Paul Krugman explains why Spain likely neither will nor should leave the Euro:

Should Spain try to break out of this trap by leaving the euro, and re-establishing its own currency? Will it? The answer to both questions is, probably not. Spain would be better off now if it had never adopted the euro — but trying to leave would create a huge banking crisis, as depositors raced to move their money elsewhere. Unless there’s a catastrophic bank crisis anyway — which seems plausible for Greece and increasingly possible in Ireland, but unlikely though not impossible for Spain — it’s hard to see any Spanish government taking the risk of “de-euroizing.”

I suppose one issue is this: Having read this column, if I had a Spanish bank account I’d now be looking for feasible ways to minimize the amount of funds in it. And once everyone starts hedging against a bank run, your bank run is under way.

The larger question posed here is whether it really makes sense to be running separate national banking systems parallel to a single continent-wide monetary authority. A regulatory system that works fine until there’s a problem doesn’t really work at all.

Since taking office in 2004, Spain’s Socialist Party led by José Luis Rodríguez Zapatero has wracked up an impressive array of achievements firmly putting his stamp on the country as the man who decisively led Spain out of Franco’s shadow. And yet his party’s now very unpopular and would get its butt kicked in an election:

Spain’s conservative Popular Party (PP) has widened its lead over the governing Socialist Workers’ Party (PSOE), according to a poll by NC Report published in La Razón. 45.2 per cent of respondents would vote for the PP in the next legislative election, up 1.6 points since March.

The PSOE is second with 35.8 per cent. 19 per cent of respondents would vote for other parties.

Are we going to start seeing articles in the American press about the “Zapatero Paradox”? Of course not! Everyone understands—and indeed the linked article emphasizes—that the PSOE is in trouble because Spain’s economy is in terrible shape. And in this case, I really do feel bad for Zapatero and the PSOE since the structure of European political institutions means that in practice there’s very little they can do to improve the situation.

When Spain beat Germany in the World Cup, I tweeted that Germany was going to double its resolve to destroy the Spanish economic with deflationary monetary policy. And it’s really worth checking out this eye-opening chart from Stephen Gordon which shows the extent to which Spanish people are bearing the burden of economic pain in Europe:

If Spain were an American state (call it “Florida”) then the collapse of its economy would spur large net fiscal transfers that help bolster and stabilize its economy. What’s more, the labor market linkages between Spain and other states would be pretty tight, letting people move from place to place. Consequently, in the US all the regions of the country are pretty closely packed on the 45 degree line.

Alternatively, if Spain were an independent country, then the collapse of its economy would spur massive devaluation. Everyone would get suddenly poorer and less able to buy imported goods. But tourists from Germany and the Netherlands would flock in to pick up good deals, Spanish wine sales would boom, and I might be able to afford some jamón ibérico de bellota.

Instead, Spain is having its monetary policy set basically according to Germany preferences and German needs even though conditions are very different. And fiscal transfers won’t be forthcoming. Some people tweeted back at me that the Spanish government is doing an okay job of destroying its economy on its own. But it really isn’t. Before the crash, the Spanish government was running budget surpluses. And it’s simply not possible for your economy to prosper if your monetary policy is set by people who aren’t even trying to create conditions that are appropriate for growth.

Royal Palace, Madrid, Spain (my photo, available under cc license)

Austerity not working out so well for Spain:

Fears of deflation in Spain and renewed concerns that tough new austerity measures across Europe would damp growth spooked investors in the region on Friday, sending the euro to new 18-month lows, share markets tumbling and gold to a new high. [...]

Core consumer prices in Spain, excluding energy and fresh food, fell 0.1 per cent from a year earlier, the National Statistics Institute in Madrid announced on Friday. The surprise fall, following a 0.2 per cent rise in March, marked the first annual decline in data going back to 1986.

Fears that deflation would exacerbate Spain’s debt problems sent financials sharply lower, with the European banking sector down 3.4 per cent in early trade led by Société Générale in France, down 5.9 per cent.

I don’t mean to deny the need for some governments to get their budget situations under control including, in the medium-term, the United States. But across the world, this only works if monetary authorities are taking vigorous measures to ensure growth and combat inflation. Economies don’t function without people, firms, and governments taking on debts. And debts—public debts, consumer debts, corporate debts, etc.—can’t be repaid if there’s not enough growth. I keep hearing that central banks are on the verge of losing their credibility as inflation fighters, but people should look at what’s actually going on. Nothing in the economy that would occur if there were inflation expectations is happening. Instead, you’re seeing the consequences of a belief that the future will hold anemic growth and flat-to-falling prices.

US policy in this regard isn’t all it could be, but it’s much better than European or Japanese policy and consequently we’re going to do much better.

I think it’s obvious that letting southern European governments collapse into insolvency would be bad for the world. But the larger issue is that while Greece combines irresponsible budgeting with a bad growth outlook, even countries like Spain whose budgeting is perfectly sound are going to collapse if they can’t grow. And they can’t grow unless they have appropriate monetary policy. So as Paul Krugman says the monetary aspects of the new European rescue plan are probably the most important part:

Announcement #2, from the ECB, changes things somewhat. It now seems that Trichet has been dragged kicking and screaming into becoming at least a semi-Bernanke, engaging in much more expansionary policies than before. (Yes, the ECB says that they’re only liquidity operations, and will be sterilized, yada yada — we can only hope that they don’t really mean it.)

A more expansionary monetary policy could make a real difference — especially if the ECB ends up accepting somewhat higher inflation. Suppose that Speece or Grain need to get relative prices down 15 percent over the next five years. If the eurozone has 1 percent inflation, that’s 10 percent deflation in the periphery. If the eurozone has 3 percent inflation, all you need is stable prices. Also, a stronger overall eurozone economy means higher GDP and hence higher revenue, making the fiscal slog less grim.

Unfortunately, my sense is that Trichet probably does “really mean it.” What’s more, the fact that its resolve is being called into question means the European Central Bank may feel compelled to err even more on the side of low-inflation, low nominal GDP growth policies.

(cc photo by simon_music)

Republicans caved on filibustering the motion to open debate on the financial regulation bill, so we’ll see what happens with that. The more important story continues to be the Greek debt crisis and the possible meltdown of European monetary institutions. Paul Krugman writes that he used to think leaving the Euro was impossible because it would cause massive bank runs, but that if Greece defaults and starts seeing massive bank runs anyway then leaving the Euro starts to look as possible as anything else.

Certainly my amateur opinion is that if a country can leave the Euro without that prompting a disaster (even if the only reason that’s possible is that a disaster is already under way), then that would look pretty compelling to me. The Euro is a questionable idea in economic theory, but it’s actually proven to be a worse idea in practice. Rather than try to run monetary policy that would be suitable for the median European economy, the European Central Bank has insisted on trying to run monetary policy that would be suitable for Germany. And not even suitable for Germany in general, but “suitable for Germany according to hard money fanatics.” That’s probably bad for Germany, but there’s certainly no reason to think it’s appropriate for southern Europe. Consequently, we’ve seen deflationary bias from the ECB for years and as Nick Rowe points out the ECB is likely to respond to this crisis with measures that prompt further disinflation.

This is a real human disaster for almost everyone involved, but never fear because one senior European monetary official once assured me that the purpose of central bank independence is that it gives him freedom to fight inflation “regardless of the human cost.” It’s true that Greece’s fiscal situation would be unsustainable regardless of monetary policy, but it’s also true that being subjected to Frankfurt’s monetary policy preferences make balanced growth in Southern Europe impossible regardless of fiscal policy. You just need to look at Spain, which pre-crisis was running a surplus with a low debt-GDP ratio:

But despite having done everything that’s now being urged on Greece, Spain is totally screwed. People like to see pat morality tales in macroeconomic events, so that today’s problem countries are being punished for past irresponsibility. But there’s honestly little reason to see that as a major part of the story. Worse than a crime, we’re looking at a mistake. A mistake for which a very large number of people around the world may wind up paying the price.

Great Paul Krugman post illustrates the point that the budget crisis in Spain has basically nothing to do with irresponsible budgeting. Pre-crisis Spain had a budget surplus and a low debt load. The problem is that the structure of the EU has made it impossible for Spain to adapt to a large negative shock:

So what happened? Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.

Alternatively, if the EU were like a real country, then funds would be flowing into Spain from other parts of the union, the way that taxpayers all across the country are sending Social Security and Medicare and Recovery Act funds to Florida.

This sorry situation strikes me as just another example of the accountability free zone the international elite has created for itself. Obviously something like a monetary union is going to be an elite-driven project. Which isn’t necessarily the worst thing in the world, but it means that when it doesn’t work out there should be some kind of . . . something . . . from the people in charge. But you don’t hear any hint from the European Central Bank officials that maybe this mass suffering in Southern Europe is the consequence of some flawed thinking out of Brussels and Frankfurt. Instead all you hear are lectures about the need for austerity. The fact of the matter is that the lecturers are right—southern Europe does need austerity. The brunt of the suffering for this error will be borne by the unemployment, and solving the problem will require cutbacks by Spanish pensioners, schoolteachers, cops, and all the rest. But the responsibility for the problems lies elsewhere.

The Spanish deficit situation is getting real:

Elena Salgado, Spain’s finance minister, said after a cabinet meeting in Madrid that spending cuts, tax rises and a return to economic growth would cut the deficit from a higher-than-predicted 11.4 per cent of gross domestic product in 2009 to 3 per cent in 2013, in line with Spain’s promises to meet EU budget rules.

To protect the long-term health of the social security system, which is currently in surplus, Spain also increased the retirement age from 65 to 67, a measure that will be introduced gradually from 2013.

Think about this when you read David Brooks say that Barack Obama should run around the country making deficit reduction his top priority. Does Brooks think that cutting Medicare is popular? That raising taxes is popular? That fighting with generals about defense cuts would be popular? A higher retirement age? All this stuff is unpopular and doing it all simultaneously is super-unpopular. Spain appears to have reached the crisis point where there’s genuinely no choice, so away they go. We should consider ourselves lucky that we’re not there yet and focus on trying to get as much economic growth as we can in the short-term. With luck, we’ll be able to tackle the deficit in a post-recession environment and avoid the sort of catastrophic depression that Spain’s going to be looking at.