Tag Archives: Macro

The myth of “financial terrorism”

Banks, English, Global Economy, On the cover

This article was published in El Confidencial on August 20

“The phenomenon of economic ignorance is so widespread and its consequences so frightening that the objective to reduce that ignorance becomes a personal goal”, Israel Kirzner.

I spent eight years of my career in the area of ​​Investor Relations and despite suffering the Latin American crisis and others, I never saw the Spanish media insulting investors and spreading conspiracy theories of British attacks on Spain as I am seeing today.

In those days we didn’t approach everything from a sense of entitlement. We had to earn the interest of a market with limited capital. We learned especially from those who criticized us. Today, the global deleveraging process is making capital even more scarce, but our country seems to invoke a right to receive “unlimited capital” unconditionally.

Blaming the waiter for the bad food of the restaurant

Today, the national sport of blaming everyone except ourselves for our problems has reached delirious levels, peaking with articles in the mainstream media accusing the United Kingdom and the markets of “financial terrorism.” It is a handy scapegoat, to use a diffuse entity, the market, as a sort of “evil Dr No” behind our troubles.

This “market” is nothing but our savings, operators which are a secondary consequence of the real causes of a crisis created by ourselves, the states with reckless spending and their central banks. An economic policy based on monetary expansion that generates structural inflation, artificially low interest rates that create bubbles and masses of debt, which ultimately becomes unaffordable, leads to defaults and devaluations that impoverish the entire population.

These media commentators demand every day that the European Union prints, devalues, and raises taxes. However, afterwards the same journalists wonder why inflation rises, and food and raw materials rocket. And their conclusion is obvious: It is the fault of some “evil conspirator” in Westminster or ‘traders’ in London that envy Spain and want to make it fail. Easy. Of course, the hedge funds all together handle a fraction of the funds that the EU manages, but in our ostrich policy of “pretend and extend” the media repeats over and over that hedge funds attack us. Reminds me of my parents’ village, where every time there is a robbery, the people blame the tourists.

Now Spain needs investors like oxygen.

It’s funny that we complain of our unfair bond yields “when the UK is in much worse condition”, the “Perfidious Albion attacking us because of envy”, as the press said of Britain in the Franco times.

When Spain multiplied its debt in four years from €390bn to €734bn and all its regions increased their debt from €60bn to €140bn no one in Spain branded the reckless spending as ‘financial terrorism’, despite squandering money that the country didn’t have. Spending is always justified, and citizens presume good intentions behind it, while now the mainstream media and many politicians attribute dark evil motives and invent conspiracy theories to explain why investors do not trust the country and decide not to buy bonds. Not purchasing, by the way, is not attacking. The country cannot force anyone to “buy.”

In terms of sovereign debt management, Spain should learn from the UK

Let me clarify one thing first. No one is more critical of the UK economic policies than me, I live in London and have been vocal about the very erroneous policy of the previous government of excessive spending and believe the current QE and monetary expansion policy is no solution for recession. But the British ten-year bond is perceived as a solid investment, and there are fundamental reasons for it.

Let me summarize the ongoing debate all over Spain’s economic media. It says: “Spanish bond yields are unreasonably high and the UK’s are unreasonably low despite the fact that the UK is in worse financial shape because the London financial institutions and media attack and exploit our weakness”. Right?, No.

Let’s start with what creates mistrust in the Spanish debt, which needs to be tackled urgently:

-The concerns when accounts do not match. Spreads started to widen aggressively despite ECB interventions with the increase in government spend (the failed 35bn “Plan E” stimulus, the 125bn injected in the savings banks) and the well-known unpaid bills, debts not accounted, while deficit figures had to be revised twice.  If Spain does not give credible and consistent economic data, bond investors, by definition the most conservative and long-term driven, will simply avoid the risk. The UK on the other hand has been detailed and clear not only about swift cuts but stimulus and about budget limitations.

-Institutional credibility and credit responsibility. Everyone knows who to blame for the deficit in the UK, and there is one body and one chancellor who can act on it. There are no debates between parties of “who is less corrupt” than the other, and institutions and their responsibilities are clear and enforced rigorously. Another problem is lack of credit responsibility. In Spain, between savings banks and 17 regional communities with 17 decision centres, each with its vested right to default and be rescued, there is no real political responsibility for the consequences. Regions miss debt targets and then “rebel” against the state. How do they rebel? Not paying their suppliers.

–The perception that reforms are cosmetic. Spending cuts in Spain so far have been reductions in expected increases, not real cuts, while the UK has made very deep cuts. Therefore, ahead of uncertainty in the economy, Spain can only count on improving revenues to achieve its targets and that’s a huge risk.

–The acceleration of spending. In Spain spending has doubled while revenues stagnated. This acceleration is very relevant. What creates more distrust among investors is the evolution of dynamic solvency ratios (increased costs versus revenue growth), not static (debt / GDP) and also future refinancing needs over the global supply of debt. In the UK, for example, issues tend to be made with very long maturities, and always seeking to avoid saturation of supply. Spain has to refinance, between 2013 and 2015, 259 billion euro, almost the same amount as the UK, 320 billion, but with less than half of GDP and much lower revenues.

–The unhelpful messages on default and exit from the euro. If an opposition leader says “if Spain was out of the euro our risk premium would be 300 basis points,” a leader of a majority party says “debt must be declared odious and stop payments” and a minister says “the German banks also benefited from our bubble”, they are unconsciously highlighting in public the risk of default. And investors do read those statements.

Of course, the UK is a country that attracts capital, maintaining investor’s interests as the State’s primary policy, the economy is extremely flexible, and with 8.6% unemployment. The challenges in Spain remain in a regulation that makes investment and job creation extremely bureaucratic, onerous and slow, and an unusually restrictive and cautious approach to foreign investment.

To think that the UK bond yields are low only because the state devalues the currency and monetizes debt is another mistake.

If the panacea to lower bond yields is to print money and have an active central bank easing, Zimbabwe or Argentina would be the countries with the lowest bond yields of the world. Without institutional credibility and credit responsibility, legal certainty and a suitable investment environment, the impact of interventions are temporary and ultimately irrelevant.

The BoE has bought less than half of the debt issued by the UK between 2009 and 2010, the other half was bought by institutions and banks, including, surprise, surprise, a few big Spanish banks.

In Spain the ECB has injected over 400 billion euro to banks, used mainly to buy sovereign debt, more than the Gilt purchases of the Bank of England in 12 months. If the monetization of debt is the reason given by the media to explain low bond yields, Spain has seen a much larger EU-funded program of bond purchases –through its domestic banks- relative to its GDP and its refinancing needs.

Without institutional trust and credit responsibility that prevents default risk on Britain’s debt, the country’s yields would also soar despite BoE purchases.

Bond yields are a reflection of the secondary bond market, ie the investor appetite for the country’s debt. Nobody profits or attacks the country by not buying bonds.

I read that the Spanish government will make a diplomatic offensive to attract investors and I think it’s a wonderful idea.

Three ways to improve:

–Stop issuing short-term debt to finance long-term spending, it will take bond yields to stratospheric levels, with or without ECB purchases. It would be positive to see lengthening maturities and a national agreement to attempt the conversion of debt held by domestic entities-nearly 70% of total-to long-term debt.

–Attracting capital, as the City of London does. Issue debt to investors who can also have access to assets. One reason for the distrust of investors is because in Southern Europe they are allowed to buy debt but not companies or assets. A national regulation that encourages investment and stops trying to keep out foreign capital would be very productive.

-Enforce compliance and responsibility to those regions and banks with problems. Irrevocable, immediate and demonstrable. If investors see that the money is given out but not controlled, they will not invest.

–Strengthen laws to defend creditors and debt repayment. It is not worth changing the Constitution as last year and then a few months later deny of such agreement.

The problem of wasteful spend disguised as ‘real’ economy

I’m getting used to read in the mainstream media that useless investments, duplicate administrations and cronyism are not so bad because they “maintain GDP and employment” and, after all, unnecessary investments in infrastructure “at least are spent in something tangible –real”. Furthermore, these “wasteful activities also generate growth”. This belief is part of a monstrous mistake that began to take shape in the mid 90s when Spain started to see money pouring in from Europe. It had to be spent to get more afterwards. It’s the widespread belief that money is free and that the right side of the balance sheet does not matter or does not exist. “Public money belongs to no one”

This is not true because it assumes that the “money” spent is capital and not debt. If it was capital, I would partially agree. That is, if I’m rich and I spend a significant part of my salary in drinks it is my decision, but it does not have a direct negative impact on my finances. But when it is debt, bad economic decisions cost a lot. That is, if I’m poor and I have two mortgages and I spend a significant part of my salary in drinks I create a double negative effect, the cost of debt and the futility of my expense. The money squandered is not only wasted but it costs, because debt and interest have to be paid by a declining percentage of the profitable and productive part of the economy.

The popular perception in Spain is that if a bridge, a phantom airport or a ghost city that is not needed is built, at least there is something real and valuable. Like China but without its economic power and wealth. The idea that the economic use of those “things” is irrelevant just because some jobs were temporarily created, when in fact there is not only an asset, but an associated liability, and the cost must be covered with the productive returns of another activity or through taxes, or more debt. Therefore, unnecessary infrastructure is not only wasted borrowed money that does not create “real activity”, but it crowds out and eventually erodes the real productive activities, enlarging the debt balloon. The useless bridge-airport-city would only have zero cost to the economy if it were funded with surplus wealth or a donation. And Spain has neither one nor the other.

In summary, Spain must attract capital, learn from its more financially mature peers and forget to support GDP with hot air. No one is attacking Spain, if anything we attack ourselves by scaring investors. The day that the country learns that inflating GDP based on useless spending generates debt that cannot be paid with air; we will start to end our problems.

Blaming the ECB. Better to sink the fleet than to repair the boat

Global Economy, On the cover, Sin categoría,
(This article was published in El Confidencial on July 8th)
 
‘Everything is subject to conditionality. There is nothing without conditionality. Conditionality is what gives credibility to these measures’, Mario Draghi, president of the European Central Bank.
 
The new mantra in Spanish media is that the European Central Bank is attacking us. Before, it was the Anglo-Saxon press, then the markets, then,Germany… Now, according to some commentators, it is unquestionably Mario Draghi, president of the ECB, who is to blame for Spain’s misfortunes.
Draghi, obviously, is to blame for the reckless spending, for doubling the national debt, for the most convoluted regulation of the Organisation for Economic Co-operation and Development (OECD), the ghost airports and the phantom cities. Evil.
We have spent a week hearing: “Draghi will connect the printing machine,” and it seemed everyone was shocked when it didn’t happen. The debt threshold is at its limit even at the ECB. Quoting the famous South Park…”Aaaand it’s gone.”
Debt is a drug. And like drug addicts in the infamous crack supermarkets of Harlem, we were looking forward to the ECB to saving us from our debt problem with more debt in order to keep spending. And like drug addicts, even if the ECB lowers rates to indecently low levels, the effects last less and less.
We blame the ECB, which after lending €288bn to Spanish banks and lowering interest rates to 0.75 percent does not “do more.” What more do we want it to do? A donation. Ah, no, my friends, there are no donations.
The ECB does not help. It lends. The ECB doesn’t rescue. It lends. The ECB does not donate. It lends.
When people hear that the ECB should buy Spanish debt they should also know that it’s not a favour, and that there are strict conditions attached to the agreement. But more importantly, people should know by now that the ECB buying bonds does not solve anything, as evidenced by previous purchases, which have not lowered bond yields for more than a very short period of time. 
 
These bond purchases of the past have done nothing but infect the ECB’s balance sheet the same way as the sub-prime debt packages of 2007, without attacking the underlying problem, which is excessive spending.
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The ECB balance sheet has ballooned to 30 percent of gross domestic product of the Eurozone. The Federal Reserve‘s and the Bank of England’s balance sheet is 20 percent of the GDP of their countries. The Fed and BoE loans are paid back. In Europe, however, no one pays back these loans.
What is a little more debt between rich friends?
The ECB, which has nearly 40 percent of its assets in toxic bank debt, and has lowered interest rates again, has to do “more”. But who contributes to the ECB when all others ask for help? No wonder that Finlandand the Netherlands say: “Me? No, my friends.”
Spain demands “more” from the ECB even when Spain has received the equivalent of two Marshall Plans in aid since 2009. After two injections of liquidity (LTROs) that have crippled the ECB to €3bn of debt, we demand “more”. Expand the balance sheet, they say, which is nothing else than packaging and hiding debt. We demand donations. Well, no.
We live in a manipulated market and the more it is manipulated, the less the placebo effects last, because the real problems are not solved. A manipulated market to benefit the states. Financial repression.
It is curious to hear more and more people demanding financial repression, because that is what they ask for when citizens demand more inflation and mutualisation of debt. And it’s funny because media and citizens demand these measures as if everything was not going to be paid by the taxpayer in the end.
 
Financial repression
 
We claim our undeniable right to be robbed of our savings by lowering interest rates and to sink our financial capacity through inflation.
Commentators tell us insistently that there is no inflation threat. We hear over and over that this is a deflationary spiral, and meanwhile American economist Paul Krugman tells us that “a little bit of financial repression is not that bad.” However, inflation is there and it is a tax, an unfair and accumulated tax created to pay the excessive government debt.
However, the media repeats that there is no risk of inflation. Of course, anyone who pays for groceries, gas, utilities and bills sees prices going up every year while their net income after taxes plummets. Inflation according to “official figures” is 2 percent, yet the real increase in the cost of living is 5 percent per year. I recommend you read this report on the actual inflation in the United States compared to the official.
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Every day, I read more suggestions from politicians, economists and other commentators calling for an “audit” of public debts and to consider “illegal” those debts incurred by a state and regional governments that have been democratically elected and supported by the majority.

When one reads “audit,” “revise debts,” or “lenders must bear some of the cost,” one needs to be aware of what it means. It means default. Because then none of us can complain that bond yields are too high. If we call for a restructuring, then bond yields are actually very low, as leaders are telling the market that here is a very high risk that one of them is elected and then defaults.
The consequences of a default are devastating:
 
. The country loses international support. The cost of the remaining debt after default would soar, as has happened in Greece and other similar countries.
. It does not reduce the need to make huge cuts. Spain has a primary deficit of almost 7 percent. Cuts would be even more severe after default, given that the funding of the structural primary deficit would be prohibitive.
. The credit crunch would be enormous. Forget lending to the real economy. The crunch would destroy growth and employment, but as the government would continue spending beyond its means, the crowding-out effect of the state would increase.
. Private companies would suffer immensely. Refinancing needs of non-financial Spanish firms are concentrated in 2014, and many would find it impossible to get financing on the market, which would lead them to cost-cutting and massive restructurings.
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One of the most important sentences Draghi said on Thursday was: “What if all countries need help?” The ECB cannot bail out the big Eurozone countries. With what funds? We are talking of infecting the ECB’s balance sheet at €500bn annually if it needs to help Spain, Italy and those who have sought bailouts, when the latest could be Slovenia.

The ECB cannot buy debt without first seeing that countries have carried out drastic reforms that will prevent this debt crisis from happening again in 2014, because Europe faces €800bn of sovereign debt maturities every year over the next three years.

Spain has to solve its structural problems of competitiveness and high spending. To do that there is plenty of support and funding, but there are no donations or quick exits to a structural problem. 
Converting the ECB into the cockroach motel, where what comes in doesn’t come out, would cost much more to all – businesses, citizens and states – instead of doing what should have been done years ago. Align expenses to revenues. What everyone is doing except the state.

Watch the documentary Fraud, Why The Big Recession here:

http://www.youtube.com/watch?v=PTpKGiVwKHY&feature=youtube_gdata_player

Further reading:

http://online.wsj.com/article/SB10001424052702304782404577488283442408896.html

 

Between junk bond and intervention

Global Economy, On the cover, Sin categoría,

(This article was published in Cotizalia on July 1st 2012)

The EU summit concluded with a surprise note. The strategy of Spain and Italy to corner their partners has been a masterstroke and it buys both countries time. Unfortunately, these agreements have had a very modest impact on the Spanish 10-year bonds, still at 6.25 percent, and the spread to the German Bund, which is around 475 basis points.

Why? Because it is still a patch. As someone in Twitter noted ” A decisive solution, using a fund that doesn’t exist to buy debt that won’t be repaid via a mechanism that hasn’t been agreed.” I’ll try to explain it as simply as possible going through the main comments from readers.

Why more uncertainty?

It doesn’t matter which entity we think will provide the funds, be it the European Central Bank, the European Financial Stability Facility or theEuropean Stability Mechanism. They will have to finance themselves in the secondary market, with capital from foreign investors, SWFs, etc. These investors see that the legal structures, mandates and limits of the European mechanisms are discussed, threatened and redesigned almost every month, generating tremendous uncertainty. Therefore, neither the EFSF nor the ESM, when approved, will enter the benchmarks used by funds to decide where to invest.

In short, threatening legal structures that underpin these mechanisms scares investors away, precisely when they are most needed. Would you invest in a fund in which each month the managers threaten to change the prospectus?

We have discussed in previous weeks the enormous difficulties faced by these mechanisms. The ECB’s balance sheet already exceeds 30% of the GDP of the Eurozone, compared with 20 percent of the US Federal Reserve or theBank of England. The European countries that contribute to these mechanisms and the ECB are extremely indebted. In addition, as time passes,there are less “net contributors” because the number of troubled countries grows. Portugal, Greece, Ireland, Spain … and Cyprus, which after four years in the EU, needs a bailout of €10 billion with a GDP of 18 billion.

France already has 89 percent public debt to GDP, Spain surprised negatively on Tuesday with a much higher deficit than expected, German default risk rose 30 percent in a month and meanwhile almost all eurozone economies are in recession or stagnation, while the vast majority of those countries are increasing their debt.

There is no money to continue this “ostrich strategy “of avoiding tackling the debt problems and kicking the can down the road in an EU that feels more isolated from the rest of the world each day.

Why bond spreads keep widening

The spread of the Spanish bond with the Bund is a reflection of the secondary market, ie the investor appetite adjusted by a certain risk. We can complain and make European entities intervene, but if markets don’t see reliable, verifiable and sustainable economic figures and an improvement in the ability to repay debt, investors will not buy bonds. That is why on Friday we saw fund flows of 3 to 1 better to sell.

Imagine a quoted company that is posting weakening results and a major shareholder buys 5 percent in a defensive move. The share price might stabilize for a few days, but then it continues to fall because institutional investors still do not trust the strategy and the profit generation ability of the company. We see the same effect on bond yields after the placebo effect of ECB purchases. Bond yields rise again, due to lack of confidence.

Grand public statements and good intentions are not enough. Until Spain publishes figures showing clear and sustainable improvement of credit qualitywe will not see bond yields fall.

201207019grafico 2

Are markets attacking us?

Investors are not buying Spanish debt. That is not attacking. It is not buying. We should analyze why an investor in bonds, which seeks the lowest risk and the longest duration, prefers to buy bonds at 0 percent yield, the Germans or Swiss, rather than bonds with 6 percent yield, the Spanish. They avoid high yield bonds because they worry more about whether the principal is ever going to be repaid. As Jim Rogers used to say “I am more interested in the return of my money than the return on my money”

With the level of uncertainty about Spain’s public finances, investors feel that 6 percent is not an attractive risk-reward. Spain has destroyed its credibility with changes in deficit figures, broken promises and hidden data for years, and now it has to bring back confidence with facts.

Bond investors do not distinguish between one political party or another, or one government or another. It is a sovereign matter. And if the state doesn’t meet its own targets, investors don’t risk their capital. Would you do it? Would you invest in the debt of a country where targets are not met or are made up? This is what Spain has to solve, now. slashing expenses.

Doesn’t Spain have less debt than Japan?

The spread of Spanish bonds is not high by coincidence or injustice. As a country, Spain always talks of its low debt to GDP, which is a misleading indicator, as GDP, for example, can be artificially inflated by borrowing to build useless things -phantom airports, ghost cities, etc.

What matters to investors is the deterioration of the public accounts, revenues falling and costs rising. Spain’s debt has doubled between 2008 and 2012 but the country has not done enough to stop the escalation of spending while tax revenues coming from the “housing bubble” disappeared. But the expenditures have remained untouched, most of all subsidies and bureaucracy. Spain had three major bubbles: Debt, Housing and State size. Of those three, State size is the one that has not been burst.

Imagine having a credit card for which one pays interest. If expenses double, but income stagnates, first one sees the interest rate rise, and if expenses don’t fall the credit card will be cancelled. And this does not mean that the issuer of the card is “attacking”, it just means that the card holder becomes an unreliable debtor.

Many will say that a country is not a credit card and that “we deserve” to be funded at lower costs. Fine, then, as a country, we should do what households and sensible companies do. Cut expenditures.

Intervention, let’s go

What happens when the credit card is cancelled? That one has to go to a lender of last resort that will solve the liquidity problem, but will demand cuts and high interests. Like those TV ads that say “reduce your monthly payments”, “we consolidate debts into one comfortable monthly payment”… at exorbitant interest rates and with severe penalties.

The problem of using the word “bailout” or “intervention” is that it has a positive connotation, almost humanitarian. I would recommend that when you hear the word, change it in your brain for “mortgage” and when you hear ECB think of “lender”. It shows a completely different meaning.

Some readers tell me they prefer an intervention than keeping our corrupt politicians. I do not know what to say. Changing politicians who have been elected to bring others who are not elected from Brussels? I am not sure, particularly when the latter have a track-record as poor as that of our own leaders.

Blame it on Germany for financing our real estate bubble

As a Finnish member of parliament said to me, “the fact that I have lent to a friend €1,000 and he has wasted the money in parties does not mean that I have to continue lending him or that he doesn’t still owe me my money”. Responsibility must be shared, but donations should not be expected.

But what if we are rated junk bond?

Rating agencies, I’ve said it many times, act always late and poorly. With Spain, investors have assessed its credit risk well below what rating agencies said since March 2011 at least. I always say that a rating agency is an entity that charges Paul McCartney to inform him that the Beatles split up.

First, Spain is not junk bond. But the risk of downgrades cannot be tackled by promising income that never comes, or by giving excuses for poor data, as any rated quoted company can tell. It is tackled by cutting costs and showing better numbers than estimated.

But if we cut spending, we lower GDP

Sure, let’s put more debt into the economy to build useless things until we have the GDP of China and let’s see how we do.

Of course cutting expenditures lowers GDP, but it also slashes the deterioration of our debt problem by a bigger percentage. Spain needs to cut political spending, duplicative administrations and unproductive debt that only generate impoverishment. We are talking of tens of billions per annum.

Print money?

It’s a unanimous cry. Let’s print money. The ECB must buy the debt of our wasted years and monetize it, creating inflation. Let’s do like the United States which “only” has a debt of $50,500 per citizen.

Print money in the EU, when the euro is only used in 25 percent of global transactions would generate high inflation. To begin with, we would have to see if our partners accept to drown the ECB in more debt. But I am surprised that people cry for inflation mentioning an “adequate” level of 5 percent-official, as real inflation would be 8 to 9 percent. I am shocked to hear people calling for their own impoverishment to allow the government to continue spending recklessly. If citizens think that raising VAT is a disgrace-and it is-inflation is the same, but “undercover” and cumulative.

Then there is no solution

Of course there is. Cut spending, duplicative administrations, subsidies and grants, be a serious country, open the doors to free market, and stop thinking that everything is arranged in the Eurozone web of cronyism, patronage and debt.

This week I wrote an article in the Wall Street Journal detailing the four points which, in my opinion, would help Spain to reduce bond yields. None of those points is to “solve a debt problem with more debt,” and the agreement of the EU is exactly that. It gives Spain and Italy time to accelerate and deepen reforms, but is nothing more than a loan.

Of course Spain will be helped and the country will emerge from this mess, but it will not be by going “back in time” like Huey Lewis & The News. It will be through cuts in spending and liberalizing the economy.

Austerity and Growth. Why It Works

Global Economy, On the cover, Sin categoría
(This article was published in El Confidencial and  Cotizalia on April 4/2012)

The great debate in modern macroeconomic analysis focuses on whether the processes of public spending cuts that are being carried out are consistent with fostering growth or whether spending cuts threaten economic development.

Many anti-austerity economists like Krugman, who calls for more spending but also massive wage cuts, or Stiglitz warn of austerity as a driver of deepening crisis.

I’d like to give a summary of the talk I gave a few months ago in Austin and Dallas called “Austerity Works” and why it is in Spain and Southern Europe where budget control is most needed.

The first thing worth to note is that Europe is not undertaking true austerity measures, but very modest cost savings. In fact, in most cases the cuts have only slowed down the speed of spending growth. As we explained here to reduce the “deficit” from 8.9% to 5 % is not austerity, it’s just fiscal prudence. It is not the same to aim for debt reduction than to reduce its increase.

The first argument often used by those who attack the austerity programs is to compare this process with what happened in the 30’s, that is, a worsening of the crisis. But these arguments tend to forget the differences between both periods.

* In the thirties there was a combination of austerity with protectionism , a lethal combination that our rulers should avoid. In a globalized world it is very difficult that we can see the wild U.S. protectionism of the 30s. Unfortunately, this is where Europe can err seriously, since political intervention and protectionism is growing, but not alarmingly.

* In the thirties interest rates were extremely high and the financial capacity of the systems was very limited. That is not the case today. The role of central banks and the globalization of the financial systems has changed this risk dramatically.

* In the thirties quantitative easing was not used as a tool to mitigate the risk of deflation and stagnation. But there is a huge problem to solve. The QE (quantitative easing) that the U.S. Fed makes floods the system with money directly, skipping the banks as an intermediary. In Europe, the monetary policies have been directed solely at banks, which hold on to the funds, buying sovereign debt, without extending credit to the real economy.

The current problem is that the increased liquidity provided by the ECB fails to reach businesses and families. As the chief executive of a large Spanish company said to me “credit crunch here is affecting the small and efficient businesses, not the inefficient overgeared large companies.”

The reasons why I believe that more spending is equivalent to a shot in the foot is as follows:

* Spending more did not work, repeating it is suicidal . Spain increased public spending by 67.2 billion euros between 2007 and 2011, 6.4% of GDP, to generate a GDP decline of 3.3% and a fall of industrial output of 12.7%, with an increase in unemployment to 24%. That increased spending also meant a cost of additional debt equivalent to 0.3% of GDP. Spain SA not only did not stop the crisis spending, but rather deepened it. The figures in Spain are devastating, but the U.S., UK and the Eurozone demonstrate the same principle, that increased spending has not produced a real positive impact on GDP.

I always speak about the debt saturation model. When an additional unit of debt does not generate additional GDP, but negative . We have saturated the dubious benefit of spending. A clear example of this aspect is the infamous Plan E of the Spanish government, 13 billion euros, only generated debt, job losses and lower GDP.

govt spend

As we have seen in the past years, “lack of austerity” is expensive, but indiscriminate spending is even worse. I always say that if Krugman was able to read the details of expenditure items in many European general budgets he would join the Austrian school in a minute. We are not just talking about tens of billions dumped in phantom cities, unused airports, useless infrastructure and outright subsidies and grants. The problem is that all these expenses are not supported by an equivalent income (no ROIC, Return on Invested Capital) thus leaving behind them not just a non-existent value, but an unpayable debt that must be covered with higher taxes destroying other activities and productive sectors.

Useless infrastructures and subsidies are not only wasteful, but the debt they leave behind is also crowding out and taxing the profitable and productive sectors. The subsidy and uneconomical public spend culture also becomes a private “investment deterrent” . No one dares to put a penny in an economy in which taxes generated by productive sectors will be used to cover liabilities of unproductive wasted capital.

Why does austerity work:

* It frees financial resources from unproductive to productive activities. Today, almost 70% of financial resources available are used to purchase public debt and finance government expenditure. It is the crowding out effect of a State that accounts for more than 50% of Europe’s economy. If the State stops monopolizing the majority of credit availability, and also stops spending on unproductive activities, private investment activity and high productivity activities return. It is no coincidence that the states that have cut public spending are the ones that create more jobs.

* It accelerates the transformation to a more productive economy. It is no coincidence that productivity falls with increasing public spending. Most public spending stimulus plans are directed to subsidies and to rescue declining industries (mining, automobile) and very low productivity activities (construction, civil engineering), and it monopolizes scarce financial resources which precludes private investment in high productivity areas. If countries rescue the inefficient by taking from the efficient one’s pocket, investors fly away from the country and moves to more attractive places.

* It helps create real jobs, not subsidized labour. When the State spends on pointless companies and investments with no return, it does not create employment, it subsidizes it by borrowing. And that cost comes from taxpayers until the State runs out of other people’s money and the pyramid collapses. Europe has seen the destruction of more than 80,000 small and medium enterprises annually while governments subsidize spending that also destroys public jobs in the medium term, when money runs out.

* The increase in interest expenses from more government debt hinders recovery and generates tax increases that discourage consumption and investment as well as repel capital. If Europe stopped issuing new debt to pay interests on old debt it would start to solve its problems.

It is relatively easy, austerity would help: Not only stop paying unnecessary subsidies and reduce billions of euros of cost of additional debt, but austerity attracts capital and reduces the loss of tax revenue by bringing new investors. And instead of removing 0.3% of GDP increasing debt, GDP would be up reducing the financial burden.

The well-intentioned recipes of Krugman and Stiglitz start from incorrect assumptions:

. That most European governments would spend taxpayers’ money more efficiently and wisely than private investors.

. Even worse, they assume that those European governments would base their investment criteria in a capitalist, return-driven, open-market, Anglo-Saxon way.

. And much, much worse, they assume that the investment decisions of most European governments are compatible with private investment, when often they aren’t.

Most of these “growth plans” have proven to crowd-out private investment, prevent competition, unfairly defend unproductive and declining sectors, and aim at safeguarding inefficient low productivity oligopolies. As such, in many cases European government spending has proven to be in most cases more damaging than helpful for economic recovery, and it widens the funding hole.

We need to escape the spiral of spending, of favors owed, protectionism and subsidies, we need to stop rescuing the unproductive and, through lower taxes and lower spending, foster investment private capital, innovation and growth.

Further read:

My article in The Wall Street Journal:
http://online.wsj.com/article/SB10001424052702304782404577488283442408896.html?mod=WSJEUROPE_hpp_sections_opinion

also here:

http://energyandmoney.blogspot.co.uk/2012/06/recipe-for-spanish-comeback.html#frameId=uWidget20a9e6e60130f5c6a6f0&height=131

The Myth Of European Austerity

What If Germany Turns Off The Funding Tap?

The European House Of Cards

http://energyandmoney.blogspot.co.uk/2012/06/euro-house-of-cards-and-greek-temporary.html

Real Austerity Does Work

http://pompeunomics.com/2012/07/09/real-austerity-does-work/