Interest Rates and the Euro

After the introduction of the euro, many peripheral countries in the euro area experienced a major credit boom. The reason for this was that these countries previously had “soft” currencies, this is to say, they regularly devalued their currencies instead of implementing economic reform.

Devaluation is the easy way out for policymakers after all. The supposed “advantages” of currency devaluation, illusory, misleading and fleeting as they are, are always experienced as the first effect. The disadvantages – which dwarf all the so-called advantages – are only becoming visible at a later stage, by which time most people are no longer able to properly assess the cause-effect vector.

This failure to understand cause and effect in economics is widespread. Unfortunately, one group among which it is widespread are economists. Looking at the assertions made by many of today’s most prominent economists, we are often struck by how superficial they appear, especially with respect to monetary debasement.

Frédéric Bastiat: a classical “proto-Austrian” economist whose writings remain highly pertinent.

Photo via Wikimedia Commons

As Frédéric Bastiat pointed out more than 170 years ago, this is precisely what differentiates good from bad economists:

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa.”

(italics in original)

Favorable immediate effects followed by disastrous later consequences is incidentally an excellent characterization of the policy of monetary debasement and devaluation.

Given that countries like Spain once were well-known for their devaluation policies, investors demanded relatively high interest rates before committing funds to fixed-income securities issued by such countries. After the introduction of the euro, it became impossible for national governments to unilaterally devalue and this price premium disappeared from interest rates.

Euro area interest rates thus converged toward German interest rates, as Germany is the largest economy in Europe and the ECB was held to be modeled after the German Bundesbank. German rates were the lowest in the euro zone, given that Germany was the quintessential “hard currency” country and reported very low price inflation rates. When the euro area’s sovereign debt crisis broke out, this convergence was reversed: a reflection of growing re-denomination risk.

Interest rate convergence and divergence in the euro area 

In Spain, the boom instigated by the convergence of interest rates was mainly concentrated in the real estate sector. The strongest employment growth was seen in the construction sector. This continued until Spain had attained the highest ratio of houses per inhabitant in the world.

The boom was fueled additionally by the fact that the introduction of the euro happened just as interest rates were about to be pushed lower by central banks around the world in the wake of the bursting of the technology bubble in the US stock market. When rates were raised again between 2003 and 2007, the boom in the euro area’s periphery quickly turned to bust.

Lies, Damned Lies and Statistics …

Spain has a major post-bust problem that refuses to go away to this day. A great many construction workers and others who benefited from the real estate boom have lost their jobs. Construction work is relatively well paid, and requires skill sets that are in most cases of little use in other lines of work. The adjustment process is therefore taking a long time.

Initially, many workers probably hoped that the boom might come back and were therefore reluctant to take jobs that paid considerably less. Moreover, capital that has been misinvested in housing as a rule has to be largely written off. It cannot be easily transformed and put to new uses. As a result, not a great many alternative jobs were available anyway. In the meantime, economic growth has returned and Spain’s unemployment rate has begun to decline, but the process remains painfully slow.

This is especially pertinent for youth unemployment, as young workers were hit the hardest by the bust. Spain’s youth unemployment rate is finally declining as well, but remains at a very high 49.3%.

Spain’s youth unemployment rate – still at an extremely high 49.3%

Not surprisingly, many young people no longer see a future for themselves in Spain and have begun to emigrate in droves. However, Spain’s government has decided it should lie about the extent of emigration (sorry, has decided to “prettify the statistics” on emigration). This has recently been reported in the European press (here is an example). Apparently there is “mass emigration” underway, and the government doesn’t want anyone to know about it.

“Spanish government statistics institute INE reported at the end of June that overall, 78,785 Spaniards have emigrated in 2014. A transnational collective of expatriate Spaniards called “Marea Grenade” (“garnet-red flood”) had doubts about the official figures emanating from Madrid – and compared them with information from the destination countries. This information consists of data about residence permits, social security applications, or job seekers registering with employment agencies. The influx of Spaniards into the UK, Germany, Austria, US, Ireland, Uruguay, Norway, Denmark and Iceland has been examined in this context.

According to Marea Grenade, in some of the nine destination countries ten times more Spanish economic migrants had arrived than stated by INE. For example, according to INE only 9,797 Spaniards emigrated to the UK in 2014. However, according to London statistics, in the same year 50,260 Spanish citizens applied for the so-called “National Insurance Number”, which is essential in order to work legally and get insurance in the UK. In Ireland, the figures published by Madrid (722) are extremely at odds with those published by Dublin (5,195) as well, and the same goes for Uruguay (668 vs. 6,462).

(emphasis added)

This has almost Goebbels-like qualities (“the bigger the lie, the more easily it is believed”). Spain’s government presumably wants to downplay the emigration numbers because it regards them as bad PR.

“Prime Minister Mariano Rajoy’s government constantly minimizes the real emigration numbers”, Marea Grenade notes in its critique. For example, in the “State of the Union” parliamentary debate in February, Rajoy stated that only 24,638 young Spaniards had moved abroad since 2011 – while the Youth Institute of the Ministry of Social Affairs listed 218,000 Spaniards under the age of 35 who had turned their backs on their homeland between 2008 and 2013.”

(emphasis added)

Prime minister Rajoy, indicating how small the number of emigrants is in his opinion

Photo credit: losangelespress.org

This flood of emigration isn’t exactly good news for Spain’s already deteriorating demographic situation and likely also represents a sizable brain drain, as the most talented and entrepreneurial people are also the most likely to leave. On the other hand, it has often been said that a lack of labor mobility is one of the biggest drawbacks of the euro area (compared to e.g. the US).

It appears though that labor mobility is actually improving in the EU under the pressure of the economic crisis. A positive side effect of this is greater integration, which in this case is the result of voluntary decisions by individuals (while economic pressure is what motivates them, the decision to emigrate is still voluntary). Mr Rajoy may feel that mass emigration from Spain is an indictment of his government’s policies, but it actually shifts some of the burden of the crisis from countries that have problems bearing it to those that can.

Conclusion

The Chinese term for “crisis” consists of two symbols – one signifies “danger”, the other “opportunity”. Emigration from Spain and other crisis-hit countries in Europe should probably be seen through this lens as well.

Wise Chinese words – the term for crisis is a mixture between danger and opportunity.

Charts by: Thomson-Reuters, TradingEconomics