Juan Laborda – Economic Orthodoxy: Responsible for the Next Spanish Recession (I)

In Spain a balanced budget, together with the combination of a fiscal surplus and current account deficit, would lead to a recession similar to that of 2008.

This is supported by today’s PMI reading

Juan Laborda teaches Financial Economics at the University of Carlos III and Money and Banking, Syracuse University (Madrid)

Originally published in Spanish at vozpopuli

Bolsa de Madrid

They do not learn from the past. The Spanish government is slowly activating a process of unsustainability in the Spanish economy. Mainly responsible will be, again, for the umpteenth time, the politician’s completely myopic economic and academic orthodoxy. In a context where the rest of the world and the volume of world trade are slowing, demanding a fiscal adjustment made by Brussels could activate one of the 7 unsustainable processes defined by Wynne Godley. If the rest of the world saves, the fact of forcing a budgetary adjustment in Spain, reducing current public deficits from around 2%-3% of GDP to 0%, is the breeding ground for a new recession of private balance sheets. And all this in a context where non-financial companies have not done their homework, having not taken advantage of Spain’s internal devaluation, which they vehemently demanded, to increase the productivity of their companies, via investment processes in tangible and intangible capital-revolution 3.0 and 4.0 -.

To understand how this new process of instability could well be fomenting, we shall use two instruments: First, Wynne Godley’s sector balances for the Spanish economy; Secondly, the aggregate balance sheet of Spanish non-financial companies, obtained from the financial accounts of the Spanish economy published by the Bank of Spain, and included in chapter 2 of that report. To comprehend this fully, we must also incorporate the effects of the financialisation process after the Great Recession.

The intense financialisation process of the last two decades is not independent of monetary policy. The implementation of an excessively expansionary monetary policy involves debt processes and the activation of different financial bubbles. First the dot-com bubble, then the housing bubble, and nowadays the American corporate bond bubble. But we already know that any attempt to escape reality, via bubbles, ends in disaster. It is in this context that the process of the assault of financial capital on the global productive ecosystem, including Spain’s, takes place after the Great Recession. As of today, except for some financial assets of emerging markets, the rest offer ex ante negative returns. In this context, the search for return by global capital is activated. In a “financialized” economy there is a high risk of being absorbed by a large company, an investment fund, a risk capital or joint-venture company. The negative externalities associated with this process should force public authorities to implement economic policy measures that will limit the perverse effects of financialization on our productive system, and favour and protect the real sectors of our economy. But nothing of this sort has been initiated.

Wynne Godley’s sectoral balances

A fundamental principle of accounting establishes that for each financial asset there is a financial liability that compensates it. Thus, for example, the net financial equity of a household is equal to the sum of all its financial assets minus the sum of its financial liabilities. If it is greater than zero, it will have a positive net financial equity. So that, for example, the private sector accumulates net financial assets, this has to take the form of financial entitlements against another sector, be it the public sector or the foreign sector. Although it sounds like something elementary, it seems that it has not been for many economists who even today do not understand that the deleveraging process of the private sector after the bursting of the property bubble required by definition high public deficits. Although our foreign sector has played a formidable role since 1994, it was not enough to absorb the reduction in private debt.

We are going to divide the economy into three sectors: the national private sector, formed by households and companies (financial and non-financial); national public sector that includes all the governmental levels (central state, autonomous communities, town halls, and social security); and the foreign sector (foreign companies, households and public sectors). There is an accounting principle that is always fulfilled: If we add up the deficits in which one or more sectors incur, the result must be equal to the surpluses incurred by another sector or sectors. Following Wynne Godley we obtain the following equation:

Private Sector Balance + Domestic Public Balance + External or Rest of the World Balance = 0

Macro accounting, using Wynne Godley’s sectoral balances, always tells us the truth. The debt of one sector is for another an asset. Therefore, government debt is the asset of the private sector. Understanding how one sector relates to another using a sectoral equilibrium framework is very useful, as is understanding the Levy-Kalecki’s profit equation, or the way in which reserves work in one of the financial system. Accounting is not glamorous and its results should not be taken as forecasting tools, however they can help us to detect unsustainable situations.

For example, after the Great Recession, the brutal deleveraging of the Spanish private sector, as a result of the rescue of private businesses faced with bankruptcy at the expense of taxpayers, generated a recession of private balance sheets, private savings, whose counterpart was a huge public debt and sovereign dissaving, and, to a lesser extent, expansion of debt to the foreign sector. The Great Recession could have ended in a depression if budget policy was not relaxed, and Mario Draghi had not been allowed to utilise the balance sheet of the European Central Bank. Since the end of 2013, with the consent of Brussels, austerity was relaxed. The structural deficit however has since increased. The new monetary policy and fiscal expansion allowed the recovery of the Spanish economy which was also favoured by the depreciation of the euro and the evolution of the price of raw materials. All this explains the economic growth compatible with a surplus in the current account balance, since 2014. There is no miracle from the supply side policies but an adequate use of macroeconomic policy instruments.

However, the commitment of the Sánchez government to move from a budget deficit of 2% -3% of GDP to 0% can trigger Wynne Godley’s unsustainable processes. The government does not seem to understand that the state deficit is necessarily equal to the savings of the non-public sector. If we exclude the foreign sector then the dissaving of the State is identical – up to the cent – to savings of households and businesses. If we add that our current account balance begins to be in deficit, and that the rest of the world can begin to save, then the effect of a budgetary balance of the government would be increases in the indebtedness of private households and companies – private household debt, whose savings rate nowadays is at an historic lows. This can only lead to a new financial crisis like the one we experienced in 2008. Let’s put it clearly, the combination of fiscal surplus and current account deficit would lead to a recession similar to that of 2008.

In the following blog we will analyse the evolution of the balance sheets of non-financial companies and certain dynamics that in the described context can activate and accelerate perhaps one of the worst Wynne Godley’s unsustainable processes.

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