Spain, Spain, Spain

Andrew Hunt has an excellent analysis of Spain’s balance of payments position, in which he argues that outflows from Spain have been a massive 20% of GDP in the year to 31st March. That means that it is hardly surprising that Spanish yields have risen.

What does one do with this information? The massive external deficit means that, in order to avoid soaring interest rates and a collapse in domestic demand, Spain needs inflows from the EU and ECB. Are these inflows happening? Clearly, yes. The Bank of Spain’s TARGET2 liabilities increased by EUR 235bn in the year to the end of March, and have increased another EUR 69bn in April and May ( Further, European governments have just agreed to lend up to EUR 100bn to Spain so that the country can recapitalise its banks. I therefore see no reason for an imminent collapse.

However, on this argument, I see no reason for Spanish bond yields to have increased at all, and this is exactly the point that has been perplexing me in recent days. Spain’s banks can borrow an unlimited amount from the Bank of Spain/ECB and Spain should therefore be able to sell them an unlimited amount of bonds. Why, then, are bond yields rising? I can see two potential reasons. The first is the view that I argued held for Greece and Ireland: the banks lost faith in the solvency of the sovereign, and were therefore not prepared to buy its bonds. It seems to me to be unlikely that Spanish banks would rationally take this view of their own sovereign. The second is that Spanish banks are on hold while they wait for a) details of their own recapitalisation and/or b) the Greek election. It is this second reason that I find most persuasive. Thus I expect Spain’s market access to return if and when these questions are resolved.

There is an argument that Spain’s capital needs make its continued presence in the Eurozone unsustainable. I do not think that this is true. If one took the capital outflows from Spain as exogenous and considered what they would mean for Europe on an ongoing basis, then the answer is ongoing transfers from the core to the periphery. Many consider this politically impossible, but I do not. It is already happening in huge size and, fundamentally, Europeans have an emotional commitment to EU integration (that we Anglo-Saxons do not share or understand).

If, on the other hand, one tries to construct a model in which capital outflows from Spain are endogenous, the prospect of an improvement appears. A simple model that I set out earlier in the week sees every negative point about Spain as a reason for incremental capital outflows. The negative points, I said, were: i) government’s failure to hit its deficit target in 2011, ii) the worsening recession, iii) its having become apparent that the banks need more capital than previously thought and iv) the Greek situation. Perhaps I should have summarised (i) and (ii) as v) the deteriorating debt-GDP dynamics. Austerity, which I have long argued was a bad idea, does not mean negative growth forever — (v) will eventually improve, which means that the EU’s task is to keep Spain going until it does. That task is large, but finite. (iii) is in the process of being dealt with. (iv) remains a major issue; but I do not believe that the EU will allow Greece to leave the Eurozone. The point here is that, in avoiding that disastrous outcome, the EU would deal with a major part of Spain’s problem. Thus I conclude that Spain’s capital-outflow problem, while huge, is in theory manageable, using just the kind of tools that have so far been employed, and ought to abate as (iii) and (iv) are resolved.

Fed Action

There is some expectation that the Fed may announce further easing after its next meeting on June 19-20. Why?

In Q1 it seemed that the Fed had announced, as I put it at the time, either a ratchet put on the unemployment rate or a put on the rate of improvement of unemployment. If that was right, and given that the unemployment rate has recently ticked up, it would be reasonable to expect further Fed action. Further, the risks posed to the US economy by the European situation are significant. Tim Duy ( interprets recent comments by other Fed governors as suggesting that they would be prepared to vote for further easing if Bernanke supports that course.

Set against this, however, is the fact that the European situation is at present more fluid than disastrous, and that unemployment has only ticked up for a month. Leading indicators ticked down in April but have so far been mixed for May. Further, given that the Fed’s theoretical belief is that its stimulus measures — QE or OT — work by reducing interest rates vis a vis the unknowable counterfactual (i.e. the Fed doing nothing) via the portfolio balance effect, and that interest rates are at present extremely low thanks to the enhanced communication strategy, I wonder whether there is a good rationale for further action. The best argument, it seems to me, is that the market does not understand the situation as I have just laid it out, and would take a cessation of Operation Twist, due to expire in June, as a monetary tightening. On that basis, even though I think OT is achieving very little, it would be reasonable for the Fed either to continue the programme or to announce some new measure.

What effect would any new measures have? QE, especially QE involving the purchase of MBS, should have a money-flow effect on financial markets — i.e. it should drive them up. OT I think has very little effect and a continuation of the programme would merely signal that the Fed had not changed its easing bias. Janet Yellen has argued that an increase in the duration of forward guidance, into 2015 or beyond, would have a diminishing marginal effect, but that does not necessarily rule it out. Charles Evans continues to favour more explicit forward guidance — say, that the Fed will remain on hold until either the unemployment falls below 7% or inflation rises above 3% — but as Duy points out, to make such a statement on inflation would be to come into implicit conflict with Bernanke’s new, hard-won, 2% inflation target, whose purpose is to anchor inflation expectations. On this argument I suppose that a continuation of OT is the most likely outcome, but I do not think that I have a superior ability to read the runes here, and such is the uncertainty about the Fed’s likely action in the market that I have little fear that, if there is a trade in the offing, one will miss it on account of having waited for the actual announcement.


Mariano Rajoy declared “battle” on the ECB, which he says needs to buy more Spanish government bonds. Wow. A direct attack on the ECB is a serious thing. It is also a good thing. The ECB is, quite simply, mad. Its hard-money mania is making Europe’s problems far worse than they need to be. Control of the asylum needs to be wrested from the lunatics in Frankfurt and if this is the start of such a move, then good luck to Mr. Rajoy.


  • New Zealand held rates at 2.5%, a.e.
  • Japan IP for April was revised down from 0.2% to -0.2%, d.e.
  • Switzerland held rates, as expected. Jordan reiterated the SNB’s determination to maintain the EUR 1.20 maximum for the CHF.
  • Eurozone CPI 2.4% YOY a.e. May. Core 1.6% a.e. Come on ECB! Inflation is subdued. Act!

Coming Up

  • US CPI
  • BoJ rate and statement