dumping of government bonds, fast increases in government bond yields, and a liquidity crisis, forcing the Spanish government to institute an intense austerity program. Although the UK faced similarly unfavourable fundamentals – a banking crisis, a deep recession, and exploding government debt – it was spared the panic, the ensuing liquidity crisis, and sky-high interest rates. This difference between Spain and the UK was explained by the fact that Spain did not enjoy a liquidity backstop from the central bank, while the UK government could count on the Bank of England to provide liquidity in times of crisis.

In De Grauwe (2011), I concluded that what Spain (and other Eurozone countries) needed was a liquidity backstop provided by the ECB. Two years after the start of the sovereign debt crisis, the ECB announced it would be ready to provide such a backstop in the Eurozone. It is therefore interesting to analyse how this announcement affected the ‘pain in Spain’, and to revisit the difference in macroeconomic and budgetary adjustments in Spain and the UK.

Crashes and bubbles in the government bond markets

Figure 1 shows the evolution of 10-year government bond yields in Spain and the UK. The most remarkable phenomena are:

First, the dramatic increase in the Spanish government bond yield at the start of the sovereign debt crisis in 2010.

Second, the equally dramatic decline of this yield from the middle of 2012.

Today, in 2014, the yields of Spanish and UK government bonds are more or less equal – very much like before the sovereign debt crisis.

This remarkable turnaround in Spanish government bond yields appears even more remarkable against the evolution of the government debt to GDP ratios in the two countries, shown in Figure 2. We observe that in 2010, at the start of the sovereign debt crisis, the Spanish government debt ratio was significantly lower than the UK one. Since then, however, the Spanish debt ratio increased much faster than the UK debt ratio and now exceeds 100% of GDP – almost 10 percentage points above the UK debt ratio. The latter appears to have stabilised, while the Spanish debt ratio is still on an upward-sloping path.

Thus, despite this unfavourable development in the most important fundamental variable explaining the yields, the latter declined dramatically. The fundamental reason why this was possible was the ECB’s announcement in 2012 that it would perform the role of lender of last resort in the government bond markets. This took the fear factor out of the market, and allowed yields in the Spanish (and other) government bond markets to decline without fundamentals showing much – if any – improvement. De Grauwe and Ji (2014) provide more empirical evidence, showing that the decline of the spreads since 2012 in the peripheral countries cannot be explained by improvements in fundamental variables such as the government debt-to-GDP ratio, the real exchange rate, the external debt position, and the growth of the economy. Instead, the decline in the spreads was caused by the announcement of Outright Monetary Transactions. (See also the extensive empirical analysis of Saka et al. 2014 confirming this conclusion.)

Figure 1. 10-year government bond rates in Spain and the UK

Source: Datasource

Figure 2. Government debt-to-GDP ratios in Spain and the UK

Source: Eurostat and European Commission Spring Forecast 2014

Debt sustainability in Spain and the UK

The formula for debt sustainability (see Annex for details) requires that the primary surplus, S, equals or exceeds the difference between the real interest rate, r, and the real growth rate, g (in symbols, S=(r-g)B).

We now compare the yearly evolution of r, g, and S in Spain and the UK since 2010 – the first year of the sovereign debt crisis. We first concentrate on r and g, in Figures 3 and 4. We use yearly data.

Figure 3 shows how, since the crisis, the Spanish government yields have been systematically higher than the UK yields. In 2014, the Spanish yields tended to converge again with the UK yields. The nominal growth rate, g (see Figure 4) – which is the sum of the real growth rate and inflation – evolved in a very different manner in the two countries. We see that over the whole period the nominal growth rate in the UK was significantly higher than in Spain. This was made possible by the fact that in the UK – a stand-alone country – the adjustment mechanism included a large currency depreciation that led to a significantly higher nominal growth rate than in Spain, where currency depreciation was not possible and where intense austerity measures were imposed.

In Figure 5, we show r – g. The contrast between the UK and Spain is very strong. In the UK, r – g remained negative – implying that the UK could stabilise its debt to GDP ratio without having to generate a positive primary balance. In Spain, however, r – g was positive throughout the period. Thus Spain, as a member of a monetary union, was caught by a dynamic instability of its debt-to-GDP ratio that it could only counter by generating a positive primary balance. From Figure 5 it can be seen that the need to apply austerity (a positive S) in order to stabilise the debt to GDP ratio was much higher in Spain than in the UK. Even in 2014, when the Spanish interest rate had declined significantly thanks to the ECB’s Outright Monetary Transactions programme, Spain had to generate 4% of GDP more austerity than the UK to stabilise the debt (see Table 1). This in a way can be said to be the price Spain paid for being in a monetary union.

Figure 3. 10-year government bond yields

Source: Eurostat and European Commission Spring Forecast 2014

Figure 4. Nominal GDP growth in the UK and Spain

Source: Eurostat and European Commission Spring Forecast 2014

Figure 5. Nominal interest rate - nominal growth rate

Source: Eurostat and European Commission Spring Forecast 2014



Table 1. Primary surplus needed to stabilise debt (% GDP)

2011 2013 2014 UK -1.22 -1.94 -1.995 Spain 2.30 4.34 1.836

Neither of the two countries managed to generate the conditions for stabilising their debt-to-GDP ratios in 2014, but the UK comes close as can be seen from Table 2 and Figure 2. In 2014 the UK is forecasted to have a primary deficit of 3.5%, which is too high to stabilise the debt-to-GDP ratio, but comes close to it. This is not the case in Spain. In 2014 Spain needs to achieve a primary surplus of 1.8% to stabilise its debt to GDP ratio (see Table 1), while its primary balance shows a deficit of 2.8% – a gap of 4.6%. Thus if Spain wishes to stabilise its debt-to-GDP ratio in 2014, it would have to institute an additional austerity effort of 4.6% of GDP – a heroic effort.

Table 2. Observed primary balance (% GDP)

2011 2013 2014 UK -5 -4.5 -3.5 Spain -7.6 -4.2 -2.8

Source: IMF Fiscal Observer, April 2014

It cannot be said that Spain did not try to bring down its debt-to-GDP ratio. In fact, it tried harder than the UK. Figure 6 shows the increase of the cyclically adjusted primary balance in Spain and the UK. It measures the intensity of austerity measures over that period. It can be seen that Spain instituted more intense austerity measures than the UK since the start of the sovereign debt crisis.

Figure 6. Change in cyclically adjusted primary balance, 2010–2014 (% GDP)

Source: IMF Fiscal Monitor, April 2014

Conclusion

The ECB’s Outright Monetary Transactions programme was instrumental in reducing Spanish government bond yields. This alleviated the Spanish fiscal position, but did not make it sustainable. The continuing unsustainability of the Spanish government debt has to do with two factors:

First while r (the interest rate) declined, g (nominal growth) remained much lower in Spain than in the UK.

The latter was due to the deflationary forces in the Eurozone – themselves a result of excessive austerity and the absence of currency depreciation (which was made possible in the UK thanks to the expansionary monetary policies of the Bank of England). As a result, r – g continued to be positive in Spain, thereby keeping Spain on an explosive debt path.

Second, as Spain was kept on an explosive debt path, it was forced to apply stronger austerity measures.

These in fact did not help to solve the Spanish fiscal crisis as it fed back into a low g, keeping Spain on the same explosive debt path. We know from history that it is generally not a good idea to fight excessive debt levels by organising deflation. This lesson from history was forgotten in Europe.

Annex

In order to analyse the sustainability of the Spanish versus the UK fiscal position, we start from the well-known definition of the government debt constraint:

B = government debt to GDP ratio;

= the rate of change of the government debt to GDP ratio;

r = nominal interest rate on the government debt;

g = nominal growth rate of the economy;

S = primary budget surplus.

When r > g, there is an explosive dynamic that leads to an ever-increasing debt ratio. This explosive development can then only be stopped by generating a sufficiently large surplus in the primary budget balance, S. More formally, a necessary condition for maintaining solvency is that B be stabilised, i.e.

= 0

or S=(r-g)B.

References

De Grauwe, P and Y Ji (2014), “Disappearing government bond spreads in the eurozone – Back to normal?”, CEPS Working Documents, May.

Krugman, P (2009), “The pain in Spain …”, The Conscience of a Liberal, 19 January.

Krugman, P (2011), “The Pain in Spain”, The Conscience of a Liberal, 4 May.

Saka, O, A Fuertes, and E Kalotychou (2014), “ECB Policy and Eurozone Fragility: Was De Grauwe Right?”, CEPS Working Documents, June.

