“Spain has been trying to be a good citizen by keeping the German bankers happy”

-In 2012 you were among the analysts who believed Spain could leave the euro. What do you think of the current situation? Would you put Spain in the same basket as Greece, Portugal, Italy or Ireland?

I still think Spain is under tremendous pressure to leave the euro because there has been no resolution of Spain’s two great problems. Its debt is still too high and rising. Unemployment is high and will remain high for many years largely because Spain has no tools with which to manage its forced absorption of weak German demand.

As long as Germany refuses to increase its domestic demand and continues to export capital to Spain (in the form of rolling over Spanish debt, which has created the false feeling that the crisis is over), Spain must choose either between another consumption boom (which after the 2008 crisis is no longer possible) or high unemployment.

So far Spain has been willing to stay in the euro in order to protect German banks and Germany’s ability to keep its export industries strong, but I wonder how many more years of suffering Spanish workers will tolerate before they decide that Germany should resolve its own weak internal demand. My guess is that year after year the European right wing will gain votes until they are finally strong enough to force countries like Spain, France, Italy, Portugal etc. to deal seriously with the root causes of the European crisis. Once this happens, the move to leave the euro will be hard to resist. Of course if any other country leaves the euro first, the pressure on Spain will be much, much worse.

-EZ countries are trying to have one voice, although how can this be possible? Germany has the equivalent of 100% of its GDP abroad, and therefore it is in their best interest to have a strong euro. However, Spain’s debt represents 100% of its GDP, and a weaker euro would benefit its economic recovery. Can these two neighbors ever agree?  Does it make sense for them to agree actually?

Actually Germany benefits from a weak euro and Spain suffers from a strong euro. The cost differentials in the two countries, driven primarily by the huge export of capital from Germany to Spain in the 2000-2008 period, have driven up Spanish costs to the point where it has a vastly overvalued currency. Meanwhile the problems of Spain and the rest of Europe have kept the euro from rising enough to eliminate Germany’s very cheap euro. Because Germany refuses to increase domestic demand, while Spanish demand is collapsing because of unemployment, eventually the euro will rise higher as European exports stay strong and European imports drop. Germany can absorb a stronger euro but Spain cannot.

 

-Germany points that the IMF also suggests that a higher German fiscal deficit would not necessarily increase the demand in the southern countries of Europe. What is your take on that?

It is nonsense, as much IMF advice tends to be. The IMF’s solution to every problem is to cut wages to gain international competitiveness. This might work if you are a small, developing country, whose demand is a tiny share of global demand, but in Europe, where average wages are already too low thanks to German policies to force down the wages of German workers, cutting wages in countries like Spain can only make the global demand imbalance worse. If everyone cuts their wages, then households must buy less and businesses must invest less (who will buy their products?). In that case where does demand come from? Why should anyone hire workers?

-If economic theory states that when we pump money into the system it will show up either as growth or inflation, and right now Europe needs both, why is the ECB waiting so much to act? It definitely needs to do something in June, and the Bundesbank is not likely to oppose, but why that late?

Pumping money into the system creates growth by raising asset prices and making households feel wealthier, which causes them to spend more money. But it raises consumption indiscriminately, when what we really need is for German consumption to rise. Europe must solve its demand imbalance, but instead it is trying to return to the unbalanced growth before the 2008 crisis. This is not the right solution. By the way, it infuriates me when people say that Germans are benefitting from their thriftiness and Spaniards are paying for their profligacy. The German savings rate did not rise because Germans became thrifty but because after 2000-01, ordinary Germans were forced to receive a smaller and smaller share of what they produced. Naturally they consumed less, while the difference went to the rich, who save most of what they earn. This is the only reason why their national savings rate went up.

-Do you think there is a real deflation risk in Europe or you just see disinflation?

I think we have seriously to worry about deflation. There is real excess capacity in the world and insufficient demand. The problem, of course, is that deflation is a disaster for heavily indebted countries like Spain.

-You recommended Spain to lead the EU’s south economic recovery. Do you think Madrid has followed that path or would you recommend further action in that sense?

No. Madrid has been trying to be a good citizen by keeping the German bankers happy, even if this means allowing Spanish workers (and German workers too) to pay for the crisis. They do not understand that Germany did not lend money to Spain because of fraternal feelings but rather because it needed Spain to run large trade deficits that allowed German underconsumption to be absorbed. This is the only reason why countries lend other countries money — to buy their products. The huge inflow of German money set off a speculative real estate boom in Spain which caused Spanish households to spend money that they did not really have, and their expenditures stabilized the European economy by offsetting polices in Germany. As long as Germany refuses to rebalance its own domestic demand, Spain must choose between leaving the euro or maintaining high unemployment for many more years. I am not sure why Spain prefers the latter, but I do not believe they will prefer it for many more years.

 

NOTE FROM THE EDITOR: Shortly after our interview, Mr Pettis wrote a long blog post called “Some things to consider if Spain leaves the euro.” You can check it here.