Much talk on youth unemployment and just a little action

Youth unemployment moves up the agenda

Recent weeks have seen increased traction to the perception that youth unemployment across the EU, especially the euro zone, has to be treated as a major—indeed the major crisis, if one is reassured that financial meltdown of the euro zone has been relegated. Of course the danger of the latter cannot be treated as though it had been eliminated but rising unemployment, especially of young people, could undermine the political support needed to sustain the kind of policies in southern Europe, and even in France, that are required to prevent financial meltdown, as so clearly indicated by the result of the Italian election of March 24-25th where huge swings in votes to the rightwing PdL and the internet based protest movement M5S, must be interpreted as protests against the well intentioned policies of the previous government led by the respected academic Mario Monti, to comply with the desiderata of the EU institutions.


Situation in southern Europe cannot be ignored in the north

This means not only that youth unemployment must become the top priority of governments in the peripheral countries most affected, and of the European institutions, but also of the countries like Germany the Netherlands and Finland that are doing much better in terms both of overall economic performance and specifically in providing opportunities for young job-seekers. If these countries are committed to the survival, let alone deepening, of the process of European political integration that goes back to 1951, as the great majority of political parties in all these countries claim to be (with the exceptions of Geert Wilders’ Netherlands Freedom Party and Timo Soini’s True Finns), then the employment crisis in fellow member states has to be taken as a serious challenge to their own credibility.

Recently some members of Germany’s government have shown signs that they are aware of this challenge. In mid-May the German employment minister, Ursula von der Leyen signed an agreement with her Spanish counterpart, Fatima Banez,  to facilitate the availability of apprenticeships in Germany for Spanish nationals and for German experts to provide advice to Spanish companies willing to learn on how aspects of the successful German apprenticeship system, whose roots go back centuries and which has been a major feature of the post-Second World War German economy, might be implemented in Spain. This would build on existing Spanish government efforts to promote apprenticeships. The  scheme has been supported by Wolfgang Schauble, the formidable German finance minister who has said “we must be faster and more definitive in fighting youth unemployment”. He also agreed on May 22nd with the Portuguese finance minister, Vitor Gaspar, that the German state development bank, KfW, should help set up a Portuguese institution to promote work or training for young people. On June 3rd the KfW signed a deal to lend €800m to its already existing Spanish counterpart, ICO  (with an extra €200m once agreed by parliament for “mezzanine” financing). On July 3rd, Angela Merkel is to host a meeting of EU employment ministers in Berlin.


But measures so far are mere drops in the ocean

However, the measures mentioned above are no more than drops in the ocean. While the subject of youth unemployment has risen dramatically in the field of international discussion across Europe, as seen in the OECD Forum at its headquarters in Paris on May 28-29th, there is as yet no policy measures which are likely to be make a significant impact. The €6bn of EU funds structural funds which are frequently mentioned are over the whole 2014-20 period so amounting to less than €1bn a year, which is 1% of the EU’s modest budget and 0.01% of EU GDP. It can be argued that larger sums if made available might be mis-spent given high levels of corruption in parts of southern Europe but that means that the rapid use and of EU funds to provide job and training opportunities, followed by rigorous assessments of their success with a view to applying any lessons to further funding, are urgently required.

How much is EU commitment to guaranteeing opportunities to young people worth?


Is EU tilting at windmills?

On April 22nd the Council of Ministers formally adopted a Commission proposal made in December that every young person leaving education or losing a job should have the offer of a job or training within four months. This is in some degree capable of being achieved in the more successful economies of northern Europe but in much of southern Europe looks like an aspiration divorced from the reality of youth unemployment ranging from 38% in Italy and Portugal to nearly 60% in Spain and Greece. The economies of southern Europe are now at or close to external current account balance so they are now longer consuming more than they produce and are, in addition, servicing high levels of foreign debt. But government deficits remain high leaving no extra finance for governments to fulfill the promise that they have made at EU level.


Southern Europe countries can not meet guarantee on their own

The emergency has to be treated as an EU one and its resources put into the struggle to make its commitment more than empty words. The EU budget at 1% of its GDP is small and 40% is still taken up with agriculture where employment can only continue to decline. But the regional fund should be re-directed from physical infrastructure which in southern Europe is mostly now adequate after decades of EU funding to human and enterprise development.

Good work by the European Investment Fund, which specialises in finance for small and medium businesses, and the European Investment Bank, should be supported by increased financial resources.

Ways must be found, by the European Central Bank, the national central banks and the banks themselves, to eliminate the huge difference in the cost of bank finance that is being charged to businesses in Spain and Italy compared with Germany and France. This may require risks being taken by the ECB in increasing its exposure but the risks of its exposure to southern Europe are already high and the risks to inflation of unorthodox policies have to be set against the risk to social and political cohesion and also the ability of the southern European economies to recover and so be in a position to raise the revenue to meet the stability requirements to their government finances.

Newspapers and politicians have insisted that Germany and its partner creditor countries are not prepared to subsidise southern European who retire early and lead leisurely lives. But that should not mean an unwillingness to act against the enforced leisure afflicting so many young people and others at present.

A meeting of minds did take place on May 10th between the new Italian prime minister, Enrico Letta and the president of the European Parliament, the German socialist, Martin Schulz. The latter said he was in complete agreement with with Letta’s statement that “Europe must respond to the greatest problem of today, the rising level of youth unemployment to unsustainable levels”. Specifically Schulz said that the €6bn provided for youth training in the 2014-20 EU budget be brought forward. He added that the problem was too urgent to wait for the result of the German election in September 2013. His proposal could if taken up be a start but would be far from enough to solve the problem but would give an indication of serious intent. Letta has proposed that youth employment measures be seen as an investment in the future and so justify financing like investment outside the normal budgetary rules. That means any measures could only be temporary otherwise they would add permanently to budgetary costs. Moreover Letta’s government has yet to show that it can manage the normal budget successfully replacing the lucrative property tax Imu which it is committed to abolishing with other revenue or spending cuts. But the challenge is not just for the southern member states but the whole EU or at least the whole euro zone.

Budget negotiations are key to future image of EU

On February 5th Herman Van Rompuy put out a video message ( which made an admirably concise plea for a budget to focus on jobs and particularly jobs for young people and also insisted on moderation, which he surprisingly defined as a real terms cut. This would imply that the demands of the UK, Sweden and the Netherlands in terms of expenditure discipline would be met or even exceeded.

Budget is small in relative terms,but high in absolute terms

As a percentage of national budgets (about 2%) the EU budget is much smaller than implied by the claims of over-centralisation of power. It has remained at around 1% of gross national income (considered a fairer measure than gross domestic product) over the last 20 years well below its allowed maximum of 1.24% of GNI. To have done this during a period when the EU has expanded to include 12 new countries almost all well below the 75% of average income threshold which entitles them to substantial funding to help catch up, and when a monetary union has been created for 17 member states, an embryonic diplomatic service has been set up and effective measures for criminal justice have been put in place is a significant achievement.

The gains in terms of both political stability and prosperity from the single market are not possible to measure but surely hugely outweigh the costs of the EU. Nevertheless when expressed in absolute terms, the amounts are large enough to become politically contentious, at a time when all countries are having to make cuts which are causing large scale public redundancies, closures of hospitals, and other public services like libraries. The UK, France and Italy are currently spending about €16bn (£13bn) in gross terms and €6bn (£5bn) in net terms in contributions to the EU budget.

Some but not all is all is well spent

Some of this money is very well spent. There is huge over-demand for the 11% of the total EU budget spent on boosting collaboration between EU countries (and sometimes also other countries) on scientific research and the development of new technologies. This is money well spent on boosting the EU’s economic potential and ability to thrive in the face of competition from rapidly growing economies like China and India. A strong plea for this spending to be maintained was made on February 5th in a letter to the Financial Times by leading British scientists. Another area of money well spend is co-operation on justice mainly criminal justice, which takes up just 2% of the budget. According to the British Association of Chief Police Officers (ACPO) if, as is being considered, the UK were to opt out of the European Arrest Warrant (EAW) just one of about 20 important EU measures in the field of criminal justice, the result would be “fewer extraditions, longer delays, higher costs, more offenders evading justice and increased risks to public safety”.

Slightly lower in terms of money well spent is the category of administration which absorbs 6%. At 0.06% of national income this is good value for underpinning the benefits of a rules-based single market with a level playing field evened by the enforcement of rules on competition. Yet at a time of austerity the pay and privileges of the upper tiers of the Commission which exceed those of leaders of national governments look excessive.

The largest items of spending are agriculture and regional policy. Agricultural spending, narrowly defined to standard income support for farmers amounts to 27% of spending. If the EU were starting from scratch this might see excessive, but there has been a continuing decline from about 70% when the UK joined the EU in 1973 and most of the spending no longer supports (ie increases) prices as it used to. There is however an additional item called rural development environment and fisheries which absorbs 10% of the total. This is almost as much as is spent on research and innovation and yet its purpose. It includes the very different objectives of environmental conservation or improvement and diversification to non-farming economic activities. It is a category which at least merits careful scrutiny.

Focus of regional spending should be on job creation

But the category which needs most attention is the 37% spent on helping the poorer or most economically troubled regions. This spending has in the past been heavily focused on infrastructure, which does not necessarily bring fundamental economic development. What is most needed is to foster the development and expansion of new micro, small and medium businesses which having already  been responsible for the great majority of job creation across the EU in recent years have the best potential to provide employment opportunities in southern European regions where rates of youth unemployment often exceed 50%.


Peace prize is for more than avoiding war but achievement is under immediate threat

The award of a Nobel Peace Prize to the EU comes at a crucial time. Some critics of the EU regard the reward as absurd because war between its member states is inconceivable and would, the critics say, remain inconceivable even if the EU broke up. The contrary argument is that the EU has been so successful that it has not only prevented war but made it seem inconceivable; and this despite the fact that brutal wars were fought just outside EU frontiers in the 1990s. In addition to avoiding war, the EU has hitherto enabled conflicts to be sorted out within an institutional framework, becoming a possible model for areas of conflict.

However, though there would be no immediate or foreseeable danger of war even if the euro zone breaks up, the EU’s status as model for the institutionalisation of peace is under immediate threat from a possible break-up of the euro zone, particularly if such a break-up occurred in a chaotic way and was accompanied by an increase in the acrimony between EU member states that has already been seen between Greece and Germany in particular. The visit of Angela Merkel to Athens on October 9th, to meet members of the Greek government, appeared to have been constructive despite hostile demonstrations, but whether it actually was so will only be confirmed if the next tranche of the euro zone/IMF financial facility is soon released (although Germany is crucial this also requires the agreement of other countries).

In June, Greek voters gave a narrow but clear majority to the three political parties that not only wanted to stay in the euro but also committed themselves to continuing with the most severe programme of austerity imposed in any EU country since the Second World War. It would be a tragic failure if Greece’s euro zone creditors cannot agree with the government on a moderate alleviation of the extent of continuing spending cuts over the next two years. This surely is the moment where tightening the squeeze on Greece could just fall slightly short of the current harsh demands. That does not mean that the troika and other euro zone countries should not put pressure on Greece to introduce other measures, such as radical clampdown on tax evasion, effective laws and sanctions against corruption, privatisation of state assets where feasible, compiling a land registry, and action against restrictive prices which have kept prices high while wages have drastically fallen. But it is partly the fault of the troika and the creditor countries that these issues have not been addressed with the same urgency as expenditure cuts and tax increases; and proof of effective action will necessarily have to wait until after the next tranche of  the loan facility is released.

There is also increasing cause for concern about what is happening in a much larger country, Spain. Generally in Spain, the large demonstrations, and the encampments in Madrid, have been more peaceful than in Greece. The near 25% rate of unemployment (double that for youth unemployment) has been regarded as less alarming than the headline indicator would suggest because of large scale unregistered employment and the fact that similar unemployment percentages were recorded in the 1990s. However, signs of social stress have recently increased, one being that the Spanish Red Cross is this year for the first time devoting funds collected on Red Cross Flag Day (October 10th) mainly to helping support the destitute in Spain, rather than in developing countries.

As worrying is the rapid development of a crisis affecting the future unity of the country. Until recently, the regional Catalan political parties, unlike the Scottish National Party (SNP), had not demanded independence but this has changed quite dramatically in the last two months. The main reason for the change is the question of how to share the pain of austerity. Unlike Scotland in the UK, Catalonia as one of the richer regions makes a substantial net contribution to Spain’s overall budget. It estimates that it sends the equivalent of 4% of its GDP more to Madrid than it receives back. While it is true that Catalonia is richer than the Spanish average it is also very severely affected by unemployment and despite having to make severe expenditure cuts, the regional finances have plunged into deficit. Because the deficits of Catalonia and other regions are the main reason why Spain is likely to overshoot its 6.5% of GDP general government deficit target this year, the Popular Party government led by Mariano Rajoy, has been putting pressure on all regions to cut their deficits. By effectively treating Catalonia which makes net contributions (without which its budget would be in surplus) the same as Andalusia which is a net beneficiary it has riled opinion in Catalonia, which in the present economic circumstances feels that Catalonia would be better off on its own.

No country has yet broken up while being a member state of the EU (although several broke up or broke away before becoming members). If a settled majority of public opinion in a region comes to demand independence, there is a strong case for allowing that such democratic wishes should be fulfilled but that independence should take place in well-planned way in agreement with the country it is leaving with the minimum of economic disruption. But a sudden lurch to independence in defiance of the central government, both resulting from and exacerbating an economic crisis would be serious blow to the political stability which the EU member states have hitherto been able to claim.

It might be desirable that EU institutions or a team from other EU countries should try to mediate between Madrid and Barcelona.  The Spanish government should recognize that both the historical and cultural status of Catalonia and its net contributions to the Spanish budget mean that its government should be treated with diplomatic respect, rather than on the same level with Murcia or Andalusia. For its part, the Catalans should appreciate that the post-Franco order in Spain has provided the region with the conditions to become prosperous and to restore the cultural identity. It would be highly irresponsible rapidly to abrogate their financial contributions deriving from the position as a richer part of the Kingdom of Spain at a time of crisis.

Equally important, however, is that the euro zone countries in less dire financial straits stick to what they agreed at the June European Council, rather than trying to backtrack the moment the financial market pressures on Spain and other countries look a bit less threatening in the short term, as they have done in early October.

Writing from the UK, a country of which not very much is being asked, it should be said that it would be helpful if the prime minster, David Cameron, could be a little more consistent instead of berating his euro zone partners for not acting and as soon as they do act, veto the agreement, whether on a fiscal pact as last December or a banking union now under discussion.

Is unelected ECB likely to be too powerful?

Two major steps

Two developments are likely enormously to increase the role of the European Central Bank (ECB) in the euro zone. First it has announced its intention by a large majority on its board of governors, though against one of the two German members of the board, Jens Weidman, to be prepared to purchase unlimited amounts of the bonds of governments of up to three years duration, whose interest rate spreads against those of other euro zone countries are unacceptably high, but on the condition that the governments of such countries accept what they see as the humiliating need to subject themselves to agreed programmes monitored by a troika of the ECB itself, the IMF and the European Commission as has been the case for Greece, Ireland and Portugal.

Secondly, plans being developed for a “banking union” of euro zone countries envisage a single prudential regulatory authority, namely the ECB, banks in all the participating countries.

Does this mean democratic deficit will increasee?

In both cases, the stability and prosperity of the euro zone is at stake and it makes good sense from a practical point of view to give these powerful roles to a body which has established its independence, brings together representatives of all euro zone countries and can draw on a deep well of economic and financial expertise. On the other hand, the ECB board is not elected which means that the existing democratic deficit of the euro zone will be increased. The moves can be justified by the fact that popular opinion in most countries favours keeping the euro zone together rather than a return to national currencies and given the risks that the latter could happen unintentionally, the best policies available should be used to hold the currency together. Nevertheless, the consequences for democratic accountability need to be debated, taking heed of concerns expressed by bodies like the German constitutional court, which on September 12 gave the go-ahead to a new permanent European Stability Mechanism to take over from the temporary European Financial Stability Facility (EFSF) but emphasised the need for the German parliament to remain involved and agree only after proper debate to any further commitments. The constitutional court had previously expressed its opinion that the European Parliament does not have a high enough profile to replace the need for the involvement of national parliaments in the development of the euro zone. One conclusion should be that efforts should be made to enhance the oversight role of the European Parliament but another is that there is no foreseeable prospect that this will replace the need for oversight of key euro zone policy developments by national parliaments, despite the difficulty of making a coherent policy out of 17 different parliaments.

The role of the troika

The ECB has been right to insist that it will only intervene from now on in government bond markets if the country concerned has agreed to a programme monitored by the troika since that ensures that the decision is shared. Although the IMF has no effective democratic accountability, the Commission can be thrown out by the European Parliament and does have to take account of the views of the elected governments of participants. Moreover the programmes are monitored and debated by national parliaments and the press in creditor countries. There is inevitably going to be conflict between the democratically expressed wishes of debtor and creditor countries, as is continuing in an acute form in the case of Greece. It can be argued that Spain and Italy are already trying to implement very severe austerity programmes and that any more austerity might well be counter-productive by depressing the economies and their tax-raising capacities. However, it cannot be predicted  what will happen if and when current governments lose power. The Spanish government is relatively new but is still vulnerable as a result of disenchantment and tensions with regional nationalities, Catalonia and the Basque Country, while the government of Mario Monti in Italy cannot last beyond the next election due in April 2013. On this issue therefore the ECB chaired by Mario Draghi (but the ECB decisions are collective) has given a coherent and balanced lead which is as far as possible compatible with democratic criteria but it will have many future challenges.

ECB could have done much more to oversee national banking systems

On the question of bank supervision more reservations are in order. It is important that the ECB be held accountable and it has not been very effectively held to account to date. It is true that it did not have the same degree of authority over financial stability as it is to be given but it clearly should have been a concern to the ECB while many of the national banks, part of the European System of Central Banks (ESCB) with the ECB, did have responsibility for bank supervision. The ECB did point to the dangers posed by government deficits and but failed to point to the equal dangers posed by banking imbalances, particularly in Spain and Ireland. In fact it did not consider it important to examine what was happening in individual countries, believing instead that the euro zone could be treated as a single economy. That was a position that it had to take with regard to setting interest rates but is not appropriate for seeing signs of financial instability. A good first move would be to publish comparative statistics for the different countries rather that just euro zone wide statistics as it has done so far, in contrast for example to the IMF and OECD. The ECB if it is to live up to its new role needs to learn lesson from its past failings and should be made to explain why it failed by the European Parliament. The result would not be likely to be that the task of supervising banks is passed to other institution since none that would have been likely to have been more prescient exists but it would help the cause of democratic accountability in the euro zone. The European Parliament is a parliament for the whole EU but what happens in the euro zone and what the ECB does is a matter of importance also for non-euro zone EU countries.





Can labour market reforms boost plight of young people without jobs?

The euro zone’s southern countries fiscal and banking problems have exacerbated an underlying social challenge, one facing all countries, but most acutely those of southern Europe, namely that of providing job opportunities for young people. Even when their economies were performing better, Italy and Spain had developed dual labour markets, in which a large number of established employees enjoyed a high degree of job security, together with relatively good wages, while most young job-seekers could only obtain a succession of short-term jobs which provided little or no training. Now that these countries are in the second part of a double-dip recession, the opportunities for young people are even worse: half of those not in education under 25 in Spain, and a third in Italy, are unable to find a job at least other than completely unregistered jobs in the shadow economy.

Labour market reform is therefore rightly high on the agenda of these countries. Many economists and other commentators believe that, if job security were reduced, employment would increase, pointing to Denmark and the Netherlands, two countries which have achieved not only low levels of unemployment but high rates of participation by bringing into the labour force those, especially women, who in southern Europe do not seek jobs. These countries models are described as “flexicurity” since those who lose jobs have both relatively good unemployment benefits and a labour market which provides opportunities for re-employment. Unfortunately there are huge obstacles towards moving to this model. Allowing the easier dismissal of existing workers would certainly increase redundancies, but despite the evidence from countries like Denmark and the Netherlands that it would increase opportunities for new jobs, this cannot be proved and, from the perspective of trade union members remains a  matter of speculation, and under existing economic circumstances the prospects do not look very good. Moreover, it has to be pointed out that Spain and Italy already do have a large section (the second tier) of their labour markets which are highly flexible – some would say excessively so—and although this second tier has led in Italy at least to the creation of jobs which were not there before, they have by no means produced north European levels of employment even when economic conditions were better.  An obstacle particular to Italy is that this country at present only provides an adequate cushion of unemployment benefits to a limited group of the work force through the so called Cassa Integrazione. Those not covered by this fund receive negligible benefits. Efforts are being made to fill this gap in the social security system but these are limited the need to bring the public finances into surplus so as to begin to reduce the 120% of GDP public debt.

More fundamentally, the functioning of labour markets is dependent not just on the legal framework but on patterns of industrial and social relations which have developed over generations. The experience of countries with well-functioning labour markets should be given prominence and lessons should be learned but applying those lessons is not as easy as just tearing up excessive regulation. Labour markets are highly political and it is not easily possible to impose common euro zone rules that over-ride domestic politics on top of the increasing severity of fiscal rules needed to address the sovereign debt crisis.

Nevertheless Spain has brought about a significant reform which should limit dismissal costs for standard contract employees to a month’s pay for every year worked, ending the uncertainty over costs which had been such a disincentive previously, although this applies only to newly taken on employees. Those already employed before the reform retain existing rights. The reform has not yet resulted in any beneficial effects on job creation but this is likely to have to wait till the elusive economic recovery takes place.

Negotiations over a bill to reform labour markets in Italy put forward by Mario Monti’s employment and pensions minister, Elsa Fornero, was the major domestic policy preoccupation between March 2012 and the end of June when, after amendments by parliament, the bill was passed into law. It has been severely attacked by the employers’ organization, Confindustria, and by some Italian commentators. On one of the government’s objectives, the simplification of legislation, it certainly fails, running to nearly 100 pages of dense text. However it does make some significant changes, which should be for the better. With regard to the highly contentious Article 18 of the 1970 Workers’ Statute, regarding individual dismissals, it makes these considerably easier if they are for economic reasons. Protection against dismissal for disciplinary reasons can rightly still be contested in the courts. If the employee is vindicated he or she has a right to compensation but will no longer have an automatic right to be re-instated, the latter now is dependent on the judge.

Controversially, the new law makes some changes, which increase the rights of employees on short-term contracts. The law also increases the obligations of employers towards the training of apprentices, an aspect where the ministry claims to have the support of both sides of industry.

With regard to bringing young people into the labour force, an example that southern countries could benefit from looking at is that of Germany. Its latest youth unemployment rate in May 2012 was 7.9% compared to 37% in Italy and 50% in Spain. Of course the recent overall performance of the German economy has been much better than those of Italy and Spain, which clearly provides a more favourable background to taking on young people. But the German youth unemployment rate has throughout the cycle kept much closer to the overall rate—youth unemployment peaked at just over 15% in 2005. A likely reason for Germany’s better performance is the longstanding priority in German business culture to apprenticeships, backed up by a system of days released for external vocational education. Apprenticeship programmes are supervised and monitored by local chambers of commerce. Although the German system is an old one it has adapted to changed needs by introducing 43 (out of total of 344) new types of apprenticeship in the last ten years and changing many others. In other countries, employers often complain about the quality of school education, but results for German 15 year olds in the OECD’s comparative studies known as PISA have not compared favourably with other EU countries which reinforces the likelihood that low German youth unemployment is linked to the apprenticeship system.

The German labour market also benefits from reforms introduced in the mid-2000s under the heading Agenda 2010, although the reforms were incremental rather than consisting of a radical sweeping away of regulations.  Indeed in some ways it increased regulation. For example, employees serving notice now have a right to time off to seek new employment. An important change was a radical reform of the federal labour market agency, incorporating elements of a private job agency and integrating its work with the provision of benefits.

Arguably more important than government-driven reforms has been a decentralization of bargaining over wages and conditions, which has taken place over the last decade. This has increased the role of existing works councils, which have long been provided for by German law and have gradually come to be seen as a valuable tool by company management and owners for concerted approaches to competitive challenges. They have allowed greatly increased flexibility within companies for tackling changes in demand and between companies depending on the performance of companies.

Italy and Spain should likewise strive to increase the say of employees at company and local level, where large national trade unions cannot be expected to know the conditions. National agreements may continue but, as is the case now in Germany, they should be increasingly open to adaptation at company and local levels. However this does require central union organisations to be willing to devolve some of the powers.

Follow-up to summit undoes its good work

Euro zone policy makers have failed to follow up the small successes of June summit 29th with a consistent message which could inspire investors’ confidence. There were three main specific policy moves of significance and potential benefit that the summit agreed on: first that the European Stability Mechanism (ESM), when it comes existence as it is supposed to in the coming months, should be able to buy government debt of Italy and Spain without the same arrangements involving wide-ranging programmes of the type applied to Greece, Ireland and Portugal which are monitored by the troika of the European Commission (although there would still have to be policy commitments by the governments). Secondly, such debt if bought by the ESM should not become senior to other debt, which would have taken away any realistic chance that it could actually support the private sector market. And finally that, once the ECB has been given regulatory supervision over the euro zone banks, the ESM can provide capital to support troubled banks without that capital being underwritten by the government of the country in which those banks are based, so avoiding an sovereign debt burden that would weaken confidence in the ability of the country to manage its debt.

All three were significant moves and all should have had a beneficial impact on what at present appears the most intractable problem affecting the euro zone’s prospects, namely the threat that lack of market confidence in the solvency of Italy and Spain becomes self fulfilling by charging interest rates in those countries debts that becomes unaffordable. They did have such a beneficial impact but this was very short-lived and in little more than a weak the spreads between Italian/Spanish and German government debt had risen to even higher than they had been before the summit. This partly reflects the fact that though the agreements should have been helpful none will be decisive. Assuming the ESM comes into existence, it will have a lending power of €500bn against a Spanish government debt of €800bn and an Italian one of almost €2,000bn.

Given this gap, it is possible that there is nothing that can be done to prevent the gradual deterioration of the situation unless or until there is a massive underwriting of the weaker countries’ debt by the euro zone as a whole either through euro bonds or the ECB. This possibility has become more likely as a result of the follow-up from the summit. It is in the interests of the creditor nations to try to prevent this.

A lesson that should be learned is that it is not only important to reach agreements on policy but also to agree on how what has been decided is presented. If each country tries to interpret it in a way most favourable to its own domestic political situation, as has happened, the effect will be to undo any beneficial impact of the agreements on the financial markets.

Some criticism can be made against the governments of Spain and Italy. They both said that they were more favourably treated than Greece, Ireland or Portugal in that they had not agreed to the same Memorandums of Understanding and detailed monitoring. They needed on the contrary to tell markets they are doing just as much as these countries to correct their finances and reform their economies. However, both these countries have, following the summit, introduced swingeing further expenditure cuts on top of those previously put into effect. Given that such measures will intensify and prolong the second recession they are experiencing, it is hard to see how they can be expected to do more.

Criticism can also be directed at the post-summit comments and interpretations  of the creditor member states. The German has been more keen to emphasise what it has not agreed to (euro bonds) that what it has agreed to and Wolfgang Schauble, the German finance minister, has emphasized that the transfer of regulatory authority to the ECB will not happen till next year so that the rescue of the Spanish bank, Bankia, will in the meantime have to be added to Spanish debt. On the other hand the German parliament has given a large majority to legislation providing for the establishment of the ESM. Of great concern has been the apparent attempts of the Netherlands and Finnish governments to pull back from what their prime ministers agreed to at the summit. Both these countries face difficult domestic political situations with populist politicians exploiting voter concerns about the potential costs of participating in the ESM. However, the reality that they should explain to voters is that the whole euro zone is threatened with disastrous financial and economic consequences if major euro zone countries become insolvent. This is likely to be most difficult in the case of Finland. The Netherlands lies at the heart of the euro zone and its banks are heavily exposed to other euro zone countries. Finland is the only Nordic member of the euro zone and the Nordic countries are at present experiencing benign economic conditions. These conditions are still at risk from developments elsewhere in Europe including the euro zone but there is a danger that in order hold back the gains made by the populist and anti-euro True Finns in the 2011 election, the government and parliament will prevaricate in a way which could be highly damaging for the euro zone.  It may be that Finland will have to be treated as a special case able to negotiate special conditions for its contributions, although if other countries were to try to copy Finland the whole exercise could be threatened. But it would be better if Finnish politicians could recognize that Finland’s longer term prospects like other EU countries depend on preventing the euro zone crisis from continuing to deteriorate.

Spain: the need to separate the sovereign debt and banking crises

The rescue for Spanish banks by the euro zone announced on June 10th may succeed in rescuing Spain’s weaker banks, such as Bankia, but it has failed to halt the deterioration of confidence of investors in Spain’s sovereign debt position. The latter should not be an insuperable concern, given that debt at the end of the first quarter was still lower than that of Germany, France or the UK in relation to its GDP. However, Spain is now threatened with a repeat of what happened in Ireland, where a deterioration in public finance due to severe recession has been hugely exacerbated by the costs of bailing out banks. In the case of Ireland the cost relative to the country’s economy has been considerably higher than is likely to be the case for Spain since virtually the whole of the Irish banking sector became insolvent whereas in Spain only about a third of the sector is threatened by insolvency without external support. Nevertheless the additional amount has, rightly or wrongly, been deemed by rating agencies as highly significant, causing them to severely downgrade their assessments of Spain’s creditworthiness. The sum allowed for in the new loan facility of €100bn, which should be far more than is needed, has instead of giving confidence, undermined confidence because it has been seen as the actual figure that will be added to Spanish sovereign debt because, crucially, the rescue of the banking sector is not a direct one but an indirect one through the Spanish state, thus adding to sovereign debt and moreover probably doing so in a way which gives the new loan seniority to private lenders so increasing the risk to the latter

What is needed is a serious attempt to separate the sovereign debt and banking crises. It should be recognized that Spain like Ireland in fact managed their public sector finances well up to the economic crisis, which was caused by mistakes made by banks. Banks in other euro zone countries should never have provided the finance for Spain which led to the construction and property bubble that proved so disastrous. The problem in Spain’s banking sector is a result of private sector and euro zone policy mistakes across the euro zone and not just in Spain. It is not therefore just that all the cost should be carried by Spain. Policy makers in the stronger euro zone countries, such as Germany and the Netherlands, should be willing to acknowledge that the current situation has come about as a result of mistakes made by banks in these countries and policy makers in the euro zone as a whole. If they did so it would have followed naturally that the rescue should have been carried out by the new European Stability Mechanism directly so not adding to Spain’s sovereign debt. This could have been a first move to a European banking union. Such a move would not have been a first step towards a “transfer union” in which German taxpayers subsidise public expenditure in southern economies since the money would not be used by the government but would rather be a fair sharing of risk in tackling the banking crisis, which is at present is causing most concern in Spain but which affects the whole euro zone and indeed countries like the UK outside the euro zone.

Is there more bad news to come from Spain?

The news from Spain seems recently to be only bad. Its deficit last year was significantly higher than expected, it is again in recession, government bond yields have been rising and there are renewed concerns over banks. On May 7th, the government was forced to announce that it would be using the agency for bank rehabilitation, FROB, to inject about €10bn into Bankia, itself a merger of a large number of savings banks including Caja Madrid and Bancaja, together with a management reorganisation including the departure of the former finance minister Rodrigo Rato. S&P had recently downgraded the two leading banks, Santander and BBVA. An article put on the Bloomberg website on May 2nd argued that unlike Ireland which has taken on board the full force of its property collapse since 2008 (with the consequence that the country was forced at the end of 2010 to ask for a financial rescue package from the EU and IMF) Spanish developers are continuing to build in denial of the collapse in demand since 2008 and still falling house prices (  The article argues that Spanish banks are trying to prop up house prices by offering favourable 100% mortgages, a practice which in view of experience should have been discontinued. The article suggests there is a possibility of a widespread collapse of Spain’s banks having as disastrous an effect on public sector indebtedness as did the collapse of Irish banks on Ireland’s indebtedness.

However, while there are no grounds for complacency, the evidence available suggests that Spain’s other  larger banks, including Santander, BBVA and La Caixa, which are much more diversified in and outside Spain than the Irish banks, are still in reasonable good financial shape and that recapitalization of smaller banks can be managed. It is underway with the number of banks having been reduced from 45 to 11 but still has a way to go over the coming months. While it is likely to require intervention by the Spanish state, it is not likely to do so to the same extent as happened in Ireland. Between February and April 2012 the IMF conducted a major (five-yearly) review of the Spain’s financial system. It calls for rapid action to complete cleaning up the weak banks so as to avoid contaminating the stronger ones but states that “the largest banks appear sufficiently capitalized and have strong profitability”. It does expect further credit losses from the property sector but points out that loan-loss provisions have been increased. It carried out stress tests for 90% of the sector and concluded that most banks could withstand new shocks.

The public sector debt to GDP ratio of Spain, which was 68% at the end of 2011, is likely to rise to about 75% by the end of 2012 as a result of the ongoing deficit. If the government is required to step in to recapitalize the banks, because the private sector is unwilling to provide the funding—at present estimated at €53bn—debt could rise further. In a much worse scenario that the €53bn turns out to be only half the amount required and that it all has to come from the government, the impact on Spain’s debt to GDP ratio would be to raise it to around 85%, an amount which should still be manageable.  The weaker parts of the Spanish financial sector do indeed require careful watching but the probability is that they will be successfully rehabilitated over the next few months at a significant but manageable cost to the Spanish state.

In the medium to longer term, however, the health of the financial sector will depend on the health of the overall Spanish economy, which in turn depends on its ability to redress its economic imbalances, in particular the external current account imbalance which led too the accumulation of first private and more recently public debt. Substantial progress has been made in reducing the current account deficit from peaks of close to 10% of GDP in 2007 and 2008 to 3.5% in 2011, or €37.8bn. Merchandise exports increased by 16.8% in value terms and 15% in volume terms in 2010 and by 14.8% in value terms and 9.6% in volume terms in 2011, both well above the growth rate in markets and so representing recoveries in market share. These figures represent a substantial turnaround but the deficit remains significant and progress has stopped in the first two months of 2012. That is due to the weakness in Spain’s main EU markets but such an excuse is of little comfort. Unless Spain can move into current account surplus, either private or public debt will continue to rise, and they both need to start falling before Spain can be said to have turned the corner decisively. Until the debt dynamics change, domestic demand is likely to continue to fall so any growth will only come from the external sector.

While the new Spanish government, in office since December 2011, has been hesitant in addressing the country’s public finances, it has taken decisive measures to improve the performance of Spain’s labour market. Its measures include allowing companies to cut wages which some are reported to have begun doing this year following average wage growth of 2.7% in 2011.  Lower wages will further depress the domestic economy but should help companies gain competitive advantage. A second key reform to the labour market fixes 33 days pay  per year worked as the maximum compensation for “unjustified” dismissals. It is hard for companies needed to cut their workforce to convince courts that they need to do so, so 80% of dismissals are classified as “unjustified”.  This limit should provide conditions for companies to take on more employees in open-ended contracts rather than the short term contracts which characterize the majority of new employment.

These reforms give Spain a potential advantage over many of its partners. But unemployment is officially 25% and youth unemployment 50%. The Spanish unemployment statistics have for decades given figures which look higher than the reality and in comparison with figures in other countries a rate of 15% may be a better indicator. Nevertheless the labour market situation especially for young people is very serious. The government needs to continue to work to extend its reforms into liberalizing professions and trades and facilitating the start and growth of new businesses. The growth agenda at the euro zone or EU level which the governor of the European Central Bank has along with others began to talk about is certainly needed. More action such as boosting the capital of the European Investment Bank as he specifically suggested is urgently awaited. Spain should be able to reassure investors on their financial concerns this year but it is likely to continue to struggle to turn its economy for some time yet.

Is Spain on the right track?

While Italy looks less close to disaster than it did six months ago (an improvement which could easily be reversed) market perceptions of Spain have deteriorated.

Despite a much lower public debt than Italy’s, and after a 2012 budget which was just been presented on March 30th and is described as the harshest since Spain became a democracy, with swinging cuts averaging 17%, and up to 54%, on all ministries, rates on Spanish ten-year bonds on March 30th remained distinctly higher than those on Italian bonds, with both over 5% and more than 300 points above German equivalent bonds.

Although the amount available in rescue funds is likely to be increased gradually to around €700bn (€500bn from the proposed European Stability Mechanism (ESM) plus funds earmarked for Greece, Portugal and Ireland) European policy makers will be earnestly hoping that this does not have to be used to rescue Spain, given the likely contagion effect on Italy and other countries.

There are three main reasons for increased concern over Spain. The first is the considerably worse than expected outturn of the general government budget in 2011 when the deficit amounted to 8.5% of GDP, after already two years of severe austerity under the previous Socialist government. The worse than expected outcome cannot be blamed primarily on the Socialists since the principle cause was higher regional deficits. The harsh 2012 budget aims to reduce the deficit to 5.3% of GDP. The second reason is concern over Spain’s banks, particularly its savings banks, which are being called on to realize their capital losses from the collapse in Spain’s property market since 2008, and raise €50bn in new capital. They will be forced to sell property into a weakening property market, with prices continuing to decline after already falling about 30%. The third reason is the continuing weakness of the Spanish economy with unemployment at 23% the highest in the EU and only weak signs of a pick-up in exports. The austerity measures though necessary are likely to further weaken the economy.

The political situation in Spain should be favourable. In December 2011 a newly elected centre-right Popular Party government, led by Mariano Rajoy, took office committed to a combination of the necessary fiscal austerity and economic reforms to boost employment and growth. However, although the government has consistently pursued its policies, it has made presentational mistakes. These include delaying the 2012 budget even more than it had already been delayed by the general election and change of government, in order to allow regional elections to take place in the misplaced hope that delaying the bad news would help the PP in these elections. This gave the impression that at a time when the government should having its four year term ahead have been free from party political considerations, it was giving priority to political maneuvering over tackling Spain’s economic problems.

A second presentational mistake was in the course of discussion over the reasonable request to revise the 2012 budget target in view of the 2011 overshoot, Mr Rajoy talked about Spain’s “sovereign” right to decide its own budget. In reality he should recognize that a vulnerable country like Spain has sovereignty limited by the need to convince investors to buy Spanish debt and that as a member of the euro zone it also has to consider the impact of its own policies on the rest of the euro zone. However, despite such criticisms the budget itself is as good an effort as is possible in unfavourable circumstances to tackle the budget deficit. Policy actions are more important than presentation and at present these seem to be in the right direction.  But the mountain to climb remains formidable.